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Derivatives
Basics
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N
D
I
I TRO UCT ON
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Akhir kya hai derivative!
 It’s
a contract which does not
have any value on its own.
 It derives its value from
underlying
 Underlying can be index, stock,
commodity, interest, currency.
 Derivatives can be futures or
options contract.
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Forward vs. futures
 Futures = Traded Forward Contract.

Features Forward
Futures
Trading
Non SE traded
SE traded
Size
Non standard Standard
Liquidity
Poor
Very High
Risk
Exists
Safety thru SE Clg
Settlement Non standard Standard as per SE
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What is option
 Or
privilege is a contract giving
buyer right but not obligation to
buy/sell a stock/index/ asset
(underlying).
 Trading started in in 2 indices &
31 equities from 2nd July 01.
 Derivative traded on NSE & BSE.
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THE WORLD OF OPTIONS
 Options are used worldwide everyday.
Car insurance is well known example.
 ESOP, Convertible Debentures &
Warrants are options created by
Companies.
 Risk containing instrument.
 Traders wouldn’t have lost heavily had
options were available post budget.
 Range of choices which were not
available previously.

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OPTIONS Vs STOCKS
Similarities
 Both
are securities
 Both trade like stocks.
 Both trade in different
market segments.
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OPTIONS Vs STOCKS
Differences
 Options derive value from
underlying stock.
 Options have expiry date &
strike prices.
 No corporate benefits to holders
directly but reflected in price.
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TYPES OF OPTIONS
Only of two types:
 Call Options
 Put Options
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CALL OPTION
 Is
an option to buy a stock at a
specified price on or before a
certain date.
 Option holder has the right but
not the obligation to honour
the contract.
 Holder has to pay a premium as
you pay for insurance.
stock+option
 Call
xpress
Option Simplified 1:
 “A” agrees to buy 125 Infy @ 2200 on
or before 28th Feb. from “B”.
 “A” pays a premium @ Rs 50 /share.
 SCENE 1: Infosys rises to Rs 2450
• “A” enforces the option
• “A” gets Rs 250 (2450-2200) per
share or Rs 31,250/contract
• Net Profit to “A” Rs 200 (250-50) or
Rs 31,250 per contract on Rs 6,250.
stock+option
 Call

xpress
Option Simplified 2:
“A” agrees to buy 125 Infy @ Rs 2200 on
or before 28th Feb from “B” & pays Rs 50
per share (Rs 6,250/contract) premium.
 SCENE
2:
Infy falls to Rs 2000
• “A” is not obliged to honour contract
• Premium forfeited & net loss is Rs 50/Eq.
• Call holder therefore enjoys limited losses
but unlimited profits.
•
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Infosys 2200 call
125 @ Rs 50 premium
CMP Rs
2450
2000
2240
250
0
40
50
50
50
Profit / loss
200
- 50
-10
Per contract
25000
-6250
-1250
Value at expiry
Less premium
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TERMS FREQUENTLY USED
 Price paid to buy an option is
premium. We actually trade in
premium on option terminal.
 Price at which the option is
agreed upon is the strike price.
 Date till which option is valid
is called the expiry date.
 Option buyer is option holder.
 Option Seller is option writer.
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PUT OPTION
 Is right to sell at a strike price
on/before expiry date.
 “X”
buys a put option from “Y” @
Rs 20 premium to sell 500 Tata
Steel for Rs 400 on or before 30th
August.
 If Tata Steel is 350, “X” can
enforce the contract.
 If Tata St rises to 450, “X” is not
obliged to honour the contract &
loses premium.
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500 Tata St 400 put @ 20 premium
CMP
350
450
388
Value at expiry
50
0
12
Less Premium
Profit/loss
Per Contract
20
30
20
-20
20
-8
+
15000
10000
4000
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PREMIUM MOVEMENT :
Option Type
Call
Put
Market Up
Market Down
We trade in Premium on Option
Trading Terminal.
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Lets Crystallise-1
Call
buyer
Put
Buyer
Buyer of
Security
Seller of
Security
Right holder to exercise
& get Delivery
Call
Seller
Seller of Obliged for making
Security delivery
Put
Seller
Buyer of Obliged for receiving
Security delivery
Right holder to exercise
& make Delivery
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Lets Crystallise -2
VIEW
BULLISH
BEARISH
ACTION
RISK
REWARD
BUY CALL
Premia only
UNLIMITED
SELL PUT
Unlimited PREMIA ONLY
BUY PUT
Premia only
SELL CALL
UNLIMITED
Unlimited PREMIA ONLY
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CALL WRITING
 You
own 500 RIL, CMP 750
 Sell 500 RIL 780 call @ Rs 10
 Premium earned Rs 5000.
 Margin invested @ 25% of
contract value = Rs 94,000.
 Return = 6 % per month.
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PUT WRITING
 RIL
CMP Rs 750
 Sell 500 RIL 700 Put @ Rs 9
 Premium earned Rs 4500.
 Margin invested @ 25% of
contract value = Rs 87,500
return = 5 % per month.
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 SELLING
xpress
OR WRITING OPTIONS
For Novice selling an option is too risky as it
has limited profits & unlimited losses as
against buying where reverse is the case.
 It does not actually make much sense.
 Than one natural question arises- who is
taking this unlimited risk.
 If selling option is that risky as it looks than
why options are so popular & recording
volumes 10 times of cash market in USA.

stock+options
 Writing
xpress
is avoided by most option
traders when they trade first time
for fear of unlimited losses.
 This fear is also because of not
being educated on the strategy.
 Further most traders are bulls.
 Lets study this strategy in a great
detail.
stock+options
 Let
xpress
me answer who is selling option at
this juncture.
 PROFESSIONAL TRADERS are option
sellers & profit majority of time.
 These professional traders are in
minority on any option exchange but
takes away majority of the profit.
 This is like 80:20 real life ratio. 80% of
the profits are taken by 20% traders.
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Why writer take majority of profits.

1.
2.
3.
4.
FACTORS THAT FAVOUR WRITING:
TIME DECAY
Wasting asset as it comprises time value.
You are actually intend to buying assets at
a far discounts to prevailing market rate at
the time of writing.
It’s like a 100 meter race & writer is
starting 4 steps ahead & buyer 4 steps
behind the start line. Who is likely to win?
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Why writer take majority of profits.
FACTORS THAT FAVOUR WRITING:
1. TIME DECAY

One constant in universe is passage of time.
Time is most valuable component in option
pricing. Option are a wasting asset which is
loosing its value every moment. Adding
insult to injury is the rate of decay increases
as expiration draws near. The majority of this
disappear in final 1/3 rd of its life. During
last 1/3rd underlying must move substantially
in your favor just to offset time value loss in
an OTM & ATM option.
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
Time Value Trading Facts:

ATM Option are most expensive in term of TV & is
best for writing on TV consideration alone.
OTM options are cheapest in term of time value &
is the worst for option writing but safest.
DELTA is the measure of the amount that an option
moves in relation to underlying movement in cash
market. This is stated in % from 0 to 100.
Delta for ATM is typically 50
Delta for OTM is less than 50
Delta for ITM is more than 50





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Why writer make majority of profits-2

X
X
X
X
X
Stakes are against option buyer from
day one as buyer has to meet following
conditions to become a winner:
Reaching Strike Price
Within expiry period
With higher break even
Daily erosion in option value
In the money option looses time value.
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Sample Portfolio as on 14/2
Put Option
Prem
CMP Pr/Amt Margin Return %
1500 Acc 140
0.45
167
675
33600
2.01
1100 BPCL 260
1.55
301
1705
45760
3.73
1300 HPCL 180
0.60
230
780
37440
2.08
2500 M&M 100
0.30
128
750
40000
1.75
1600 MTNL 120
0.50
160
800
30720
2.60
1200 Satyam 220
0.85
294
1020
42240
2.41
1000 SBI 210
0.95
250
950
33600
2.83
1800 TISCO 90
0.35
105
630
25920
2.43
RETURN NETT FOR 14 DAYS
1.90 %
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OPTIONS Salient features:








Limited losses unlimited profits.
Right, not obligation to enforce
contract.
Cash settlement.
Various strike prices.
Various expiry dates.
Value of contract & specified lot.
Premium = intrinsic + time value.
American/ European option.
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Strike Price
 The
price at which the stock
can be bought/sold as specified
in the option contract.
 At a time trading in option can
be done at 5 strike prices.
 However all the Strike prices
are displayed & traded for
applicable month.
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STRIKE PRICES
SLABS
Below Rs. 100
Rs. 5
100-200
Rs. 10
200-500
Rs. 20
500-1000
Rs. 30
1000-2500
Rs. 50
Above 2500
Rs. 100
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EXPIRY DATE
Date on which option
ceases to exist.
Expiry date on NSE is last
Thursday of the month.
Option available for 3
consecutive months.
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Value of Premium
= Intrinsic value +Time value
 Premia never in negative.







e.g. RCom call 65 Strike @ 3 CMP 64.
Built in intrinsic value = Rs 1 (65-64)
Intrinsic value = in the money price
Time Value = 2 (3-1) which depends on:
Time till expiry & interest. High interest
leads to call & put premium.
Volatility & market sentiments
View taken as on expiry date.
CMP Rs 65 RCom
Intrinsic
Time
70
60
60 Call premia 7 65Call Premia 5 70 Call premia 2
Intrinsic Value 5 Intrinsic Value 0 Intrinsic Value 0
Time Value
2 Time Value
5 Time Value
2
IN
AT
OUT
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EXERCISE
 Option
buyer have a right
which they can exercise.
ASSIGNMENT
 When
option holder exercises his
right to buy/sell, a seller/buyer
is chosen to make good his/her
obligation.
 So it is assigned on seller/writer.
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STYLES OF OPTION
American Option
Can be exercised any time before
expiry. Stock Options are American
Options
 European Options
Can only be exercised on
predetermined expiry date only.
Index Options are European options.

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OPTION CASH FLOW
A call/put option is :
 In
the Money CMP is higher/lower
than strike price.
 At the Money CMP= to strike price.
 Out of Money CMP is lower /
higher than strike price.
 Option can be exercised only
when “in” or “at” the money.
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TERMINATION OF CONTRACT
On exercise by holder.
 On squaring up of
premium.
 On expiry date.

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Value of Contract
 Benchmark is Rs 2 lacs.

Lot size per contract is different
for different stocks. Example:
Infosys
ITC
Nifty
Reliance Ind
Axis Bank
Hindalco
JP
125
1000
50
500
250
2000
4000
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Why Options?






Risk limited to premium.
High leverage.
Low cost hedging.
Additional income like badla.
Buying stock below CMP.
Low brokerage.
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OPTIONS Vs FUTURES
Difference
OPTIONS
FUTURES
Losses
Only Premium
UNLIMITED
Profit
UNLIMITED
UNLIMITED
Premium
Paid to
NO PREMIA
but MARGIN
SELLER
stock+option
 Why
xpress
write a call
 Earning
premium income.
 To supplement dividend
income if call expires.
 Downward protection in
covered writing.
 Why
write a put
 Seeking
income from premium.
 Purchase stock at specified
exercise price (usually lower than CMP)
during life of contract.
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WRITE
Ideal time for option writing.
Actual
sell
call
+ call
here
Logical
decay line
TIME VALUE PATTERN
Rapid decay
Black hole
period
x
stock+option press
Margin in
Derivatives:
Futures
25% upfront +M2M
Option
Buyer
No Margin.
Pay premium only.
Option
Seller
Get Premium but
25% upfront +M2M
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Stock/Futures/Options
Buy 1000 ITC CMP Rs 220
STOCK
FUTURE
Investment 2,20,000 55000 margin
OPTION
3000
M to M
NIL
Actual losses
NIL
Delivery
Yes
No
Yes/ No
Risk
Full
Full
Premium
Leverage
1000
4,000
75,000
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Daily Jobbing Vs Option trader
Potential maximum loss
Option Premium for ITC
CMP 242 Circuit at 10%
Max Loss (premium)in days
Rs 25- 30 in 30 remaining
days
Rs 10 - 25 in 20 remaining
days
Rs 0 - 10 in 3 remaining
Best
Deal
Jobbers
Loss
per day
30
Why stock+option xpress
Real time quotes.
 Ambience.
 Access to analytics.
 Formulation of advanced strategies
to suit your needs.
 Stocks, Futures & Options on 1 desk.
 Education.
 Competitive.
 Professional Fund
Management.

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Derivatives in USA
CBOE, largest & 1st listed option
exchange started in 1973 trades in
1332 SO & 41 indices with 1500 MM.
 Daily T/O Rs 1,17,500 Cr in 10 lac
contract.
 Not traded on NYSE & NASDAQ.
 85% volume from retail. Rest from
institution & funds.

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USA Derivative Market
Data for 1Oth JAN 2005
 Total
Contracts 3,942,741
 Equity Options 3,524,184
 Index Options
414,213
 Open Interest 94,042,845
 Equity Call:Put Ratio 1.78
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KAUN BANEGA
DERIVATIVE CHAMP
We shall be asking few
questions to test your
understanding of
workshop.
Are you ready?
Let’s start quiz.
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Question # 1
A _________ conveys the
right to buy
*
*
*
*
1.
2.
3.
4.
A
A
A
A
call option
put option
future contract
strike price
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Question # 2
One contract of listed options
is standardised for approx. Rs
___ to ____lac value of
contract
*
*
*
*
1.
2.
3.
4.
One to Two
Two to Four
Three to Six
One to Ten
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Question # 3
There are ________ strike
prices available for trading
at all times.
* 1. Two
* 2. Three
* 3. Four
* 4. Five
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Question # 4
If you sell call option, you
become__
*
*
*
*
1.
2.
3.
4.
Option holder
Option writer
Future trader
Call broker
stock+option
 Question
xpress
#5
All listed options expire on
________ of each month.
*
*
*
*
1.
2.
3.
4.
First Thursday
Last day
Last Thursday
Last Friday
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Question # 6
On NSE, option trading is allowed
in _____ stocks excluding Nifty
*
*
*
*
1. Five
2. Thirty One
3. Thirty Five
4. More than 35
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Question # 7
In a futures contract, the buyer
pays premium to___________
*
*
*
*
1.
2.
3.
4.
Seller
Exchange
Option writer
None of above
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Question # 8
As a owner of HLL Equity, you
feel that the market is about to
fall. What shall be your
strategy?
* 1. Buy call in HL
* 2. Buy a put in HL
* 3. Buy a future index
* 4. Sell a put in HL
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Question # 9
The two components of option
premium are ______Value &
____Value.
* Bullish & bearish
* Intrinsic & exercise
* Intrinsic & Time
* Call & put
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Question # 10
The option trading lot of JP Ass is 4000.
Call option is quoted 1.50-1.75. How
much premium shall you pay to buy one
contract.
* 1. Rs 6000
* 2. Rs 7000
* 3. Rs 4000
* 4. None of above
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Question # 11
ACC CMP is 200. You bought
ACC Call of 190 strike at Rs 11
premium. The option is__
* 1. In the money
* 2. Out of money
* 3. At the money
* 4. None of above
x
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Question # 12
If you own 700 strike put of
RIL & its CMP is Rs 730, your
option is _________
* 1. In the money
* 2. Out of money
* 3. At the money
* 4. None of above
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Question # 13
SBIN CMP is 2246. Call option
at Rs 2200 costs Rs 62.50.
Calculate time value of the
option?
* 1. Rs 46.00
* 2. Rs 62.50
* 3. Rs 16.50
* 4. Rs 0