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1.1.

1 Derivatives – Introduction
Risk takes a prime place in the financial system. There is
always an exposure to risk because of variations / fluctuations in
prices of commodities, interest rates, foreign exchange rates, etc.
arising due to demand and supply conditions. Financial
instruments (Shares, Bonds, Debentures, Other securities) are
always under a threat of continuous price change. Hence, all the
participants in financial system are constantly exposed to the risk
of losses. In order to overcome risk in financial system,
‘Derivatives’ have been introduced. Derivatives facilitate to control
volatility in prices. It helps to minimize the impact of these
fluctuations, by locking-in asset prices.

Origination of Derivatives marked can be traced back to


Agriculture markets. During traditional era, farmers used to have
their grains ready in the market for sale and potential buyers of the
products before buying the grains, would negotiate on the price.
Problem with this scenario was that farmers failed to get the
optimum prices. Also, there was problem with availability of
storage facilities. In order to overcome this, ‘Derivatives’ were
introduced in Chicago. Chicago Board of Trade (CBOT) was
established in 1848 as a linkage for farmers and merchants. The
main aim of derivatives was to standardize the quality and quantity
of grains. Within few years the first futures-type contract was
developed – It was known as a ‘to-arrive’ contract. Soon,
speculators also started showing interest in these contracts as they
found it to be an attractive alternative for trading of grains. Also, in
1919, a rival futures exchange, the Chicago Mercantile Exchange
(CME) was established. International Monetary market was
established in 1972 for future trading in foreign currencies.

Derivative contracts have been quite popular since


inception, however, the number of transactions in this market has
boosted after 1990’s (Around two-third of total derivative
transactions took place post 1990). Recently, the number of
transactions, instruments, complexity and turnover in derivatives
market has increased immensely. In India before the derivatives
trading started, NSE and BSE were dealing in electronic equity spot
market. Derivatives trading in India started in June 2000.
1.1.2 Derivatives – Meaning
There is a constant volatility in the financial environment
which leads to fluctuations of price of the asset. Because of the
changes in demand and supply forces, the value of assets increases
or decreases, which leads to increase in exposure to financial risk
and loss. As this risk is unavoidable, mitigating the risk and
uncertainty is very important. Derivatives help the investors to
mitigate the risk effectively.

As per Merriam Webster Dictionary: Derivative is “a


substance that can be made from another substance.” In simple
terminology; Derivative is an instrument that derive its value from
some asset it represents. For example ‘Curd’ is a derivate product
derived of ‘Milk’. ‘Derivative’ is a contract or financial instrument
whose value is derived on the basis of value of another asset. These
assets are known as ‘underlying assets’. ‘Derivative’ is not a
product – it is a contract deriving its price from variation in the
price of underlying asset. Performance of derivatives instrument is
dependent on the movement of prices of underlying assets.

An underlying asset is a financial instrument (such a stock,


commodity, index currency, etc.) on which the price of a derivative
is determined. Example: Value of a gold futures contract is
determined from the value of its underlying asset (i.e. Gold). The
value of Derivatives contract keeps changing as per the value of
underlying. Types of underlying assets can be financial and non-
financial. Detailed break-up is as follows:

A) Financial Assets:
(i) Equity Instruments – Equity shares (Raymond Ltd,
ICICI etc.); Indices (Sensex, Nifty etc.)
(ii) Debt-market Instruments – Interest Rates, Bonds etc.
(iii) Other Instruments – Forex, Currency, Temperature,
Carbon Credits etc.

B) Non-Financial Assets:
Commodities, Cereals, Pulses, Dairy Products, Metals,
Derivatives themselves etc.
Definition of Derivative:
“A derivative is a financial instrument whose value depends on (or
derives from) the values of other, more basic underlying variables”
- John C. Hull

“A financial instrument “which has a value determined by the price


of something else. This “something else” can be almost anything: it
can be assets or commodities”
- Robert L. Mc Donald

“A security derived from a debt instrument, share, loan whether


secured or unsecured, risk instrument or contract for differences or
any other form of security”
- Securities Contracts (Regulation) Act, 1956

1.1.3 Elements of Derivatives Contract:


A derivatives contract need to have a minimum of the following
five elements:
 A legally binding contract
 Involvement of two or more parties
 Existence of an ‘Underlying asset’
 A determined future date
 A determined future price

1.1.4 Derivatives – Need and Importance


The primary rationale of derivatives is to reduce/mitigate and
hedge risk. Everyone who deals in a financial system is exposed to
financial risk – which everyone wants to get rid of. Some of the
examples of Derivatives contract are:
1) ABC, an airline company needs to buy fuel for its planes. They
are exposed to risk of changes in oil price. In case there is an
enormous increase in the price, ABC face huge loses. To
overcome this risk, ABC Company can buy Oil Futures
Contracts. With this, they are locking-in oil prices. Thus,
derivative helps them to mitigate the risk.
2) A local farmer harvest and sell mangoes. There is a time lag
between harvest period and sale of mangoes – during which the
price of mangoes could fall and in turn impact Farmer’s earning.
Here the farmer can get into a derivative contract by locking-in
the price of mangoes today to mitigate the risk that may arise
during sale.

3) XYZ, an Indian company sell its products across the globe. They
may earn in various currencies. Ultimately theses earnings in
other currencies have to be converted in INR. There can be a risk
of changes in the foreign exchange rates which may lead to
reduction in net earnings after conversion. In order to avoid this
risk, XYZ can get into a derivatives contract for locking-in the
exchange rate.

Derivatives contract have emerged because of the complexity


and risk in financial markets. Derivatives help in risk mitigation
and management. Due to this, the efficiency in financial market can
be improved. Need and importance of derivatives can be
explained as follows:
1) Enhances price discovery process: Derivatives help in price
discovery by predicting future prices based on current prices.
The analysis is based on actual valuation and expectations.
2) Risk Management: Derivatives help in risk mitigation. It
enables transfer of risk from those who are risk-averse to those
who are risk-lovers.
3) Entrepreneurship: It increases the entrepreneurial activities
amongst participants. It may attract various investors who are
creative, educated and business-minded in nature. Overall
benefit is increase in employment opportunities.
4) Trading volumes: It catalyzes economic growth by increasing
trading volumes due to participation of players from various
sectors.
5) Savings & Investment: It increases the savings habit in the
investors and also enhances investment opportunities in long-
run.
6) Signals of market movements: It provides an indicator of how
the market moves. Also, it improves market efficiency process
for the Underlying Asset.
7) Low transaction cost: Derivative instruments are quite simple
to operate. Also, all these instruments are low-cost products –
the cost of trading is comparatively low.
8) Increased Liquidity: Participants in the derivatives contract
can easily get-in and come-out of the deals very easily, and that
too without high cost. This leads to enhance liquidity in the
market. It also improves liquidity of underlying assets.
9) Organized market: Derivatives market helps in shifting the
trade from an unorganized market to an organized one – which
in turn provide stability to the financial markets.

1.2 Major Players in Derivative Markets:


As there are various participants in any financial market,
derivatives market also has certain players. Derivatives can be
used for various reasons like (1) management of risk (ii) profit
making by taking risk and (iii) benefiting from price differentiation
in different markets at any given point of time. Corporations,
Banking Institutions, Financial Institutions, Brokers, Dealers and
Individuals can be found as participants the derivative markets.
These players are usually classified in three categories on the basis
of their motive in the market, they are:
 Hedgers
 Speculators
 Arbitrageurs

1) Hedgers: The term ‘hedge’ means ‘to reduce the risk’. Hedgers
are the participants / investors who look at reducing their risks
in the market. They use derivatives for mitigating risk
associated with price movement of a financial asset. All the
participants of financial markets (corporates, banks, financial
institutes etc.) may use derivative products to hedge their risk
exposures. Hedgers use futures markets to mitigate risk because
of the price movements of assets, exchange rates, commodities,
interest rates, etc. Hedgers try to hedge price of the assets by
getting in to an exactly opposite deal in the derivatives market.
Hence, they pass over the risk to participants willing to bear it.

Example of Hedging: There is a farmer who sows crop in the


month of April and receives harvest in the month of July – may
face risk over the price. In certain periods, he may get attractive
prices whereas, there could be a possibility he has to sells his
produce at a very low price. This price uncertainty can be
overcome by farmer by getting into a hedging contract, whereby
he will lock-in the future prices today and mitigate the risk of
price decrease in the future.

2) Speculators: Speculators are the participants who take a view on


the future price movements in the market and accordingly make
profits. They look for opportunities and accordingly take risk
with the motive of making higher returns. They are high risk-
takers in the derivative markets – who invest merely from the
intension of making higher profits. They need to effectively
forecast market trends to take positions that don’t in any way
guarantee safely of invested capital or returns. They need to
forecast possible market trends. If they feel the price of an asset
is expected to fall because of some market developments, they
would short sell the assets. This would generate good profit for
them

Example of Speculation: Current gold price is Rs.25000 per 100


gram. There is a participant in the market who expects price of
gold to reach Rs.30000 per 100 gram after two months. In this
case, he can get into a long position and expect the profit of
Rs.5000 per 100 gram. There is risk in this deal, as the price of
the gold may also reduce below current market price too.

3) Arbitrageurs: Arbitrageurs are the participants who make


profits by taking benefit of differences in prices of the same asset
in two different markets. They earn a riskless profit.
Arbitrageurs exploit inefficiencies in the markets and make
profits from it. They simultaneously purchase assets from one
market and correspondingly sale the same in another market.

Example of Arbitraging: Suppose a laptop is being sold in


Mumbai market at Rs.50000 and the same laptop is sold in Delhi
market at Rs.55000, the Arbitrageur will buy the laptop from
Mumbai market and sell in Delhi market, thereby earning a
profit of Rs.5000.

Snapshot of Hedgers, Speculators and Arbitrageurs:


Heading Hedgers Speculators Arbitrageurs
Meaning Participants Participants Participants
who protect who accept the who take
themselves from risk in order to advantage of
the risk of increase their price difference
movements in profits in two or more
price markets in
order to make
profits
Role Helps in Helps in Helps in price
transferring risk identifying consistency and
from one person direction of the price discovery
(with low-risk futures prices –
appetite) to also provides
another (with liquidity and
high-risk depth to the
appetite) market
Involves Protection Making profits Making profits
against risk by taking by
associated with higher risk simultaneously
price movement from price entering in two
movement or more
markets
Approach Least risk-lovers Risk-lovers Risk-free
Intention Reduce risk Make profits Make profits
from price from difference
movement in prices of two
markets

1.3 Features of Derivatives Contract


There are various types of Derivatives Contract:
 Forward
 Future
 Options
 Swaps

Forward Contract: A forward contract is a customized type of


contractual agreement between two parties to buy or sell an
underlying asset on a specific future date at today’s pre-agreed
price. Both buyers as well sellers are bound to honor the deal –
irrespective of the price of underlying asset at the expiry date of
contract (date of delivery). They are over-the-counter (OTC)
contracts where both the parties negotiate and customize the terms
and conditions of the contract, without involvement of the stock
markets. They may be privately dealt in by two parties.
These are relatively simpler derivative contract. Forward
contract is different from spot contract. Spot contract is an
agreement to buy or sell an asset today whereas in forward contract
the delivery happens at the future date. One of the parties in
forward contract takes a long (buyer) position and agrees to buy
the underlying asset on a specified future date at a pre-decided
price. Whereas the other party assumes a short (seller) position and
agrees to sell the asset on the same date for the same price.
Example of Forward Contract: If a farmer plans to grow
corn in his farms. He could sell the corns in future for whatever the
market price is when he harvests it. Else, he can also lock-in a price
now by getting into a forward contract that obligates him to sell his
corns to ABC Company at a fixed price. By locking-in the price
now, the farmer reduces the risk of falling prices of corn in future.
In case the prices rises, he will get only what his contract entitles to.

Features of forward contract: Some of the features of forward


contract are as follows:
1) Bilateral: Forward contracts are bilateral (two-sided)
contracts. It is a contract between two parties (without any
exchange between them). Both the parties are exposed to
counter-party risk. These two parties can be (a) A bank and
a customer (b) Two banks of same country (c) Two banks of
different countries.

2) Counter-party risk: As these are OTC contracts, there can be


a risk of non-performance of obligation by either parties.
These are a bit risky in nature.
3) Customized contracts: Forward contract are quite flexible as
they are custom designed (not standardized). Both the
parties can negotiate the terms of the contract.
4) Not traded on Exchanges: Forward contracts are not traded
on any exchanges. They are entered by two parties to meet
their specific needs. Hence, the prices of these contracts are
not available on public domain.
5) No premium and margin required: There is no premium
and margin money involved in forward contracts.
Premium amount is to be paid in case of options contract,
whereas margin requirement is a feature of futures contract
(which will be discussed in later chapters).
6) Physical delivery: These contracts have to be settled by
delivery of the underlying asset on expiration date. One
party is bound to sell and the other one to purchase at the
pre-decided price.
7) All the terms decided today: All the terms of forward contract
(like contract size, expiration date, asset type, quantity and
quality) are pre-decided at the time of contract
8) Widely used: As they are quite simpler contracts, they are
quite popular and have been in use (in commodities and
forex market) since ages.

1.4 Features of Futures Contract:


Futures contracts were designed to solve the problems with
forward contracts. Futures contracts are exactly like forward
contracts in terms of basic economics. However, future contracts
are standardised and trading is centralised, so that futures markets
are highly liquid. There is no counterparty risk (as the clearing
houses become counterparty to both parties and they guarantee the
trade). Futures contract is defined as a standardised agreement
with an organized exchange to buy or sell an underlying asset at a
fixed price at pre-decided date in future.
In short,
 Futures contract is an agreement between two parties to
buy or sell something at a future date.
 They are standardized contracts.
 There is an agreement to buy or sell the underlying asset.
 The transaction takes place on a predetermined future date
and predetermined price.
 Forward contracts are OTC whereas Futures contracts trade
on organized exchanges.

Features of Futures Contract:


1) Bilateral: Like forward contracts, future contracts are also
bilateral contracts. It is a contract between two parties (one
who takes a long position and the other who takes a short
position). Participants can be banks, corporations, FI’s,
individual investors etc. Some participants also deal
through brokers.
2) No counter-party risk: As future contracts are not OTC
contracts, there is no risk of non-performance of obligation
by either parties. The exchange puts the margin
requirement on both parties, to overcome the problem of
non-performance.
3) Organised Exchanges: Forward contracts are traded in
OTC market, whereas future contracts are traded on
organised exchanges. This offers liquid in the market.
4) Standardized contracts: In Futures contract, all the terms
are standardised by the exchange on which the contract is
traded. Tick size (i.e. the minimum amount by which the
price quoted can change) is also decided by exchange.
5) Involvement of Clearing House: The exchange acts as a
clearing house for all the futures contract. Hence if two
parties X and Y enter into a futures contract, the same is
replaced internally by two contracts – one between X and
clearing house and second between B and clearing house.
6) Margin money: The exchange makes it mandatory for the
parties of futures contract to deposit certain margin money
with clearing house. The margin money is usually in the
range of 2.5 to 10% (of value of contract), which may vary.
This margin can be either cash or securities like T-Bills, Bank
LC’s etc.
7) Mark to market: A system, called Mark-to-market (MTM),
is used by exchanges. It is also known as “Daily
Settlement”. It is a process of valuing underlying assets in
a futures contract at the end of each trading day. The profit
or loss is settled by the exchange. At the end of each trading
session, all outstanding contracts are calculated at
settlement price of that trading session.
8) Actual Delivery may not happen: In forward contracts, the
underlying asset is actually delivered by seller to the buyer.
In case of Futures contract, actual delivery may not happen.
Futures are used as a medium to hedge against price risk.
It can be used as a way of betting against price movements.
Most of the futures contracts are nullified by a matching
contract in the opposite direction before maturity of the
first.
Other features of Futures Contract are:
High Liquidity, Simple and easy to understand, less volatile
market as compared to other trading products, Low margin with
high leverage.

1.5 Forward V/s. Futures


Heading Forward Futures
Nature OTC Exchange traded
Counter party Exists Does not exist
risk
Contract terms Customized Standardized
Guarantee of Does not use clearing Uses clearing houses
contract houses to guarantee to guarantee
fulfillment
Margin Not required Required
payments
Transparency No transparency in Transparency in
markets markets
MTM Not marked to Marked to market on
market on a daily a daily basis
basis
Closed prior to No Mostly
delivery
Profits or losses No Yes
realized daily
Actual Delivery Actual delivery of Actual delivery of
asset happens at the asset may or may not
end of the contract happen
Liquidity Less More
Settlement Settlement happens Follows daily
at the end of contract settlement
Price Discovery Not efficient Efficient (Markets are
Mechanism (Markets are common and
scattered) centralized)
Market place On phone or telex Electronic exchange
Familiarity of the Both the buyer and Buyer and seller need
parties trading seller are known to not know each other
each other

1.6 Theoretical Future Price


Before understanding Theoretical Futures Price, let us
understand the meaning of the term ‘Basis’. Futures prices and
Spot prices are different – They coincide at the time of expiration of
a contract.

Convergence of Spot and Futures Prices

Before settlement, futures and spot prices need not be the same.
The difference between the prices is called the basis of the futures
contract. It converges to zero as the contract approaches maturity.
The basis is defined as the difference between the spot and futures
price.
B=S–F
Where;
 B is basis points
 S is Spot Price
 F is Futures Price

Example: (i) On October 12th a foreign exchange currency is


trading at Rs.45.96 per $. The November futures contract is
Rs.45.99; then the basis is -3 cents.

Example:
If the spot price on 1st July 2017 is 72 cents, calculate the basis for the
following futures contract:
Settlement Aug 2017 Sept 2017 Dec 2017 Feb 2018
Month
Futures 75 70 78.5 69.5
Price

Ans. (-3, 2, 6.5, 2.5)

THEORETICAL FUTURES PRICE:


Theoretical Futures Price (TFP), also known as Fair Price, is the
mathematical calculation of a price of a future’s contract. It is a
theoretical equilibrium price of future contract. Theoretical price is
also known as fair value of a futures contract.

Fair value is the theoretical assumption of where a futures


contract should be priced given such things as the:
 Spot price
 Dividend yield
 Time to maturity
 Risk-free interest rate

Simply put, TFP or Fair Futures Price is Spot price + Holding /


Carrying Cost. Carrying cost (cost of carry) includes the cost of
holding the underlying till maturity minus any dividend expected
till the expiry of the contract. Cost of carry includes variables like
storage cost and interest rates.
F=S+C
Where;
 S is Spot Price
 C is Cost of carry

Formula for calculation of Futures – Theoretical Price / Fair Price:


# Underlying Asset type Examples Formula
1. Underlying Asset paying no Gold, F = S*e rT
income till maturity Silver
2. Paying Fixed Income – Bonds, T- F = S*e (r-y)T
interest rate is continuously Bills
compounding
3. Paying Discreet Income Equity F = (S-Y)*erT
Shares

Where F = Future’s fair price, S = Spot Price, e = continuous


compounding factor (value is 2.71828), r = risk-free interest rate, y
= % income yield pa, T = Time till maturity.

‘e’ stands for exponential (x) function. It is continuous


compounding factor. e is the number called as Napier's Number
and its approximate value is 2.718281828.

1.7 Initial Margin and Maintenance Margin

Think of taking a flat on rent. Before getting the possession, the


tenant has to pay a security deposit to the owner of the flat. In case
In case there are any damages to the flat, the same is adjusted with
the security deposit we pay. Similarly, in Futures contract, a
security deposit is paid which is known as Margin. If there is any
decrease in the value of the underlying asset – the same is adjusted
from the margin account.

Margin accounts allow investors to make investments in futures contract.


It ensures that investors are serious about the buying and selling of stocks.
Margin money ascertains the buyer pays the deal amount on time and the
seller also honours his commitment.
Margin money is a very important concept in trading commodity futures
and derivatives. Futures margin is the money one needs to deposit to
operate a futures contract.

Margin rates are fixed by futures exchanges. Also, the brokers add some
extra premium to the margin rate set by exchange – in order to lower the
risk exposure.

As long as the margin in an account remains at a level equal to or greater


than prevailing initial requirements, the investor is free to use the account
in any way he or she sees fit. If the value of the investor’s holdings
declines, the margin in his or her account will also drop.

Due to various uncertainties in stock markets, there can be movement of


stock prices. This risk can be covered up with the help of margin system.

Simply put, there are two types of margins:


Initial Margin
Maintenance Margin

1) Initial Margin: Initial margin means the minimum amount of


capital or equity provided by investors at the time of entering into
a futures contract. It is required in order to avoid overtrading and
excessive trading in futures contract. Initial margin is the amount
required at the time of purchasing a futures contract. It is usually
determined in % terms. Initial margin is applicable in futures
trading (for both buying and selling a futures contract).

Initial margin is denoted as a % of total contract value. The %


may keep changing as per the market in which contract is dealt
in. Till the time there is sufficient margin in investor’s account
(greater than or equal to initial requirement), the investor can keep
using his account. If the margin in the account is below the initial
margin required, it requires the investor to deposit the sufficient
margin money.

Example: If a person goes long on futures contract for ABC stock


trading for 100 shares (market price of Rs.100) and if the initial
margin required is 20%, the initial margin will be calculated as 100
* 100 * 20% = Rs.2000.

2) Maintenance Margin: Maintenance margin is the minimum


balance that one needs to keep in account in order to keep the
futures position valid. It is the amount that an investor is required
to maintain all the time in his margin account. If the margin falls
below the maintenance margin, investor will be required to deposit
the necessary amount, else the broker will sell the required equity
in order to bring the earlier level back. The investor receives a
call from the broker to maintain the margin level, if the margin
comes below required level – this is called as "Margin Call".
Hence, Maintenance margin is a limit post which a broking
firm can make a margin call to the investor.
Maintenance margin protects the interest of
both – Brokerage house as well as investors.
1.8 Marking to Market and Variation Margin

Marking to Market: Also known as “Daily Settlement”, Marking-


to-market (MTM) is a process of valuing underlying assets in a
futures contract at the end of each trading day. The profit or loss is
settled by the exchange. At the end of each trading session, all
outstanding contracts are calculated at settlement price of that
trading session. The exchange makes an adjustment by debiting
(subtracting) the margin accounts of members who are at a loss and
crediting the accounts of members who gain.
2.1 Options - Introduction
As seen earlier that various types of Derivatives contract are
Forward, Future, Options and Swaps. In Futures Contract both the
parties have an obligation (compulsion) to purchase or deliver a
specific commodity at a predetermined time & price. Options are
one of the most important group of derivative contract. Option may
be defined as a contract, between two parties whereby one party
obtains the right, but not the obligation, to buy or sell a particular
asset, at a specified price, on or before a specified date. There are
two parties involved – Option Holder and Option Writer. The
person who gets the right is known as the option buyer or option
holder, while the other person (who confers/gives the right) is
known as option seller or option writer. The seller of the option for
giving such option to the buyer charges an amount which is known
as the option premium.
In short one party gets an option to buy or sell while the other
party has an obligation to sell or buy respectively. First party gets
an option and second party has an obligation, hence the second
party receives a payment (for taking the risk), called as option
premium.
Options can be divided into two types:
 Call Option
 Put Option
A call option gives the holder the right to buy an asset at a
specified date for a specified price whereas in put option, the
holder gets the right to sell an asset at the specified price and time.
The specified price in such contract is known as the exercise price
or the strike price and the date in the contract is known as the
expiration date or the exercise date or the maturity date.

Participant Call Option Put Option

Buyers (Long Right to buy stock if Right to sell stock if


Position) exercised exercised
Sellers (Short Obligation to sell stock Obligation to buy
Position) if assigned stock if assigned

2.2 Basic Terminologies:


(1) Call Option: An option giving the buyer of the option, the
right but not the obligation to BUY an underlying asset.
(2) Put Option: An option giving the buyer of an option, the right
but not the obligation to SELL an underlying asset.
(3) Option Buyer/Holder: A person who buys an option to either
buy (call option) or sell (put option) underlying asset.
(4) Option Seller/Writer: A person who sells/writes a call or a put
option to option buyer. He/she has the obligation to buy (in
case of put option wrote) or to sell (in case of call option wrote),
if the option holder of exercises the option.
(5) Spot price: The price at which the underlying asset trades in
the spot market is called as Spot price.
(6) Exercise / Strike Price: The fixed price, at which, the buyer of
option contract can exercise his option to buy/ sell the
underlying asset.
(7) Expiration/Maturity date: The Last day on which option can
be either exercised or lapsed.
(8) Exercise Date: The date on which the option is actually
exercised.
(9) Option Premium/Price: Price paid by option buyer to the
option seller to acquire the right to buy or sell the underlying
at a specific exercise price.
(10) Lot size: The number of units of underlying asset in a contract
is called as Lot size. Lot size of Nifty option contracts is 75.
(11) European Option: An option which can be exercised only on
the specified date is called as European option. European
option is can only be exercised at the maturity of option.
(12) American Option: An option which can be exercised on any
date up to expiry date is called as American Option.
(13) Bermuda Option: Bermuda option is a combination of
American and European option. It can exercised at the date of
expiration/maturity; and on certain specified date between
purchase date and date of expiration.
(14) Intrinsic Value: It is the amount by which the option is In-the-
Money. It is the portion of an option's price that is not lost due
to the passage of time.
Intrinsic value of Out-the-Money and At-the-Money options is
always zero.
Intrinsic value of call option = Underlying asset’s current price
– Strike price.
Intrinsic value of put option = Strike Price – Underlying asset’s
current price.
(15) Time value: The price that the buyers pay for the expectation
that price will move in his favour. It is the amount by which
the price of an option exceeds its intrinsic value. Time value of
an option is directly related to the time an option has until
expiration.
Time value of call option = Call Premium – Intrinsic Value
Time value of put option = Put Premium – Intrinsic Value
(16) Naked call and covered call: In options, ‘covered’ are the
contracts sold by traders who actually own the underlying
shares whereas, ‘naked’ are those contracts where the writer
does not own the underlying assets. Naked call writing is the
technique of selling a call option without owning the
underlying security. A covered call means selling a call option
that is covered by a long position in the asset. This strategy
provides downside protection on the stock while generating
income for the investor. Whereas, a regular short call option,
or a naked call, is an options strategy where an investor sells a
call option. Writers of naked options are thus unprotected
from an unlimited loss.

2.3 Call – Long / Short; Put – Long / Short


2.3.1 Long Call:
Long call means to purchase one or more call options on a
stock or index. The term "going long" refers to buying a security
(and not selling one). Long call option strategy is one of the most
basic option strategy. In this, trader buys call options with a hope
that price of underlying asset will go up.
Buyer of a call is said to be “long on call”. As he is buying
the call, he gets a right and not obligation to buy the underlying
asset in the contract. A person who has ‘Long the call’:
 Has got the right to exercise the call option
 Has potential loss limited to the premium amount paid
 Has profit dependent on price of the underlying asset at the
time of exercise/expiry of the contract

2.3.2 Short Call:


Short call means to sell one or more call options on a stock
or index. The term “going short” is the contrast of “going long”. It
means that the person has to sell a security.
Seller of a call is said to be “short on option”. As he is selling
the call, he has the obligation and no right to sell the underlying
asset in the contract. A person who has ‘Put the call’
 Has the obligation to exercise the call option
 Has unlimited potential loss (theoretically)
 Has maximum profit as the amount of premium received

Long Call Payoff – Graphical representation


Short Call Payoff – Graphical representation

2.3.3 Long Put:


Long put means to buy one or more put options on a stock
or index. The term "going long" refers to buying a security (and not
selling one). Long put option strategy is one of the most basic
option strategy. In this, trader buys put options with a hope that
price of underlying asset will go down. A long put option can be
an alternative to short selling. It gives the right to sell a strike price
generally at or above the stock price.
Buyer of a put is said to be “long on put”. As he is buying
the put, he gets a right and not obligation to sell the underlying
asset in the contract. A person who has ‘Long the put:
 Has got the right to exercise the put option
 Has potential loss limited to the premium amount paid
 Has profit dependent on price of the underlying asset at the
time of exercise/expiry of the contract

2.3.4 Short Put:


Short put means to sell one or more put options on a stock
or index. The term “going short” is the contrast of “going long”.
Seller of a put is said to be “short on option”. As he is selling
the put, he has the obligation and no right to buy the underlying
asset in the contract. A person who has ‘Put the call’
 Has the obligation to exercise the put option
 Has unlimited potential loss (theoretically)
 Has maximum profit as the amount of premium received

Long Put Payoff – Graphical representation

Short Put Payoff – Graphical representation

2.4 Options V/s. Futures


Heading Futures Options

Meaning Futures is a contract Options is a contract


in which both the between two parties
parties have an whereby one party
obligation to obtains the right, but not
purchase or deliver a the obligation, to buy or
specific commodity sell a particular asset, at
at a predetermined a specified price, on or
time & price before a specified date.

Obligation Buyer obligated to No obligation on buyer


on buyer honour the contract to honour the contract

Execution of On the agreed date Any time before the


contract expiry of the agreed date

Risk High Limited

Advance No advance payment Paid in the form of


payment premiums

Degree of Unlimited Unlimited profit and


profit/loss limited loss

Margin Higher margin Lower margin payment


money payment

Preferred by Speculators and Hedgers


Arbitrageurs

Payoffs Linear (the profits / Non-linear (the loss of


losses of the buyers the option buyer is
and sellers are limited and profits
unlimited) potentially unlimited,
whereas profits of option
writer is limited and loss
potentially unlimited)
Heading Futures Options

Trading Exchange traded Both OTC and Exchange


traded

2.5 Writer of an Option


In an option contract there are two parties:
1) Buyer / Holder / One who takes Long position
2) Seller / Writer / One who takes Short position
An option contract involves a buyer and writer. Buyer of an
option gets a right whereas, the writer has an obligation to honour
the contract, provided the buyer takes a decision in his favour.
Writer of option is the person who sells an option contract. He in
turn earns premium. Option premium is the amount / fee paid by
the buyer of the option (whether it be a call or put option) to the
option writer (seller). It is paid in order to induce the writer to
accept the risk associated with the contract. It is actually the price
paid by the option buyer to buy an option.
 Call Option: In call option, the writer gives the buyer of
the option the right to purchase from him the underlying
asset.
 Put Option: In put option, the writer gives the buyer of the
option the right to sell the underlying asset.
When writing a call option, the seller agrees to deliver the
specified amount of underlying shares to a buyer at the strike price
in the contract, while the seller of a put option agrees to buy the
underlying shares. In short, Seller of the option is called the writer
of the option.
Writer / Seller of a call is said to be “short on option”. As
discussed earlier, a writer of an options contract:
 Has the obligation to exercise the option
 Has unlimited potential loss (theoretically)
 Has maximum profit as the amount of premium received
2.6 At the Money, In the Money and Out of the Money Options
Moneyness of Options: Moneyness describes the relationship
between the spot price of the underlying asset and the strike /
exercise price of an option. Moneyness describes the intrinsic value
of an option in its current state. Moneyness includes terms like in-
the-money, out-of-the-money and at-the-money describe the
moneyness of options. In short, Moneyness indicates the holders
of the options whether exercising / honouring the contract will lead
to a profit or not.

(1) In-the-Money (ITM): An ITM option results in positive


cash-flow to the holder of the option, when exercised. An
ITM option has positive intrinsic value. ITM options are
comparatively more expensive as their premiums consist of
significant intrinsic value on top of their time value.
 An ITM call option is an option where the strike
price is less than the spot price of underlying asset.
 An ITM put option is an option where the strike
price is more than the spot price of underlying asset.
(2) At-the-Money (ATM): An ATM option results in nil cash-
flow to the holder of the option, when exercised. An ATM
option has no intrinsic value. In ATM option, strike price is
equal to the spot price of underlying asset. In practice, it is
difficult to find an ATM option (where strike price is exactly
equal to the spot price).
(3) Out-of-the-Money (OTM): An OTM option results in
negative cash-flow to the holder of the option, when
exercised. An OTM option has zero intrinsic value. OTM
options are comparatively cheaper as they may expire
worthless.
 An OTM call option is an option where the strike
price is more than the spot price of underlying asset.
 An OTM put option is an option where the strike
price is less than the spot price of underlying asset.

In short, ITM, ATM and OTM can be explained as follows:

Moneyness Call Put Cash Intrinsic


Option Option Flows Value
ITM S>X S<X Positive Yes
ATM S=X S=X Zero No
OTM S<X S >X Negative No
Note: S is ‘Spot price’ and X is ‘Strike price’
2.7 Intrinsic and Time Value
As discussed earlier, Option price/premium is a price paid by
option buyer to the option seller to acquire the right to buy or sell
the underlying at a specific exercise price. The question arises as to
how much should be the option premium paid by the buyer to the
seller of the contract. An option premium consists of two
components: Intrinsic value and Time value (Also known as
speculative value).
Option premium = Intrinsic value + Time value
Intrinsic Value: Intrinsic value is also termed as Monetary Value.
The value of an option determined through fundamental analysis
without reference to its market value is called as Intrinsic Value. It
is the amount by which the option is In-the-Money. It is the portion
of an option's price that is not lost due to the passage of time.
Intrinsic value represents the profit that the holder would have if
he exercises the option. Intrinsic value of Out-the-Money and At-
the-Money options is always zero.
 Intrinsic value of call option = Underlying asset’s current
price – Strike price.
 Intrinsic value of put option = Strike Price – Underlying
asset’s current price.
Time Value: The Time value is also referred to as the Extrinsic
Value. Time value of an option is the total value of the option minus
the Intrinsic Value. As the option moves towards expiration date,
the time value decreases to zero. This is also termed as ‘Time
decay’. Options that have a longer duration for expiration are more
expensive than those expiring in the near future. Time value is
calculated by subtracting Intrinsic Value of option from Option
Premium. Time value is never negative.
 Time value of call option = Call Premium – Intrinsic Value
 Time value of put option = Put Premium – Intrinsic Value

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