1.

Introduction
What are derivatives?
A derivative is a financial instrument that derives its value from an underlying asset. This underlying asset can be stocks, bonds,
currency, commodities, metals and even intangible, pseudo assets like stock indices.

Derivatives can be of different types like futures, options, swaps, caps, floor, collars etc. The most popular derivative instruments are
futures and options.

There are newer derivatives that are becoming popular like weather derivatives and natural calamity derivatives. These are used as a
hedge against any untoward happenings because of natural causes.

What exactly is meant by “ derives its value from an asset”?

What the phrase means is that the derivative on its own does not have any value. It is considered important because of the importance
of the underlying. When we say an Infosys future or an Infosys option, these carry a value only because of the value of Infosys.

What are financial derivatives?

Financial derivatives are instruments that derive their value from financial assets. These assets can be stocks, bonds, currency etc.
These derivatives can be forward rate agreements, futures, options swaps etc. As stated earlier, the most traded instruments are futures
and options.

What kind of people will use derivatives?

Derivatives will find use for the following set of people:
· Speculators: People who buy or sell in the market to make profits. For example, if you will the stock price of Reliance is expected to
go upto Rs.400 in 1 month, one can buy a 1 month future of Reliance at Rs 350 and make profits
· Hedgers: People who buy or sell to minimize their losses. For example, an importer has to pay US $ to buy goods and rupee is
expected to fall to Rs 50/$ from Rs 48/$, then the importer can minimize his losses by buying a currency future at Rs 49/$
· Arbitrageurs: People who buy or sell to make money on price differentials in different markets. For example, a futures price is
simply the current price plus the interest cost. If there is any change in the interest, it presents an arbitrage opportunity. We will
examine this in detail when we look at futures in a separate chapter.
Basically, every investor assumes one or more of the above roles and derivatives are a very good option for him.

How has this market developed over time?

Derivatives have been a recent development in the Indian financial markets. But there have been derivatives in the commodities
market. There are Cotton and Oilseed futures in Mumbai, Soya futures in Bhopal, Pepper futures in Cochin, Coffee futures in
Bangalore etc. But the players in these markets are restricted to big farmers and industries, who need these as an input to protect
themselves from the vagaries of agriculture sector.
Globally too, the first derivatives started with the commodities, way back in 1894. Financial derivatives are a relatively late
development, coming into existence only in the 1970’s. The first exchange where derivatives were traded is the Chicago Board of
Trade (CBOT).
In India, the first derivatives were introduced by National Stock Exchange (NSE) in June 2000. The first derivatives were index
futures. The index used was Nifty. Option trading was started in June 2001, for index as well as stocks. In November 2001, futures on
stocks were allowed. Currently, there are 30 stocks on which derivative trading is allowed.

The 30 stocks on which trading is allowed currently are:

Name of the Scrip Lot Size
1. ACC 1500
2. Bajaj Auto 800
3. BHEL 1200
4. BPCL 1100
5. BSES 1100
6. Cipla 200
7. Digital Global Soft 400
8. Dr Reddy Laboratories 400
9. Grasim 700
10. Gujarat Ambuja 1100
11. Hindalco 300
12. Hindustan Lever 1000
13. HPCL 1300
14. HDFC 300
15. Infosys 100
16. ITC 300
17. L&T 1000
18. MTNL 1600
19. M&M 2500
20. Ranbaxy 500
21. Reliance Industries 600
22. Reliance Petroleum 4300
 23. Satyam Computers 1200
24. SBI 1000
25. Sterlite Opticals 600
26. TELCO 3300
27. TISCO 1800
28. Tata Power 1600
29. Tata Tea 1100
30. VSNL 700
31. NIFTY 200
32. SENSEX 50
The trading is done on the exchange in the F&O (Futures and Option) segment. Index F&O is also traded in the market. The indices
traded are the Nifty and the Sensex.

Since we have talked of hedging, can we compare derivatives to insurance?

You buy a life insurance policy and pay a premium to the insurance agent for a fixed term as agreed in the policy. In case you survive,
you are happy and the insurance company is happy. In case you don’t survive, your relatives are happy as the insurance company pays
them the amount for which you are insured. Insurance is nothing but transfer of risk. An insurance company sells you risk cover and
buys your risk and you sell your risk and buy a risk cover. The risk involved in life insurance is the death of the policyholder. The
insurance companies bet on your surviving and hence agree to sell a risk cover for some premium.
There is a transfer of risk here for a financial cost, i.e. the premium. In this sense, a derivative instrument can be compared to
insurance, as there is a transfer of risk at a financial cost.
Derivatives also work well on the concept of mutual insurance. In mutual insurance, two people having opposite risks can enter into a
contract and reduce their risk. The most classic example is that of an importer and exporter. An importer buys goods from country A
and has to pay in dollars in 3 months. An exporter sells goods to country A and has to receive payment in dollars in 3 months. In case
of an importer, the risk is of exchange rate moving up. In case of an exporter, the risk is of exchange rate moving down. They can
cover each others risk by entering into a forward rate after 3 months.

2. Futures
Future, as the name indicates, is a trade whose settlement is going to take place in the future. However, before we take a look at
futures, it will be beneficial for us to take a look at forward rate agreements

What is a forward rate agreement

A forward rate agreement is one in which a buyer and a seller enter into a contract at a specified quantity of an asset at a specified
price on a specified date.
An example for this is the exporters getting into forward rate agreements on currencies with banks.
But there is always a risk of one of the parties defaulting. The buyer may not pay up or the seller may not be able to deliver. There
may not be any redressal for the aggrieved party as this is a negotiated contract between two parties.

What is a future?
A future is similar to a forward rate agreement, except that it is not a negotiated contracted but a standard instrument.

A future is a contract to buy or sell an asset at a specified future date at a specified price. These contracts are traded on the stock
exchanges and it can change many hands before final settlement is made.
The advantage of a future is that it eliminates counterparty risk. Since there is an exchange involved in between, and the exchange
guarantees each trade, the buyer or seller does not get affected with the opposite party defaulting.

Futures Forwards
Futures are traded on a stock Forwards are non tradable, negotiated
exchange instruments

Futures are contracts having standard Forwards are contracts customized by

terms and conditions the buyer and seller

No default risk as the exchange High risk of default by either party

provides a counter guarantee

Exit route is provided because of high No exit route for these contracts
liquidity on the stock exchange
Highly regulated with strong margining No such systems are present in a
and surveillance systems Forward market.

There are two kinds of futures traded in the market- index futures and stock futures.
There are three types of futures, based on the tenure. They are 1, 2 or 3 month future. They are also known as near and far futures
depending on the tenure.

What are Index Futures?

Index futures are futures contract on the index itself. One can buy a 1, 2 or 3- month index future. If someone wants to take a call on
the index, then index futures are the ideal instruments for him.
Let us try and understand what an index is. An index is a set of numbers that represent a change over a period of time.
A stock index is similarly a number that gives a relative measure of the stocks that constitute the index. Each stock will have a
different weight in the index. The Nifty comprises of 50 stocks. BSE Sensex comprises of 30 stocks.
For example, Nifty was formed in 1995 and given a base value of 1000. The value of Nifty today is 1172. What it means in simple
terms is that, if Rs 1000 was invested in the stocks that form in the index, in the same proportion in which they are weighted in the
index, then Rs 1000 would have become Rs 1172 today
There are two popular methods of computing the index. They are price weighted method like Dow Jones Industrial Average (DJIA) or
the market capitalization method like Nifty or Sensex.

What the terminologies used in a Futures contract?

The terminologies used in a futures contract are:
· Spot Price: The current market price of the scrip/index
· Future Price: The price at which the futures contract trades in the futures market
· Tenure: The period for which the future is traded
· Expiry date: The date on which the futures contract will be settled
· Basis: The difference between the spot price and the future price

Why are index futures more popular than stock futures?

Globally, it has been observed that index futures are more popular as compared to stock futures. This is because the index future is a
relatively low risk product compared to a stock future. It is easier to manipulate prices for individual stocks but very difficult to
manipulate the whole index. Besides, the index is less volatile as compared to individual stocks and can be better predicted than
individual stock.

How is the future price arrived at?

Future price is nothing but the current market price plus the interest cost for the tenure of the future.
This interest cost of the future is called as cost of carry.
If F is the future price, S is the spot price and C is the cost of carry or opportunity cost, then
F=S+C
F = S + Interest cost, since cost of carry for a finance is the interest cost
Thus,
F=S (1+r)T
Where r is the rate of interest and T is the tenure of the futures contract.
The rate of interest is usually the risk free market rate.
Example 2.1:
The spot price of Reliance is Rs 300. The bank rate prevailing is 10%. What will be the price of one-month future?
Solution
The price of a future is F= S (1+r)T
The one-month Reliance future would be the spot price plus the cost of carry. Since the bank rate is 10 %, we can take that as the
market rate. This rate is an annualized rate and hence we recalculate it on a monthly basis.
F=300(1+0.10)(1/12)
F= Rs 302.39
Example 2.2:
The shares of Infosys are trading at 3000 rupees. The 1 month future of Infosys is Rs 3100. The returns expected from the Gsec funds
for the same period is 10 %. Is the future of Infosys overpriced or underpriced?
Solution
The 1 month Future of Infosys will be
F= 3000(1+.0.10) (1/12)
F= Rs 3023.90
But the price at which Infosys is traded is Rs 3100. Thus it is overpriced by Rs 76.

What happens if dividend is going to be declared?

Dividend is an income to the seller of the future. It reduces his cost of carry to that extent. If dividend is going to be declared, the same
has to be deducted from the cost of carry
Thus the price of the future in this case becomes,
F= S (1+r-d) T
Where d is the dividend.
Example 2.3:
The spot price of Reliance is Rs 300. The bank rate prevailing is 10%. What will be the price of one-month future? Reliance will be
paying a dividend of 50 paise per share
Solution:
Since Reliance is paying 50 paise per share and the face value of reliance is Rs 10, the dividend rate is 5%.
So while calculating futures,
F=300(1+0.10-0.05) (1/12)
F= Rs. 301.22

What happens if dividend is declared after buying a future?

If the dividend is declared after buying a one month future, the cost of carry will be reduced by a pro rata amount. For example, if
there is a one month future ending June 30th and dividend is declared on June 15th, then dividend benefit will be reduced from the
cost of carry for 15 days. Since the seller is holding the shares and will transfer the shares to the buyer only after a month, the dividend
benefit goes to the seller. The seller will enjoy the benefit to the extent of interest on dividend.
Thus net cost of carry = cost of carry – dividend benefits

Example 2.4:
The spot price of Reliance is Rs 300. The bank rate prevailing is 10%. Reliance declares a dividend of 5%. What will be the price of
one-month future?
Solution:
The benefit accrued due to the dividend will be reduced from the cost of the future. One month future will be priced at
F= 300(1+0.10) (1/12)
F = 302.39
Cost of Carry= Rs 302.39-Rs 300 = Rs 2.39
The interest benefit of the dividend is available for 15 days, ie 0.5 months. Dividend for 15 days = 300(1+0.05) (0.5/12)
Dividend Benefit = Rs300.61- Rs 300= Rs0.61
Therefore, net cost of the carry is,
Rs2.39-Rs0.61 = Rs 1.78
Therefore the price of the future is Rs 300+Rs 1.78 = Rs 301.78
In practice, the market discounts the dividend and the prices are automatically adjusted. The exchange steps into the picture if the
dividend declared is more than 10 % of the market price. In such cases, there is an official change in the price. In other cases, the
market does the adjustment on its own.

What happens in case a bonus/ stock split is declared on the stock in which I have a futures position?
If a bonus is declared, the settlement price is adjusted to reflect the bonus. For example, if you have 200 Reliance at Rs 300 and there
is a 1:1 bonus, then the position becomes 400 Reliance at Rs 150 so that the contract value is unaffected.

But is the Future really traded in this way in the market?

What has been discussed above is the theoretical way of arriving at the future price. This can be used as a base for calculation future
price But the actual market price that we see on the trading screen depends on liquidity too. So the prices that we observe in real world
are also a function of demand-supply position in that stock.

How do future prices behave compared to spot prices?

Future prices lead the spot prices. The spot prices move towards the future prices and the gap between the two is always closing with
as the time to settlement decreases. On the last day of the future settlement, the spot price equals the future price.

Is the futures price always higher than the spot price?

The futures price can be lower than the spot price too. This depends on the fundamentals of the stock. If the stock is not expected to
perform well and the market takes a bearish view on them, then the futures price can be lower than the spot price.
Future prices can fall also due to declaration of dividend.

What happens in case of index futures?

In case of index futures, the treatment of the futures calculation is the same. The future value is calculated as the spot index value plus
the cost of carry.

What happens if I buy an index future and there is a dividend declared on a stock that comprises the index?
Practically speaking, the index is corrected for these things in case there is a dividend declared for such a stock. Theoretically,
dividend is adjusted in the following manner:
1.The contribution of the stock to the index is calculated. The index, as discussed earlier, is a market capitalization index.
2. Then the number of shares in the index is calculated. This is obtained by dividing the contribution to the index by the market price.
3. The dividend on the index is the dividend on the number of shares of the stock in the index.
4. The interest earned on the dividend is calculated and reduced from the cost of carry to obtain the net cost of carry.
Example 2.5:
The index is at 1000. There is a dividend of Rs 5 per share on HLL. HLL contributes to 15 % of the index. The market price of HLL is
Rs 150. What will be the cost of the 1 month future if the bank rate is 10%?
Solution:
The future will be priced at
F= 1000(1+0.10)(1/12)
F= 1008
The weight of HLL in the index is 15% ie 0.15*1000=150.
The market price of HLL is Rs 150. Therefore, the number of shares of HLL in the index=1
The dividend earned on this is Rs 5
Dividend benefit on Rs 5 is 5(1+0.10) (1/12)
Dividend benefit = Rs 0.04
Cost of the future will be Rs 1008-Rs 0.05= Rs 1007.95
But in practice, the market discounts the dividends and price adjustment is made accordingly.

All that is okay in theory, but what happens in the real world?
In the real world, derivatives are highly volatile instruments and there have been lot of losses in the various financial markets. The
classic examples have been Long Term Capital Markets (LTCM) and Barings. We will examine what happened exactly at various
places later in the book.
As a result, the regulators have decided that a minimum of Rs 2 lacs should be the contract size. This is done primarily to keep the
small investors away from a volatile market till enough experience and understanding of the markets is acquired. So the initial players
are institutions and high net worth individuals who have a risk taking capacity in these markets. Because of this minimum amount, lots
are decided on the market price such that the value is Rs 2 lacs. As a result one has to buy a minimum of 200 Nifties or in case of
Sensex, 50.

Similarly minimum lots are decided for individual stocks too. Thus you will find different stock futures having different market lots.
The lots decided for each stock was such that the contract value was Rs 2 lacs. This was at the point of introduction of these
instruments. However the lot size has remained the same and has not been adjusted for the price changes. Hence the value of the
contract may be slightly lower in case of certain stocks. Trading, i.e. Buying and Selling take place in the same manner as the stock
markets. There will be an F & O terminal with the broker and the dealer will enter the orders for you. Another fact of the real world is
that, since the future is a standard instrument, you can close out your position at any point of time and need not hold till maturity.

How is the trading done on the exchange?

Buying of futures is margin based. You pay an up front margin and take a position in the stock of your choice. Your daily losses/ gains
relative to the future price will be monitored and you will have to pay a mark to market margin. On the final day settlement is made in
cash and is the difference between the futures price and the spot price prevailing at that time
For example, if the future price is Rs 300 and the spot price is Rs 330, then you will make a cash profit of Rs 30. In case the spot price
is Rs 290, you make a cash loss of Rs 10. Thus futures market is a cash market.
In future, there is a possibility that the futures may result in delivery. In such a scenario, the future market will be merged with the spot
market on the expiration day and it will follow the T+ 3 rolling settlement prevalent in the stock markets

How does the mark to market mechanism work?

Mark to market is a mechanism devised by the stock exchange to minimize risk. In case you start making losses in your position,
exchange collects money to the extent of the losses up front. For example, if you buy futures at Rs 300 and its price falls to Rs 295
then you have to pay a mark to market margin of Rs 5. This is over and above the margin money that you pay to take a position in the
future.

3. Options
What are options?
As seen earlier, futures are derivative instruments where one can take a position for an asset to be delivered at a future date. But there
is also an obligation as the seller has to make delivery and buyer has to take delivery.
Options are one better than futures. In option, as the name indicates, gives one party the option to take or make delivery. But this
option is given to only one party in the transaction while the other party has an obligation to take or make delivery. The asset can be a
stock, bond, index, currency or a commodity But since the other party has an obligation and a risk associated with making good the
obligation, he receives a payment for that. This payment is called as premium.
The party that had the option or the right to buy/sell enjoys low risk. The cost of this low risk is the premium amount that is paid to the
other party. Thus we have seen an option is a derivative that gives one party a right and the other party an obligation to buy /sell at a
specified price for a specified quantity.
The buyer of the right is called the option holder. The seller of the right (and buyer of the obligation) is called the option writer. The
cost of this transaction is the premium.
For example, a railway ticket is an option in daily life. Using the ticket, a passenger has an option to travel. In case he decides not to
travel, he can cancel the ticket and get a refund. But he has to pay a cancellation fee, which is analogous to the premium paid in an
option contract. The railways, on the other hand, have an obligation to carry the passenger if he decides to travel and refund his money
if he decides not to travel. In case the passenger decides to travel, the railways get the ticket fare. In case he does not, they get the
cancellation fee.
The passenger on the other hand, by booking a ticket, has hedged his position in case he has to travel as anticipated. In case the travel
does not materialize, he can get out of the position by canceling the ticket at a cost, which is the cancellation fee.

But I hear a lot of jargons about options? What are all these jargons?
There are some basic terminologies used in options. These are universal terminologies and mean the same everywhere.
a. Option holder: The buyer of the option who gets the right
b. Option writer: The seller of the option who carries the obligation
c. Premium: The consideration paid by the buyer for the right
d. Exercise price: The price at which the option holder has the right to buy or sell. It is also called as the strike price.
e. Call option: The option that gives the holder a right to buy
f. Put option: The option that gives the holder a right to sell
g. Tenure: The period for which the option is issued
h. Expiration date: The date on which the option is to be settled
i. American option: These are options that can be exercised at any point till the expiration date
j. European option: These are options that can be exercised only on the expiration date
k. Covered option: An option that an option writer sells when he has the underlying shares with him.
l. Naked option: An option that an option writer sells when he does not have the underlying shares with him
m. In the money: An option is in the money if the option holder is making a profit if the option was exercised immediately
n. Out of money: An option is in the money if the option holder is making a loss if the option was exercised immediately
o. At the money: An option is in the money if the option holder evens out if the option was exercised immediately

How is money made in an option?

The money made in an option is called as the option pay off. There can be two pay off for options, for put and call option

Call option:
A call option gives the holder a right to buy shares. The option holder will make money if the spot price is higher than the strike price.
The pay off assumes that the option holder will buy at the strike price and sell immediately at the spot price. But if the spot price is
lower than the strike, the option holder can simply ignore the option. It will be cheaper to buy from the market. The option holder loss
is to the extent of premium he has paid.
But if the spot price increases dramatically then he can make wind fall profits. Thus the profits for an option holder in a call option is
unlimited while losses are capped to the extent of the premium.
Conversely, for the writer, the maximum profit he can make is the premium amount. But the losses he can make are unlimited.

Put option
The put option gives the right to sell. The option holder will make money if the spot price is lower than the strike price. The pay off
assumes that the option holder will buy at spot price and sell at the strike price, But if the spot price is higher than the strike, the
option holder can simply ignore the option. It will be beneficial to sell to the market. The option holder loss is to the extent of
premium he has paid. But if the spot prices fall dramatically then he can make wind fall profits. Thus the profit for an option holder in
a put option is unlimited while losses are capped to the extent of the premium. This is a theoretical fallacy as the maximum fall a stock
can have is till zero, and hence the profit of a option holder in a put option is capped.
Conversely, the maximum profit that an option writer can make in this case is the premium amount. But in the above pay off, we had
ignored certain costs like premium and brokerage. These are also important, especially the premium.
So, in a call option for the option holder to make money, the spot price has to be more than the strike price plus the premium amount.
If the spot is more than the strike price but less than the sum of strike price and premium, the option holder can minimize losses but
cannot make profits by exercising the option. Similarly, for a put option, the option holder makes money if spot is less than the strike
price less the premium amount.
If the spot is less than the strike price but more than the strike price less premium, the option holder can minimize losses but cannot
make profits by exercising the option.
Example 3.1:
The call option for Reliance is selling at Rs 10 for a strike price of Rs 330. What will be the profit for the option holder if the spot
price touches a) Rs. 350 b)337
Solution
a. The option holder can buy Reliance at a price of Rs 330. He has also paid a premium of Rs 10 for the same. So his cost of a share of
Reliance is Rs 340. He can sell the same in the spot market for Rs 350. He makes a profit of Rs 10
b. The option holder can buy Reliance at a price of Rs 330. He has also paid a premium of Rs 10 for the same. So his cost of a share of
Reliance is Rs 340. He can sell the same in the spot market for Rs 337
He makes a loss of Rs 3.
But he has reduced his losses by exercising the option. Had he not exercised the option, he would have made a loss of Rs 10, which is
the premium that he paid for the option.

But should one always buy an option? The buyer seems to enjoy all advantages, then why should one write an option?
This is not always the case. The writer of the option too can make money. Basically, the option writers and option holders are people
who are taking a divergent view on the market. So if the option writer feels the markets will be bearish, he can write call options and
pocket the premium. In case the market falls, the option holder will not exercise the option and the entire premium amount can be a
profit But if the option writer is bullish on the market, then he can write put options. In case the market goes up, the option holder will
not exercise the option and the premium amount is a profit for the option writer.
The other area that an option writer makes money is the spot price lying in the range between the strike price and the strike plus
premium For example, if you write a call option on Reliance for a strike price of Rs 300 at a premium of Rs 30. If the spot price is Rs
320, then the option holder will exercise the option to reduce losses and buy it at Rs 300. But you have already got the premium of Rs
30. So in effect, you have sold the stock at Rs. 330, which is Rs 10 above the spot price! This profit increases even more if you
calculate the opportunity cost of Rs 30 as this amount is received up front.
Let us look at a typical pay off table for a call option, for the buyer as well as writer. Let us assume a call option with a strike price of
Rs 200 and a premium of Rs 10
Table 3.1: Pay off Table for buyer and writer of an option
Spot Price Whether Buyer’sgain/loss Writergain/loss Net
Exercised
180 No -10 +10 0
190 No -10 +10 0
195 No -10 +10 0
200(=Strike rice) Yes/No -10 +10 0
205 Yes -5 +5 0
210 Yes 0 0 0
220 Yes +10 -10 0

In the above pay off table, if we take 200 as the median value, we see that the writer has made money 5 out of 7 occasions. He has
made money even when the option is exercised, as long as the spot price is below the strike price plus the premium. Thus writers also
make money on options, as the buyer is not at an advantage all the time.

What are the options that are currently traded in the market?
The options that are currently traded in the market are index options and stock options on the 30 stocks. The index options are
European options. They are settled on the last day. The stock options are American options.
There are 3 options-1, 2,3 month options. There can be a series of option within the above time span at different strike prices.
Another lingo in option is Near and Far options. A near option means the option is closer to expiration date. A Far option means the
option is farther from expiration date. A 1 month option is a near option while a 3 month option is a far option.
In option trading, what gets quoted in the exchange is the premium and all that people buy and sell is the premium.

We said we could have different option series at various strike prices. How is this strike price arrived at?
The strike price bands are specified by the exchange. This band is dependent on the market price.
. .
Market Price Rs Strike Price Intervals Rs
<50 2.5
50-150 5
150-250 10
250-500 20
500-1000 30
>1000 50

Thus if a stock is trading at Rs. 100 then there can be options with strike price of Rs 105,110,115, 95, 90 etc.

How is the premium of an option calculated?

In practice, it is the market that decides the premium at which an option is traded. There are mathematical models, which are used to
calculate the premium of an option. The simplest tool is the expected value concept. For example, for a stock that is quoting at Rs 95.
There is a 20 % probability that it will become Rs 110. There is a 30 % probability that it will become Rs 105. There is 30%
probability that the stock will remain at Rs.95 and a 20 % probability that it will fall to Rs 90.
If the strike price of a call option is to be Rs 100, then the option will have value when the spot goes to Rs 105 or Rs 110. It will be
un-exercised at Rs 95 and Rs 90.
If it is Rs105 and Rs 110, the money made is Rs 10 and 15 respectively. The expected returns for the above distribution is
0.20*15+0.30*10=Rs 6.
Thus this the price that one can pay as a premium for a strike price of Rs 100 for a stock trading at Rs 95. Rs 6 will also be the price
for the seller for giving the option holder this opportunity. This is a very simple thumb calculation. Even then, one would require a lot
of background data like variances and expected price movements.
There are more advanced probabilistic models like the Black Scholes model and the Binomial Pricing model that calculates the
options. One need not go deep into those and it would suffice to say that option calculators are readily available.

I keep reading about option Greeks? What are they? They actually sound like Greek and Latin to me.
There are something called as option Greeks but they are nothing to be scared of. The option Greeks help in tracking the volatility of
option prices.
The option Greeks are
a. Delta: Delta measures the change in option price (the premium) to the change in underlying. A delta of 0.5 means if the
underlying changes by 100 % the option price changes by 50 %.
b. Theta: It measures the change in option price to change in time
c. Rho: It is the change in option price to change in interest rate
d. Vega: It is the change in option price to change in variance of the underlying stock
e. Gamma: It is the change in delta to the change in the underlying. It is a double derivative (the mathematical one) of the
option price with respect to underlying. It gives the rate of change of delta.
a. These are just technical tools used by the market players to analyze options and the movement of the option prices.

We saw that the stock options are American options and hence can be exercised any time. What happens when one decided to
exercise the option?
When the option holder decides to exercise the option, the option will be assigned to the option writer on a random basis, as decided
by the software of the exchange. The European options are also the similarly decided by the software of the exchange. The index
options are European options. In future, there is a possibility that the options may result in delivery. In such a scenario, the option
market will be merged with the spot market on the expiration day and it will follow the T+ 3 rolling settlement prevalent in the stock
markets

4. Trading Strategies using Futures and Options

So far, we have seen a lot of theoretical stuff on derivatives. But how is it going to help me in practice?
There are a lot of practical uses of derivatives. As we have seen, derivatives can be used for profits and hedging. We can use
derivatives as a leverage tool too.

How do I use derivatives as a leverage?

You can use the derivatives market to raise funds using your stocks. Conversely, you can also lend funds against stocks.

Does that mean derivatives are badla revisited?

The derivative product that comes closest to Badla is futures. Futures is not badla, though a lot of people confuse it with badla. The
fundamental difference is badla consisted of contango and backwardation (undha badla and vyaj badla) in the same market. Futures is
a different market segment altogether. Hence derivatives is not the same as badla, though it is similar.

How do I raise funds from the derivatives market?

This is fairly simple. Say, you have Infosys, which is trading at Rs 3000. You have shares lying with you and are in urgent need of
liquidity. Instead of pledging your shares and borrowing from banks at a margin, you can sell the stock at Rs 3000. Suppose you need
this liquidity only for a month and also do not want to
part with Infosys. You can buy a 1 month future at Rs 3050. After a month you get back your Infosys at the cost of an additional Rs
50. This Rs 50 is the financing cost for the liquidity. The other beauty about this is you have already locked in your purchase cost at
Rs 3050. This fixes your liquidity cost also and you are protected against further price losses.

How do I lend into the market?

The lending into the market is exactly the reverse of borrowing. You have money to lend. You can buy a stock and sell its future. Say,
you buy Infosys at Rs 3000 and sell a 1 month future at Rs 3100. In effect what you have done is lent Rs 3000 to the market for a
month and earned Rs 100 on it.

Suppose I don’t want to lend/borrow money. I want to speculate and make profits?
When you speculate, you normally take a view on the market, either bullish or bearish. When you take a bullish view on the market,
you can always sell futures and buy in the spot market. If you take a bearish view on the market, you can buy futures and sell in the
spot market.
Similarly, in the options market, if you are bullish, you should buy call options. If you are bearish, you should buy put options
Conversely, if you are bullish, you should write put options. This is so because, in a bull market, there are lower chances of the put
option being exercised and you can profit from the premium
If you are bearish, you should write call options. This is so because, in a bear market, there are lower chances of the call option being
exercised and you can profit from the premium

How can I arbitrage and make money in derivatives?

Arbitrage is making money on price differentials in different markets. For example, future is nothing but the future value of the spot
price. This future value is obtained by factoring the interest rate. But if there are differences in the money market and the interest rates
change then the future price should correct itself to factor the change in interest. But if there is no factoring of this change then it
presents an opportunity to make money- an arbitrage opportunity.

Let us take an example.

Example 4.1:
A stock is quoting for Rs 1000. The 1-month future of this stock is at Rs 1005. The risk free interest rate is 12%. What should be the
trading strategy?
Solution:
The strategy for trading should be : Sell Spot and Buy Futures
Sell the stock for Rs 1000. Buy the future at Rs 1005.
Invest the Rs1000 at 12 %. The interest earned on this stock will be
1000(1+.012)(1/12)
=1009
So net gain the above strategy is Rs 1009- Rs 1005 = Rs 4
Thus one can make a risk less profit of Rs 4 because of arbitrage
But an important point is that this opportunity was available due to mis-pricing and the market not correcting itself. Normally, the time
taken for the market to adjust to corrections is very less. So the time available for arbitrage is also less.
As everyone rushes to cash in on the arbitrage, the market corrects itself.

How is a future useful for me to hedge my position?

One can hedge one’s position by taking an opposite position in the futures market. For example, If you are buying in the spot price,
the risk you carry is that of prices falling in the future. You can lock this by selling in the futures price. Even if the stock continues
falling, your position is hedged as you have firmed the price at which you are selling. Similarly, you want to buy a stock at a later date
but face the risk of prices rising.
You can hedge against this rise by buying futures.
You can use a combination of futures too to hedge yourself. There is always a correlation between the index and individual stocks.
This correlation may be negative or positive, but there is a correlation. This is given by the beta of the stock.
In simple terms, what b (Beta) indicates is the change in the price of a stock to the change in index. For example, if b of a stock is 0.8,
it means that if the index goes up by 10, the price of the stock goes up by 8. It will also fall by a similar level when the index falls.
A negative b means that the price of the stock falls when the index rises. So, if you have a position in a stock, you can hedge the same
by buying the index at b times the value of the stock.
Example 4.2:
The b of HPCL is 0.8. The Nifty is at 1000 . If I have Rs 10000 worth of HPCL, I can hedge my position by selling 8000 of Nifty. Ie I
will sell 8 Nifties.
Scenario 1
If index rises by 10 %, the value of the index becomes 8800 ie a loss of Rs 800 The value of my stock however goes up by 8 % ie it
becomes Rs 10800 ie a gain of Rs 800.
Thus my net position is zero and I am perfectly hedged.
Scenario 2
If index falls by 10 %, the value of the index becomes Rs 7200 a gain of Rs 800 But the value of the stock also falls by 8 %. The value
of this stock becomes Rs 9200 a loss of Rs 800.
Thus my net position is zero and I am perfectly hedged.
But again, b is a predicted value based on regression models. Regression is nothing but analysis of past data. So there is a chance that
the above position may not be fully hedged if the b does not behave as per the predicted value.

How do I use options in my trading strategy?

Options are a great tool to use for trading. If you feel the market will go up. You should buy a call option at a level lower than what
you expect the market to go up.
If you think that the market will fall, you should buy a put option at a level higher than the level to which you expect the market fall.
When we say market, we mean the index. The same strategy can be used for individual stocks also.
A combination of futures and options can be used too, to make profits.

We have seen that the risk for an option holder is the premium amount. But what should be the strategy for an option writer
to cover himself?
An option writer can use a combination strategy of futures and options to protect his position. The risk for an option writer arises only
when the option is exercised. This will be very clear with an example.
Suppose I sell a call option on Reliance at a strike price of Rs 300 for a premium of Rs 20. The risk arises only when the option is
exercised. The option will be exercised when the price exceeds Rs 300. I start making a loss only after the price exceeds Rs 320(Strike
price plus premium). More importantly, I have to deliver the stock to the opposite party. So to enable me to deliver the stock to the
other party and also make entire profit on premium, I buy a future of Reliance at Rs 300.
This is just one leg of the risk. The earlier risk was of the call being exercised. The risk now is that of the call not being exercised. In
case the call is not exercised, what do I do? I will have to take delivery as I have bought a future. So minimize this risk, I buy a put
option on Reliance at Rs 300. But I also need to pay a premium for buying the option. I pay a premium of Rs 10.Now I am fully
covered and my net cash flow would be:
Premium earned from selling call option : Rs 20
Premium paid to buy put option : (Rs 10)
Net cash flow : Rs 10
But the above pay off will be possible only when the premium I am paying for the put option is lower than the premium that I get for
writing the call. Similarly, we can arrive at a covered position for writing a put option too, Another interesting observation is that the
above strategy in itself presents an opportunity to make money. This is so because of the premium differential in the put and the call
option. So if one tracks the derivative markets on a continuous basis, one can chance upon almost risk less money making
opportunities.

What are the other strategies using derivatives?

The other strategies are also various permutations of multiple puts, calls and futures. They are also called by exotic names , but if one
were to observe them closely, they are relatively simple instruments.
Some of these instruments are:
· Butter fly spread: It is the strategy of simultaneous buying of put and call
· Calendar Spread - An option strategy in which a short-term option is sold and a longer-term option is bought both having the same
striking price. Either puts or calls may be used.
· Double option – An option that gives the buyer the right to buy and/or sell a futures contract, at a premium, at the strike price
· Straddle – The simultaneous purchase and sale of option of the same specification to different periods.
· Tandem Options – A sequence of options of the same type, with variable strike price and period.
· Bermuda Option – Like the location of the Bermudas, this option is located somewhere between a European style option which can
be exercised only at maturity and an American style option which can be exercised any time the option holder chooses. This option
can be exercisable only on predetermined dates

5. SETTLEMENT OF DERIVATIVES

How are futures settled on the stock exchange?

Mark to market settlement

There is a daily settlement for Mark to Market .The profits/ losses are computed as the difference between the trade price or the
previous day’s settlement price, as the case may be, and the current day’s settlement price. The party who have suffered a loss are
required to pay the mark-to-market loss amount to exchange which is in turn passed on to the party who has made a profit. This is
known as daily mark-to-market settlement.
Theoretical daily settlement price for unexpired futures contracts, which are not traded during the last half an hour on a day, is
currently the price computed as per the formula detailed below:
F = S * e rt
where :
F = theoretical futures price
S = value of the underlying index/ stock
r = rate of interest (MIBOR- Mumbai Inter bank Offer Rate)
t = time to expiration
Rate of interest may be the relevant MIBOR rate or such other rate as may be specified.
After daily settlement, all the open positions are reset to the daily settlement price.
The pay-in and pay-out of the mark-to-market settlement is on T+1 days ( T = Trade day). The mark to market losses or profits are
directly debited or credited to the broker account from where the broker passes to the client account

Final Settlement
On the expiry of the futures contracts, exchange marks all positions to the final settlement price and the resulting profit / loss is settled
in cash.The final settlement of the futures contracts is similar to the daily settlement process except for the method of computation of
final settlement price. The final settlement profit / loss is computed as the difference between trade price or the previous day’s
settlement price, as the case may be, and the final settlement price of the relevant futures contract. Final settlement loss/ profit amount
is debited/ credited to the relevant broker’s clearing bank account on T+1 day (T= expiry day). This is then passed on the client from
the broker. Open positions in futures contracts cease to exist after their expiration day

How are options settled on the stock exchange?

Daily Premium Settlement

Premium settlement is cash settled and settlement style is premium style. The premium payable position and premium receivable
positions are netted across all option contracts for each broker at the client level to determine the net premium payable or receivable
amount, at the end of each day.
The brokers who have a premium payable position are required to pay the premium amount to exchange which is in turn passed on to
the members who have a premium receivable position. This is known as daily premium settlement.
The brokers in turn would take this from their clients.
The pay-in and pay-out of the premium settlement is on T+1 days ( T = Trade day). The premium payable amount and premium
receivable amount are directly debited or credited to the broker, from where it is passed on to the client.

Interim Exercise Settlement for Options on Individual Securities

Interim exercise settlement for Option contracts on Individual Securities is effected for valid exercised option positions at in-the-
money strike prices, at the close of the trading hours, on the day of exercise. Valid exercised option contracts are assigned to short
positions in option contracts with the same series,
on a random basis. The interim exercise settlement value is the difference between the strike price and the settlement price of the
relevant option contract. Exercise settlement value is debited/ credited to the relevant broker account on T+3 day (T= exercise date).
From there it is passed on to the clients.

Final Exercise Settlement

Final Exercise settlement is effected for option positions at in-the-money strike prices existing at the close of trading hours, on the
expiration day of an option contract. Long positions at in-the money strike prices are automatically assigned to short positions in
option contracts with the same series, on a random basis.
For index options contracts, exercise style is European style, while for options contracts on individual securities, exercise style is
American style. Final Exercise is Automatic on expiry of the option contracts.
Exercise settlement is cash settled by debiting/ crediting of the clearing accounts of the relevant broker with the respective Clearing
Bank, from where it is passed to the client.
Final settlement loss/ profit amount for option contracts on Index is debited/ credited to the relevant broker clearing bank account on
T+1 day (T = expiry day), from where it is passed
Final settlement loss/ profit amount for option contracts on Individual Securities is debited/ credited to the relevant broker clearing
bank account on T+3 day (T = expiry day), from where it is passed.
Open positions, in option contracts, cease to exist after their expiration day.