Dissertation

Research work On Analytical studies of various derivatives trading strategies

SUBMITTED BY: Sunil Patidar (Specialization: Finance)

SUBMITTED TO: Prof. Milind Patil

INSTITUTE OF PROFESSIONAL EDUCATION & RESEARCH

May June, 2011

ACKNOWLEDGEMENT

I would like to express my sincere gratitude to my project guide Prof. Milind Patil for his guidance, suggestions & help during the entire period of my project work, without which the feasibility of this project was impossible.

I am also thankful to my parents for providing me all the courage & support needed for the completion of my project.

I would like to thank my entire faculty & friends who were directly or indirectly involved in this study, for their support, assistance & encouragement.

SUNIL PATIDAR PGDM 3RD TRIM

CONTENTS CHAPTERS NATURE PAGE NUMBER

Chapter 1 Conceptual Overview Chapter 2 Research Methodology 10 5

2.1- Objective of Study 2.2- Methodology 2.3- Significance 2.4- Limitation

Chapter 3 Theoretical Background 13

Chapter 4 Data Analysis 21

Chapter 5

Findings

69

References

54

Chapter-1: Conceptual Overview

Definition A derivative security is a financial contract whose value is derived from the value of something else such as a stock price, a commodity price, an exchange rate, an interest rate, or even an index of prices. Derivatives may be traded for a variety of reasons. A derivative enables a trader to hedge some preexisting risk by taking positions in derivatives markets that offset potential losses in the underlying or spot market. In India, most derivatives users describe themselves as hedgers and Indian laws generally require that derivatives be used for hedging purposes only. Another motive for derivatives trading is speculation. In practice, it may be difficult to distinguish whether a particular trade was for hedging or speculation and active markets require the participation of both hedgers and speculators. A third type of trader, called arbitrageurs, profit from discrepancies in the relationship of spot and derivatives prices, and thereby help to keep markets efficient. Indias tryst with equity derivatives began in the year 2000 on the NSE and BSE. Trading first commenced in Index futures contracts, followed by index options in June 2001, options in individual stocks in July 2001 and futures in single stock derivatives in November 2001. Since then, equity derivatives have come a long way. New products; expanding list of eligible investors; rising volumes and best of risk management framework for exchange traded derivatives have been the hallmark of the journey of equity derivatives so far .Indias
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experience with the launch of equity derivatives market has been extremely positive. The derivatives turnover on the NSE has surpassed the equity market turnover. The turnover of derivatives on the NSE increased from Rs. 23,654million (US $ 207 million) in 2000-01 to Rs. 110,104,821 million (US $ 2,161 bn) in 2008-09. The average daily turnover in this segment of the markets on the NSE was Rs. 453,106 mn in 2008-09.India is one of the most successful developing countries in terms of a vibrant market for exchange-traded derivatives. This reiterates the strengths of the modern development of Indias securities markets, which are based on nationwide market access, anonymous electronic trading, and a predominantly retail market. There is an increasing sense that the equity derivatives market is playing a major role in shaping price discovery. DERIVATIVE MARKET WORLD SCENARIO 2008-09 was a turbulent year for the derivatives markets following the events surrounding the Lehman Brothers bankruptcy and its after effects seen throughout the global financial world. Despite all the turbulence, the overall growth trend in Futures and Options was still positive. The total number of futures and options contracts traded on the 69 exchanges tracked by the Futures Industry Association was USD 17.65 billion during January to December 2008, an increase of 13.69% over 2007. Volume in the U.S., the epicenter of the credit crisis, rose 14% from 2007 and in Europe and Asia by 16%. Looking at global trends in derivatives volume by category, Equity futures and options, both index and single stock and commodity products were the most powerful drivers of increase in volumes of exchange traded derivative contracts in 2008. The trading in foreign currency derivatives grew at 25.5% in 2008. However, with the credit crisis the trading of interest rate products was greatly reduced. On a global basis, interest rate volumes went down by 14.4% relative to 2007, the first time in many years the markets have had such a big setback. Long-term interest rate futures were especially hard hit. Ten-year Treasury futures trading tumbled 26.5% from 2007. Euro bund futures fell 23.8%; and JGB futures slid 21.5%. Short-term interest rate products were mixed, with Euribor futures up slightly, Eurodollar futures down slightly, and Euroyen futures way down by 42.6%. GLOBAL Equity Indices Individual Equities Interest Rate Agricultural Energies Currency Precious Metals Non-precious metals Others Jan-Dec 2009 6,488.62 5,511.19 3,204.84 888.83 580.4 577.16 180.37 175.79 45.5 Jan-Dec 2010 5,499.83 4,400.44 3,745.18 640.68 496.77 459.75 150.98 106.86 26.14 (%) Change 17.98 25.24 -14.43 38.73 16.83 25.54 19.47 64.5 74.06

Total Volume

17,652.70

15,526.63

13.69

DERIVATIVE MARKET INDIA India had started with a controlled economic system and from there it moved on to become a destination that witnesses constant fluctuation in prices on a daily basis now. Persistent efforts of Reserve Bank of India (RBI) in building currency forward market and liberalization process provided the risk management agencies their much needed momentum. Derivatives are the indispensable components of liberalization process to handle risk. With National Stock Exchange (NSE) measuring the market demands, the process of launching derivative markets in India got started. In the year 1999, derivatives trading took place in India. Indian derivatives markets can be divided into two types including 1) The transaction which depends on the exchange, and 2) The transaction which takes place 'over the counter' in one-to-one scenario. They can thus be referred to as:

Exchange Traded Derivatives Over the Counter (OTC) Derivatives Over the Counter (OTC) Equity Derivatives Operators in the Derivatives Market

There are different kinds of traders in the derivatives market. These include:

Hedgers-traders who are interested in transferring a risk element of their portfolio. Speculators-traders who deliberately go for risk components from hedgers in look out for profit. Arbitrators-traders who work in various markets at the same time in order to gain profit and do away with mis-pricing.

In terms of the growth of derivatives markets, and the variety of derivatives users, the Indian market has equaled or exceeded many other regional markets.13 While the growth is being spearheaded mainly by retail investors, private sector institutions and large corporations, smaller companies and state-owned institutions are gradually getting into the act. Foreign brokers such as JP Morgan Chase are boosting their presence in India in reaction to the growth in derivatives. The variety of derivatives instruments available for trading is also expanding. There
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remain major areas of concern for Indian derivatives users. Large gaps exist in the range of derivatives products that are traded actively. In equity derivatives, NSE figures show that almost 90% of activity is due to stock futures or index futures, whereas trading in options is limited to a few stocks, partly because they are settled in cash and not the underlying stocks. Exchangetraded derivatives based on interest rates and currencies are virtually absent. Liquidity and transparency are important properties of any developed market. Liquid markets require market makers who are willing to buy and sell, and be patient while doing so. In India, market making is primarily the province of Indian private and foreign banks, with public sector banks lagging in this area a lack of market liquidity may be responsible for inadequate trading in some markets. Transparency is achieved partly through financial disclosure. Financial statements currently provide misleading information on institutions use of derivatives. Further, there is no consistent method of accounting for gains and losses from derivatives trading. Thus, a proper framework to account for derivatives needs to be developed. Further regulatory reform will help the markets grow faster. For example, Indian commodity derivatives have great growth potential but government policies have resulted in the underlying spot/physical market being fragmented (e.g. due to lack of free movement of commodities and differential taxation within India). Similarly, credit derivatives, the fastest growing segment of the market globally, are absent in India and require regulatory action if they are to develop. As Indian derivatives markets grow more sophisticated, greater investor awareness will become essential. NSE has programmers to inform and educate brokers, dealers, traders, and market personnel. In addition, institutions will need to devote more resources to develop the business processes and technology necessary for derivatives trading. Jan-Dec 2009 Jan-Dec 2010

Chapter-2 Research Methodology

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Objective: To study the various trading strategy used in derivatives market.

Compare there returns over a period of five year and see which strategy has given maximum returns.

Sample size: A sample of data will be taken from the NSE and the time horizon of the data will be five year. Various tactical tools will be applied on the data to get the result.

Methodology: The present study is purely an exploratory study, dependent on the Secondary sources of data. Various derivatives strategies like covered call writing, protective put, straddle, Strangle, strips, straps etc. will be applied on the actual market conduction and will try to find which trading strategy has given maximum return in the given period of time. First, we will give a brief on each derivatives trading strategy then we will apply those strategy on the five years data taken from NSE.

Significance Give a deep understanding about various derivatives trading strategies. Help us study practical usage of derivatives trading strategies.

Help us to study which trading strategy has given better return over the period of five years so that we can apply it to various market conductions like 1. 2. 3. Bullish market Bearish market Neutral market

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Limitations Time period. Data size.

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CHAPTER 3 THEORETICAL BACKGROUND

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Derivatives are nothing but a kind of security whose price or value is determined by the value of the underlying variables. It is more like a contract of future date in which two or more parties are involved to alleviate future risk. Usually, derivatives enjoy high leverage. Its value is affected by the volatility in the rates of the underlying asset. Some of the widely known underlying assets are

Indexes (consumer price index (CPI), stock market index, weather conditions or inflation) Bonds Currencies Interest rates Exchange rates Commodities Stocks (equities)

Types of Derivatives The range of derivatives is really wide. But some of the most commonly known derivatives are: Forwards-This is a tailor-made contract between two parties. In case of this contract, a settlement is done on a scheduled future date at today's pre-decided rate. Futures-When two entities decide to purchase or sell an asset at a given time in the future at a given price, it is called futures contract. Futures contracts can be said to be a special kind of forward contracts, as they are customized exchange-traded agreements. Options-It is of two different kinds such as calls and puts. Those who take calls option, they are not obligated to purchase given quantity of the underlying variable, at a mentioned price on or prior to a scheduled future date. On the other hand, buyers in case of puts option may not necessarily sell a mentioned quantity of the underlying variable at a mentioned price on or prior to a given date. Swaps-These are private contracts between two entities to deal in cash flows in the future following a pre-decided formula. They are somewhat like forward contracts' portfolios. Swaps are also of two types such as interest rate swaps and currency swaps. Interest rate swaps-in this case, only interest related cash flows can be exchanged between the entities in one currency. Currency swaps-in this case of swapping, principal and interest can be exchanged in one currency for the same in other form of currency.

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Importance of Derivatives Financial transactions are fraught with several risk factors. Derivatives are instrumental in alienating those risk factors from traditional instruments and shifting risks to those entities that are ready to take them. Some of the basic risk components in derivatives business are:

Credit Risk: When one of the two parties fails to perform its role as per the agreement, this is called the credit risk. It can also be referred to as default or counterparty risk. It varies with different sources. Market Risk: This is a kind of financial loss that takes place due to the adverse price movements of the underlying variable or instrument. Liquidity Risk: When a firm is unable to devise a transaction at current market rates, it can be referred to as liquidity risk. There are two kinds of liquidity risks involved in the scenario. First is concerned with the liquidity of separate items and second is related to supporting the activities of the organization with funds comprising derivatives. Legal Risk:Legal issues related with the agreement need to be scrutinized well, as one can deal in derivatives across the different judicial boundaries.

Options Options on stocks were first traded on an organized stock exchange in 1973. Since then there has been extensive work on these instruments and manifold growth in the field has taken the world markets by storm. This financial innovation is present in cases of stocks, stock indices, foreign currencies, debt instruments, commodities, and futures contracts. An option gives the holder of the option the right to do something. The holder does not have to exercise this right. In contrast, in a forward or futures contract, the two parties have committed themselves to doing something. Whereas it costs nothing (except margin requirements) to enter into a futures contract, the purchase of an option requires an up-front payment OPTION TERMINOLOGY Index options: These options have the index as the underlying. Some options are European while others are American. Like index futures contracts, index options contracts are also cash settled. Stock options: Stock options are options on individual stoc ks. Option currently trade on over 500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified price. Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer.

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 Writer of an option: The writer of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him. There are two basic types of options, call options and put options. Call option: A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price. The Call option gives the buyer a right to buy the requisite shares on a specific date at a specific price. This puts the seller under the obligation to sell the shares on that specific date and specific price. The Call Buyer exercises his option only when he/ she feels it is profitable. This Process is called "Exercising the Option". This leads us to the fact that if the spot price is lower than the strike price then it might be profitable for the investor to buy the share in the open market and forgo the premium paid. The implications for a buyer are that it is his/her decision whether to exercise the option or not. In case the investor expects prices to rise far above the strike price in the future then he/she would surely be interested in buying call options. On the other hand, if the seller feels that his shares are not giving the desired returns and they are not going to perform any better in the future, a premium can be charged and returns from selling the call option can be used to make up for the desired returns. At the end of the options contract there is an exchange of the underlying asset. In the real world, most of the deals are closed with another counter or reverse deal. There is no requirement to exchange the underlying assets then as the investor gets out of the contract just before its expiry.

Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price. Option price/premium: Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium. Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity. Strike price: The price specified in the options contract is known as th strike price or the exercise price. American options: American options are options that can be exercised a any time upto the expiration date. Most exchange-traded options are American. European options: European options are options that can be exercised only on the expiration date itself. European options are easier to analyze than American options, and properties of an American option are frequently deduced from those of its European counterpart. In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cashflow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price

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(i.e. spot price >strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price. At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cashflow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price(i.e. spot price = strike price). Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cashflow if it were exercised immediately. A call option on the index is out-ofthe-money when the current index stands at a level which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price. Intrinsic value of an option: The option premium can be broken down into two components intrinsic value and time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it another way, the intrinsic value of a call is Max[0, (St K)] which means the intrinsic value of a call is the greater of 0 or (St K). Similarly, the intrinsic value of a put is Max[0, K St],i.e. the greater of 0 or (K St). K is the strike price and St is the spot price. Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an option's time value, all else equal. At expiration, an option should have no time value.

Options strategies Basic Bullish Options Strategies: Long Call Options Buying call options, or also known as Long Call Options or simply Long Call, is the simplest bullish option strategy ever and is a great starting point for beginner option traders. Buying call options / Long Call Options offers the protection of limited downside loss with the benefit of leveraged gains. When applied correctly, it allows even beginner option traders to consistently make more profits than losses. Buying call options / Long Call Options also allows you to transform the position into more exotic option strategies like the Bull Call Spread in order to hedge against risk at any point before expiration. That makes Buying Call Options / Long Call Options an extremely versatile option strategy in the correct hands. Buying Call Options / Long Call Options is in reality, a leveraged way of trading the underlying stock for much more profits on the same move in the stock. One should be familiar with call options before executing this strategy.

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Naked Put Write: Naked Put Write is sometimes known as a Put Write, Naked Put, Write Put Options, Short Put, Uncovered Put Write, Selling Naked Puts or Short Put Options. A Naked Put Write is when you sell to Open Put options without first being short in the underlying stock. Which also means that you are selling a put option when you do not own that put option in the first place. When the stock rises, the put options that you sold expire out of the money, giving the whole price of the put options as profit. One would use a Naked Put Write to speculate a quick rise in the price of the underlying stock and still to make a profit even if the underlying stock stays stagnant.

Bull Butterfly Spread: The Bull Butterfly Spread is a complex bullish options strategy with limited profit and limited loss. It makes its maximum profit when the underlying stock rises to a pre-determined higher price. Like a normal butterfly spread, the Bull Butterfly Spread can be constructed using only call options, known as the Bull Call Butterfly Spread, or only put options, known as the Bull Put Butterfly Spread. The Bull Butterfly Spread is really just a normal butterfly spread using a higher middle strike price, effectively moving the maximum profit point up to a higher strike price. The Bull Butterfly Spread also has the highest Return on Investment of all the complex bullish options trading strategies due to its extremely low capital requirement.

Basic Bearish Options Strategies Long Put Options: Buying Put options, or also known as Long Put Options or simply Long Put, is the simplest bearish option strategy ever. Stock traders wanting to profit from a drop in the underlying stock needs to short that stock, running into margin and credit risks and unlimited loss potential. Buying Put options / Long Put Options allows an option trader to profit from a down move exactly the same way as one would profit from an up move without all the margin and credit requirements of shorting the stock or its futures. Naked Call Write: Naked Call Writes are sometimes known as a Call Write, Naked Call, Write Call Options, Short Call, Uncovered Call Write, Selling Naked Calls or Short Call Options. A Naked Call Write is when you Sell To Open Call options without first owning the underlying stock. Which means that you are selling the right to buy the underlying stock at a certain price without even owning the stock in the first place... like signing a contract to sell a car when you do not even have that car...yet. If the stock falls, you get to keep the whole cost of the call options as profit as the call options expire out of the money.
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Bear Butterfly Spread The Bear Butterfly Spread is a complex bearish options strategy with limited profit and limited loss. It makes its maximum profit when the underlying stock drops to a predetermined lower price. This makes the Bear Butterfly Spread ideal for price targeting. Like a normal butterfly spread, the Bear Butterfly Spread can be constructed using only call options, known as the Bear Call Butterfly Spread, or only put options, known as the Bear Put Butterfly Spread. The Bear Butterfly Spread is really just a normal butterfly spread using a lower middle strike price, effectively moving the maximum profit point down to a lower strike price. The Bear Butterfly Spread also has the highest Return on Investment of all the complex bearish options trading strategies due to its extremely low capital requirement.

Basic Neutral Options Strategies Deep In the Money Covered Call: An options trading strategy designed to profit when a stock remains stagnant, moves up or moves down to a certain limit by purchasing the stock and writing deep in the money call options against it. The Deep in the Money Covered Call is a neutral / volatile options strategy which makes its maximum profit even when the stock remains stagnant or moves up / down. Profiting in all 3 directions. Due to its deep protection, its returns are also very small.

Short Strangle: The Short Strangle is a very similar option trading strategy to a Short Straddle and is the complete reversal of a Long Strangle. You are the buyer of a Strangle Position in a Long Strangle but in a Short Strangle, you are the one who is selling that position to a buyer of a Long Strangle. When the buyer of the long strangles make money, you as the short strangler loses money. When the buyers of the long strangle loses money, you as the short strangler makes money.

Short Straddle: A Short Straddle, is a neutral option trading strategy that profits when a stock stays stagnant. This is the exact opposite of a Long Straddle which profits when the underlying stock moves strongly either to upside or downside. When you execute a Short Straddle, you are in fact selling (or "writing") a Long Straddle to another party. In this sense, the person who bought the Straddle position that you sold, profits when the underlying stock moves strongly in either
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direction, whereas conversely, you profit when the underlying stock stays stagnant. As you are "Selling" or "Writing" a position, you make in profit the amount of money the buyer paid for the Straddle and that creates a net credit to your account. This is what be call a Credit Spread.

Short Strip Straddle: The Short Strip Straddle, also known simply as a Short Strip, is a short straddle which writes more put options than call options. As a Neutral Options Strategy, Short Strip Straddles are useful when a stock is expected to stay stagnant but if the underlying stock should breakout, chances are that it will break out to upside. Short Strip Straddles are designed to make a smaller loss when the underlying stock breaks out upwards than if the stock breaks out downwards.

Short Strap Straddle: The Short Strap Straddle, also known simply as a Short Strap, is a Short straddle which writes more call options than put options and has a bearish inclination. As a Neutral Options Strategy, Short Strap Straddles are useful when a stock with a neutral outlook is assessed to have a higher chance of breaking out to downside than upside. Short Strap Straddles transfers some of the upside risk to downside, creating an asymmetric risk graph that makes a lower loss if the stock breaks to downside than upside. Short Strap Straddles also make a higher maximum profit than a regular short straddle due to the fact that the minimum amount of short options are more than a regular short straddle.

Butterfly Spread: The Butterfly Spread is an advanced neutral option trading strategy which profits from stocks that are stagnant or trading within a very tight price range. A Butterfly Spread derived its name from the fact that it consists of three option trades at once, just like the two wings built on the body of a butterfly. This is an options trading strategy where a very large profit is realized if the stock is at or very near the middle strike price on expiration day. When implemented properly, the potential gain is higher than the potential loss, but both the potential gain and loss will be limited. Unlike many basic option trading strategies, you can put on a butterfly spread for a much lesser price than most other strategies due to the fact that one leg or "wing" of the position is a credit spread that offsets much of the price of the other leg or "wing".

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Chapter 4 Data Analysis

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Straddle Strategy: This strategy involves purchasing one call and one put of the same strike price and same expiration period. On the first day of the option series one call and one put both at the money are purchased at the same strike price nearest to the index closing price of the day. In some cases option price with exact stick or closing are not available. The payoff by using this strategy are calculated below

Index (opening) Call option price put option price Premium (call) Premium ( put ) Expiring date index(closing) pay off

4150.85 4150 4150 115.05 101.3 31-May-07 4295.8 -70.55

We can see that the closing the index is at 4295.8. Therefore the put option become out-of-the-money and therefore we will not exercise it. The call option will be exercised and the payoff will be 4295.8 4150 = 145.8 Deduction the premium from this we will get 145.8 (115.05 + 101.3) = -70.55 Therefore the final payoff is negative , i.e. we incur loss. This process is repeatedly applied on the data from Jan- 2007 to May-2011. The corresponding results and graphs are given below

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STRADDLE RESULTS 2007 Jan Fab Mar Apr May Jun Jul Aug Sep Oct Nov Dec -75.6 -131.85 -285.8 243.85 -70.55 -227.65 -35.8 -308.5 268.25 228.25 -204.1 -164.85 2008 621.35 -543.6 -456.05 -99.4 137.8 119.5 112.1 -195.1 -63.9 917.65 -145.8 -84.15 2009 -72.25 -247.1 187.3 172.9 323.55 -78.4 -189.15 -277.95 25.1 33.85 186.95 -206 2010 144.65 -195.85 5.8 -139.6 31 102.2 -73.55 -148.05 394.5 -102.5 104.25 -78.8 2011 354 -41.25 28.7 -168.25 110.7

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As seen from the above graphs when there was large movement in the index the final pay-off is positive, regardless of the direction of the index movement. When the index is close to the stick price at the time of expiry of contract we realize profit. This is equal to premium paid initially. When the index move above the stick price the call option is exercised and when it moves below the strike price the put option is exercised. In any case the loss is limited to the premium paid however the profit potential is unlimited.

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Strangle strategy This strategy involve writing one call and one put with different strike price but same expire date. On the first day of the option contract cycle one call and one put option are written. Both contract expait in one month. This strategy can be applied in two ways. Purchase of call and put option with different strike price but same expiry date. Writing of call and put option with different strike price but same expiry date.

The first one work best when large movement in the market is expected but the direction of the movement is uncertain. The second one also called top vertical strangle assumes no large movement in the market. Thus the profit is realize if the index movement is within the range of two strike price of the all and the put. Now we will use this strategy on the NSE data from Jan-2007 to May-2011. The payoffs using this strategy are as fallows (in this strategy we will take deepest out of money call option)

Expiry date Call option Put option Premium (call) Premium (put) Index (closing)

25-Jan-07 4110 3590 46.95 11.1 4147.7

Suppose we have written these call and put options then the payoff is as follows As we can see the index closing is 4147.7, now since the call option is in the money it will be exercised and we will have loss equal to 4147.7 4110 = 37.7 But we will also get the premium amount of 49.95 which mean we will have a profit of 9.25. and if we see the put option the put option is out of the money therefore it will not be exercised so we will get the premium amount of 11.1. so the actual profit from this strategy will be 9.25 + 11.1 = 20.32

This process is repeatedly applied on the data from Jan- 2007 to May-2011. The corresponding results and graphs are given below

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STRANGLE STRATEGY 2007 Jan Fab Mar Apr May Jun Jul Aug Sep Oct Nov Dec 20.35 46.65 68.95 225.05 96.25 56.95 -159.8 43.2 -251.2 -261.2 100.65 70.45 2008 -49 90.35 116.3 46.65 28.1 18.1 172.7 22.85 8.1 -887.7 40.95 52.1 2009 31.75 44.65 18.5 4.35 -202.25 4.4 9.25 18.65 7.05 4.6 16.85 4.8 2010 4.45 19.65 2.4 2.6 2.5 1.85 2.95 3 3 9 2.55 3.8 2011 -4.45 -19.65 -2.4 -2.6 -2.5

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As we can see from the above graph this strategy is very risky with unlimited loss potential and limited profit potential (maximum profit is premium received). But the loss is incurred only when there is extraordinary movement in the index which rarely happens. As the deepest out of the money contract are taken the chances of index going out of the range are less. The strategy works well in the bearish market.

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Strips and straps strategy A strips consists of a long position in one call and two puts with the same strike price and expiration date. A straps consist of a long position in two call and one put with the same strike price and expiration date. In a strap the investor is betting that there will be a big stock price movement and consider a decrease in the stock price to be more likely than an increase. In strap the investor is also betting that there will be a big stock price movement. However in this case an increase in the stock price is considered to be most likely than decrease. Now we will use this strategy on the NSE data from Jan-2007 to May-2011. The payoffs using this strategy are as fallows Strips payoffs Expiry Index closing Call (1) Put (2) Premium (call) Premium (put) 31-May-07 4295.8 4150 4150 115.05 101.3

The index closing is 4295.8 and we are the buyer of the call and put option so the call options will we in the money so our gain will be 4294.8 4150 115.05 = 29.75 But the put options are out of the money so we will have a loss of premium paid on two put option 101.3 * 2 = 202.6 So the net position will 29.75 202.6 = - 172.85. We have incurred a loss of -202.6. This process is repeatedly applied on the data from Jan- 2007 to May-2011. The corresponding results and graphs are given below

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STRIPS STRATEGY 2007 Jan Fab Mar Apr May Jun Jul Aug Sep Oct Nov Dec -75.6 -131.85 -285.8 243.85 -70.55 -227.65 -35.8 -308.5 268.25 228.25 -204.1 -164.85 2008 621.35 -543.6 -456.05 -99.4 137.8 119.5 112.1 -195.1 -63.9 917.65 -145.8 -84.15 2009 -72.25 -247.1 187.3 172.9 323.55 -78.4 -189.15 -277.95 25.1 33.85 186.95 -206 2010 144.65 -195.85 5.8 -139.6 31 102.2 -73.55 -148.05 394.5 -102.5 104.25 -78.8 2011 354 -41.25 28.7 -168.25 110.7

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Straps payoffs Expiry Index closing Call (2) Put (1) Premium (call) Premium (put) 31-May-07 4295.8 4150 4150 115.05 101.3

The index closing is 4295.8 and we are the buyer of the call and put option so the call options will we in the money so our gain will be [{2(4294.8 4150)} {( 115.05*2)}] = 59.5 But the put options are out of the money so we will have a loss of premium paid on one put option 101.3 So the net position will 59.5 101.3 = - 39.8. We have incurred a loss of 39.8. This process is repeatedly applied on the data from Jan- 2007 to May-2011. The corresponding results and graphs are given below

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STRaps STRATEGY 2007 Jan Fab Mar Apr May Jun Jul Aug Sep Oct Nov Dec -29.85 -207.35 -505.05 598.2 -39.8 -361.5 91.9 -449.3 684.1 602.05 -414.65 -134.15 2008 411.15 -812.1 -806.05 -18.8 -14.5 -35.75 443.65 -376.2 -230.7 741.65 -377.75 5 2009 -231 -331.85 517.8 477.7 848.85 -277.6 -141.75 -457.15 245.1 -136.3 528.2 -251.2 2010 4.8 -312.85 154.45 -235.4 -86.05 364.1 -13.8 -173.55 887.7 -276.45 -47.4 -35.3 2011 212.5 -168.85 210.55 -317.05 -14.45

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Butterfly strategy A butterfly involves positions in options with three different strike price. It can be created by buying a call options with a relatively low strike price, k1, buying a call option with a relatively high strike price k3, and sell two call options with a strike price k2, halfway between k1 & k3. Generally k2 is close to the current stock price. A butterfly strategy leads to a profit if the stock prices stay close to k2, but rise to a small loss if there is a significant stock price movement either way. It is therefore appropriate strategy for all an investor who feels that large stock price moves are unlikely. The strategy requires a small investment initially. The payoffs of butterfly strategy are given below. 36

Expiry Call option(K1 ) 2 Call option(K2) Call option(K3) 25-Jan-07 25-Jan-07 25-Jan-07

Strike Price 4110 4000 3590

Premium 46.95 101.95 300.45

index closing 4007.4 4007.4 4007.4

Now we can see that index closing is 4007.4 and we have purchase two call options (k1 &k3 ) and we have sold two call option (k2), as we see both the call options i.e. k1 & k3 are out of the money so we will not exercise those call options. So the loss will be the premium amount paid 46.95 + 300.45 = 347.4 And the buyer of the call option will exercise the call option so the cash flow from the transaction will be 2* (4007.4 4000 + 101.95 )= 217.9 So the net amount from the transaction will be 217.9 347.4 = - 129.5 This process is repeatedly applied on the data from Jan- 2007 to May-2011. The corresponding results and graphs are given below BUTTERFLY STRATEGY 2007 Jan Fab Mar Apr May Jun Jul Aug Sep Oct Nov Dec -119.1 -159.05 -493.35 -577.25 41.95 379.25 -354.8 -405.25 5.2 -119.25 -398.6 -449.95 2008 -411.7 -605.2 -743.55 -397.85 -143.1 -264.15 -314.95 -367.55 -244.05 -419.3 -412.5 -415.65 2009 -273.5 -212.45 -141.05 -221.55 -355.1 -311.9 -371.05 -282.85 -271.7 -159.4 -212.75 -252.7 2010 -219.9 -246.55 -175.3 -222.1 -172.9 -152.95 -191.1 -131.7 -133.35 -301.05 -299.1 -167.2 2011 -141.45 -339.7 -269.3 -268.3 -346.65

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Butterfly strategies have given negative return in all the period because these year there was a great volatility in the stock price movement.

Buy and hold strategy Buy and hold strategy simply involves buying a index at a price at the opening of the month and selling at the end of the month. The corresponding results and graphs are given below for the buy and hold strategy.

BUY & HOLD STRATEGY 2007 Jan Fab Mar Apr May Jun Jul Aug Sep Oct Nov 140.3 -97.2 -13.1 544.25 144.95 -15.05 306.05 66.45 525.8 500 -231.85 2008 -1006.9 -32.15 -122.75 260.3 -392.9 -423.75 436.2 -199.55 -238.1 -1253.7 -288.75 2009 -209.5 19 407.65 413.6 683.1 -288.05 230.55 -23.2 361.2 -332.85 441.65 2010 -364.95 -39.95 243.4 -36.35 -219.65 350.4 157.5 46.25 558.1 -155.7 -317.8 2011 -553.3 -154.5 311.45 -40.6 -288.95

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Dec

216.5

276.25

79.05

140.95

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Comparison of various derivatives trading strategies(on monthly basis from jan-2007 to may2011)

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Chapter 5: Findings and Conclusions

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A number of common trading strategies involve options and the underlying stock. For example writing a covered call involves buying the stock and selling a call options on the stock. A protective put involves buying a put option and buying the stock. The former is similar to selling a put option the latter is similar to buying a call options. Spreads involves either taking a position in two or more call or taking positions in two or more puts. A bull spread is created by buying a call (put) with a low strike price and selling a call (put) with a high strike price. A bear spread can be created by buying a put (call) with a high strike price and selling a put (call) with a low strike price. A butterfly spread involves buying calls (puts) with low and a high strike price and selling two calls (puts) with some intermediate strike price. Combinations involve taking two positions in both calls and puts on the same stock. A straddle combination involves taking a long position in a call and a long position in one call and two put with the same strike price and expiration date. A strap consists of a long position in two calls and one put with the same strike price and expiration date. A strangle consist of a long position in a call and a put with different strike prices and the same expiration date. There are many other ways in which options can used to produce interesting payoffs. It is not surprising that options have steadily increased in popularity and continues to fascinate investors. The conclusions for the strategies are as follows Straddle strategy Long straddle fails when the market prices do not move. The risk with the long straddle is limited with the potential to earn profits is huge. Short straddle fails when the market moves sharply. The risk in short straddle is unlimited while the profit potential is limited to premiums earn. The trader may incur loss of his entire investment paid as premium in case of market moves sideward. The premium of call and put options are generally high due to unanticipated volatility.

Strangle strategy Strangle is speculative on the price of stock, whether it will move a lot or not. It is ideal position to enter into irrespective of the implied volatility swing up or down. The long strangle will profit immaterial of the market movement while the short strangle is a neutral strategy. Short strangle will always give satisfaction i.e. when the movement of the market is sideward maximum profit can be achieved through short strangle. The advantage of strangle is that the construction of strangle as compare to straddle is less costly and depending upon the position taken like a short or long strangle the risk can be minimized. Although one cannot say that this is a totally risk free strategy.

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Butterfly strategy Butterfly strategy is most suited to the traders who feel that large stock price movements are not likely to occur. Tough this complex strategy it offers limited risk and also the time value impact is neutral in his strategy. This strategy when implied properly will give limited profit with chance of potential gain rather then potential loss both being limited. This is best strategy to be chosen by an investor who is risk averse.

Overview of the return given by all strategies. stradel strangel strips strap butterfly-ce butterfly-pe buy & hold

2-Jan-07 1-Feb-07 1-Mar07 2-Apr-07 3-May07 1-Jun-07 2-Jul-07 1-Aug07 3-Sep-07 1-Oct-07 1-Nov07 3-Dec-07 1-Jan-08 1-Feb-08 3-Mar08 1-Apr-08 2-May08 2-Jun-08 1-Jul-08 1-Aug08 1-Sep-08 1-Oct-08

-75.6 -131.85 -285.8 243.85 -70.55 -227.65 -35.8 -308.5 268.25 228.25 -204.1 -164.85 621.35 -543.6 -456.05 -99.4 137.8 119.5 112.1 -195.1 -63.9 917.65

20.35 46.65 68.95 225.05 96.25 56.95 -159.8 43.2 -251.2 -261.2 100.65 70.45 -49 90.35 116.3 46.65 28.1 18.1 172.7 22.85 8.1 -887.7

-196.95 -188.2 -352.35 133.35 -171.85 -321.45 -199.3 -476.2 120.65 82.7 -197.65 -360.4 1452.9 -818.7 -562.1 -279.4 427.9 394.25 -107.35 -209.1 39 2011.3

-29.85 -207.35 -505.05 598.2 -39.8 -361.5 91.9 -449.3 684.1 602.05 -414.65 -134.15 411.15 -812.1 -806.05 -18.8 -14.5 -35.75 443.65 -376.2 -230.7 741.65

-119.1 -159.05 -493.35 -577.25 41.95 379.25 -354.8 -405.25 5.2 -119.25 -398.6 -449.95 -411.7 -605.2 -743.55 -397.85 -143.1 -264.15 -314.95 -367.55 -244.05 -419.3

-258.6 -356.05 -47.2 -280.9 -304.55 -321.75 -351.3 -331.05 -206.9 -294.7 -608.45 -381.75 -384.8 -942.15 -524.9 -719.45 -275.55 -313.25 -652.05 -406.45 423 -361.55

140.3 -97.2 -13.1 544.25 144.95 -15.05 306.05 66.45 525.8 500 -231.85 216.5 -1006.9 -32.15 -122.75 260.3 -392.9 -423.75 436.2 -199.55 -238.1 -1253.7
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3-Nov08 1-Dec-08 1-Jan-09 2-Feb-09 2-Mar09 1-Apr-09 4-May09 1-Jun-09 1-Jul-09 3-Aug09 1-Sep-09 1-Oct-09 3-Nov09 1-Dec-09 4-Jan-10 1-Feb-10 2-Mar10 1-Apr-10 3-May10 1-Jun-10 1-Jul-10 2-Aug10 1-Sep-10 1-Oct-10 1-Nov10 1-Dec-10 3-Jan-11 1-Feb-11 1-Mar11 1-Apr-11 2-May11

-145.8 -84.15 -72.25 -247.1 187.3 172.9 323.55 -78.4 -189.15 -277.95 25.1 33.85 186.95 -206 144.65 -195.85 5.8 -139.6 31 102.2 -73.55 -148.05 394.5 -102.5 104.25 -78.8 354 -41.25 28.7 -168.25 110.7

40.95 52.1 31.75 44.65 18.5 4.35 -202.25 4.4 9.25 18.65 7.05 4.6 16.85 4.8 4.45 19.65 2.4 2.6 2.5 1.85 2.95 3 3 9 2.55 3.8 1.15 2.1 2.9 0.55 1.05

-59.65 -257.45 14.25 -409.45 44.1 41 121.8 42.4 -425.7 -376.7 -169.8 237.85 32.65 -366.8 429.15 -274.7 -137.05 -183.4 179.05 -57.5 -206.85 -270.6 295.8 -31.05 360.15 -201.1 849.5 45.1 -124.45 -187.7 346.55

-377.75 5 -231 -331.85 517.8 477.7 848.85 -277.6 -141.75 -457.15 245.1 -136.3 528.2 -251.2 4.8 -312.85 154.45 -235.4 -86.05 364.1 -13.8 -173.55 887.7 -276.45 -47.4 -35.3 212.5 -168.85 210.55 -317.05 -14.45

-412.5 -415.65 -273.5 -212.45 -141.05 -221.55 -355.1 -311.9 -371.05 -282.85 -271.7 -159.4 -212.75 -252.7 -219.9 -246.55 -175.3 -222.1 -172.9 -152.95 -191.1 -131.7 -133.35 -301.05 -299.1 -167.2 -141.45 -339.7 -269.3 -268.3 -346.65

-535.4 1946.6 -260.95 -327.9 2021.5 -276.65 -338.95 -1215.6 -357.4 -247.3 -253.15 -249.8 -260.6 -146.15 -159.95 -229.1 -238.25 -142.35 -122.75 -287.95 -161.25 -102.25 -180.2 -151.85 -71.95 -565.8 -122.35 701.2 -344.7 -96.5 -74.1

-288.75 276.25 -209.5 19 407.65 413.6 683.1 -288.05 230.55 -23.2 361.2 -332.85 441.65 79.05 -364.95 -39.95 243.4 -36.35 -219.65 350.4 157.5 46.25 558.1 -155.7 -317.8 140.95 -553.3 -154.5 311.45 -40.6 -288.95

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From the above it can be easily concluded that buy and hold strategy gives the maximum payoff but at a high risk. However strangle strategy have given reasonable payoff but at a very low risk. Looking to the five years data investors willing take higher risk for small increase in the return will chose buy & hold strategy. However applying this strategy blindly can also result in huge losses. Even options strategies like straddle or strangle applied blindly cannot ensure consistent results. The investor can combine two or more strategies to minimize there risk and ensure consistence returns. For this we need to know the market sentiment, we need to do some technical and fundamental analysis before we conclude as to which combination of strategies would be appropriate.

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BIBLIOGRAPHY
Combination of trading strategies, Aditya lycngar Derivative market. INDIAN DERIVATIVES MARKETS, Asani Sarkar Straddle The Most Popular Strategy, Radha A Purswani Options, futures and other derivatives, John C. Hall National Stock Exchange Strangle: A Protective Strategy, Smitha Ramachandran NCFM Derivatives Beginners module.

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