4. Applications of Futures & Options V.

Shankar

To trade securities

Customer must open trading account with securities broker Customer must open demat account with securities depository Buying securities involves putting up all the money upfront Shareholder receives the rights & privileges associated with the security (dividends, invitation to general meetings, power to vote) Selling possible only if securities are held by the seller

To trade futures
Customer must open futures trading account with derivatives broker Buying futures involves simply putting in the margin money With purchase of futures on a security, the holder makes a legally binding

promise/obligation to buy the underlying security on a future date (expiration date) Securities futures do not represent ownership in the company

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 Futures

contracts have linear payoffs

Losses and profits for buyer/seller are unlimited

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E.g.: Speculator buys 2-month Nifty index futures contract when Nifty is 3500 When the index moves up, the long futures position starts making profits When the index moves down, the long position starts making losses
Profit

3300

3400

3500

3600

3700

Nifty

Loss

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E.g.: Speculator sells 2-month Nifty index futures contract when Nifty is 3800 When the index moves down, the short futures position starts making profits When the index moves up, the short position starts making losses
Profit

3600

3700

3800

3900

4000

Nifty Loss

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 Pricing Fair

futures contract is simple

value of futures contract calculated using cost-of-carry logic

=SerT

Where F = fair value of futures contract on underlying S = spot price of underlying e = value of exponent (2.71828) r = cost of financing (using continuously compounded interest rate) T = time till expiration in years
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Long security, sell futures E.g. Investor sees value of his shares falling from Rs.450 to Rs.390 and expects the prices to slide further In the absence of stock futures, he will suffer further value erosion or sell securities upfront to limit further loss With stock futures, he can minimize price risk Assuming spot price of Rs.390, 2-months futures would cost him Rs.402 Investor takes short position on stock futures pays initial margin Payoff position if share price drops to Rs.350
Futures will trade at a lower price hence this position starts making

profits, partly offsetting losses in security

Index futures are effective against market risk of portfolio

Long portfolio + Short Nifty

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Bullish security, buy futures E.g. Speculator believes that a security trading at Rs.1000 is undervalued In the absence of stock futures, he will buy the security and hold it
Assuming 100 shares, his investment will be Rs.1 lakh 2 months later, he sells at Rs.1010 (hunch proves correct) Annual return = 6%

With futures, the speculator can improve his returns

2-months futures trades at Rs.1006 Assume minimum contract value = Rs.1 lakh He buys 100 stock futures margin payment of Rs.20,000 On expiration date, futures price converges to spot price (Rs.1010) Profit of Rs.400 on investment of Rs.20,000 in 2 months Annual return = 12%

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Bearish security, sell futures E.g. Speculator believes that the price of a security is overvalued He sells one 2-month ABC futures contract at Rs.240 each contract of 100 underlying shares; pays margin 2 months later, ABC closes at Rs.220 (spot price = futures price on expiration date) Profit of Rs.2000 on one contract
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Overpriced futures: buy spot, sell futures Whenever futures price deviates substantially from its fair value, arbitrage opportunities arise E.g. ABC trades at Rs.1000 and 1-month ABC futures trade at Rs.1025 (overpriced according to you)

Day 1, borrow funds, buy ABC at Rs.1000 Day 1, sell ABC futures at Rs.1025 Day 3, take delivery of ABC and hold Day 30 (expiration date), price of ABC is Rs.1015 (hunch proves correct) Day 30, sell ABC at Rs.1015; profit of Rs.15 Day 30, futures contract expires with profit of Rs.10 Day 30, total profit = Rs.25 (riskless) Day 30, return the borrowed funds

Cash-and-carry situation

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Underpriced futures: buy futures, sell spot Whenever futures price deviates substantially from its fair value, arbitrage opportunities arise Futures price on ABC (held by you) seems underpriced E.g. ABC trades at Rs.1000 and 1-month ABC futures trade at Rs.965

Day 1, sell ABC at Rs.1000 Day 1, buy ABC futures at Rs.965 Day 3, deliver ABC Day 30 (expiration date), price of ABC is Rs.975 (hunch proves correct) Day 30, buy ABC at Rs.975; profit of Rs.25 Day 30, futures contract expires with profit of Rs.10 Day 30, total profit = Rs.35 (riskless)

Reverse cash-and-carry

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Options

contracts have non-linear

payoffs For options buyer, losses are limited, but profits are unlimited For options writer, profits are limited to premium, but losses are unlimited

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 E.g.

A buys 3-month call option on Nifty with a strike of 2400 at a premium of Rs.100 Payoff profile for A
Profit

2300 100

2400

2500

2600

2700

2800

Nifty

Loss

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 E.g.

B sells 3-month call option on Nifty with a strike of 2400 at a premium of Rs.100 Payoff profile for B
Profit 100

2300

2400

2500

2600

2700

2800

Nifty

Loss

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 E.g.

C buys 3-month put option on Nifty with a strike of 2400 at a premium of Rs.50 Payoff profile for C
Profit

2300 50

2400

2500

2600

2700

2800

Nifty

Loss

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 E.g.

D sells 3-month put option on Nifty with a strike of 2400 at a premium of Rs.50 Payoff profile for D
Profit

50

2300

2400

2500

2600

2700

2800

Nifty

Loss

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 There

are many models to estimate true price of options

most of them are variants of Black-Scholes model

for pricing European options

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Black-Scholes formulae for prices of European calls and puts on non-dividend paying stock are: C = S N (d1) X e rT N (d2)

P = X e rT N (-d2) S N (-d1)
ln (S/X) + (r + 2/2) T where d1 =
-----------------------------------------

sqrt (T)

where d2 = d1 sqrt (T)

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where r = compounded rate of interest = ln (1 + r) N ( ) = cumulative normal function N (d1) = delta of option measure of change in option price w.r.t. change in price of underlying = annualized standard deviation of continuously compounded returns of the underlying; i.e. a measure of volatility annual = daily x sqrt (no. of trading days per year)

X = exercise price
S = spot price T = time to expiration measured in years
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Hedging

Speculation

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Effective

where owners of stocks / equity portfolio wish to protect downside risk To protect stock / portfolio from falling below a particular level, buy right no. of put options with the right strike price Portfolio insurance through put options used by mutual funds
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Bullish

security, buy calls or sell puts

Used when investors expect security prices

to rise Downside to buyer of call option is limited to options premium; upside unlimited Upside to seller of put option is limited to options premium; downside unlimited

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Underlying 1250 1250

Options strike price 1200 1225

Call premium 80.10 63.65

Put premium 18.15 26.50

1250
1250 1250

1250
1275 1300

49.45
37.50 27.50

37.00
49.80 64.80

Risk-free rate = 12% p.a. Volatility of underlying security = 30%

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Profit

1200

1250

1300

1350 Underlying security

27.50

49.45

80.10

Loss

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Profit 64.80

37.00 18.15 1200 1250 1300 1350 Underlying security

Loss

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Bearish

security, sell calls or buy puts

Used when investors expect security prices

to fall Upside to seller of call option is limited to options premium; downside unlimited Downside to buyer of put option is limited to options premium; upside unlimited

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Profit

80.10
49.45 27.50 1200 1250 1300 1350 Underlying security

Loss

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Profit

1200

1250

1300

1350 Underlying security

18.15 37.00

64.80

Loss

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 S&P CNX Nifty Contract size lot size of 100 units (min value Rs.2 lakh) Price steps Re.0.05 Settlement basis mark to market and final settlement are cash settled on T+1 basis Settlement price daily settlement price will be the closing price of futures contracts for that day and final settlement price will be the closing value of the underlying index on last trading day
Underlying
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 S&P CNX Nifty Contract size lot size of 100 units (min value Rs.2 lakh) Price steps Re.0.05 Style of option European Strike price interval Rs.10 Daily settlement price premium value (net) Final settlement price closing value of the index on last trading day
Underlying

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 individual securities Contract size as specified by the exchange (min value Rs.2 lakh) Price steps Re.0.05 Settlement basis mark-to-market and final settlement are cash settled on T+1 basis Settlement price daily settlement price will be the closing price of futures contracts for that day and final settlement price will be the closing price of the underlying security on the last trading day
Underlying
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Underlying individual securities Contract size as specified by the exchange (min value Rs.2 lakh) Price steps Re.0.05 Style of option American Strike price interval as specified by the exchange Settlement basis daily settlement on T+1 basis and final option exercise settlement on T+3 basis Daily settlement price premium value (net) Final settlement price closing price of underlying on exercise day or expiry day

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E.g. Suppose Nifty is at 2000 Then, Nifty options would be available at strikes of 2070, 2060, 2050, 2040, 2030, 2020, 2010, 2000, 1990, 1980, 1970, 1960, 1950, 1940, 1930 When Nifty closing price crosses 2070, seven new OTM strikes start trading from next day When Nifty closing price falls below 1930, seven new ITM strikes start trading from next day

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Price of underlying

Strike price interval (Rs.) 2.5 5 10 20

Scheme of strikes to be introduced (ITM-ATM-OTM) 3-1-3 3-1-3 3-1-3 3-1-3

Less than or equal to Rs.50 Rs.50 Rs.250 Rs.250 Rs.500 Rs.500 Rs.1000

Rs.1000 Rs.2500
More than Rs.2500

30
50
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3-1-3
3-1-3

Nifty index level

Strike interval

Scheme of strikes to be introduced (ITM-ATM-OTM) 3-1-3 5-1-5 7-1-7 9-1-9

Upto 1500 1500 2000 2000 2500 Above 2500

10 10 10 10

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V. Shankar