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DERIVATIVES (Futures & Options) :

DERIVATIVES (Futures & Options)

PowerPoint Presentation:

What will we look at? Basic concepts of Derivatives (Futures & Options) How to protect equity investments using some basic strategies in derivatives. Market direction / trend indicators

Specified Guide lines - Derivatives:

Specified Guide lines - Derivatives Contract Size : SEBI has specified minimum contract value of Rs. 200,000.00 Lot Size : Different lot size applicable for different underlying Contract for three different months in existence known as Near month, Middle month & Far month. Expiry Date : Date on which F/O contract will ceases to exist. It is always Last Thursday of the month or the day prior in case last Thursday of the month is a Trading holiday Settlement : Futures & Options are CASH SETTLED.

Derivatives Products :

Futures Index Futures Stock Futures Options Index Options Stock Options Derivatives Products Derivatives is a product which does not have its own value but is derived from some underlying. Incase of Futures & Options value is derived from the CASH or SPOT Market

Benefits Of Derivatives:

Benefits Of Derivatives Reduces market risk Willingness to Trade Lower cost of trading Increase trading volume in stock market liquidity.

Futures - Definitions:

Futures - Definitions Future Contract : Legally binding agreement to buy or sell a financial instrument sometime in future. Quantity – Lot size fixed. Delivery time - Expiry date is fixed Futures Position BUY Futures : Right as well as obligation to buy the underlying shares at the future date SELL Futures : Right as well as obligation to sell underlying shares at the future date Right – To claim profit, if any Obligation – To pay loss, if any

Futures - Pricing:

Futures - Pricing FUTURES = S (Spot price) + C (Cost to carry) COST OF CARRY = Interest Cost / Opportunity Cost COST OF CARRY (factors affecting it) Prevailing interest rate Volatility of the stock Demand and Supply of stock (Determination of cost of carry is not fixed. Its entirely market driven)

Futures – Pricing……….(contd):

Futures – Pricing……….(contd) Expiry Date SPOT PRICE = FUTURES PRICE (Cost to Carry is zero) WHEN IS SPOT PRICE HIGHER THAN FUTURES PRICE Dividend declared by company (during the contract period) Mis-pricing (Lack of Price discovery) 3 months Contract Price 2 month Contract Price 1 month Contract Price SPOT Price

Futures – Risk & Settlement:

Futures – Risk & Settlement Both BUY & SELL position carries unlimited risk Both positions are margined Mark to Market on daily basis at closing price of a particular contract Difference is paid/recovered on T+1 basis Settlement Price : Closing price on underlying in Cash /Spot market on contract expiry date

How To Use Index Futures:

How To Use Index Futures Speculation Hedging

Speculation – Bearish outlook:

Speculation – Bearish outlook What to do: Believe market would go down Sell liquid stocks like Infosys Sell entire index portfolio What can go wrong Costly to sell the entire set of stocks Vulnerable to company specific risk What you could do Short Sell S&P CNX Nifty futures

Speculation (contd.):

Speculation (contd.) 04th April 2011 You feel the market will fall Sells 100Nifties expiring on Apr 28 Nifty April contract is trading at 5600 Your position is worth Rs. 560000 28th April 2011 Nifty April futures has fallen to 5500 Square off your position at 5500 Make a profit of Rs. 10,000 (100*100)

Payoff for Nifty Futures Short at 5600:

Payoff for Nifty Futures Short at 5600 NIFTY PAYOFF 5600 0 5550 50 5500 100 5450 150 5400 200

Speculation – Bullish outlook:

Speculation – Bullish outlook What to do: Believe market would go up Buy liquid stocks like Infosys Buy entire index portfolio What can go wrong Costly to buy the entire set of stocks Vulnerable to company specific risk What you could do Long Buy S&P CNX Nifty futures

Speculation (contd.):

Speculation (contd.) 04th April 2011 You feel the market will rise Buy 100 Nifties expiring on April 28 Nifty April contract is trading at 5600 Your position is worth Rs. 5,60,000 28th April 2011 Nifty April futures has risen to 5650 Square off your position at 5650 Make a profit of Rs. 5,000 (100*50)

Payoff for Nifty Futures Long at 5600:

Payoff for Nifty Futures Long at 5600 NIFTY PAYOFF 5400 -200 5500 -100 5600 0 5700 100 5800 200

Hedging:

Hedging Stocks carry two types of risk :- Company specific Market risk Company specific risk can be reduced by divercification. Market risk cannot be diversified but has to be hedged. Market risk is known from Beta

How to hedge your stock position using futures :

How to hedge your stock position using futures This first thing one needs to know is the beta of the stock. That is the impact a 1 per cent movement in the Nifty will have on the stock This is known as hedging

How to hedge your stock position using futures :

How to hedge your stock position using futures Lets assume you expect Reliance to go up and want to take a long position on Reliance worth Rs 2,50,000. The scrip has a beta of 1.07. To remove the hidden Nifty exposure in the above position the size of the sell position that will have to be taken in the Nifty futures is 1.07 * 2,50,000 = 2,67,500.

Hedging:

Hedging So if the Nifty is at 5600 and each market lot is 100(one contract) Then the contract size would be Rs 5,60,00. As such, to sell Rs 5,60,000 worth of Nifty we need to sell one market lot (rounded off to the nearest market lot).

Hedging:

Hedging This would give us the following position. Long (Buy)2 lots(250) Reliance Rs 5,00,000 Short (Sell) Nifty Rs 5,600,000 By building such a position what you are essentially doing is removing the hidden Nifty exposure and a position which will reflect the price changes inherent only to Reliance. Assuming the Index falls and Reliance also moved in line you will lose on Reliance but the losses and risk could be offset or reduced by the short Nifty.

Futures - Advantages over Cash :

Futures - Advantages over Cash You can take 4 – 5 times more than limits Close positions anytime before expiry. On expiry day, exchange automatically closes out positions. Keep your positions open up to 3 months Lower brokerage / transaction costs Profits / losses are paid / recovered on a daily basis If you feel the market will be bearish, take short positions in futures, which is not possible in CASH segment without actual shares in demat.

OPTIONS - DEFINITION :

Confers right to the holder/buyer of option to buy/sell a specified assets at a specific price on or before a specific date. Seller/Writer has an obligation to fulfil the contract if buyer/holder exercises his option BUYER SELLER Gets a RIGHT Has an OBLIGATION Pays PREMIUM Receives PREMIUM OPTIONS - DEFINITION

Option-Definitions :

CALL OPTIONS : BUYER Buyer gets a RIGHT, To BUY underlying shares at a price. On or before a determined date. SELLER Seller has an obligation To SELL underlying shares at a price On or before a determined date Option- Definitions

.:

. PUT OPTIONS : BUYER Buyer gets a RIGHT, To SELL underlying shares at a price. On or before a determined date. SELLER Has an obligation To BUY underlying shares at a price. On or before the determined date.

Options-Positions:

BUY CALL: Buyer gets right to BUY underlying at the strike price BUY PUT: Buyer gets right to SELL underlying at the strike price SELL CALL: Seller has an obligation to SELL the underlying at strike price SELL PUT: Seller has an obligation to BUY the underlying at strike price Options- Positions

Options - Exercisability & Settlement :

American Options : It is exercisable anytime on or before the expiry date. OPT-RELIANCE-APR-28--2011-1000-CA European Options : It is exercisable only on the expiry date on contract note. OPT-NIFTY-28-APR-2011-2050-CE Indian Scenario: Index Options - European cash settled Stock Options - American cash settled Settlement Price : Difference between Strike Price and Underlying Price Options - Exercisability & Settlement

Options- Spot & Strike price Relationship:

In The Money Concepts from the buyers perspective. Option is said to be in the money when the option has intrinsic value . Call option is in the money when the Strike price is < Spot price Put option is in the money when the strike price is > spot price Eg. Strike Price 950 Call option of Reliance industries when the Spot price is 1000. The difference of Rs. 50 is said to be the intrinsic value of the option. Options- Spot & Strike price Relationship

Options- Spot & Strike price Relationship:

Out of The Money Option is said to be out of money when it does not have any intrinsic value Call option is out of the money when the Strike price is > CMP Put option is out of the money when the strike price is < CMP Eg. Strike Price 1200 Call option of a Reliance when the Spot price is 1000. At The Money Strike price = Spot Price Options- Spot & Strike price Relationship

Options- Pricing:

Intrinsic Value Difference between the Strike Price and Spot Price Time Value - Theta Time to expiry of the contract As the expiry date comes nearer, the options premium decays Volatility of underlying- Beta Higher volatility of stock would attract higher premium Premium in HINLEV (low beta) would be lesser than SATCOM (high beta) - other factors remaining same Options- Pricing

Options-Risk :

BUYER of CALL / PUT options Maximum loss : PREMIUM Maximum Gain : UNLIMITED SELLER of CALL / PUT options Maximum loss : UNLIMITED Maximum Gain : PREMIUM Options- Risk

Options-Margin:

Options- Margin BUY positions are not margined since carries no risk. Loss / Premium already paid by buyer. All SELL positions are margined because of unlimited risk profile. Different margin for different underlying depending upon the volatility

Options-Exercise:

Options- Exercise Only In the Money (ITM) options are allowed to be exercised Buyer/Holder receives the difference Call Option: Spot price-Strike price Put Option: Strike price-Spot price Writer/Seller pays the difference Call Option : Spot price-Strike price Put option: Strike price-Spot price All At the Money (ATM) and Out of the Money (OTM) contracts expires worthless Assigned to seller/writer who is Out of the Money (OTM)

Options - Exercise v/s Square-off:

Options - Exercise v/s Square-off EXERCISE SQUARE- OFF Difference Difference between between STRIKE PRICE and PREMIUM Amounts at CLOSING PRICE of the time of Square- off. underlying on exercise day EXERCISE can be done only by the BUYER. SQUARE-OFF can be made by both BUYER & SELLER

Square Off or Exercise:

Square Off or Exercise What you should do-Square-off or Exercise ? You buy one Call Option of reliance at strike price of Rs. 950 expiring 28 th April. You pay Rs.35 as premium. Spot price of Reliance has increased to 1020 The premium of this 1000 Call option has now increased to Rs.55.

Option 1:

Option 1 Square off the position and gain profit on the difference between the premium paid and premium received. Take an opposite position i.e Sell call option of Rs.1000 expiring April 28. You would receive the premium of Rs.40 The difference in the premium paid and received is the profit. Reliance close at 980 You made a profit of Rs.20 (40-20)

Option 2:

Option 2 Exercise the option You get the difference between the Strike Price and the Closing Price of reliance on 28 th April. In this case it would be 1000-980-= 20

.:

. It is advisable to close position by squaring-off, however sometimes the option becomes illiquid.In such a case you would be unable to squareoff by taking an opposite position. In such a case you would have to exercise your option. All In the Money options will be automatically exercised at the end of expiry day. However ATM and OTM options expire worthless.

Options – Advantages:

Options – Advantages Very high leverage. Requires just fraction of the total lot value to be paid as premium Losses are limited to the extent of premium with unlimited profit potential

Option Strategies :

Option Strategies Bullish Buy Call Sell Put Bearish Sell Call Buy Put

PowerPoint Presentation:

Bullish Outlook Buy Nifty Call Option What is it? Buying a right to buy at a cost (Premium) Why Buy a Call Option? If you think that the market will rise. The strike price should be a price which the underlying would definitely exceed - since profits would start once underlying rises beyond the strike price. Buyer’s Risk : Loss limited to premium paid

PowerPoint Presentation:

Example: Buy Nifty Call Spot Nifty: 5550 One month call Strike price: 5600 Premium: Rs. 50 Loss limited to premium Breakeven: strike + premium : 5500 + 50 (5550)

PAYOFF FOR BUYER OF A CALL:

PAYOFF FOR BUYER OF A CALL 300 200 100 0 -100 -200 -300 Net Profit/ Loss -5 -20 -50 -100 -100 -200 -300 Premium Paid 200 100 20 0 0 0 0 Value of 5500Call Above Strike AboveStrike Break Even At Strike Below Strike Below Strike Below Strike 5800 5700 5600 5500 5400 5300 5200 NIFTY SPOT

PowerPoint Presentation:

Sell Nifty Put What is Sell Put? –Selling a right to sell- Have an obligation to buy Why Sell Nifty Put ? –Market expectations - Neutral to bullish –Index will not go down! –Motive : to receive premium income –Acquire stock at lesser cost –Premium is the profit –Limited profit and substantial loss

PowerPoint Presentation:

Example Sell Nifty Put Spot Nifty 5500 Strike price 5600 Premium = 100 Breakeven is strike price - premium :5500 + 100 (5600) i.e. If Nifty closes at any price above 5600 there is a fixed profit of Rs.100

PAYOFF FOR SELLER OF A PUT:

PAYOFF FOR SELLER OF A PUT 250 100 0 -100 -200 -300 -400 Net Profit/ Loss 250 200 150 120 80 50 10 Premium Recd. 250 200 150 120 -80 -50 -10 Value of 5600 Put Above Strike Above Strike Above Strike At Strike Break Even Below Strike Below Strike 5800 5700 5600 5500 5400 5300 5200 NIFTY SPOT

PowerPoint Presentation:

Bearish Outlook Buy Nifty Put Option What is it? Buy the right to sell Why Buy a Put Option? If you think that the market will fall. The strike price should be a price which the underlying would definitely fall below - since profits would start once underlying falls below the strike price. Buyer’s Risk : Loss limited to premium paid

PowerPoint Presentation:

Example: Buy Nifty Put Option Spot Nifty: 5500 One month put Strike price: 5400 Premium: Rs. 100 Loss limited to premium Max gain: if Nifty = 0 Breakeven: strike - premium : 5300 (5400 - 100)5300

PAYOFF FOR BUYER OF A PUT:

PAYOFF FOR BUYER OF A PUT -50 -50 -100 -120 100 200 300 Net Profit/ Loss -50 -50 -100 -120 -100 -80 -50 Premium Paid 0 100 120 100 80 50 Value of 5400 Put Above Strike Above Strike Above Strike At Strike Break Even Below Strike Below Strike 5700 5600 5500 5400 5300 5200 5100 NIFTY SPOT

PowerPoint Presentation:

Sell Nifty Call What is it? Sell the right to buy-have an obligation to sell Why Sell Call? Neutral to bearish Index will not go up ! Motive : to receive premium income Premium is the profit Limited profit and maximum loss

Example: Sell Nifty Call Option:

Example: Sell Nifty Call Option Spot Nifty: 5500 One month call Strike price: 5600 Premium: Rs. 100 Profit limited to premium Breakeven: strike price + premium : 5400 + 100 (5400)

Payoff For Seller of a CALL:

Payoff For Seller of a CALL -300 -150 -30 0 300 400 500 Net Profit/ Loss 20 50 70 100 300 400 500 Premium recd. -20 50 70 100 300 400 500 Value of 5600 Call Above Strike Above Strike Break Even At Strike Below Strike Below Strike Below Strike 5800 5700 5600 5500 5300 5200 5100 NIFTY SPOT

PowerPoint Presentation:

Some Market Direction Indicators

Using Open Interest to determine market trend...:

Using Open Interest to determine market trend... Open Interest applies primarily to the futures market . Open interest, or the total number of open contracts on a security, is often used to confirm trends and trend reversals for futures and options contracts. There are certain rules to open interest that must be understood and remembered.

Open Interest Rules...:

Open Interest Rules... If prices are rising and open interest is increasing at a rate faster than its average, this is a bullish sign. More participants are entering the market, involving additional buying and any purchases are generally aggressive in nature. If the open interest numbers flatten following a rising trend in both price and open interest, take this as a warning sign of an impending top. High open interest at market tops is a bearish signal if the price drop is sudden, since this will force many ‘weak' longs to liquidate. Occasionally, such conditions set off a self-feeding, downward spiral.

Open Interest Rules...:

Open Interest Rules... An unusually high or record open interest in a bull market is a danger signal. When a rising trend of open interest begins to reverse, expect a bear trend to get underway. A decline in both price and open interest indicates liquidation by discouraged traders with long positions. As long as this trend continues, it is a bearish sign. Once open interest stabilizes at a low level, the liquidation is over and prices are then in a position to rally again.

Open Interest (OI) in a nutshell:

Open Interest (OI) in a nutshell Bullish: an increasing OI in a rising market. Bearish: a declining OI in a rising market. Bearish: an increasing OI in a falling market. Bullish: a declining OI in a falling market.

Put-Call Ratio:

Put-Call Ratio A ratio of the trading volume of put options to call options. It is used to gauge investor sentiment. For example, a high volume of puts compared to calls indicates a bearish sentiment in the market.

Put-Call Ratio (contd…):

Put-Call Ratio (contd…) Contrarian -sentiment measure Too many put buyers could also signal that a market bottom is nearby. While too many call buyers can typically indicate a market top is in the making.

Interpretation of Put Call Ratio:

Interpretation of Put Call Ratio

PowerPoint Presentation:

Which strike price to select? Speculator or investor? Buying an OTM options - very bullish / bearish - very cheap Same expiry OTM cheaper than ITM Less investment Speculator may look for more leverage with OTM Your perceptions of the market movement Your perceptions of the volatility and interest rates in the market.

PowerPoint Presentation:

To sum up Some of the key uses of options are… -          Leverage -          Protecting the value of equity positions -          Limiting risk -          Alternative to direct investment in equity markets.

PowerPoint Presentation:

How can you get the most out of these instruments? - Adopt the appropriate strategy that suits… - Your personal circumstances and - Your market view

PowerPoint Presentation:

Thank you!

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