Derivatives (Futures & Options)

April , 2014

Derivatives
Derivatives is used to refer to financial instruments !ic! derive t!eir value from some underl"in# assets Assets could $e e%uities (s!ares), de$t ($onds, &'$ills, and notes), currencies, and even indices of t!ese various assets, suc! as t!e (ift" )0 *nde+ Derivatives can $e traded eit!er on a re#ulated e+c!an#e, suc! as t!e (,- or off t!e e+c!an#es, i.e., directl" $et een t!e different parties, !ic! is called over't!e'counter (O&/) tradin#.

Derivatives
&!e $asic purpose of derivatives is to transfer the price risk (inherent in fluctuations of the asset prices) from one part" to anot!er0 they facilitate the allocation of risk to those who are willing to take it . *n so doin#, derivatives !elp miti#ate t!e ris1 arisin# from t!e future uncertaint" of prices.
For e+ample, on (ovem$er 1, 2012 a rice farmer ma" is! to sell !is !arvest at a future date (sa" 3anuar" 1, 2014) for a pre'determined fi+ed price to eliminate t!e ris1 of c!an#e in prices $" t!at date. ,uc! a transaction is an e+ample of a derivatives contract. &!e price of this derivative is driven by the spot price of rice which is the "underlying".

Derivatives
&!e earliest evidence of t!ese t"pes of instruments can $e traced $ac1 to ancient 4reece Derivatives contracts initiall" developed in commodities. &!e first futures contracts can $e traced to t!e 5odo"a rice mar1et in Osa1a, 3apan around 16)0. &!e farmers ere afraid of rice prices fallin# in t!e future at t!e time of !arvestin#. &o loc1 in a price (t!at is, to sell t!e rice at a predetermined fi+ed price in t!e future), t!e farmers entered into contracts it! t!e $u"ers. &!ese ere evidentl" standardi7ed contracts, muc! li1e toda"8s futures contracts. as esta$lis!ed to facilitate tradin# of for ard contracts on it! or#ani7ed tradin# in cotton *n 1949, t!e /!ica#o :oard of &rade (/:O&) various commodities.

Derivatives mar1ets !ave $een functionin# since t!e nineteent! centur", t!rou#! t!e esta$lis!ment of t!e /otton &rade Association in 19;).

Derivatives, as e+c!an#e traded financial instruments ere introduced in *ndia in 3une 2000. &!e (ational ,toc1 -+c!an#e ((,-) is t!e lar#est e+c!an#e in *ndia in derivatives, tradin# in various derivatives contracts. &!e first contract to $e launc!ed on (,- as t!e (ift" )0 inde+ futures contract.

Derivatives
Spot Market : *n t!e conte+t of securities, t!e spot market or cash market is a securities market in which securities are sold for cas! and delivered immediatel".
&!e deliver" !appens after t!e settlement period. -#< &!e (,-8s cas! mar1et se#ment is 1no n as t!e /apital =ar1et (/=) ,e#ment. *n t!is mar1et, s!ares of ,:*, >eliance, *nfos"s, */*/* :an1, and ot!er pu$lic listed companies are traded. &!e settlement period in t!is mar1et is on a &?2 $asis i.e., t!e $u"er of t!e s!ares receives t!e s!ares t o or1in# da"s after trade date and t!e seller of t!e s!ares receives t!e mone" t o or1in# da"s after t!e trade date.

&!ree $asic t"pes of derivative instruments are <

For ards Futures Options

Derivatives
For ards <
A for ard contract or simpl" a for ard is a contract between two parties to buy or sell an asset at a certain future date for a certain price t!at is pre-decided on the date of the contract. &!e future date is referred to as expiry date and t!e pre-decided price is referred to as Forward Price. Forwards are private contracts and t!eir terms are determined by the parties involved. *t is a commitment $" $ot! t!e parties to engage in a transaction at a later date with the price set in advance. &!is is different from a spot market contract which involves immediate payment and immediate transfer of asset. &!e part" t!at a#rees to $u" t!e asset on a future date is referred to as a long investor and is said to have a long position. @art" t!at a#rees to sell t!e asset in a future date is referred to as a short investor and is said to have a short position. &!e price agreed upon is called the delivery price or the Forward Price.

Forward contracts are traded only in !ver the "ounter (!#") market and not in stoc1 e+c!an#es. O&/ mar1et is a private mar1et !ere *ndividualsAinstitutions can trade t!rou#! ne#otiations on a one to one $asis.

-+amples of a for ard

@i77a for ard contract. Order pi77a $" p!one. ,pecif" toppin# (t"pe), si7e, deliver" time and location and price ' fi+ed !en contract is esta$lis!ed. @a" on deliver". -ner#" for ard
5ou $u" )0,000 cu$ic feet ()0 =cf) of !eatin# #as in summer from "our !eatin# compan" for B10 per t!ousand cu$ic feet (=cf), delivera$le from 3an. C =arc!. Don# in for ard< 5ou ,!ort< Eeatin# /o.

Derivatives
Settlement of forward contracts @!"sical settlement /as! settlement Physical $ettlement @!"sical deliver" of t!e underl"in# asset $" a s!ort investor (i.e. t!e seller) to t!e lon# investor (i.e. t!e $u"er) @a"ment of t!e a#reed for ard price $" t!e $u"er to t!e seller on t!e a#reed settlement date

Derivatives
%llustration & /onsider t o parties (A and :) enter into a for ard contract on 1 Au#ust, 200F !ere, A a#rees to deliver 1000 stoc1s of Gnitec! to :, at a price of >s. 100 per s!are, on 2F t! Au#ust, 200F (t!e e+pir" date). *n t!is contract, A, !o !as committed to sell 1000 stoc1s of Gnitec! at >s.100 per s!are on 2Ft! Au#ust, 200F !as a s!ort position and :, !o !as committed to $u" 1000 stoc1s at >s. 100 per s!are is said to !ave a lon# position. *n case of p!"sical settlement, on 2Ft! Au#ust, 200F (e+pir" date), A !as to actuall" deliver 1000 Gnitec! s!ares to : and : !as to pa" t!e price (1000 H >s. 100 I >s. 10,000) to A. *n case A does not !ave 1000 s!ares to deliver on 2Ft! Au#ust, 200F, !e !as to purc!ase it from t!e spot mar1et and t!en deliver t!e stoc1s to : .

!n the expiry date the profit'loss for each party depends on the settlement price that is the closing price in the spot market on ()th *ugust (++). Dependin# on t!e closin# price, t!ree different scenarios of profitAloss are possi$le for eac! part".

Derivatives
$cenario %. "losing spot price on () *ugust (++) ($ #) is greater than the Forward price (F#)
Assume t!at t!e closin# price of Gnitec! on t!e settlement date 2F Au#ust, 200F is >s. 10). ,ince t!e s!ort investor !as sold Gnitec! at >s. 100 in t!e For ard mar1et on 1 Au#ust, 200F, !e can $u" 1000 Gnitec! s!ares at >s. 10) from t!e mar1et and deliver t!em to t!e lon# investor. &!e person !o !as a s!ort position ma1es a loss of (100 C 10)) J 1000 I >s. )000. *f t!e lon# investor sells t!e s!ares in t!e spot mar1et immediatel" after receivin# t!em, !e ould ma1e an e%uivalent profit of (10) C 100) J 1000 I >s. )000.

Derivatives
$cenario %%. "losing $pot price on () *ugust ($ #) (++) is the same as the Forward price (F #)
&!e s!ort seller ill $u" t!e stoc1 from t!e mar1et at >s. 100 and #ive it to t!e lon# investor. As t!e settlement price is same as t!e For ard price, neit!er part" ill #ain or lose an"t!in#.

$cenario %%%. "losing $pot price ($ #) on () *ugust is less than the futures price (F #)
Assume t!at t!e closin# price of Gnitec! on 2F Au#ust, 200F is >s. F). &!e s!ort investor, !o !as sold Gnitec! at >s. 100 in t!e For ard mar1et on 1 Au#ust, 200F, ill $u" t!e stoc1 from t!e mar1et at >s. F) and deliver it to t!e lon# investor. &!erefore t!e person !o !as a s!ort position ould ma1e a profit of (100 C F)) J 1000 I >s. )000 &!e person !o !as lon# position in t!e contract ill lose an e%uivalent amount (>s. )000), if !e sells t!e s!ares in t!e spot mar1et immediatel" after receivin# t!em.

,isadvantage of physical settlement&

&ransaction costs in terms of actual purc!ase of securities $" t!e part" !oldin# a s!ort position (in t!is case A) and transfer of t!e securit" to t!e part" in t!e lon# position (in t!is case :). *f t!e part" in t!e lon# position is actuall" not interested in !oldin# t!e securit", t!en s!e ill !ave to incur furt!er transaction cost in disposin# off t!e securit".

@a"offs From For ard /ontracts

Det ST denote t!e spot price of t!e asset at t!e deliver" date & and let Ft $e t!e deliver" price (price set at t pa"a$le at T) &!e pa"offs on t!e deliver" date are< lon# position pa"off< ST Ft s!ort position pa"off< Ft ST

Derivatives
"ash $ettlement
/as! settlement does not involve actual deliver" or receipt of t!e securit". -ac! part" eit!er pa"s (receives) cas! e%ual to t!e net loss (profit) arisin# out of t!eir respective position in t!e contract. *n case of ,cenario *, !ere t!e spot price at t!e e+pir" date (,&) as #reater t!an t!e for ard price, A ill simpl" pa" >s. )000 to : on t!e e+pir" date. &!e opposite is t!e case in ,cenario (***), !en ,& K F&. &!e lon# part" ill $e at a loss and !ave to pa" an amount e%uivalent to t!e net loss to t!e s!ort part". *n our e+ample, : ill !ave to pa" >s. )000 to A on t!e e+pir" date. *n case of ,cenario (**) !ere ,& I F&, t!ere is no need for an" part" to pa" an"t!in# to t!e ot!er part". @rofit and loss position in case of p!"sical settlement and cas! settlement is t!e same e+cept for t!e transaction costs !ic! is involved in t!e p!"sical settlement.

Default risk in forward contracts

L!et!er t!e contract is for p!"sical or cas! settlement, t!ere e+ists a potential for one part" to default. &!is ris1 of ma1in# losses due to an" of t!e t o parties defaultin# is 1no n as counter part" ris1.

Derivatives
Futures
An a#reement $et een t o parties in !ic! t!e $u"er a#rees to $u"Asell an underl"in# asset from t!e seller, at a future date at a price t!at is a#reed upon toda" A futures contract is not a private transaction $ut #ets traded on a recogni-ed stock exchange A futures contract is standardi-ed by the exchange *ll the terms other than the price are set by the stock exchange (rather than by individual parties as in the case of a forward contract). :ot! $u"er and seller of t!e futures contracts are protected against the counter party risk by an entity called the "learing "orporation &!e "learing "orporation holds an amount as a security from both the parties. #his amount is called the .argin money and can be in the form of cash or other financial assets. ,ince t!e futures contracts are traded on t!e stoc1 e+c!an#es, t!e parties have the flexibility of closing out the contract prior to the maturity by s/uaring off the transactions in the market.

Derivatives
Forwards
@rivatel" ne#otiated contracts (ot standardi7ed ,ettlement dates can $e set $" t!e parties Ei#! counter part" ris1

Futures
&raded on an e+c!an#e ,tandardi7ed contracts Fi+ed settlement dates as declared $" t!e e+c!an#e Almost no counter part" ris1

Derivatives
An option is a derivative contract $et een a $u"er and a seller, !ere one party gives to the other the right but not the obligation to buy from (or sell to) the First Party the underlying asset on or before a specific day at an agreed-upon price. *n return for #rantin# t!e option, t!e part" #rantin# t!e option collects a pa"ment from t!e ot!er part". &!is pa"ment collected is called the 0premium1 or price of the option. &!e right to buy or sell is held by the 0option buyer1 (also called t!e option !older)0 t!e part" #rantin# t!e ri#!t is t!e 0option seller1 or 0option writer1. Options re%uire a cas! pa"ment (called t!e premium) upfront from t!e option $u"er to t!e option seller. Options can $e traded eit!er on t!e stoc1 e+c!an#e or in over t!e counter (O&/) mar1ets.

Derivatives
Call option
A call option is an option granting the right to the buyer of the option to buy the underlying asset on a specific day at an agreed upon price but not the obligation to do so. &!e person !o !as t!e ri#!t to $u" t!e underl"in# asset is 1no n as t!e 0buyer of the call option1. &!e price at !ic! t!e $u"er !as t!e ri#!t to $u" t!e asset is a#reed upon at t!e time of enterin# t!e contract (strike price of the contract - call option strike price in this case). &!e $u"er ill exercise his right to buy the underlying asset if and only if the price of the underlying asset in the market is more than the strike price on or before the expiry date of the contract. #he buyer of the call option does not have an obligation to buy if he does not want to

Derivatives
Put option
A put option is a contract #rantin# the right to the buyer of the option to sell the underlying asset on or before a specific day at an agreed upon price but not the obligation to do so. It is t!e seller !o #rants t!is ri#!t to t!e $u"er of t!e option. &!e person !o !as t!e right to sell t!e underl"in# asset is 1no n as t!e $u"er of t!e put option. &!e price at !ic! t!e $u"er !as t!e ri#!t to sell t!e asset is a#reed upon at t!e time of enterin# t!e contract. #his price is known as the strike price of the contract (put option strike price in this case). &!e $u"er of t!e put ill exercise his right to sell the underlying asset if and only if the price of the underlying asset in the market is less than the strike price on or before the expiry . &!e $u"er of t!e put option does not !ave t!e o$li#ation to sell if !e does not ant to.

Derivatives
*llustration
,uppose A !as $ou#!t a call option of 2000 s!ares of Eindustan Gnilever Dimited (EDD) at a stri1e price of >s 260 per s!are at a premium of >s 10.
&!is option #ives A, t!e $u"er of t!e option, t!e ri#!t to $u" 2000 s!ares of EDD from t!e seller of t!e option, on or $efore Au#ust 2;, 200F (e+pir" date of t!e option). &!e seller of t!e option !as t!e o$li#ation to sell 2000 s!ares of EDD at >s 260 per s!are on or $efore Au#ust 2;, 200F (i.e. !enever as1ed $" t!e $u"er of t!e option).

,uppose instead of $u"in# a call, A !as sold a put option on 100 >eliance *ndustries (>*D) s!ares at a stri1e price of >s 2000 at a premium of >s 9.
&!is option is an o$li#ation to A to $u" 100 s!ares of >eliance *ndustries (>*D) at a

price of >s 2000 per s!are on or $efore Au#ust 2; (e+pir" date of t!e option) i.e., as and !en as1ed $" t!e $u"er of t!e put option.

*t depends on t!e option $u"er as to !en !e e+ercises t!e option. &!e $u"er does not !ave t!e o$li#ation to e+ercise t!e option.

Derivatives
Futures
:ot! t!e $u"er and t!e seller are under an o$li#ation to fulfill t!e contract.

!ptions
&!e $u"er of t!e option !as t!e ri#!t and not an o$li#ation !ereas t!e seller is under o$li#ation to fulfill t!e contract if and !en t!e $u"er e+ercises !is ri#!t. &!e seller is su$Mected to unlimited ris1 of losin# !ereas t!e $u"er !as limited potential to lose ( !ic! is t!e option premium).

&!e $u"er and t!e seller are su$Mect to unlimited ris1 of loss.

&!e $u"er and t!e seller !ave &!e $u"er !as potential to ma1e potential to ma1e unlimited #ain or unlimited #ain .On t!e ot!er !and loss. t!e $u"er !as a limited loss potential and t!e seller !as an unlimited loss potential.

Derivatives
Ne" &erminolo#ies Spot price (ST : ,pot price of an underlying asset is the price that is /uoted for immediate delivery of the asset. For e+ample, at t!e (,-, t!e spot price of >eliance Dtd. at an" #iven time is t!e price at !ic! >eliance Dtd. s!ares are $ein# traded at t!at time in t!e /as! =ar1et ,e#ment of t!e (,-. !orward price or futures price (! : For ard price or futures price is t!e price t!at is a#reed upon at t!e date of t!e contract for t!e deliver" of an asset at a specific future date. #hese prices are dependent on the spot price the prevailing interest rate and the expiry date of the contract.

Derivatives
Ne" &erminolo#ies Strike price (" : &!e price at !ic! t!e $u"er of an option can $u" t!e stoc1 (in t!e case of a call option) or sell t!e stoc1 (in t!e case of a put option) on or $efore t!e e+pir" date of option contracts is called stri1e price. ,tri1e price is used in t!e case of options onl"0 it is not used for futures or for ards. #$piration date (T : *n t!e case of Futures, For ards, *nde+ and ,toc1 Options, -+piration Date is t!e date on !ic! settlement ta1es place. *t is also called t!e final settlement date.

Derivatives
Ne" &erminolo#ies Types of options : Options can $e divided into t o different cate#ories
dependin# upon t!e primar" e+ercise st"les associated it! options< #uropean %ptions: #uropean options are options that can be e$ercised only on the e$piration date. &merican options: &merican options are options that can be e$ercised on any day on or $efore t!e e+pir" date.

Contract si'e : As futures and options are standardi7ed contracts traded on an

e+c!an#e, t!e" !ave a fi+ed contract si7e. One contract of a derivatives instrument represents a certain num$er of s!ares of t!e underl"in# asset. For e+ample, if one contract of :E-D consists of 200 s!ares of :E-D, t!en if one $u"s one futures contract of :E-D, t!en for ever" >e 1 increase in :E-D8s futures price, t!e $u"er ill ma1e a profit of 200 J 1 I >s 200 and for ever" >e 1 fall in :E-D8s futures price, !e ill lose >s 200.

Contract (alue : /ontract value is notional value of t!e transaction in case one
contract is $ou#!t or sold. *t is t!e contract si7e multiplied $ut t!e price of t!e futures. /ontract value is used to calculate mar#ins etc. for contracts. *n t!e e+ample a$ove if :E-D futures are tradin# at >s. 2000 t!e contract value ould $e >s. 2000 + 200 I >s. 6 lacs.

Derivatives
Ne" &erminolo#ies
Margins : *n t!e spot mar1et, t!e $u"er of a stoc1 !as to pa" t!e entire transaction amount (for purc!asin# t!e stoc1) to t!e seller.
For e+ample, if *nfos"s is tradin# at >s. 2000 a s!are and an investor ants to $u" 100 *nfos"s s!ares, t!en !e !as to pa" >s. 2000 J 100 I >s. 2,00,000 to t!e seller. &!e settlement ill ta1e place on &?2 $asis0 t!at is, t o da"s after t !e transaction date.

*n a derivatives contract, a person enters into a trade toda" ($u" or sell) $ut t!e settlement !appens on a future date. :ecause of t!is, t!ere is a !i#! possi$ilit" of default $" an" of t!e parties. *n order to prevent an" of t!e parties from defaultin# on !is trade commitment, t!e clearin# corporation levies a mar#in on t!e $u"er as ell as seller of t!e futures and option contracts. &!is mar#in is a percenta#e (appro+imatel" 20O) of t!e total contract value. For t!e aforementioned e+ample, if a person ants to $u" 100 *nfos"s futures, t!en !e ill !ave to pa" 20O of t!e contract value of >s 2,00,000 I >s 40,000 as a mar#in to t!e clearin# corporation. &!is mar#in is applica$le to $ot!, t!e $u"er and t!e seller of a futures contract. A maintenance mar#in is set lo er t!an initial mar#in. L!en $alance falls $elo maintenance mar#in t!e investor receives mar#in call and !as to topup t!e account to initial mar#in level.

Derivatives
Margins : )n*estor contacts his broker to buy + ,old futures
contracts (one contract is of -.. ounces . The current future price is /0.. per ounce. The initial margin re1uirement is /+... per contract. The maintenance margin is /-2.. per contract. Calculate margin re1uirements for below futures price mo*ements.
,ay Futures price 600 1 2 2 4 ) 6 ; 9 )F; (600) (600) ,aily 2ain'3oss "umulativ e gain'loss .argin account balance 4000 2400 .argin call

Derivatives
Margins : )n*estor contacts his broker to buy + ,old futures
contracts (one contract is of -.. ounces . The current future price is /0.. per ounce. The initial margin re1uirement is /+... per contract. The maintenance margin is /-2.. per contract. Calculate margin re1uirements for below futures price mo*ements.
,ay Futures price 600 1 2 2 4 ) 6 ; 9 )F; )F6.1 )F9.2 )F;.1 )F6.; )F).4 )F2.2 )F2.6 (600) (190) 420 (220) (90) (260) (420) 60 (600) (;90) (260) ()90) (660) (F20) (1240) (1290) ,aily 2ain'3oss "umulativ e gain'loss .argin account balance 4000 2400 2220 2640 2420 2240 2090 2660 4060 1240 .argin call

Derivatives
.oneyness of an !ption& =one"ness of an option indicates !et!er an option is ort! e+ercisin# or not i.e. if t!e option is e+ercised $" t!e $u"er of t!e option !et!er !e ill receive mone" or not.
=one"ness of an option at an" #iven time depends on !ere t!e spot price of t!e underl"in# is at t!at point of time relative to t!e stri1e price. &!e premium paid is not ta1en into consideration !ile calculatin# mone"ness of an Option, since t!e premium once paid is a sun1 cost and t!e profita$ilit" from e+ercisin# t!e option does not depend on t!e si7e of t!e premium.

Derivatives
.oneyness of an !ption&
)n3the3money option : An option is said to $e in't!e'mone" if on e+ercisin# t!e option, it ould produce a cas! inflo for t!e $u"er. /all Options are in't!e'mone" !en t!e value of spot price of t!e underl"in# e+ceeds t!e stri1e price. @ut Options are in't!e' mone" !en t!e spot price of t!e underl"in# is lo er t!an t!e stri1e price. =one"ness of an option s!ould not $e confused it! t!e profit and loss arisin# from !oldin# an option contract. L!ile mone"ness of an option does not depend on t!e premium paid, profitAloss depend on premium paid. &!us a !older of an in't!e'mone" option need not al a"s ma1e profit as t!e profita$ilit" also depends on t!e premium paid.

Derivatives
.oneyness of an !ption&
%ut3of3the3money option : An out'of't!e'mone" option is an opposite of an in't!e'mone" option.
*n option-holder will not exercise the option when it is out-of-the-money. A /all option is out'of't!e'mone" !en its stri1e price is #reater t!an t!e spot price of t!e underl"in# A @ut option is out'of't!e mone" !en t!e spot price of t!e underl"in# is #reater t!an t!e option8s stri1e price.

&t3the3money option
An at't!e'mone"'option is one in !ic! t!e spot price of t!e underl"in# is e%ual to t!e stri1e price.

.oneyness of an !ption
"all !ption 4567
Option Payoff 0 75 At the money Underlying Price Option Payoff

Put !ption 4577

Out of the money

Out of the money

In the money

In the money

0 55 At the money Underlying Price

Derivatives
*llustration <
/onsider some /all and @ut options on stoc1 J5P. *s on 89 *ugust (++) :;< is trading at =s 88>.(7. &!e ta$le $elo #ives t!e information on closin# prices of four options, e+pirin# in ,eptem$er and Decem$er, and it! stri1e prices of =s. 887 and =s. 886.7+.

$trike Price >s 11).00 >s 11;.)0

$eptember "all option >s. 9.2) >s. 4.00

,ecember "all option >s. 12.20 >s. 9.1)

$eptember Put option >s. 4.00 >s. 9.00

,ecember Put option >s. 9.00 >s. 12.00

$uppose the spot price of the underlying (closing share price) as at end of $eptember is =s. 88> and at end of ,ecember is =s. 88?. On t!e $asis of t!e rules stated a$ove, !ic! options are in't!e'mone" and !ic! ones are out'of't!e'mone"Q

Derivatives
%n-the-money !ptions !ut-of-money !ptions !ption @ustification !ption @ustification

Derivatives
%n-the-money !ptions !ut-of-money !ptions !ption @ustification !ption @ustification

,eptem$er 11) /all ,eptem$er 11;.)0 @ut Decem$er 11) /all Decem$er 11;.)0 /all

>s. 11) K >s. 116

,eptem$er 11) @ut ,eptem$er 11;.)0 /all Decem$er 11) @ut

>s. 11) K >s. 116

>s. 11;.)0 R >s. 116 >s 11) K >s 119

>s. 11;.)0 R >s. 116 >s 11) K >s 119

>s 11;.)0 K >s 119

Decem$er 11;.)0 >s 11) K >s 119 @ut

Derivatives
*nvestors can $e $roadl" classified into t!ree #roups< Eed#ers ,peculators Ar$itra#eurs

Derivatives
4edgers : &!ese investors !ave a position (i.e., !ave $ou#!t stoc1s) in t!e underl"in# mar1et $ut are orried a$out a potential loss arisin# out of a c!an#e in t!e asset price in t!e future.
Lant to loc1 t!e prices at !ic! t!e" ill $e a$le to transact in t!e future. A !ed#er normall" ta1es an opposite position in t!e derivatives mar1et to !at !e !as in t!e underl"in# mar1et. Eed#in# in futures mar1et can $e done t!rou#! t o positions, vi7. s!ort !ed#e and lon# !ed#e.

Derivatives
,!ort !ed#e
A s!ort !ed#e involves ta1in# a s!ort position in t!e futures mar1et. ,!ort !ed#e position is ta1en $" someone !o alread" o ns t!e underl"in# asset or is e+pectin# a future receipt of t!e underl"in# asset An investor !oldin# >eliance s!ares ma" $e orried a$out adverse future price movements and ma" ant to !ed#e t!e price ris1. Ee can do so $" !oldin# a s!ort position in t!e derivatives mar1et.
&!e investor can #o s!ort in >eliance futures at t!e (,-. &!is protects !im from price movements in >eliance stoc1. %n case the price of =eliance shares falls the investor will lose money in the shares but will make up for this loss by the gain made in =eliance Futures.

A s!ort position !older in a futures contract ma1es a profit if t!e price of t!e underl"in# asset falls in t!e future. *n t!is a", futures contract allo s an investor to mana#e !is price ris1. ,imilarl", a su#ar manufacturin# compan" could !ed#e a#ainst an" pro$a$le loss in t!e future due to a fall in t!e prices of su#ar $" !oldin# a s!ort position in t!e futuresA for ards mar1et.
*f t!e prices of su#ar fall, t!e compan" ma" lose on t!e su#ar sale $ut t!e loss ill $e offset $" profit made in t!e futures contract.

Derivatives
Don# Eed#e < A lon# !ed#e involves !oldin# a lon# position in t!e futures mar1et. A Don# position !older a#rees to $u" t!e underl"in# asset at t!e e+pir" date $" pa"in# t!e a#reed futuresA for ard price.

#his strategy is used by those who will need to ac/uire the underlying asset in the future. For e+ample, a c!ocolate manufacturer !o needs to ac%uire su#ar in t!e future ill $e orried a$out an" loss t!at ma" arise if t!e price of su#ar increases in t!e future. &o !ed#e a#ainst t!is ris1, t!e c!ocolate manufacturer can !old a lon# position in t!e su#ar futures. *f t!e price of su#ar rises, t!e c!ocolate manufacture ma" !ave to pa" more to ac%uire su#ar in t!e normal mar1et, $ut !e ill $e compensated a#ainst t!is loss t!rou#! a profit t!at ill arise in t!e futures mar1et. A lon# position !older in a futures contract ma1es a profit if t!e price of t!e underl"in# asset increases in t!e future. Don# !ed#e strate#" can also $e used $" t!ose investors !o desire to purc!ase t!e underl"in# asset at a future date (t!at is, !en !e ac%uires t!e cas! to purc!ase t!e asset) $ut ants to loc1 t!e prevailin# price in t!e mar1et. &!is ma" $e $ecause !e t!in1s t!at t!e prevailin# price is ver" lo .

Derivatives
*llustration<
For e+ample, suppose t!e current spot price of Lipro Dtd. is >s. 2)0 per stoc1. An investor is e+pectin# to !ave >s. 2)0 at t!e end of t!e mont!. &!e investor feels t!at Lipro Dtd. is at a ver" attractive level and !e ma" miss t!e opportunit" to $u" t!e stoc1 if !e aits till t!e end of t!e mont!. *n suc! a case, !e can $u" Lipro Dtd. in t!e futures mar1et. :" doin# so, !e can loc1 in t!e price of t!e stoc1. Assumin# t!at !e $u"s Lipro Dtd. in t!e futures mar1et at >s.2)0 (t!is $ecomes !is loc1ed'in price), t!ere can $e t!ree pro$a$le scenarios<

Derivatives
$cenario %& Price of Aipro 3td. in the cash market on expiry date is =s. 9++.
As futures price is e%ual to t!e spot price on t!e e+pir" da", t!e futures price of Lipro ould $e at >s. 200 on e+pir" da". &!e investor can sell Lipro Dtd in t!e futures mar1et at >s. 200. @rofit < 200 C 2)0 I >s. )0 in t!e futures trade. *nvestor can no $u" Lipro Dtd in t!e spot mar1et at >s. 200. &!erefore, !is total investment cost for $u"in# one s!are of Lipro Dtd e%uals >s.200 (price in spot mar1et) C )0 (profit in futures mar1et) I >s.2)0. &!is is t!e amount of mone" !e end of t!e mont!. as e+pectin# to !ave at t!e

*f t!e investor !ad not $ou#!t Lipro Dtd futures, !e ould !ave !ad onl" >s. 2)0 and ould !ave $een una$le to $u" Lipro Dtd s!ares in t!e cas! mar1et. &!e futures contract !elped !im to loc1 in a price for t!e s!ares at >s. 2)0.

Derivatives
$cenario %%& Price of Aipro 3td in the cash market on expiry day is =s. (7+.
As futures price trac1s spot price, futures price ould also $e at >s. 2)0 on e+pir" da". &!e investor ill sell Lipro Dtd in t!e futures mar1et at >s. 2)0. :" doin# t!is, !e !as made >s. 0 in t!e futures trade. Ee can $u" Lipro Dtd in t!e spot mar1et at >s. 2)0. Eis total investment cost for $u"in# one s!are of Lipro ill $e I >s. 2)0 (price in spot mar1et) ? 0 (loss in futures mar1et) I >s. 2)0.

Derivatives
$cenario %%%& Price of Aipro 3td in the cash market on expiry day is =s. (++.
As futures price trac1s spot price, futures price ould also $e at >s. 200 on e+pir" da". &!e investor ill sell Lipro Dtd in t!e futures mar1et at >s. 200. :" doin# t!is, !e !as made a loss of 200 C 2)0 I >s. )0 in t!e futures trade. Ee can $u" Lipro in t!e spot mar1et at >s. 200. &!erefore, !is total investment cost for $u"in# one s!are of Lipro Dtd ill $e I 200 (price in spot mar1et) ? )0 (loss in futures mar1et) I >s. 2)0.

Derivatives
Speculators
A ,peculator is one !o $ets on t!e derivatives mar1et $ased on !is vie s on t!e potential movement of t!e underl"in# stoc1 price. ,peculators ta1e lar#e, calculated ris1s as t!e" trade $ased on anticipated future price movements. &!e" !ope to ma1e %uic1, lar#e #ains0 $ut ma" not al a"s $e successful. &!e" normall" !ave s!orter !oldin# time for t!eir positions as compared to !ed#ers. *f t!e price of t!e underl"in# moves as per t!eir e+pectation t!e" can ma1e lar#e profits. *f t!e price moves in t!e opposite direction of t!eir assessment, t!e losses can also $e enormous.

Derivatives
)llustration
/urrentl" */*/* :an1 Dtd (*/*/*) is tradin# at, sa", >s. )00 in t!e cas! mar1et and also at >s.)00 in t!e futures mar1et. A speculator feels t!at post t!e >:*8s polic" announcement, t!e s!are price of */*/* ill #o up. &!e speculator can $u" t!e stoc1 in t!e spot mar1et or in t!e derivatives mar1et. *f t!e derivatives contract si7e of */*/* is 1000 and if t!e speculator $u"s one futures contract of */*/*, !e is $u"in# */*/* futures ort! >s )00 J 1000 I >s. ),00,000. Ee ill !ave to pa" a mar#in of sa" 20O of t!e contract value to t!e e+c!an#e. &!e mar#in t!at t!e speculator needs to pa" to t!e e+c!an#e is 20O of >s. ),00,000 I >s. 1,00,000. &!is >s. 1,00,000 is !is total investment for t!e futures contract. *f t!e speculator ould !ave invested >s. 1,00,000 in t!e spot mar1et, !e could purc!ase onl" 1,00,000 A )00 I 200 s!ares. Det us assume t!at post >:* announcement price of */*/* s!are moves to >s. )20. Lit! one la1! investment eac! in t!e futures and t!e cas! mar1et, t!e profits ould $e< ()20 C )00) J 1,000 I >s. 20,000 in case of futures mar1et and ()20 C )00) J 200 I >s. 4000 in t!e case of cas! mar1et. &!e opposite price movement ill result in case of adverse movement in stoc1 prices, !erein t!e speculator ill $e losin# more in t!e futures mar1et t!an in t!e spot mar1et.

Derivatives
&rbitrageurs : Ar$itra#eurs attempt to profit from pricin# inefficiencies in t!e mar1et $" ma1in# simultaneous trades t!at offset eac! ot!er and capture a ris1'free profit. An ar$itra#eur ma" also see1 to ma1e profit in case t!ere is price discrepanc" $et een t!e stoc1 price in t!e cas! and t!e derivatives mar1ets. On 1st Au#ust, 200F t!e ,:* s!are is tradin# at >s. 1;90 in t!e cas! mar1et and t!e futures contract of ,:* is tradin# at >s. 1;F0, t!e ar$itra#eur ould $u" t!e ,:* s!ares (i.e. ma1e an investment of >s. 1;90) in t!e spot mar1et and sell t!e same num$er of ,:* futures contracts. On e+pir" da" (sa" 24 Au#ust, 200F), t!e price of ,:* futures contracts ill close at t!e price at !ic! ,:* closes in t!e spot mar1et. /alculate pa"offs if ,:* closes at 2000, 1;90 & 1)00 in t!e spot mar1et and overall profit to t!e ar$itra#eur. @ossi$le price scenarios at !ic! ,:* can close on e+pir" da"

Derivatives
$cenario %& $B% shares closes at a price greater than 86?+ (say =s. (+++) in the spot market on e+pir" da" (24 Au#ust 200F) ,:* futures ill close at t!e same price as ,:* in spot mar1et on t!e e+pir" da" i.e., ,:* futures ill also close at >s. 2000. &!e ar$itra#eur reverses !is previous transaction entered into on 1 Au#ust 200F. @rofitA Doss (C ) in spot mar1et I 2000 C 1;90 I >s. 220 @rofitA Doss (C ) in futures mar1et I 1 ;F0 C 2000 I >s. ( C) 210 (et profitA Doss (C ) on $ot! transactions com$ined I 220 C 210 I >s. 10 profit.

Derivatives
$cenario %%& $B% shares close at =s 86?+ in the spot market on expiry day ((C *ugust (++)) ,:* futures ill close at t!e same price as ,:* in spot mar 1et on e+pir" da" i.e., ,:* futures ill also close at >s 1;90. &!e ar$itra#eur reverses !is previous transaction entered into on 1 Au#ust 200F. @rofitA Doss (C ) in spot mar1et I 1;90 C 1;90 I >s 0 @rofitA Doss (C ) in futures mar1et I 1;F0 C 1;90 I >s. 10 (et profitA Doss (C ) on $ot! transactions com$ined I 0 ? 10 I >s. 10 profit.

Derivatives
$cenario %%%& $B% shares close at =s. 87++ in the spot market on expiry day ((C *ugust (++)) ,:* futures ill close at >s. 1)00. &!e ar$itra#eur reverses !is previous transaction entered into on 1 Au#ust 200F. @rofitA Doss (C ) in spot mar1et I 1)00 C 1;90 I >s. (C) 290 @rofitA Doss (C ) in futures mar1et I 1;F0 C 1)00 I >s. 2F0 (et profitA Doss (C ) on $ot! transactions com$ined I (C) 290 ? 2F0 I >s. 10 profit.

&radin# Derivatives
#rading Futures
&!e @a"'off of a futures contract on maturit" depends on t!e spot price of t!e underl"in# asset at t!e time of maturit" and t!e price at !ic! t!e contract as initiall" traded. &!ere are t o positions t!at could $e ta1en in a futures contract< Don# position< one !o $u"s t!e asset at t!e futures price (F) ta1es t!e lon# position ,!ort position< one !o sells t!e asset at t!e futures price (F) ta1es t!e s!ort position @a"'off for a lon# position in a futures contract on one unit of an asset is< Don# @a"'off I , & C F (F is t!e traded futures price and ,& is t!e spot price of t!e asset at e+pir" of t!e contract) &!e lon# investor ma1es profits if t!e spot price (,&) at e+pir" e+ceeds t!e futures contract price F, and ma1es losses if t!e opposite !appens. @a"'off from a s!ort position in a futures contract on one unit of asset is<

,!ort @a"'off I F C ,& *nvestor ma1es profits if t!e spot price (,&) at e+pir" is $elo t!e futures contract price F, and ma1es losses if t!e opposite !appens.

&radin# Derivatives
* theoretical model for Future pricing (cost of carr" model)
Futures prices in realit" are determined $" demand and suppl", one can o$tain a t!eoretical futures price, usin# t!e follo in# model<

L!ere< F I Futures price , I ,pot price of t!e underl"in# asset r I /ost of financin# (usin# continuousl" compounded interest rate) & I &ime till e+piration in "ears e I 2.;1929

,ecurit" J5P Dtd trades in t!e spot mar1et at >s. 11)0. =one" can $e invested at 11O per annum. /alculate t!e fair value of a one'mont! futures contract

&radin# Derivatives
#rading !ptions& !ption Payoffs
(on'linear pa"off for options
losses for t!e $u"er of an option are limited, !o ever t!e profits are potentiall" unlimited. For a riter (seller), t!e pa"off is e+actl" t!e opposite. Eis profits are limited to t!e option premium, !o ever !is losses are potentiall" unlimited.

&radin# Derivatives
DO(4 /ADD ,&>A&-45 < =r. J5P is bullish on Difty on 24t! 3une, !en t!e (ift" is at 41F1.10. Ee $u"s a call option it! a stri1e price of >s. 4600 at a premium of >s. 26.2), e+pirin# on 21st 3ul". *f t!e (ift" #oes a$ove 4626.2), =r. J5P ill ma1e a net profit (after deductin# t!e premium) on e+ercisin# t!e option. *n case t!e (ift" sta"s at or falls $elo 4600, !e can fore#o t!e option (it ill e+pire ort!less) it! a ma+imum loss of t!e premium
"urrent Difty index /all Option ,tri1e @rice (>s.) =r. J5P @a"s @remium (>s.) :rea1 -ven @oint (>s.) (,tri1e @rice ? @remium) C8)8.8+ !n expiry Difty closes at 4100.00 4200.00 4)00.00 4626.2) 4;00.00 4F00.00 )100.00 Det Payoff from "all !ption (=s.)

4600 26.2) 4626.2)

&radin# Derivatives
DO(4 /ADD ,&>A&-45 < =r. J5P is bullish on Difty on 24t! 3une, !en t!e (ift" is at 41F1.10. Ee $u"s a call option it! a stri1e price of >s. 4600 at a premium of >s. 26.2), e+pirin# on 21st 3ul". *f t!e (ift" #oes a$ove 4626.2), =r. J5P ill ma1e a net profit (after deductin# t!e premium) on e+ercisin# t!e option. *n case t!e (ift" sta"s at or falls $elo 4600, !e can fore#o t!e option (it ill e+pire ort!less) it! a ma+imum loss of t!e premium
"urrent Difty index /all Option ,tri1e @rice (>s.) =r. J5P @a"s @remium (>s.) :rea1 -ven @oint (>s.) (,tri1e @rice ? @remium) C8)8.8+ !n expiry Difty closes at 4100.00 4200.00 26.2) 4626.2) 4)00.00 4626.2) 4;00.00 4F00.00 )100.00 )200.00 Det Payoff from "all !ption (=s.) -9>.97 -9>.97 -9>.97 0 >9.>7 (>9.>7 C>9.>7 >>9.>7

4600

Don# /all
@rofit from $u"in# one -uropean call option< option price I B), stri1e price I B100, option life I 2 mont!s

30 Profit #$% 20 10 0 5 70 !0 "0 100 &erminal 'toc( price #$% 110 120 130

&radin# Derivatives
,EO>& /ADD ,&>A&-45 < =r. J5P is bearish about Difty and e+pects it to fall. Ee sells a /all option it! a stri1e price of >s. 2600 at a premium of >s. 1)4, !en t!e current (ift" is at 26F4. *f t!e (ift" sta"s at 2600 or $elo , t!e /all

option ill not $e e+ercised $" t!e $u"er of t!e /all and =r. J5P can retain t!e entire premium of >s. 1)4.
"urrent Difty index /all Option ,tri1e @rice (>s.) =r. J5P receives @remium (>s.) :rea1 -ven @oint (>s.) (,tri1e @rice ? @remium) (>)C !n expiry Difty closes at 2400 2)00 2600 2;00 2;)4 2900 2F00 Det Payoff from "all !ption (=s.)

2600 1)4 2;)4

&radin# Derivatives
,EO>& /ADD ,&>A&-45 < =r. J5P is bearish about Difty and e+pects it to fall. Ee sells a /all option it! a stri1e price of >s. 2600 at a premium of >s. 1)4, !en t!e current (ift" is at 26F4. *f t!e (ift" sta"s at 2600 or $elo , t!e /all

option ill not $e e+ercised $" t!e $u"er of t!e /all and =r. J5P can retain t!e entire premium of >s. 1)4.
"urrent Difty index /all Option ,tri1e @rice (>s.) =r. J5P receives @remium (>s.) :rea1 -ven @oint (>s.) (,tri1e @rice ? @remium) (>)C !n expiry Difty closes at 2400 2)00 1)4 2;)4 2600 2;00 2;)4 2900 2F00 2000 Det Payoff from "all !ption (=s.) 87C 87C 87C 7C + -C> -8C> -(C>

2600

,!ort /all
@rofit from ritin# one -uropean call option< option price I B), stri1e price I B100 Profit #$% 5 0 10 20 30 110 120 130 70 !0 "0 100 &erminal 'toc( price #$%

&radin# Derivatives
$;D#EF#%" 3!D2 "*33 - BG; $#!"4 BG; PG# & @urc!ase a stoc1 since it! $ullis! e+pectations.
&o protect a#ainst price fall $u" a @ut on t!e stoc1, !ic! #ives t!e ri#!t to sell t!e stoc1 at t!e stri1e price. &!e stri1e price can $e t!e price at !ic! "ou $ou#!t t!e stoc1 (A&= stri1e price) or sli#!tl" $elo (O&= stri1e price). *n case t!e price of t!e stoc1 rises "ou #et t!e full $enefit of t!e price rise. *n case t!e price of t!e stoc1 falls, e+ercise t!e @ut Option (remem$er @ut is a ri#!t to sell)

&radin# Derivatives
$;D#EF#%" 3!D2 "*33 - BG; $#!"4 BG; PG# < =r. J5P is $ullis! a$out A:/ Dtd stoc1. Ee $u"s A:/ Dtd. at current mar1et price of >s. 4000 on 4t! 3ul". &o protect a#ainst fall in t!e price of A:/ Dtd. (!is ris1), !e $u"s an A:/ Dtd. @ut option it! a stri1e price >s. 2F00 (O&=) at a premium of >s. 142.90 e+pirin# on 21st 3ul".. Buy $tock (.r. :;< pays) :u" @ut (=r. J5P pa"s) "urrent .arket Price (>)C of *B" 3td. ,tri1e @rice (>s.) 2F00 @remium (>s.) 142.90

:rea1 -ven @oint 4142.90 (>s.) (@ut ,tri1e @rice ? @ut @remium ? ,toc1 @rice C @ut ,tri1e @rice)H

&radin# Derivatives
$;D#EF#%" 3!D2 "*33 - BG; $#!"4 BG; PG# <
*B" 3td. closes Payoff from the at $tock (=s.) (=s.) on expiry 2400.00 2600.00 2900.00 4000.00 4142.90 4200.00 4400.00 4600.00 4900.00 Det Payoff from the Put !ption (=s.) Det Payoff (=s.)

&radin# Derivatives
$;D#EF#%" 3!D2 "*33 - BG; $#!"4 BG; PG# <
*B" 3td. closes Payoff from the at $tock (=s.) (=s.) on expiry 2400.00 2600.00 2900.00 4000.00 4142.90 4200.00 4400.00 4600.00 4900.00 '600.00 '400.00 '200.00 0 142.90 200.00 400.00 600.00 900.00 Det Payoff from the Put !ption (=s.) 2)6.20 1)6.20 '42.90 '142.90 '142.90 '142.90 '142.90 '142.90 '142.90 Det Payoff (=s.) '242.90 '242.90 '242.90 '142.90 0 )6.20 2)6.20 4)6.20 6)6.20

&radin# Derivatives
3!D2 PG# & =r. J5P is bearish on Difty on 24t! 3une, !en t!e (ift" is at 26F4. Ee $u"s a @ut option it! a stri1e price >s. 2600 at a premium of >s. )2, e+pirin# on 21st 3ul". *f t!e (ift" #oes $elo 2)49, =r. J5P ill ma1e a profit on e+ercisin# t!e option. *n case t!e (ift" rises a$ove 2600, !e can fore#o t!e option (it ill e+pire ort!less) it! a ma+imum loss of t!e premium.
"urrent Difty index @ut Option =r. J5P @a"s ,tri1e @rice (>s.) @remium (>s.) :rea1 -ven @oint (>s.) (,tri1e @rice ' @remium) (>)C !n expiry Difty closes at 2200 2600 )2 2)49 2400 2)00 2)49 2600 2;00 2900 Det Payoff from Put !ption (=s.)

2F00 Dimits ris1 to t!e amount of premium paid $ut profit potential remains unlimited

&radin# Derivatives
3!D2 PG# & =r. J5P is bearish on Difty on 24t! 3une, !en t!e (ift" is at 26F4. Ee $u"s a @ut option it! a stri1e price >s. 2600 at a premium of >s. )2, e+pirin# on 21st 3ul". *f t!e (ift" #oes $elo 2)49, =r. J5P ill ma1e a profit on e+ercisin# t!e option. *n case t!e (ift" rises a$ove 2600, !e can fore#o t!e option (it ill e+pire ort!less) it! a ma+imum loss of t!e premium.
"urrent Difty index (>)C !n expiry Difty closes at 2200 2400 2)00 2)49 2)49 2600 2;00 2900 2F00 Det Payoff from Put !ption (=s.) (C? 8C? C? 0 -7( -7( -7( -7(

@ut Option =r. J5P @a"s

,tri1e @rice (>s.) @remium (>s.) :rea1 -ven @oint (>s.) (,tri1e @rice ' @remium)

2600 )2

Dimits ris1 to t!e amount of premium paid $ut profit potential remains unlimited

Don# @ut
@rofit from $u"in# a -uropean put option< option price I B;, stri1e price I B;0

30 Profit #$% 20 10 0 7 *0 50 )0 70 !0 &erminal 'toc( price #$% "0 100

&radin# Derivatives
$E!=# PG# <=r. J5P is $ullis! on (ift" !en it is at 41F1.10. Ee sells a @ut option it! a stri1e price of >s. 4100 at a premium of >s. 1;0.)0 e+pirin# on 21st 3ul". *f t!e (ift" inde+ sta"s a$ove 4100, !e ill #ain t!e amount of premium as t!e @ut $u"er on8t e+ercise !is option. *n case t!e (ift" falls $elo 4100, @ut $u"er ill e+ercise t!e option and t!e =r. J5P ill start losin# mone". *f t!e (ift" falls $elo 2F2F.)0, !ic! is t!e $rea1even point, =r. J5P ill lose t!e premium and more dependin# on t!e e+tent of t!e fallDifty in (ift". "urrent C8)8.8 !n expiry Difty Det Payoff from
index @ut Option =r. J5P receives ,tri1e @rice (>s.) @remium (>s.) :rea1 -ven @oint for option $u"er (>s.) (,tri1e @rice ' @remium) + 4100 1;0.) 2F2F.) closes at 2400.00 2)00.00 2;00.00 2F00.00 2F2F.)0 4100.00 4200.00 4)00.00 Put !ption (=s.)

,ellin# @uts can lead to re#ular income in a risin# or ran#e $ound mar1ets.

&radin# Derivatives
$E!=# PG# <=r. J5P is $ullis! on (ift" !en it is at 41F1.10. Ee sells a @ut option it! a stri1e price of >s. 4100 at a premium of >s. 1;0.)0 e+pirin# on 21st 3ul". *f t!e (ift" inde+ sta"s a$ove 4100, !e ill #ain t!e amount of premium as t!e @ut $u"er on8t e+ercise !is option. *n case t!e (ift" falls $elo 4100, @ut $u"er ill e+ercise t!e option and t!e =r. J5P ill start losin# mone". *f t!e (ift" falls $elo 2F2F.)0, !ic! is t!e $rea1even point, =r. J5P ill lose t!e premium and more dependin# on t!e e+tent of t!e fallDifty in (ift". "urrent C8)8.8 !n expiry Difty Det Payoff from
index @ut Option =r. J5P receives ,tri1e @rice (>s.) @remium (>s.) :rea1 -ven @oint for option $u"er (>s.) (,tri1e @rice ' @remium) + 4100 1;0.) 2F2F.) closes at 2400.00 2)00.00 2;00.00 2F00.00 2F2F.)0 4100.00 4200.00 4)00.00 Put !ption (=s.) -7().7+ -C().7+ -(().7+ -().7+ + 86+.7+ 86+.7+ 86+.7+

,ellin# @uts can lead to re#ular income in a risin# or ran#e $ound mar1ets.

,!ort @ut
@rofit from ritin# a -uropean put option< option price I B;, stri1e price I B;0 Profit #$% 7 0 10 20 30 *0 50 )0 70 !0 &erminal 'toc( price #$% "0 100

&radin# Derivatives
"overed call & %nvestor $ells a "all option on a stock he owns (netting him a premium). &!e /all Option !ic! is sold in usuall" an O&= /all. &!e /all ould not #et e+ercised unless t!e stoc1 price increases a$ove t!e stri1e price. &ill t!en t!e investor in t!e stoc1 (/all seller) can retain t!e @remium as income. Gsuall" adopted $" a stoc1 o ner !o is Deutral to moderately Bullish about the stock. %f the stock price stays at or below the strike price the "all Buyer will not exercise the "all. #he Premium is retained by the investor. *n case t!e stoc1 price #oes a$ove t!e stri1e price, t!e /all $u"er !o !as t!e ri#!t to $u" t!e stoc1 at t!e stri1e price ill e+ercise t!e /all option. &!e /all seller (t!e investor) !o !as to sell t!e stoc1 to t!e /all $u"er, ill sell t!e stoc1 at t!e stri1e price. &!is as t!e price !ic! t!e /all seller (t!e investor) as an" a" interested in e+itin# t!e stoc1 and no e+its at t!at price. Besides the strike price which was the target price for selling the stock the "all seller (investor) also earns the Premium which becomes an additional gain #he income increases as the stock rises but gets capped after the stock reaches the strike price.

&radin# Derivatives
"overed call & .r. * bought :;< ltd for 9?7+ and simultaneously sells a call option at C+++ (indicating .r. *Hs belief that stock price will not go above C+++). %f price increases beyond C+++ call option will be exercised by the call buyer and * can exit his position. %f stock price does not go beyond C+++ option will not be exercised and * can retain the premium (?+) .
$tock price 9?7+

.r. * buys stock of :;< /all Option =r. A receives

:;< 3td. price closes at (=s.)

2600 2;00 2;40 2;;0 2900 2F00 4000 4200

Det Payoff (=s.)

,tri1e @rice (>s.) @remium (>s.)

4000 90 2;;0

:rea1 -ven @oint (>s.) (,toc1 @rice paid ' @remium >eceived)

&radin# Derivatives
"overed call & .r. * bought :;< ltd for 9?7+ and simultaneously sells a call option at C+++ (indicating .r. *Hs belief that stock price will not go above C+++). %f price increases beyond C+++ call option will be exercised by the call buyer and * can exit his position. %f stock price does not go beyond C+++ option will not be exercised and * can retain the premium (?+) .
.r. * buys stock of :;< /all Option =r. A receives $tock price 9?7+

:;< 3td. price closes at (=s.)

2600 2;00 2;40 2;;0 2900 2F00 4000 4200

Det Payoff (=s.) '1;0 ';0 '20 0 20 120 220 220

,tri1e @rice (>s.) @remium (>s.)

4000 90 2;;0

:rea1 -ven @oint (>s.) (,toc1 @rice paid ' @remium >eceived)

&radin# Derivatives

&radin# Derivatives
3!D2 "!.B! & $F33 * PG# BG; * "*33 < *f an investor is $ullis! !e can sell an O&= (lo er stri1e) @ut and $u" an O&= (!i#!er stri1e) /all. &!is strate#" simulates t!e action of $u"in# a stoc1 (or a futures) $ut at a fraction of t!e stoc1 price. *t is an ine+pensive trade, similar in pa"'off to Don# ,toc1, e+cept t!ere is a #ap $et een t!e stri1es. #his strategy is often referred to as 0synthetic long stock1 because the risk ' reward profile is nearly identical to long stock. *f "ou remain in t!is position until e+piration, "ou ill pro$a$l" ind up $u"in# t!e stoc1 at stri1e one a" or t!e ot!er ' %f the stock is above strike * at expiration it would make sense to exercise the call and buy the stock. %f the stock is below strike * at expiration youHll most likely be assigned on the put and be re/uired to buy the stock. A stoc1 A:/ Dtd. is tradin# at >s. 4)0. =r. J5P is $ullis! on t!e stoc1. :ut does not ant to invest >s. 4)0. Ee does a Don# /om$o. Ee sells a @ut option it! a stri1e price >s. 400 at a premium of >s. 1.00 and $u"s a /all Option it! a stri1e price of >s. )00 at a premium of >s. 2. &!e net cost of t!e strate#" (net de$it) is >s. 1.

&radin# Derivatives
3!D2 "!.B! & $F33 * PG# BG; * "*33 <
"urrent .arket Price (=s.) /urrent =ar1et @rice (>s.) ,tri1e @rice (>s.)
C7+
*B" 3td. price closes at (=s.) ;00 Det Payoff from the Put $old (=s.) Det Payoff Det Payoff from the (=s.) "all purchased (=s.)

*B" 3td.
/all Option

)00

,ells @ut

400 1 )00

6)0 600 ))0 )01 )00

=r. J5P @remium receives (>s.) :u"s /all =r. J5P pa"s
,tri1e @rice (>s.)

@remium (>s.) :rea1 -ven @oint (>s.) (Ei#!er ,tri1e ? (et De$it)

2 )01

4)0 400 2)0 200 2)0

&radin# Derivatives
3!D2 "!.B! & $F33 * PG# BG; * "*33 <
"urrent .arket Price (=s.) /urrent =ar1et @rice (>s.) ,tri1e @rice (>s.)
C7+
*B" 3td. price closes at (=s.) ;00 Det Payoff from the Put $old (=s.) 1 1 1 1 1 1 1 1 '4F 'FF '14F Det Payoff Det Payoff from the (=s.) "all purchased (=s.) 1F9 149 F9 49 '1 '2 '2 '2 '2 '2 '2 1FF 14F FF 4F 0 '1 '1 '1 ')1 '101 '1)1

*B" 3td.
/all Option

)00

,ells @ut

400 1 )00

6)0 600 ))0 )01 )00 4)0 400 2)0

=r. J5P @remium receives (>s.) :u"s /all =r. J5P pa"s
,tri1e @rice (>s.)

@remium (>s.) :rea1 -ven @oint (>s.) (Ei#!er ,tri1e ? (et De$it)

2 )01

200 2)0

&radin# Derivatives

&radin# Derivatives
"!IF=F, PG# & /overed @ut is a neutral to Bearish strategy. %nvestor expectation & @rice of a stoc1 A inde+ is #oin# to remain ran#e $ound or move do n. *nvolves a s!ort in a stoc1 A inde+ alon# it! a s!ort @ut on t!e options on t!e stoc1 A inde+. &!e investor s!orts a stoc1 $ecause !e is $earis! a$out it, $ut does not mind $u"in# it $ac1 once t!e price reac!es (falls to) a tar#et price. &!is tar#et price is t!e price at !ic! t!e investor s!orts t!e @ut (@ut stri1e price). ,ellin# a @ut means, $u"in# t!e stoc1 at t!e stri1e price if e+ercised *f t!e stoc1 falls $elo t!e @ut stri1e, t!e investor ill ill !ave to $u" t!e stoc1 at t!e stri1e price ( !ic! is an" a" !is tar#et price to repurc!ase t!e stoc1). *nvestor 1eeps t!e @remium on t!e @ut sold. &!e investor is covered !ere $ecause !e s!orted t!e stoc1 in t!e first place .
$uppose *B" 3td. is trading at =s C7++ in @une. *n investor .r. * shorts =s C9++ Put by selling a @uly Put for =s. (C while shorting an *B" 3td. stock. #he net credit received by .r. * is =s. C7++ J =s. (C 5 =s. C7(C.

&radin# Derivatives
"!IF=F, PG# &
"urrent .arket Price (=s.) C7++
*B" 3td. price closes at (=s.) 4000 Det Payoff from the $tock (=s.) Det Payoff from the Put option (=s.) Det Payoff (=s.)

$ells $tock (.r. * receive s) ,ells @ut

,tri1e @rice (>s.)

4200 24 4)24

4100 4200 4200 4400 44)0 4)00

=r. A @remium receives (>s.) :rea1 -ven @oint (>s.) (,ale price of ,toc1 ? @ut @remium)

4)24 4))0
4600

462)

&radin# Derivatives
"!IF=F, PG# &
"urrent .arket Price (=s.) C7++
*B" 3td. price closes at (=s.) 4000 Det Payoff from the $tock (=s.) )00 400 200 200 100 )0 0 '24 ')0 '100 '12) '1)0 Det Payoff from the Put option (=s.) Det Payoff (=s.)

$ells $tock (.r. * receive s) ,ells @ut

,tri1e @rice (>s.)

4200 24 4)24

'2;6 '1;6 ';6

24 24 24 24 24 24 24 24 24

224 224 224 224 124

;4 24 0

4100 4200 4200 4400 44)0 4)00

=r. A @remium receives (>s.) :rea1 -ven @oint (>s.) (,ale price of ,toc1 ? @ut @remium)

4)24 4))0
4600

'26
';6

462) 46)0

'111 '126

&radin# Derivatives
"!IF=F, PG# &

&radin# Derivatives
3!D2 $#=*,,3F & A ,traddle is a volatilit" strate#" and is used !en t!e
stoc1 price A inde+ is e+pected to s!o lar#e movements. &!is strate#" involves $u"in# a call as ell as put on t!e same stoc1 A inde+ for t!e same maturit" and stri1e price, to ta1e advanta#e of a movement in eit!er direction, a soarin# or plummetin# value of t!e stoc1 A inde+. *f t!e price of t!e stoc1 A inde+ increases, t!e call is e+ercised !ile t!e put e+pires ort!less *f t!e price of t!e stoc1 A inde+ decreases, t!e put is e+ercised, t!e call e+pires ort!less. -it!er a" if t!e stoc1 A inde+ s!o s volatilit" to cover t!e cost of t!e trade, profits are to $e made. Lit! ,traddles, t!e investor is direction neutral. All t!at !e is loo1in# out for is t!e stoc1 A inde+ to $rea1 out e+ponentiall" in eit!er direction.

$uppose Difty is at CC7+ on (6th *pril. *n investor .r. * enters a long straddle by buying a .ay =s C7++ Difty Put for =s. ?7 and a .ay =s. C7++ Difty "all for =s. 8((. #he net debit taken to enter the trade is =s (+6 which is also his maximum possible loss.

&radin# Derivatives
3!D2 $#=*,,3F &
"urrent Ialue CC7+
4)00

Difty index

/all and ,tri1e @ut @rice (>s.) =r. A pa"s &otal @remium (/all ? @ut) (>s.) :rea1 -ven @oint (>s.)

!n expiry Det Difty Payoff closes at from Put purchase d (=s.)

2900 2F00 4000

Det Payoff from "all purchased (=s.)

Det Payoff (=s.)

20;

4;0;(G)

4100 4200

42F2(D)

4224
42F2

4200 4400
4)00

&radin# Derivatives
3!D2 $#=*,,3F &
"urrent Ialue CC7+
4)00

Difty index

/all and ,tri1e @ut @rice (>s.) =r. A pa"s &otal @remium (/all ? @ut) (>s.) :rea1 -ven @oint (>s.)

!n expiry Det Difty Payoff closes at from Put purchase d (=s.)

2900 2F00 4000 4100 4200 61) )1) 41) 21) 21)

Det Payoff from "all purchased (=s.) '122 '122 '122 '122 '122 '122 '122 '122 '122 '122 '22 ;9

Det Payoff (=s.)

20;

4F2 2F2 2F2 1F2 F2

)F 0 ';

4;0;(G)

4224 42F2(D)
42F2

191
122 11) 1) '9) '9) '9)

4200 4400
4)00

'10;
'20;

4600 4;00

'10; ';

&radin# Derivatives
3!D2 $#=*,,3F &
!n expiry Det Difty Payoff closes at from Put purchase d (=s.) 4;0; 4;66 4900
4F00 )000 )100 )200 '9) '9) '9) '9) '9) '9) '9) '9)

Det Payoff from "all purchased (=s.) 9) 144 1;9 2;9 2;9 4;9 );9 6;9

Det Payoff (=s.)

0 )F F2 1F2 2F2 2F2 4F2 )F2

)200

&radin# Derivatives
$hort $traddle & *t is a strate#" to $e adopted !en t!e investor feels t!e mar1et ill not s!o muc! movement. ,ells a /all and a @ut on t!e same stoc1 A inde+ for t!e same maturit" and stri1e price. *t creates a net income for t!e investor. *f t!e stoc1 A inde+ does not move muc! in eit!er direction, t!e investor retains t!e @remium as neit!er t!e /all nor t!e @ut ill $e e+ercised. Eo ever, incase t!e stoc1 A inde+ moves in eit!er direction, up or do n si#nificantl", t!e investor8s losses can $e si#nificant. &!is is a ris1" strate#" and s!ould $e carefull" adopted and onl" !en t!e e+pected volatilit" in t!e mar1et is limited. *f t!e stoc1 A inde+ value sta"s close to t!e stri1e price on e+pir" of t!e contracts, ma+imum #ain, !ic! is t!e @remium received is made.

$uppose Difty is at CC7+ on (6th *pril. *n investor .r. * enters into a short straddle by selling a .ay =s C7++ Difty Put for =s. ?7 and a .ay =s. C7++ Difty "all for =s. 8((. #he net credit received is =s. (+6 which is also his maximum possible profit.

&radin# Derivatives
$E!=# $#=*,,3F &
"urrent Ialue CC7+
4)00

Difty index

/all and ,tri1e @ut @rice (>s.) =r. A pa"s &otal @remium (/all ? @ut) (>s.) :rea1 -ven @oint (>s.)

!n expiry Det Difty Payoff closes at from Put purchase d (=s.)

2900 2F00 4000

Det Payoff from "all purchased (=s.)

Det Payoff (=s.)

20;

4;0;(G)

4100 4200

42F2(D)

4224
42F2

4200 4400
4)00

&radin# Derivatives
$hort $traddle &
"urrent Ialue CC7+
4)00

Difty index

/all and ,tri1e @ut @rice (>s.) =r. A &otal receives @remium (/all ? @ut) (>s.) :rea1 -ven @oint (>s.)H
HFrom

!n expiry Det Difty Payoff closes at from Put $!3, (=s.)

2900 2F00 4000 4100 4200 '61) ')1) '41) '21) '21)

Det Payoff from "all $!3, (=s.)

Det Payoff (=s.)

20;

122 122 122 122 122 122 122 122 122 122 22 ';9

'4F2 '2F2 '2F2 '1F2 'F2

')F 0 ;

4;0;(G)

4224
42F2

'191
'122 '11) '1) 9) 9) 9)

42F2(D)

$u"er8s point of vie

4200 4400
4)00

10;
20;

4600 4;00

10; ;

&radin# Derivatives
$E!=# $#=*,,3F &
!n expiry Det Difty Payoff closes at from Put $!3, (=s.) 4;0; 4;66 4900
4F00 )000 9) 9) 9) 9) 9)

Det Payoff from "all $!3,(=s.)

Det Payoff (=s.)

'9) '144 '1;9 '2;9 '2;9

0 ')F 'F2 '1F2 '2F2

&radin# Derivatives

Profit

ST

&radin# Derivatives

&radin# Derivatives

&radin# Derivatives
3!D2 $#=*D23F& A ,tran#le is a sli#!t modification to t!e ,traddle to ma1e it c!eaper to e+ecute. &!is strate#" involves t!e simultaneous $u"in# of a sli#!tl" out'of't!e'mone" (O&=) put and a sli#!tl" out'of't!e'mone" (O&=) call of t!e same underl"in# stoc1 A inde+ and e+piration date.

*nvestor is directional neutral $ut is loo1in# for an increased volatilit" in t!e stoc1 A inde+ and t!e prices movin# si#nificantl" in eit!er direction. ,ince O&= options are purc!ased for $ot! /alls and @uts it ma1es t!e cost of e+ecutin# a ,tran#le c!eaper as compared to a ,traddle, !ere #enerall" A&= stri1es are purc!ased. ,ince t!e initial cost of a ,tran#le is c!eaper t!an a ,traddle, t!e returns could potentiall" $e !i#!er. Eo ever, for a ,tran#le to ma1e mone", it ould re%uire #reater movement on t!e upside or do nside for t!e stoc1 A inde+ t!an it ould for a ,traddle. &!e strate#" !as a limited do nside (i.e. t!e /all and t!e @ut premium) and unlimited upside potential. $uppose Difty is at C7++ in .ay. *n investor .r. * executes a 3ong $trangle by buying a =s. C9++ Difty Put for a premium of =s. (9 and a =s C6++ Difty "all for =s C9. #he net debit taken to enter the trade is =s. >> which is also his maximum possible loss.

&radin# Derivatives
3!D2 $#=*D23F&
"urrent Ialue C7++
4;00

Difty & index

:u" /all ,tri1e Option @rice (>s.) =r. A pa"s @remium :rea1 -ven @oint (>s.) :u" @ut Option =r. A pa"s ,tri1e @rice (>s.) @remium :rea1 -ven @oint (>s.)

!n expiry Difty closes at

2900 2F00

Det Payoff from Put Purchase d (=s.)

Det Payoff from "all Purchased (=s.)

Det Payoff (=s.)

42

4;66

4000 4100

4200

4200

4224
22

4200 4400

4224

4)00

4600

&radin# Derivatives
3!D2 $#=*D23F&
"urrent Ialue C7++
4;00

Difty & index

:u" /all ,tri1e Option @rice (>s.) =r. A pa"s @remium :rea1 -ven @oint (>s.) :u" @ut Option =r. A pa"s ,tri1e @rice (>s.) @remium :rea1 -ven @oint (>s.)

!n expiry Difty closes at

2900 2F00 4000 4100 4200

Det Payoff from Put Purchase d (=s.)

4;; 2;; 2;; 1;; ;;

Det Payoff from "all Purchased (=s.) '42 '42 '42 '42 '42 '42 '42 '42 '42 '42 '42

Det Payoff (=s.)

42

424 224 224 124 24

0

4;66

4200

4224 4200 4400

4)00

42
'22 '22 '22 '22 '22

'66 '66 '66 '66 '66

22

4224

4600 4;00

&radin# Derivatives
3!D2 $#=*D23F&
!n expiry Det Difty Payoff closes at from Put Purchase d (=s.) 4;66 4900
4F00 )000 )100 )200 )200 '22 '22 '22 '22 '22 '22 '22

Det Payoff from "all Purchased (=s.) 22 ); 1); 2); 2); 4); ));

Det Payoff (=s.)

0 24 124 224 224 424 )24

&radin# Derivatives
$E!=# $#=*D23F&
A ,!ort ,tran#le is a sli#!t modification to t!e ,!ort ,traddle. *t tries to improve t!e profita$ilit" of t!e trade for t!e ,eller of t!e options $" idenin# t!e $rea1even points so t!at t!ere is a muc! #reater movement re%uired in t!e underl"in# stoc1 A inde+, for t!e /all and @ut option to $e ort! e+ercisin#. &!is strate#" involves t!e simultaneous sellin# of a sli#!tl" out'of't!e'mone" (O&=) put and a sli#!tl" out'of't!e'mone" (O&=) call of t!e same underl"in# stoc1 and e+piration date. &!is t"picall" means t!at since O&= call and put are sold, t!e net credit received $" t!e seller is less as compared to a ,!ort ,traddle, $ut t!e $rea1 even points are also idened. &!e underl"in# stoc1 !as to move si#nificantl" for t!e /all and t!e @ut to $e ort! e+ercisin#. *f t!e underl"in# stoc1 does not s!o muc! of a movement, t!e seller of t!e ,tran#le #ets to 1eep t!e @remium.

$uppose Difty is at C7++ in .ay. *n investor .r. * executes a $hort $trangle by selling a =s. C9++ Difty Put for a premium of =s. (9 and a =s.C6++ Difty "all for =s C9. #he net credit is =s. >> which is also his maximum possible gain.

&radin# Derivatives
$E!=# $#=*D23F&
"urrent Ialue C7++
4;00

Difty & index

& ,ell /all ,tri1e Option @rice (>s.)

=r. A @remium receives :rea1 -ven @oint (>s.) ,ell @ut Option =r. A pa"s ,tri1e @rice (>s.) @remium :rea1 -ven @oint (>s.)

!n expiry Difty closes at

2900 2F00 4000 4100 4200

Det Payoff Det Payoff from Put from "all $old (=s.) $old (=s.)

Det Payoff (=s.)

42

'4;; '2;; '2;; '1;; ';;

42 42 42 42 42 42 42 42 42 42 42

'424 '224 '224 '124 '24

0

4;66

4200

4224 4200 4400

4)00

'42
22 22 22 22 22

66 66 66 66 66

22

4224

4600 4;00

&radin# Derivatives
$E!=# $#=*D23F&
!n expiry Det Difty Payoff closes at from Put $!3, (=s.) 4;66 4900
4F00 )000 )100 )200 )200 22 22 22 22 22 22 22

Det Payoff from "all $!3,(=s.)

Det Payoff (=s.)

'22 '); '1); '2); '2); '4); '));

0 '24 '124 '224 '224 '424 ')24

A ,tran#le /om$ination
Profit

K1

K2 ST

&radin# Derivatives

&radin# Derivatives

&radin# Derivatives
BG33 "*33 $P=F*, &
:u"in# an in't!e'mone" (*&=) call option, and sellin# anot!er out'of't!e'mone" (O&=) call option. Often t!e call it! t!e lo er stri1e price ill $e in't!e'mone" !ile t!e /all it! t!e !i#!er stri1e price is out'of't!e'mone". :ot! calls must !ave t!e same underl"in# securit" and e+piration mont!. #he net effect of the strategy is to bring down the cost and breakeven on a Buy "all (3ong "all) $trategy. &!is strate#" is e+ercised !en investor is moderatel" $ullis! to $ullis!, $ecause t!e investor ill ma1e a profit onl" !en t!e stoc1 price A inde+ rises. *f t!e stoc1 price falls to t!e lo er ($ou#!t) stri1e, t!e investor ma1es t!e ma+imum loss (cost of t!e trade) and if t!e stoc1 price rises to t!e !i#!er (sold) stri1e, t!e investor ma1es t!e ma+imum profit.

.r. :;< buys a Difty "all with a $trike price =s. C8++ at a premium of =s. 86+.C7 and he sells a Difty "all option with a strike price =s. CC++ at a premium of =s. 97.C+. #he net debit here is =s. 897.+7 which is also his maximum loss.

&radin# Derivatives
BG33 "*33 $P=F*, &
"urrent Ialue C8)8.8+
4100

Difty & index

:u" &*&= ,tri1e /all @rice Option (>s.) =r. J5P @a"s ,ell O&= /all Option =r. J5P >eceive s @remium ,tri1e @rice (>s.) @remium (>s.) (et @remium @aid (>s.) :rea1 -ven

!n expiry Difty closes at

2)00 2600

Det Payoff Det Payoff from "all from Buy (=s.) "all $old (=s.)

Det Payoff (=s.)

1;0.4) 4400

2;00 2900

2).40

2F00 4000

12).0)

4100 4200 422).0)

422).0)

4200

&radin# Derivatives
BG33 "*33 $P=F*, &
"urrent Ialue C8)8.8+
4100

Difty & index

&*&= ,tri1e :u" /all @rice Option (>s.)

=r. J5P @a"s ,ell O&= /all Option =r. J5P >eceive s @remium ,tri1e @rice (>s.) @remium (>s.) (et @remium @aid (>s.) :rea1 -ven

!n expiry Difty closes at

2)00 2600 2;00 2900 2F00 4000 4100 4200 422).0) 4200 4400 4)00

Det Payoff Det Payoff from "all from Buy (=s.) "all $old (=s.)
'1;0.4) '1;0.4) '1;0.4) '1;0.4) '1;0.4) '1;0.4) '1;0.4) ';0.4) '2).40 2F.)) 12F.)) 22F.)) 22F.)) 2).40 2).40 2).40 2).40 2).40 2).40 2).40 2).40 2).40 2).40 2).40 '64.60 '164.60

Det Payoff (=s.)

1;0.4) 4400

'12).0) '12).0) '12).0) '12).0) '12).0) '12).0) '12).0) '2).0) 0 64.F) 164.F) 164.F) 164.F)

2).40

12).0)

422).0)

4600

&radin# Derivatives
BG33 "*33 $P=F*, &
!n expiry Det Difty Payoff closes at from "all Buy (=s.)
4;00 4900 4F00 )000 )100 )200

Det Payoff from "all $old (=s.)

'264.60 '264.60 '464.60 ')64.60 '664.60 ';64.60

Det Payoff (=s.) 164.F) 164.F) 164.F) 164.F) 164.F) 164.F)

42F.)) )2F.)) 62F.)) ;2F.)) 92F.)) F2F.))

:ull ,pread Gsin# /alls

Profit

ST K1 K2

&radin# Derivatives
BG33 PG# $P=F*, &
A $ull put spread can $e profita$le !en t!e stoc1 A inde+ is eit!er ran#e $ound or risin#. &!e concept is to protect t!e do nside of a @ut sold $" $u"in# a lo er stri1e @ut, !ic! acts as an insurance for t!e @ut sold. &!e lo er stri1e @ut purc!ased is furt!er O&= t!an t!e !i#!er stri1e @ut sold ensurin# t!at t!e investor receives a net credit, $ecause t!e @ut purc!ased (furt!er O&=) is c!eaper t!an t!e @ut sold.

&!is strate#" is e%uivalent to t!e :ull /all ,pread $ut is done to earn a net credit (premium) and collect an income. *f t!e stoc1 A inde+ rises, $ot! @uts e+pire ort!less and t!e investor can retain t!e @remium. *f t!e stoc1 A inde+ falls, t!en t!e investor8s $rea1even is t!e !i#!er stri1e less t!e net credit received. @rovided t!e stoc1 remains a$ove t!at level, t!e investor ma1es a profit. Ot!er ise !e could ma1e a loss. &!e ma+imum loss is t!e difference in stri1es less t!e net credit received. &!is strate#" s!ould $e adopted !en t!e stoc1 A inde+ trend is up ard or ran#e $ound.

.r. :;< sells a Difty Put option with a strike price of =s. C+++ at a premium of =s. (8.C7 and buys a further !#. Difty Put option with a strike price =s. 9?++ at a premium of =s. 9.++ when the current Difty is at C8)8.8+ with both options expiring on 98st @uly..

&radin# Derivatives
BG33 PG# $P=F*, &
"urrent Ialue ,tri1e @rice (>s.) @remium C8)8.8+
4000
2)00 2600

Difty & index ,ell @ut & Option =r. J5P >eceive s :u" @ut Option =r. J5P @a"s

!n expiry Difty closes at

Det Payoff from Put Buy (=s.) 2F;.00 1F; F; '2.00 '2.00 '2.00 '2.00 '2.00 '2.00 '2.00 '2.00 '2.00 '2.00 '2.00 '2.00

Det Payoff from Put $old (=s.) '4;9.)) '2;9.)) '2;9.)) '1;9.)) ';9.)) 2 21.4) 21.4) 21.4) 21.4) 21.4) 21.4) 21.4) 21.4) 21.4)

Det Payoff (=s.) '191.)) '191.)) '191.)) '191.)) '91.)) 0 19.4) 19.4) 19.4) 19.4) 19.4) 19.4) 19.4) 19.4) 19.4)

21.4)

2;00 2900 2F00

,tri1e @rice (>s.) @remium (>s.) (et @remium >eceived (>s.) :rea1 -ven @oint

2900

2F91 4000 4100 4200 4200 4400 4)00 4600

2 19.4)

2F91.))

4;00 4900

:ull ,pread Gsin# @uts

Profit K1 K2 ST

&radin# Derivatives
BF*= "*33 $P=F*, &
&!e :ear /all ,pread strate#" can $e adopted !en t!e investor feels t!at t!e stoc1 A inde+ is eit!er ran#e $ound or fallin#. &!e concept is to protect t!e do nside of a /all ,old $" $u"in# a /all of a !i#!er stri1e price to insure t!e /all sold. &!e investor receives a net credit $ecause t!e /all !e $u"s is of a !i#!er stri1e price t!an t!e /all sold. &!e strate#" re%uires t!e investor to $u" out'of't!e'mone" (O&=) call options !ile simultaneousl" sellin# in't!e'mone" (*&=) call options on t!e same underl"in# stoc1 inde+. &!is strate#" can also $e done it! $ot! O&= calls it! t!e /all purc!ased $ein# !i#!er O&= stri1e t!an t!e /all sold. *f t!e stoc1 A inde+ falls $ot! /alls ill e+pire ort!less and t!e investor can retain t!e net credit. *f t!e stoc1 A inde+ rises t!en t!e $rea1even is t!e lo er stri1e plus t!e net credit. @rovided t!e stoc1 remains $elo t!at level, t!e investor ma1es a profit. Ot!er ise !e could ma1e a loss. &!e ma+imum loss is t!e difference in stri1es less t!e net credit received..

.r. :;< is bearish on Difty. Ee sells an %#. call option with strike price of =s. (>++ at a premium of =s. 87C and buys an !#. call option with strike price =s. (?++ at a premium of =s. C).

&radin# Derivatives
BF*= "*33 $P=F*, &
"urrent Ialue (>)C
2600

Difty & index

!n expiry Difty closes at 2100 2200 2200 2400 2)00 2600 2;00 2;0)

Det Payoff from "all $old (=s.) 1)4 1)4 1)4 1)4 1)4 1)4 )4 4F '46 '146 '246 '246 '446 ')46

Det Payoff from "all bought (=s.) '4F '4F '4F '4F '4F '4F '4F '4F '4F )1 1)1 2)1 2)1 4)1

Det Payoff (=s.) 10) 10) 10) 10) 10) 10) ) 0 'F) 'F) 'F) 'F) 'F) 'F)

,ell *&= ,tri1e & /all @rice Option (>s.) =r. J5P >eceive s :u" O&= /all Option =r. J5P @a"s @remium

1)4

,tri1e @rice (>s.) @remium (>s.) (et @remium >eceived (>s.) :rea1 -ven

2900

4F 10)

2900 2F00 2000 2100 2200

2;0)

2200

:ear ,pread Gsin# /alls

Profit

K1

K2

ST

&radin# Derivatives
BF*= PG# $P=F*, &
*nvestor to $u" an in't!e'mone" (!i#!er) put option and sell an out'of't!e'mone" (lo er) put option on t!e same stoc1 it! t!e same e+piration date. &!is strate#" creates a net de$it for t!e investor. &!e net effect of t!e strate#" is to $rin# do n t!e cost and raise t!e $rea1even on $u"in# a @ut (Don# @ut). &!e strate#" needs a :earis! outloo1 since t!e investor ill ma1e mone" onl" !en t!e stoc1 price A inde+ falls. &!e $ou#!t @uts ill !ave t!e effect of cappin# t!e investor8s do nside. L!ile t!e @uts sold ill reduce t!e investors costs, ris1 and raise $rea1even point (from @ut e+ercise point of vie ).

*f t!e stoc1 price closes $elo t!e out'of't!e'mone" (lo er) put option stri1e price on t!e e+piration date, t!en t!e investor reac!es ma+imum profits. *f t!e stoc1 price increases a$ove t!e in't!e'mone" (!i#!er) put option stri1e price at t!e e+piration date, t!en t!e investor !as a ma+imum loss potential of t!e net de$it.

Difty is presently at (>)C. .r. :;< expects Difty to fall. Ee buys one Difty %#. Put with a strike price =s. (?++ at a premium of =s. 89( and sells one Difty !#. Put with strike price =s. (>++ at a premium =s. 7(.

&radin# Derivatives
BF*= PG# $P=F*, &
"urrent Ialue (>)C
2900
!n expiry Difty closes at ((++ Det Payoff from Put Buy (=s.) C>? 9>? (>? 8>? >? -7( -9( -89( -89( -89( -89( Det Payoff Det from Payoff Put $old (=s.) (=s.) -9C? -(C? -8C? -C? 7( 7( 7( 7( 7( 7( 7( 8(+ 8(+ 8(+ 8(+ 8(+ + (+ -?+ -?+ -?+ -?+

Difty & index

:u" &*&= ,tri1e @ut @rice & Option (>s.) =r. J5P pa"s ,ell O&= @ut Option @remium ,tri1e @rice (>s.)

122
2600

(9++ (C++ (7++ (>++

=r. J5P @remium receives (>s.) (et @remium @aid(>s.) :rea1 -ven @oint (>s.)

)2 90

(6(+ (6++ (?++ ()++

2;20

9+++ 98++

:ear ,pread Gsin# @uts

Profit

K1

K2

ST