ACKNOWLEDGEMENTS

I would like to thank my project guide Mr. Vinod Dhawle, a stock broker dealing in futures and options for his valuable insights into the “real world of futures and options” and for guiding me through the project. Mr. Alok Nanavaty has helped me a lot by providing me

with the necessary reading material, which was very useful in assembling the project. I would like to thank our principal for all the facilities that

he provided me with while I was working on this project. I am grateful to our BMS Co-ordinator for guiding me to

proper avenues. Our librarian for helping me find relevant matter from our

library. I thank my family and friends whose constant

encouragement kept me going.

TABLE OF CONTENTS
SR. NO.
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15.

CONTENTS
Executive summary Evolution

PG. NO.
1 4 10 15 19 27 29 33 39 46 54 61 88 90 93

FUTURES
Basics Valuation of Forwards/Futures Contracts Futures Market Other Futures Contract

OPTIONS
Basics Types of Options Terminology Option Pricing Risk & Return on Equity Options Options Trading Strategies Options v/s Futures Futures & Options in India Bibliography

TABLE OF ILLUSTRATIONS
SR. NO.
1. 2. Call Options Put Options

CONTENTS
(Graph) (Graph)

PG. NO.
34 36

3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22.

Call Option at Expiration Put Option at Expiration Call Option Pricing Before Expiration Put Option Pricing Before Expiration Risk & Return on Call Option Risk & Return on Put Option Hedging: Long Stock Long Put Hedging: Short Stock Long Call Hedging: Long Stock Short Call Hedging: Short Stock Short Put Payoff from Bull Spread (Using Calls) Bull Spread (Using Calls) Payoff from Bull Spread (Using Puts) Bull Spread (Using Puts) Payoff from Bear Spread (Using Calls) Bear Spread (Using Calls) Payoff from Bear Spread (Using Puts) Bear Spread (Using Puts) Payoff from Butterfly Spread Butterfly Spread

(Graph) (Graph) (Graph) (Graph) (Graph) (Graph) (Graph) (Graph) (Graph) (Graph) (Table) (Graph) (Table) (Graph) (Table) (Graph) (Table) (Graph) (Table) (Graph) (Table) (Graph) (Graph) (Graph) (Table) (Graph) (Graph) (Graph) (Table)

48 50 51 52 56 / 57 60 64 65 67 68 69 70 71 71 73 74 75 75 77 78

SR. NO.
23. 24. 25. 26. 27. 28. 29. 30. 31.

CONTENTS
Payoff from Straddle Straddle Strip Strap Payoff from Strangle Strangle Long Condor Short Condor Payoff from Box Spread

PG. NO.
80 80 82 82 83 83 85 85 86

1 EXECUTIVE SUMMARY A Preview into Futures and Options .

Derivatives occupy a very significant place in the field of finance and are virtually driving the global financial markets of the day. Options . Futures and options exchanges are an integral part of virtually all the advanced economies. The futures market provides economic and social benefits through their functions of risk management and price discovery. The price of a futures contract is market related and is linked to the projected spot price of the underlying asset on the delivery date. Many more countries like India are in different stages of the process of introduction of such trading. Futures are only a more developed form of forward trading. Futures Futures have revolutionized the global commodities and financial markets ever since their advent. A futures contract involves honouring of a commitment between the buyer and the seller regarding delivery by the seller of a specified commodity or instrument after a specified period at a specified price.

strap and condors. strip. Price of an option depends on factors like stock price.Option contract helps the investor get returns on his investment while remaining fully insured against any adverse movement in stock prices. Most commonly used are spread strategies. a call option and a put option. Broadly. The complexities of the corporate risks and their management gives rise to many solutions through a series of innovative strategies in the form of combinations of options of different types. Option is a legal contract in which the writer of the contract grants to the buyer. options are of two types i. straddle. stock volatility. . the right to purchase from or sell to the writer a designated instrument or a scrip at a specified price within a specified period of time. exercise price. etc. expiration date.e. The writer is legally obligated to perform according to the terms of the option but the buyer is under no obligation to exercise the option.

Make Your Future With Options !!! . but trading in stock options began only in July 2001. these are early days and the experience of the world market has proved that futures and options are going to be the trading instruments in the future. Both Bombay Stock Exchange (BSE) and National Stock Exchange (NSE) have introduced trading in stock index futures and stock options. But however.Introduction of futures and options in India is the beginning of a new era. derivatives trading in India has not picked up as expected. However. Trading in stock index futures commenced in June 2000. So come. There are a lot of myths attached to it and the general lack of awareness among brokers and investors have led to very low volumes in trading.

EVOLUTION Lets peep into the past & see how it all began .

exchange rate. It is instead. a promise to convey ownership. share price index. Prices of all commodities – whether agricultural like wheat. rice. security. are subject to fluctuations over time in keeping with prevailing demand and supply conditions. oil price or the like. gold. Similarly. His action to invest has been motivated by his desire to multiply his acquisitions. interest rate. From spot to forward deals and then on to derivatives. prices of shares and debentures or bonds and other securities are also subject to continuous change. in the same way as the buyers are not sure what they would have to pay for their buy. Risk is the characteristic feature of all commodity and capital markets. Producers cannot be sure of the price that their produce will fetch when they sell them. futures. coffee or tea. A derivative instrument by itself does not constitute ownership. All derivatives are based on some ‘cash’ products. DERIVATIVES A derivative instrument. is a financial contract whose payoff structure is determined by the value of an underlying commodity. With the passage of time. the simple commercial transactions of purchase and sale of a commodity became increasingly complex as his desire to maximize earnings increased.Investment has been basic to man ever since he discovered commerce. etc. broadly. As the requirements of man’s life grew in content and quality. Thus a derivative instrument derives its value from some underlying variable. cotton. options and other investment alternatives – the modes and instruments have come a long way and vehicles of investment and speculation acquired innovative forms according to the needs of times. They are constantly exposed to the threat of risk. This has shaped the markets in Europe and Japan ever since the early seventeenth century. . man was able to constantly sharpen his investment skills to earn more by taking more risks. or agricultural like silver.

and mortgage derivatives. which is a protection against losses resulting from unforeseen price or volatility changes. Precious metals like gold and silver. Over-The-Counter (OTC) money market products such as loans or deposits. In addition to cash purchase. called Hedging. another way to acquire or sell assets is by entering into a forward contract. There are many kinds of derivatives including futures. Short-term debt securities such as T-bills. Foreign exchange rate. If a car is booked with the dealer and the delivery matures. Thus. However. Typically. coffee beans. including medium to long-term negotiable debt securities issued by governments. derivatives are a very important tool of risk management. Thus. Bonds of different types. Eg. security or other asset can be in the spot of forward markets. companies. options. .The underlying asset of a derivative instrument may be any product of the following type: • • • • • • Commodities including grains. the price at which the underlying commodity or assets will be traded is decided at the time of entering into the contract. the most important use of derivatives is in transferring market risk. the car is delivered after its price has been paid. the buyer agrees to pay cash at a later date when the seller delivers the goods. A spot or cash market is most commonly used for trading. The essential idea of entering into a forward contract is to peg the price and thereby avoid the price risk. In a forward contract. etc. FORWARD CONTRACT A deal for the purchase or sale of a commodity. interest rate swaps. etc. in a forward contract.

while establishment of the Chicago Board of Trade (CBOT) in 1848 led to the start of a formal commodities exchange in the USA. currency. probably started in Japan in the early 18th century. However. A forward contract is evidently a good means of avoiding price risk. on which forward contracts are traded. financial futures contracts have been evolved. The organize commodities exchanges. They encompass a variety of underlying assets – securities. are a very significant financial innovation. A futures contract is a standardized contract between 2 parties where one of the parties commits to sell and the other to buy a stipulated quantity (and quality. once a position of buy or sell is taken in a forward contract an investor cannot retreat except through mutual consent with the other party or by entering into an identical contract and taking a position that is reverse of the earlier position. probably. stock indices. each party faces the risk of default. a party to the contract may not honour its part of the obligation. Forward contracts have been in existence since quiet some time. The beginnings of financial futures were made with the introduction of foreign currency futures contracts on the International Monetary Markets (IMM) – a division of the Chicago Mercantile Exchange (CME) – in May 1972. In the USA. index or some other specified item at an agreed price on or before a given date in the future.by entering into a forward contract. but it entails an element of risk in that. where applicable) of a commodity. such contracts began trading on the Chicago Board of Trade (CBOT) in the 1860s. for instance. one is assured of the price at which one can buy / sell goods or other assets. There is another problem. Futures contracts on commodities have been traded for long. Thus. The financial futures. security. interest rates and so on. The alternatives are by no means very easy. interest rates futures . in the past 3 decades. Subsequently. FUTURES CONTRACTS The problems associated with forward contracts lead to the emergence of Futures Contracts.

or to buy or sell a specified number of underlying futures contracts.– where the contract is on an asset whose price is dependent solely on the level of interest rates – were introduced on the CBOT in October 1975. also provide a mechanism by which one can acquire a certain commodity or other asset. . index. An important development took place in the world of futures contracts in 1982 when stock index futures were introduced in USA. currency. options. A futures contract on a stock index has been a revolutionary and novel idea because it represents a contract based not on a readily deliverable physical commodity or currency or other negotiable instrument. but not the obligation. like futures. The idea of an option existed in ancient Greece and Rome. options have been in use for centuries. in order to make profit or cover risk for a price. In fact. or take positions in. Although some futures contracts on indices were traded in Europe in the 1970s. at a specified price on or before a given date in the future. to buy or sell a specified amount (and quality) of a commodity. The Romans wrote options on the cargoes that were transported by their ships. In the 17th century. A futures contract in treasury bonds is one of the most actively traded futures contracts in the world. It was in America only that a formal beginning was made when the Kansas City Board of Trade (KCBT) introduced stock index futures with the ‘value line index’ serving as the underlying index. Thus. It is instead based on the concept of a mathematically measurable index that is determined by the market movement of a predetermined set of equity stocks. OPTIONS An option is the right. there was an active options market in Holland. or financial instrument. The concept of options is not a new one.

they were. In fact. the Chicago Board Options exchange (CBOE) was created. The listing of options meant orderly and thicker markets for this kind of securities. The year 1973 witnessed some major developments. It was the first registered securities exchange dedicated to options trading. While trading in options existed for long. options on equity stocks of the companies were available on the Over-the-Counter (OTC) market only until April 1973. it experienced a gigantic growth with the creation of this exchange. looked down upon as mere speculative tools and associated with corrupt practices. Black and Scholes published a seminal paper explaining the basic principles of options pricing and hedging. Things changed dramatically in the 1970s when options were transformed from relative obscurity to a systematically traded asset. In spite of the long time that has elapsed since the inception of options. Options trading are now undertaken widely in many countries besides the USA and UK. they were declared illegal in the UK in 1733 and remained so until 1860. In the same year. options have become an integral part of the large and developed financial markets. which is an integral part of financial portfolios. Earlier. . In USA. until not very long ago.Options were traded in UK and US during the 19th century but were mainly confined to the agricultural commodities.

FUTURES .

3 BASICS Wondering what Futures trade is all about? These basic concepts will introduce you to this unique and important industry began .

in fact. assuming the right and obligation of taking delivery of the specified underlying item (say 10 quintals of wheat of a specified grade) on a specified date. Unlike a forward contract. it is not necessary to .FUTURES – THE CONCEPT A futures contract can be defined as a standardized agreement between the buyer and the seller in terms of which the seller is obligated to deliver a specified asset to the buyer on a specified date and the buyer is obligated to pay to the seller the then prevailing futures price in exchange of the delivery of the asset. he is. performance guarantee and liquidity. When an investor buys a futures contract (so that he takes a long position) on an organized futures exchange. The futures contracts represent an improvement in the forward contract in terms of standardization. so that 1. 5. the minimum amount by which the price would change and the price limits of the day’s operations. 3. to take a short position. Whereas forward contracts are not standardized. This is because of the existence of a clearing house or clearing corporation associated with the futures exchange. While there is a risk of non-performance of a forward contract. it becomes a standard asset. like any other asset to be traded. in a way. when an investor sells a contract. Futures contracts are traded on commodity exchanges or on other futures exchanges. which plays a pivotal role in the trading of futures. 4. People can buy of sell futures like other commodities. the date and month of delivery. the units of price quotation. one assumes the right and obligation to make delivery of the underlying asset. 2. it is not so in case of a futures contract. and other relevant details are all specified in a futures contract. the quantity of the commodity or the other asset which could be transferred or would form the basis of gain/loss on maturity of the contract. Similarly. the futures contract are standardized ones. the quality of the commodity – if a certain commodity is involved – and the place where delivery of the commodity would be made. Thus.

RELATIONSHIP BETWEEN SPOT AND FUTURES PRICE The price of a commodity (here we are not restricting ourselves to equity stock as the underlying asset) is.. . 106. Suppose the current spot price is Rs. among other things. he will hire a godown. the price of wheat is likely to go up. Now if others also have the same information that the wheat prices are likely to go up beyond the carrying cost. collectively called the ‘carrying costs’. the predicted futures price. like. let us consider an example. 6. he should be tempted to buy wheat now and sell the stock after 3 months at a higher price. There would be a To understand the linkage between spot and futures price. 100 and the carrying costs are Rs. pay interest on the money invested I the stock as well as pay incidental charges in holding the inventory. Let us assume that he buys a unit of wheat at Rs. say. a function of: • • • Demand and supply position of the commodity Storability – depending on whether the commodity is perishable or not Seasonality of the commodity -------------------------Example If John is certain that the demand-supply position of wheat is such that 3 months from now. he would have to be sure that spot price of wheat. Logically. etc. 6 per unit. 3 months from now should be more than Rs. For this purpose. handling charges. insurance charges. the number of buyers would increase. As the current demand for wheat increases because of this information.hold on to a futures contract until maturity – one can easily close out a position in the futures contract. 110. As we have already seen. to earn profit. 100 and the carrying costs aggregates Rs. The current spot price would keep on increasing till the anticipated future spot price becomes equal to current spot price plus the carrying costs. stock the inventory. the current spot price also starts climbing. 3 months from now is Rs. the future spot price tends to equal the current spot price plus the carrying costs.

as any increase beyond this level would mean a loss in the transaction. Basis can become positive. Such a market. 104. As a corollary. The process of the basis approaching zero is called Convergence. the spot price can exceed the futures price only if there are factors other than the cost-of-carry to influence the futures price.tendency for the current spot price to rise from Rs. is known as the Contango Market. . the very idea of futures market would vanish. If. The conclusion. we can say that it is the element of uncertainty. therefore. i. Basis will approach zero towards the expiry of the contract. i.e. the spot price is less than the futures price (which includes the full cost-of-carry) and accordingly the basis would be negative. the spot and futures prices converge as the date of expiry of the contract approaches.e. ------------------------------- Thus. in which the basis decided solely by the cost-of-carry. neither the buyer nor the seller would be interested in futures trading. is that in a perfectly predictable and certain market. Basis = Spot price – Futures price In a normal market. which gives rise to a futures market. BASIS The difference between the prevailing spot price of an asset and the futures price is known as the basis. then basis become positive and the market under such circumstances is termed as a Backwardation Market or Inverted Market. In case this happens. 100 to Rs. the current spot price would tend towards a level where there is no profit or no loss situation for both the buyer and seller alike.e. future spot prices could be forecast with 100% certainty. i.

a. Other features of the contract and related information are as follows: Time of expiration Borrowing rate Face value of the stock .25) – (0. etc. 10 Annual Dividend on the stock . there might be factors other than cost-of-carry.As already explained above.) --------------------------Example The price of ACC stocks on 31st December 2000 was Rs.25 year) . ------------------------------ .2001 Based on the above information. especially in case of financial futures I which there may be carry returns like dividends. However.15 x 0. the relationship between futures price and cash price is determined by the cost-of-carry. is Futures price = Spot price + Carrying costs – Returns (dividends. 220 and the futures price on the same stock on the same date.15% p.Rs.3 months (0. which may influence this relationship. thus.75. for March 2001 was Rs.25 x 10) = Rs. 225. in addition to carrying costs. 225. The cost-of-carry model in financial futures. the futures price is Rs. as per the ‘cost of carry’ criteria.03.75 Thus. . 230 in February 2001. This would give rise to arbitrage opportunities and consequently the two prices will tend to converge.25% payable before 31. 230. which is less than the actual price of Rs. the futures price for ACC stock on 31st December 2000 should be: = 220 + (220 x 0.

4 VALUATION OF FORWARDS / FUTURES CONTRACT Lets see how traders determine a futures fair value .

05 = 50 1050 x 0. the forward price can be computed through the following formula: A = P (1 + r / 100) t ttg Where A is the terminal value of an amount P invested at the rate of interest of r % p.51 .05 = 55.40 1220. For instance. the amount is a little higher when the frequency of compounding is increased from one to two in each year. if compounding was done twice a year. Thus. continuous compounding are used in derivative securities.125 1157. 110 after 1 yr. 100 is Rs. and Rs.37 Amt. for different compounding period at the end of 2 yrs are given below: Compounding Quarterly Monthly Weekly Daily In general terms. 100 deposited in the bank at a rate of interest of 10% would become Rs. With the still greater compounding frequency.17 1221.6254 1215.39 1221.50 1102. the amount at the end of 2 years can be calculated as follows: Beginning of period I Half–year II Half-year III Half-year IV Half-year Principle 1000 1050 1102. 121 after 2 yrs. at the end 1050 1102. Now.a. the amount at the end of the 2 yr period would increase.50 1157.05 = 52.05 = 57. Based on annual compounding. 121 after 2 yrs. 110 after 1 yr.) 1218. In terms of annual compounding.881 It is observed that with all the inputs being the same. Rs. for t years.50 1157. the amount will become Rs. semi-annual and quarterly compounding. we can say that the forward price of the fixed deposit of Rs.Let us take a simple example of a fixed deposit in a bank.5 x 0. As against the usual annual. Amount (Rs.625 Interest 1000 x 0.625 x 0.

1221. Dividend @ Rs. To know the exact amount. the above formula will read as follows: A = (P – I) e mr Where I is the present value of the income flow during the tenure of the contract.a. while for daily compounding. for eg. the value of the forward contract is as follows: Dividend proceeds = 500 x 2. m = 365.40 In case there is a cash income accruing to the security like dividends. we make the following calculation: A = 1000 x 2. the amount is likely to be the largest.1 = 1000 x 1. it can be shown mathematically that the amount may be calculated as follows: A = Pe nr Where all symbols carry the same meaning as before. In the extreme case. the compounding may be thought to be continuous. ----------------------Example Consider a 4 month forward contract on 500 shares with each share priced at Rs. the time period between successive compoundings would steadily fall.50 per share is expected to accrue to the shares in a period of 3 months. Since the compounding is continuous.7183. In such an event.7183 2 x 0.A = P (1 + r / m) mn where r is the per annum rate of interest.22140 = Rs. m = 4. and e is a mathematical constant whose value is 2. The CCRRI is 10% p. For quarterly compounding. m is the number of compoundings per annum and n is the number of yrs.50 = 1250 . 75. if the number of compoundings per annum increases more and more. 2. To carry the idea further.

37498.10) = 1219.(3/12) (0.87 x e 0.13 Value of forward contract = (500 x 75 – 1219.11 ---------------------------- .13) e = 36280.033 (4/12) (0.Present value of Dividend = 1250e .10) = Rs.

FUTURES MARKET Curious about how trade works? Come get an insight into the market in which you’ll be dealing .

2. their efficiency has to be of the highest quantity. it becomes easy for the finance managers to take optimal decisions in regard to protection. Futures markets are relevant because of various reasons. Since these low cost instruments lead to a specified delivery of goods at a specified price on a specified date. Not only the size of the monetary operation that a futures market handles but also the critical significance it has on the equilibrium of the commodities / stocks is what makes the operation of the market so crucial. the futures trade has to have a market to facilitate buying and selling. The costs involved in entering into futures contracts is insignificant as compared to the value of commodities being traded underlying these contracts. PURPOSE OF A FUTURES MARKET Futures markets provide flexibility to an otherwise rigid spot market because of their very concept. which allows a wholistic approach to the price mechanism involved in futures contracts. The future price of a commodity is a function of various commodities related and market related factors and their inter-play determines the existence of a futures contract and its price. some of which are as follows: 1. Quick and Low Cost Transactions: Futures contracts can be created quickly at low cost to facilitate exchange of money for goods to be delivered at future date. As the futures markets involve the operation and execution of financial deals of an enormous magnitude. Price Discovery Function: The pricing of futures contracts in corporates a set of information based on which the producers and the consumers can get a fair idea of the future demand and supply . consumption and inventory.As in any other trade.

the trader will lose on sale of copper but will recoup through futures. technology changes. This. In case copper prices actually fall. Through their functions of risk mgt. it is called a Market Order. will need to enter into a transaction which could protect him in the event of such an adverse change. can be adequately and efficiently hedged against through futures contract. . which prevails in the futures pit at the time.position of the commodity and consequently the future spot price. 3. leads to a more efficient allocation of resources. Advantage to Informed Individuals: Individuals who have superior information in regard to factors like commodity demand-supply. futures markets provide economic as well as social benefits. the trader will honour the delivery of the futures contract through the imported copper stocks already available with him. in turn.. On the contrary if prices rise. market behaviour. a trader who has imported a consignment of copper and the shipment is to reach within a fortnight may sell copper futures if he foresees fall in copper prices. 4. and price discovery. TYPES OF ORDERS Market Order When a trader places a buy or sells order at a price. An individual who is exposed to the risk of an adverse price change while holding a position. Hedging Advantage: Adverse price changes. the order is given. This is known as the ‘price discovery’ function of future. can operate in a futures markets and impart efficiency to the commodity’s price determination process. which may lead to losses. For eg. Thus. either long or short a commodity. etc.

Limit Order If the trader specifies a particular price or the price limit within which the order should be executed. Market-If-Touched (MIT) Order If an order is executed at the best available price after trade occurs at a particular price or at a price more favourable then the specified price. Stop Loss Orders are normally placed by specifying a range in which the order should be executed instead of giving a single price order. the specified price may get jumped. such an order is called a Limit Order. the inherent risk is that the specified price or the band may never be hit during the day and the position may not be closed out. it is called the Market-if-Touched Order. This would insure him against a run away loss in the event of a drastic adverse price movement. The risk in the latter case is that the order may not get executed as in a violent price movement. . Good Till Cancelled (GTC) Order In terms of National Stock Exchange (NSE) regulations good till cancelled orders shall be cancelled at the end of 7 calendar days from the date of entering the order. This exchange acts as a seller for the buyer and a buyer for the seller in the process of execution of a futures contract. In such orders. he would place an order specifying a rate at which the deal could close out. Stop Loss Order When a trader holds a position. THE CLEARING MECHANISM A clearing house is an inseparable part of a futures exchange. either long or short and wants to restrict his downsize.

which are encashable fast. This solvency is achieved through imposing on its members. Daily Price Limits These limits set up the upper and the lower limits for the futures price on a particular day and incase these limits are touched the trading in those futures is stopped for the day. and Seller sells to the clearing house. such that. in effect. 1. the moment the buyer and the seller agree to enter into a contract. The sum total of these limits. Net Position Limits Such limits are imposed to contain the exposure threshold of each member. • • Buyer buys from the clearing house. The solvency requirements normally imposed by the clearing house on their members are broadly as follows. the clearing house steps in and bifurcates the transaction. 3. 2. the clearing house has to be solvent enough. Thus. cash margins and/or bank guarantees or other collaterals. . Capital Adequacy Capital adequacy norms are imposed on the clearing members to ensure that only financially sound firms could become members. The clearing house monitors the solvency of its members by specifying solvency norms. The extent of capital adequacy has to be market specific and would vary accordingly. the buyer and the seller do not get into the contract directly. In order to achieve this. there is no counter party risk. is the exposure limit of the clearing association as a whole and the net position limits are meant to diversify the association’s risk. The idea is to secure the interest of both.For example. in other words.

clearing houses and the banks involved. margins are sought or released). The margin paid by the investor is kept at the disposal of the clearing house through the brokerage firms.e. The clearing house gets the protection against po0ssible business risks through the margins placed with it in this manner and by the process of ‘marking to market’ (it means. debiting or crediting the clients’ equity accounts with the loss or gains of the day. i. a mandatory minimum margin is obtained by the members from the customers. i. Such a step insures the market against serious liquidity crisis arising out of possible defaults by the clearing members owing to insufficient margin retention. to introduce a financial stake of the client. at a stipulated percentage of the net purchases and sale position while they collect the margins from clients on gross basis. Customer Margins In order to avoid unhealthy competition among clearing members in reducing margins to attract customers. MARGINS The concept of margin here is the same as that for any other trade. b) Daily maintenance margins on both. to ensure performance of the contract and to cover day to day adverse fluctuations in the prices of the securities bought. comprising the stock exchanges.4.e. separately on purchases and sales. the members collect margins from their clients as may be stipulated by the stock exchanges from time to time. In order to secure their own interest as well as that of the entire system responsible for the smooth functioning of the market. The members pass on the margins to the clearing house on the net basis i. c) The accounts of the buyer and the seller are marked to the market daily.e. based on which. . The stock exchanges impose margins as follows: a) Initial margins on both the buyer as well as the seller.

Initial Margin Unlike in an options contract where only the buyer is obligated to perform and not the seller (writer). the investor is advised to deposit cash to make up the shortfall. Maintenance margin is the margin required to be kept by the investor in the equity account equal to or more than a specified percentage of the amount kept as initial margin. both the buyer and the seller are required to put in the initial margins. the first requirement for the investor is to open an account with the firm. in a futures contract both the buyer and the seller are required to perform the contract. then the broker will close out the investor’s position by entering a reversing trade in the investor’s account. Normally. The initial margin is the first line of defense for the clearing house. If the investor does not respond. This protection is further reinforced by prescribing maintenance margin.The margin for futures contract has two components • • Initial margin. Accordingly. . In case this requirement is not met. Maintenance Margin In order to start dealings with a brokerage firm for buying and selling futures. The margin is set by the stock exchange keeping in view the volume of business and the size of transactions a well as operative risks of the market in general. has to be kept separate from any other account including the margin accounts. called the equity account. This account. and Maintenance margin. the deposit in the equity account is equal to or more than 75% to 80% of the initial margin. The initial margin is also known as the performance margin and is usually 5 to 155 of the purchase price of the contract.

Both make a deposit of Rs.500. The next day.500 and that of the seller decreases to Rs. if the seller is unable to pay. 500 and would be called upon to make up the shortfall by depositing cash. However.000 towards the initial margin. the broker would enter a reversing trade by purchasing a future of the same expiration. the stock price rises to Rs. 25.00 everyday. 1.-----------------------------Example A buyer buys a futures contract @ Rs. 1. 2. is short of Rs. 50 per share for 500 shares from a seller. the buyer and the seller are required to have a minimum equity of Rs. 52 per share. 3. 2. The seller. The equity of the buyer increases to Rs. being 10% of the total investment of Rs. As the maintenance margin is required to be maintained at 80% of the initial margin. -------------------------------- .500.500 and he has the liberty of withdrawing this sum. on the other hand. The buyer has a surplus of Rs.

6 OTHER FUTURES CONTRACT Learn about other choices in Futures .

the need for suitable hedge against this volatility has risen.STOCK INDEX FUTURES Stock index futures are drawn on stock market indices and each of these contracts are characterized by payment of cash on the delivery date of an amount equal to a multiplier times the difference between: a) The value of the index at the close of the last trading day of the contract. and b) The purchase price of the futures contract. the tremendous growth in the fixed income securities. two prime-movers for the growth of interest rate futures are: 1. increased volatility in the interest rates in the market. Predetermined periodical income through the life of such instruments and principle maturity amount at the end of the instrument’s life are the usually the features of such securities. Thus. and 2. . Interest rate futures can be used to hedge against interest rate risk and to crystallize future investment yields or future cost of borrowing. In order to hedge against the risks arising as a result of these two factors. INTEREST RATES FUTURES Futures written on fixed income instruments as the underlying securities are known as interest rate futures. These instruments have become an integral part of all balance portfolios and accordingly the growth of these securities has grown substantially. interest rates on fixed income instruments have become highly volatile. interest rate futures come in handy apart from other hedging instruments like interest-rates swaps. But ever since.

OPTIONS .

7 BASICS An introduction to Options involving the components of trading .

The writer is writing or selling a put option and the buyer is buying a put option. ---------------------------Example Suppose a writer of an option writes a contract. there is not put option involved. ------------------------------- WHO CAN WRITE AN OPTION? . if a writer writes an option which grants to the buyer the right to sell to the writer 100 shares of ITC at Rs. The writer is writing or selling a call option and the buyer is buying a call option. i. such an option is called a put option and is designated as 100 ITC 650 put. 650 per share. the right to purchase from or to sell to the writer a designated instrument or a scrip at a specified price within a specified period of time. Similarly. Similarly. from the writer at the rate of Rs. 650 per share. in the case of a put option transaction there is no call option involved. It should be noted that in a call option transaction.e. This option is called a call option and is designated as 100 ITC 650 call. The right to purchase a specified stock is called the call option. while the right to sell a specified stock is called a put option.WHAT IS AN OPTION? Option is a legal contract in which the writer of the contract grants to the buyer. which conveys or grants to the buyer the right to bur 100 shares of ITC from him.

. if the writer of the call option does not own the stock he has written the option for. If the writer of a call option owns the stock that he is obliged to deliver upon exercise of the call he has written. By letting the option lapse the buyer gets out of the contract. he is called a covered call writer. The options contract confers on you the right to either invoke the contract or let it lapse. He can conveniently let the option lapse on the date of expiration of the option. the writer or the seller is under the obligation to perform right up to the expiry of the cont6ract whenever called upon buy the buyer of the option to do so. However. you do not gain anything by exercising the option. The significance of this feature of an option is explained through the following example.e. as he is not obligated to perform. On the other. Invoking the contract means – calling upon the writer to deliver the stock at the contract price. OBLIGATION OF THE OPTION WRITER AND BUYER The writer is legally obligated to perform according to the terms of the option. i. the stock price does not appreciate enough to cover even the premium paid. On the other hand. he is called an uncovered or naked call writer and the option is called an uncovered or naked call option. the buyer of the option has bought a write to exercise the option and is under no obligation to exercise the option. This would be futile as this stock is available at equal to or even less than the exercise price in the market. During the expiration period..Anyone eligible to enter into contract as per the Law of Contract can write an option irrespective of the fact whether one owns the underlying stock or not. -----------------------------Example Suppose you buy a 100 ITC 650 Call option contract.

The name of the company on whose stock the option contract has been derived. at which the stock would be delivered. The quantity of the stock required to be delivered in the case of exercise of the option. or the exercise price or the strike price. The date when the contract expires. The price. . called the expiration date.--------------------------------- ESSENTIAL INGREDIENTS OF AN OPTION CONTRACT An options contract has four essential ingredients: 1. 2. 3. 4.

8 TYPES OF OPTIONS Lets see the kind of Options you can trade in .

Position Graphs Intrinsic Value Lines + + k Premium _ { k b Stock Price } Premium _ b Stock Price Intrinsic Value Lines (a) Buy a Call (uncovered) (b) Write a Call An option buyer starts with a loss equivalent to the premium paid. The profitability line starts climbing up at an inclination of 45 degrees after crossing the X-axis at ‘b’ and from thereon moves into the positive side of the . also called the break even point.e.CALL OPTIONS A call option gives the buyer the right to purchase a specified number of shares of a particular company from the option writer (seller) at a specified price (called the exercise price) up to the expiry of the option. the option buyer gets a right to call upon the option seller to deliver the contracted shares any time up to the expiry of the option. i. the loss starts reducing and gets wiped out as soon as the increase equals the premium. He has to carry on with the loss till the stock's market price equals the exercise price as shown in (a). In other words. The buyer is not obligated to perform. the seller is obligated to deliver the contracted shares while the buyer has the choice to exercise the option or let the contract lapse. The intrinsic value of the option up to this point remains zero and thus. The contract. As the stock price increases further. thus. represented on the graph by point ‘b’. is only one-way obligation. runs along the X-axis.

RATIONALE OF BUYING CALL OPTIONS There are broadly three reasons why an investor could buy a call option instead of buying the stock outright. 80 per share (400 (300+20)].. The position graph in (b) represents the profitability status of the writer who does not own the stock. having short sold a stock. Return on Investment An investor anticipates that a stock is shortly going to appreciate from Rs. Had he bought the stock outright.e. The inclined line beyond the point ‘b’ indicates that the option acquires intrinsic value and is. However. The maximum loss the investor may be exposed to . Rs. 100 per share on an investment of Rs.e. 30. the investor got an appreciation of 400% on his investment. i. Let us assume that the stock's share actually goes up to Rs. Hedging Trading with the objective of reducing or controlling risk is called HEDGING. These are as follows: 1. The investor thus makes a profit of Rs. i. 300 to Rs. 2. a call option on the stock is available at a premium of Rs. The graph is logically the inverse of that for the option buyer. thus referred to as the intrinsic value line. sold short. he would at least have the commitment of the option writer to deliver the stock at the exercise price. 300. a naked or an uncovered writer. 400 within the currency of the option. His investment was only to the extent of premium paid. can protect himself by buying a call option.e. the investor would have made Rs. whenever he is to effect delivery for the stock. 20. i. In the event of an increase in the stock's price. 20 per share. This should be sufficient motivation for the investor to go in f6r call options on the stock as against outright buying of the stock. An investor. Thus.000. 400 per share and buying 100 shares of the stock would involve an investment of Rs.graph. 33%.

Position Graphs Intrinsic Value Line Intrinsic Value Lines + b _ k Stock Price } Premium _ b + k } Premium Stock Price . Arbitrage Arbitrage involves buying at a lower price and selling. As in any other trade. which may exist within a market or between two markets or two products and as a result tends to bring perfection to the market. Options can thus be used as a handy tool for hedging. PUT OPTION A put option gives a buyer the right to sell a specified number of shares of a particular stock to the option writer at a specified price (called the exercise price) any time during the currency of the option.at a higher price. options arbitrage provides an opportunity to earn money by exploiting the pricing inefficiencies. if it so exists. 3.would be limited to the premium paid on the call option.

the loss to the put option buyer is restricted to the premium paid. Purchase a put option.e.(a) Buy a Put (b) Write a Put RATIONALE OF BUYING A PUT OPTION An investor. i. In the event of a fall in the stock price. Thus. Option Type Buyer of Call Writer of Call . the return on investment on buying a put option is much higher as compared to going short on the stock. if he anticipates fall in the price of some stock. writing a naked call option. thus making profit equal to the fall in the price. which may not be sufficient attraction. as in the case of a call option. in case the stock price appreciates instead of declining. has the following alternatives: 1. However. the investor would be exposed to unlimited loss.e. Writing such an option is similar to selling short. The first reason is that the investment in buying a put option is restricted to the premium as against a larger sum required for going short. Write a call option without owning the stock. Secondly. in the event of increase in the stock price. enter a sales transaction without owning the stock. Sell the stock short. i. The purchase of a put option is the most desirable policy as compared to either going short or writing a naked call option. the only difference being that the loss in the event of appreciation in the stock price would be curtailed to the extent of the premium received on writing the call option. 3. he can buy the stock at a lower price and can deliver the stock sold to the buyer. 2.

are of the American style. given above apply to the American-style options. the owner can exercise his right only on the expiration date and not before it. In case of European options. . both call and put.(Long Position) (Short Position) Call Put Right to buy asset Right to sell asset Obligation to sell asset Obligation to buy asset AMERICAN v/s EUROPEAN OPTIONS The definitions of options. It may be pointed out however. including those in Europe. that most of the options traded in the world. Besides the American type there are European-style options as well. An American option can be exercised by its owner at any time on or before the expiration date.

9 TERMINOLOGY Glossary – to foster a better understanding of the Options market .

Before into the concepts and mechanics of options trading, we need to be familiar with the basic terminology as they are repeatedly used in case of options.

EXERCISE PRICE
The exercise price (also called the strike price)is the price at which the buyer of a call option can purchase the stock during the life of the option, or the buyer of the put option can sell during the life of the option. Exercise price is that price at which the writer has to deliver the stock to the call option buyer and buy from the put buyer irrespective of the prevailing market price in case the latter decides to exercise the option.

EXPIRATION DATE
Expiration Date is the date on which the option contract expires, i.e. the last date on which options contract can be exercised. Options usually have either a monthly and/or quarterly expiration cycle. The maturity period for an option does not normally exceed nine months.

PREMIUM

Premium is the price that the buyer of an option, whether call or put, pays to the writer of the option, for the rights conveyed by the option. The premium of the option is a function of variables, such as: • • • • • Current stock price, Strike price, Time to expiration, Volatility of stock, and Interest rates.

The buyer pays the premium to the seller, which belongs to the seller whether the option is exercised, or not. If the owner of an option decided not to exercise the option, the option expires and becomes worthless. The premium becomes the profit of the option writer, while if the option is exercised; the premium gets adjusted against the loss that the writer incurs upon such exercise.

IN-THE-MONEY
A call option is In-the-Money if the prevailing stock price (of the underlying asset) is greater than the exercise price.

AT-THE-MONEY
In case the call’s market price is the same as its exercise price, it would bee called at-themoney or at-the-market.

OUT-OF-THE-MONEY
Similarly, if the market price of the stock is less than the exercise price, it shall be called out-of-the-money.

These concepts are tabulated below, wherein S indicates the present value of the stock and E is the exercise price. Condition S>E S<E S=E Call Option In-the-Money Out-of-the-Money At-the-Money Put Option Out-of-the-Money In-the-Money At-the-Money

INTRINSIC VALUE
The premium or the price of an option is made up of two components, namely, intrinsic value and time value. Intrinsic value is termed as parity value. For an option, the intrinsic value refers to the amount by which it is in money if it is inthe-money. Therefore, an option, which is out-of-the-money or at-the-money, has zero intrinsic value. For a call option, which is in-the-money, then, the intrinsic value is the excess of stock price (S) over the exercise price (E), while it is zero if the option is other than in-themoney. Symbolically, Intrinsic Value of a call option = max (0, S – E) In case, of an in-the-money put option, however, the intrinsic value is the amount by which the exercise price exceeds the stock price, and zero otherwise. Thus, Intrinsic Value of a put option = max (0, E - S)

TIME VALUE

80 85 Stocks Price (Rs) 83. a call or a put option. Option Exercise Price (Rs) 1. An in-the-money put option has a time value if its premium exceeds the intrinsic value.S-E) 1.E)] Time value of a put = C – [max (0. This is also true for the put options. which are at-the-money or out-of-the-money. have their entire premium as the time value. put options.S)] Example: Consider the following data calls on a hypothetical stock. Like for call options. the entire premium about is the time value. Generally.50 Call Option Price (Rs) 6. the longer the time of a call to maturity.75 2.S-E) 6. Option S E C Intrinsic Value Max (0. E .50 Time Value C-max (0. 83. S – E.50 83.Time value is also termed as premium over parity. For an in-the-money option time value may or may not exist.75 3. For. Accordingly. C. of a call which is in-the-money.50=3. the time value exists if the call price.25 . E – S. 2. In case.50 In-the-money Out-the-money Classification We may show how the market price of the two calls can be divided between intrinsic and time values. is greater than the intrinsic value. the greater will be the time value. which is at-the-money or out-of-the-money. The time value of an option is the difference between the premium of the option and the intrinsic value of the option.75-3. S . Time value of a call = C – [max (0. other things being equal.50 80 6.

Covered Call Options / Covered Calls Call writers are consider to be covered if they have any of the following positions: • • Along position in the underlying asset. .50-0=2.50 0 2. When they face such a risk writers are said to be uncovered (or naked). An escrow-receipt from a bank. In the absence of one of these conditions.50 85 2.50 On On the COVERED AND UNCOVERED OPTIONS An option contract is considered covered if the writer owns the underlying asset or has another offsetting option position. The put writer may have to buy the asset from the holder at a price that creates a loss. the writer is exposed to the risk of having to fulfill the contractual obligations by buying the asset at the time of delivery at an unfavorable price. The call writer may have to purchase the underlying asset at a price that is higher than he strike price.2. 83.

MARGIN REQUIREMENTS As in the case of futures contracts. on the returns and risk on the position. . the exchange has. and whether the option is a call or a put. if I write a naked call. and in turn assure the exchange of the performance of the contract. A warrant exercisable for requisite number of shares of the underlying security. As a general rule.• • • A security that is convertible into requisite number of shares of the underlying security. should the buyer of the option choose to exercise the call. The requirements vary depending upon the brokerage firm. initial margins are at least 30% of the stock price when the option is written. for example. A long position in a call on the same security that has the same or the lower strike price and that expires at the same time or later than the option being written. Covered Put There is only one way for put writer to be covered. in turn. the writers of options are required to meet the margin requirements. my broker would need a guarantee in some form that I would have the necessary funds to be able to deliver the asset. plus the intrinsic value of the option. consequently. the price of the underlying asset. Thus. margin requirements exist as a form of collateral to ensure that the writer of a naked call can fulfill the terms of the contract. They must own a put on the same underlying asset with the same or later expiration month and the higher strike price than the option being written. the performance of contracts is also assured by the options exchanges (the OCC) the buyer of an option enjoys the right of its performance exchange. For this. Accordingly. to make sure that the contract will be honoured. the price of the option. The amount of margin has an influence on the degree of financial leverage that the investor has and.

10 OPTION PRICING Want to know on what your option price depends? .

. or the buyer of the put option can sell during the life of the option. we need to be familiar with the basic terminology as they are repeatedly used in case of options. Exercise price is that price at which the writer has to deliver the stock to the call option buyer and buy from the put buyer irrespective of the prevailing market price in case the latter decides to exercise the option.e. EXERCISE PRICE The exercise price (also called the strike price)is the price at which the buyer of a call option can purchase the stock during the life of the option. i.Before into the concepts and mechanics of options trading. EXPIRATION DATE Expiration Date is the date on which the option contract expires. the last date on which options contract can be exercised.

for the rights conveyed by the option. it would bee called at-themoney or at-the-market. or not. such as: • • • • • Current stock price. the option expires and becomes worthless. Time to expiration. Volatility of stock. The premium becomes the profit of the option writer. If the owner of an option decided not to exercise the option. IN-THE-MONEY A call option is In-the-Money if the prevailing stock price (of the underlying asset) is greater than the exercise price.Options usually have either a monthly and/or quarterly expiration cycle. PREMIUM Premium is the price that the buyer of an option. The maturity period for an option does not normally exceed nine months. which belongs to the seller whether the option is exercised. Strike price. whether call or put. AT-THE-MONEY In case the call’s market price is the same as its exercise price. The buyer pays the premium to the seller. while if the option is exercised. OUT-OF-THE-MONEY . The premium of the option is a function of variables. the premium gets adjusted against the loss that the writer incurs upon such exercise. and Interest rates. pays to the writer of the option.

which is out-of-the-money or at-the-money. For a call option. the intrinsic value refers to the amount by which it is in money if it is inthe-money. which is in-the-money. the intrinsic value is the amount by which the exercise price exceeds the stock price. S – E) In case. wherein S indicates the present value of the stock and E is the exercise price. however.S) . Therefore. the intrinsic value is the excess of stock price (S) over the exercise price (E). if the market price of the stock is less than the exercise price. Intrinsic Value of a put option = max (0. Symbolically. of an in-the-money put option. has zero intrinsic value. Thus. Intrinsic Value of a call option = max (0.Similarly. then. For an option. E . These concepts are tabulated below. intrinsic value and time value. Condition S>E S<E S=E Call Option In-the-Money Out-of-the-Money At-the-Money Put Option Out-of-the-Money In-the-Money At-the-Money INTRINSIC VALUE The premium or the price of an option is made up of two components. it shall be called out-of-the-money. while it is zero if the option is other than in-themoney. and zero otherwise. Intrinsic value is termed as parity value. an option. namely.

the time value exists if the call price.50 Call Option Price (Rs) 6. put options. have their entire premium as the time value.E)] Time value of a put = C – [max (0.S)] Example: Consider the following data calls on a hypothetical stock. other things being equal. S – E. Like for call options. Option Exercise Price (Rs) 1. a call or a put option.TIME VALUE Time value is also termed as premium over parity. . 80 85 Stocks Price (Rs) 83. This is also true for the put options.50 83. An in-the-money put option has a time value if its premium exceeds the intrinsic value. the entire premium about is the time value. Accordingly. For an in-the-money option time value may or may not exist. In case. C. Time value of a call = C – [max (0. E – S. the longer the time of a call to maturity. which is at-the-money or out-of-the-money. 2. E .75 2. The time value of an option is the difference between the premium of the option and the intrinsic value of the option. of a call which is in-the-money. is greater than the intrinsic value. For. S . the greater will be the time value. which are at-the-money or out-of-the-money. Generally.50 In-the-money Out-the-money Classification We may show how the market price of the two calls can be divided between intrinsic and time values.

50 0 On On the COVERED AND UNCOVERED OPTIONS An option contract is considered covered if the writer owns the underlying asset or has another offsetting option position.50-0=2. 83.S-E) 6.S-E) Time Value C-max (0. The put writer may have to buy the asset from the holder at a price that creates a loss. the writer is exposed to the risk of having to fulfill the contractual obligations by buying the asset at the time of delivery at an unfavorable price.75 2.75-3. The call writer may have to purchase the underlying asset at a price that is higher than he strike price.50 3.50 80 85 6. 2. Covered Call Options / Covered Calls .25 2. When they face such a risk writers are said to be uncovered (or naked). In the absence of one of these conditions.Option S E C Intrinsic Value Max (0.50 83.50=3.50 1.

the performance of contracts is also assured by the options exchanges (the OCC) the buyer of an option enjoys the right of its performance exchange. An escrow-receipt from a bank. the price of the option. Thus. The requirements vary depending upon the brokerage firm. the exchange has. initial . in turn.Call writers are consider to be covered if they have any of the following positions: • • • • • Along position in the underlying asset. if I write a naked call. my broker would need a guarantee in some form that I would have the necessary funds to be able to deliver the asset. should the buyer of the option choose to exercise the call. the price of the underlying asset. They must own a put on the same underlying asset with the same or later expiration month and the higher strike price than the option being written. and whether the option is a call or a put. Accordingly. to make sure that the contract will be honoured. MARGIN REQUIREMENTS As in the case of futures contracts. and in turn assure the exchange of the performance of the contract. A warrant exercisable for requisite number of shares of the underlying security. the writers of options are required to meet the margin requirements. As a general rule. Covered Put There is only one way for put writer to be covered. A long position in a call on the same security that has the same or the lower strike price and that expires at the same time or later than the option being written. margin requirements exist as a form of collateral to ensure that the writer of a naked call can fulfill the terms of the contract. For this. for example. A security that is convertible into requisite number of shares of the underlying security.

on the returns and risk on the position. plus the intrinsic value of the option. consequently.margins are at least 30% of the stock price when the option is written. RISK & RETURN ON EQUITY OPTIONS Lets consider the gains/losses resulting with long & short positions in Options . The amount of margin has an influence on the degree of financial leverage that the investor has and.

the short and long positions. 2001 Size of contract = 100 shares Date of entering into contract =January 5.50 Price of option on the date of contract = Rs 10 . say ABC Suppose the contract is made between two investors X and Y. CALL OPTIONS Consider a call option on a certain share. respectively. The other details are given below: Exercise price = Rs 120 Expiration month = March. 2001 Price of share on the date of contract = Rs 124. who take.We will now see the risk and return associated with equity stock options.

) 90 100 110 120 130 140 150 160 Investor X 1000 1000 1000 1000 0 -1000 -2000 -3000 Investor Y -1000 -1000 -1000 -1000 0 1000 2000 3000 The profit profile for this contract is indicated below. On the date of maturity. 1000 (= 10 x 100) Investor Y takes a long position and pays Rs 1000 for it. Profit / Loss Profile for the Investors . the profit or loss to each investor would depend upon the price of the share ABC prevailing on that day. At a price equal to Rs 130 a break-even point is reached. Only when the price exceeds Rs 120 per share will a call be made. Figure (a) shows the profit/loss function for the investor X. The buyer would obviously not call upon the call writer to sell shares if the price happens to be lower than Rs 120 per share. The profit/loss made by each of the investors for some selected values of the share price of ABC is indicated below. Having paid Rs 10 per share for buying an option.Call Option Possible Price of ABC at Call Maturity (Rs. Investor X writes a contract and receives Rs. .At the time of entering in to the contract. the writer of the call. the buyer can make a profit only in case the share price would be at a point higher than Rs 120 + Rs 10 = Rs 130. while Figure (b) gives the same for the other investor Y. the buyer of the option.

Profit 1500 – 1000 – 500 – 0 500 – 1000 – 1500 – 2000 – 2500 – Loss (a) For Investor X Stock Price 90 100 110 120 130 140 150 160 Profit 3000 – 2500 – 2000 – 1500 – 1000 – 500 – 0– 500 – 1000 – 1500 – Loss (b) For Investor Y Stock Price 90 100 110 120 130 140 150 160 .

However. the profit profile is different from the one in a call option where the rights and obligations are different. 2001 Share price on the date of contract = Rs 1 12 Price of put option on the date of contract = Rs 7. The other details . two investors X are given below: Exercise price = Rs I 10 Expiration month = March.It is evident that the call writer's profit is limited to the amount of call premium but. there is no limit to the losses if the stock price continues to increase and the writer does not make a closing transaction by purchasing an identical call. since the investor with a long position has a right to sell the stock and the writer is obliged to buy it at the will of the buyer. theoretically. depending on the stock price. The situation is exactly opposite for the call buyer for whom the loss is limited to the amount of premium paid. PQP. PUT OPTIONS In a put option. 2001 Size of contract= I 00 shares Date of entering into contract =January 6. a loss (gain) to one party implies an equal amount of gain (loss) to the other party. Consider a put option contract on a certain share. there is no limit on the amount of profit which can result for the buyer.50 and Y enter into a contract and take short and long positions respectively. Being a 'zero-sum' game. Suppose.

if the value of the underlying share falls to zero. If the price of the share falls below the exercise price. the writer of the option. Thus. For instance. a loss would result to the writer and a gain to the buyer. Possible Price of PQR at Investor X Investor Y Put Maturity (Rs) 80 90 100 110 120 130 140 150 Investor X Investor Y -2250 -1250 -250 750 750 750 750 750 2250 1250 250 -750 -750 -750 -750 -750 The break-even share price would be Rs 102. 102.50).50 = Rs. the gain/loss to each party depends on the ruling price of the share. At the same time. Y At the time of maturity. it represents the maximum loss that the buyer is exposed to. 7. X will receive Rs 750 (=7.50 per share. the loss to the writer is equal to Rs. as the contract is entered into.Now. the gain/loss for each of the investors may be calculated as shown below. The maximum loss that the writer may theoretically be exposed to is limited by the amount of the exercise price. the writer would make a loss-and the buyer makes a gain. If the price of the share is Rs 110 or greater than that.50 x 100) from the buyer. 110 – Rs. so that the writer pockets the amount of put premium-the maximum profit which can accrue to a seller. . the option will not be exercised. The profit/loss for some selected values share are given below. when the price of the share is Rs 100.50 (= Rs 110 Rs 7. If the price of the share happens to be lower than this.

As indicated earlier. Fig. the profiles of the two investors replicate each other. 10000 Net profit(loss) = -750 + 11000 .10000 = Rs. (b) gives the same for the other investor Y. 250) Investor Y Option premium paid = 7.5 x 100 = Rs.11000 + 10000 = (Rs.Investor X Option premium received = 7.5 x 100 = Rs. while the Fig. 10000 Net Profit(Loss) = 750 . the buyer of the option. 250 The profile of profit/loss for each of the investors is given in Figures below. (a) shows the profit/loss function for the investor X the writer of the put. 750 Amount to be paid for shares = 110 x 100 = Rs. Profit 1500 – 1000 – 500 – 0 500 – 1000 – 1500 – 2000 – 2500 – 3000 – Loss 90 100 110 120 130 140 150 160 Stock Price (a) For investor X . 11000 Market value of the shares = 100 x 100 = Rs. 11000 Market value of the shares = 100 x 100 = Rs. 750 Amount to be received for shares = 110 x 100 = Rs.

(b) For Investor Y Profit 2500 – 2000 – 1500 – 1000 – 500 – 0– 500 – 1000 – Loss 90 100 110 120 130 140 150 Stock Price OPTIONS TRADING STRATEGIES Learn some Strategies which will profit you in this market environment .

the more out-of-the money option should one buy. The maximum loss to the writer of a put option on an . a long put would gain value as the underlying asset. the equity share price or the market index. The more bullish market sentiment or perception. The payoffs associated with a long or short call. a number of trading strategies involving options may be employed by the investors. we may consider investment in a single stock option. The writer of a put option would get the maximum profit equal to the premium amount but would be exposed to loss should the market collapse. the writer of a call has a mirror image position along the break-even line. or in a strategy using the underlying instrument (equity stock. for example). In fact. It is important to note that an investor need not take positions in naked options only or in a single option alone. A long call is used when one expects that the market would rise.We have considered above the profit/loss resulting to the investors with long and short positions in the call and put options. the loss is limited to the premium payable while the profit is potentially unlimited. Options may be used on their own. and a long or short put option has already been discussed. In case of the put option. We now discuss some of the commonly used strategies. The writer writes a call with the belief or expectation that the market would not show an upward trend. For the option buyer in this strategy. declines. To begin with. On the other hand. One of the attractions of options is that they could be used for creating a very wide range of payoff functions. The loss for a put buyer is limited to the amount paid for the option if the market ends above the option exercise price. a put is bought when a decline is expected in the market. in conjunction with the futures contracts. Accordingly.

the hedges are not perfect because they cannot eliminate all losses. Such options are called covered options in contrast to the uncovered or naked options. The offsetting position may be in the same or a different security. options in equities are employed to hedge a long o short position in the underlying common stock. a hedge strategy strives to prevent large losses without significantly reducing the gains. be combined in several Ways without taking positions in the underlying assets or they might be used in conjunction with the underlying assets for purposes of hedging. In most cases. Thus. while selling of options may be used as a legitimate means of generating premium income and bought in the expectation of making profit from the likely bullish / bearish market sentiments. They may. Hedging a Long Position in Stock . which we describe in the next section. they may or may not be used alone. HEDGING USING CALL AND PUT OPTIONS Hedging represents a strategy by which an attempt is made to limit the losses in one position by simultaneously taking a second offsetting position.equity hare could be equal to the exercise price (since the stock price cannot be negative). Typically. however. discussed earlier. Very often.

16 for an exercise price of. he buys a put for Rs. the net loss equals to Rs. the put will be exercised and the resulting profit would be Rs. 30 incurred for the reason of holding the share. 110. exercise the option only if the price of the share were to be less than Rs. For instance. 100. equal to Rs. say..e. He would. at a share price of Rs. . Profit / Loss for Selected Share Values: Long Stock Long Put Share Price 70 80 90 100 110 120 130 140 Exercise Price 110 110 110 110 110 110 110 110 Profit on Exercise (i) 24 14 4 -6 -16 -16 -16 -16 Profit / Loss on Share Held (ii) -30 -20 -10 0 10 20 30 40 Net Profit (i) + (ii) -6 -6 -6 -6 -6 4 14 24 The profits resulting from the strategy of holding a long position in stock and long put are shown in the figure below. With a loss of Rs. 110 – Rs.An investor buying a common stock expects that its price would increase. Rs. In such a case. 6. buying the right to sell. obviously. or Rs 40 minus the put premium of Rs. To guard against the risk of loss from a fall in its price. 70. 24. Consider an investor who buys a share for Rs. 70. a hedge could be formed by buying a put i. there is a risk that the price may in fact fall. Table below gives the profit/loss for some selected values of the share price on maturity of the option. However. 110. 16.

4 with a strike price of Rs. To minimize the risk involved.Hedging : Long Stock Long Put Profit 50 40 30 20 10 0 10 20 30 40 Loss Profit on Exercise of Put Profit / Loss on Hedging E Stock Price Profit / Loss on Long Stock Hedging a Short Position in Stock Unlike an investor with a long position in stock. By shorting the stock now and buying it at a lower price in the future. Let us suppose. Any price increase can bring losses because of an obligation to purchase at a later date. 105. the investor intends to make a profit. 100 and buys a call option for Rs. the investor can buy a call option with an exercise price equal to or close to the selling price of the stock. a short seller of stock anticipates a decline in stock price. Profit / Loss for Selected Share Values: Short Stock Long Call . an investor shorts a share at Rs. The conditional payoffs resulting from some selected prices of the share are shown in a table below.

Share Price 90 95 100 105 110 115 120 Exercise Price 105 105 105 105 105 105 105 Profit on Exercise (i) -4 -4 -4 -4 1 6 11 Profit / Loss on Share Held (ii) 15 10 5 0 -5 -10 -15 Net Profit (i) + (ii) 11 6 1 -4 -4 -4 -4 The payoff function associated with this policy is shown below. Hedging : Short Stock Long Call Profit 50 40 30 20 10 0 10 20 30 40 Loss Profit / Loss on Short Stock Profit / Loss on Call Option E Stock Price Profit / Loss on Hedging .

Profit / Loss for Selected Share Values: Long Stock Short Call Share Price 90 95 100 105 110 115 Exercise Price 105 105 105 105 105 105 Profit on Exercise (i) 3 3 3 3 -2 -7 Profit / Loss on Share Held (ii) -10 -5 0 5 10 15 Net Profit (i) + (ii) -7 -2 3 8 8 8 . If the common stock is not expected to experience significant price variations in the short run. is a very conservative strategy.. you would have to make a reversing transaction. To illustrate the strategy of writing a covered call. The writing of covered calls. consider an investor who has bought a share for Rs 100. you will not derive any benefit if large price changes occur because then the option will be exercised or. i. The profit/loss occurring at some prices of the underlying share is indicated in table below. then you may write a call on these. agreeing to sell the stock you have. and receives a premium of Rs. else. Options may also be used for enhancing returns from the positions in stock. suppose that you hold shares of a stock which you expect will experience small changes in the short term. and who writes a call with an exercise price of Rs. you tend to raise the short-term returns. This is known as writing covered calls. 105.e. Of course. 3. By writing covered call options.HEDGING WITH WRITING CALL AND PUT OPTIONS Both the strategies discussed above aim at limiting the risk of an underlying position in an equity stock. As an example. then the strategies of writing calls and puts may be usefully employed for the purpose.

Clearly. Hedging : Long Stock Short Call Profit 50 40 30 20 10 0 10 20 30 40 Loss Profit / Loss on Long Stock Profit / Loss on Call Option Profit / Loss on Hedging E Stock Price In a similar way. by limiting the profit that could be made when the stock price declines. . 100 and write a put option for Rs. having an exercise price of Rs. the buyer of the put will exercise the option only if the share price does not exceed the exercise price. As an example. 100. 3. the investor hopes to reduce the magnitude of loss that would be occurring from an increase in the stock price. By undertaking to ‘be the buyer’. suppose that you short a share at Rs. an investor who shorts stock can hedge by writing a put option.120 105 -12 20 8 Figure depicts the payoff function for the strategy of writing covered calls. The conditional payoffs resulting from some selected values of the share price are contained in table below.

Hedging : Short Stock Short Put Profit 50 40 30 20 10 0 10 20 30 40 Loss Profit / Loss on Short Stock Profit / Loss on Hedging Profit / Loss on Put Option Stock Price E SPREADS A spread trading strategy involves taking a position in two or more options of the same type.Profit / Loss for Selected Share Values: Short Stock Short Put Share Price 90 95 100 105 110 115 120 Exercise Price 100 100 100 100 100 100 100 Profit on Exercise (i) -7 -2 3 3 3 3 3 Profit / Loss on Share Held (ii) 10 5 0 -5 -10 -15 -20 Net Profit (i) + (ii) 3 3 3 -2 -7 -12 -17 The figure below gives a general view of the profit function associated with the policy of writing a protected put. Bull Spreads .

If the price of stock at the time of exercise is. If the stock price is greater than higher exercise price. 50 = Rs. Further. Accordingly. 2). 4. if the stock price rules between the strike prices of the two calls.Rs 6 = Rs. if the stock remains below the lower strike price. the price payable for buying a lower exercise price option is more than the premium receivable from writing an option with a greater exercise price and. both calls would expire unexercised and the loss will be limited to the initial cost of the spread. A bull spread reflects the bullish sentiment of a trader and can be created by purchasing a call option on a stock and selling another call on the stock and with the same expiry but a higher exercise price. 2 = Rs. a cost is involved in buying the spread. To illustrate this suppose that you buy a call option with an exercise price of Rs. 58. 10 . 8 + Rs. Finally. 60 for a premium of Rs. if the price of the stock is higher than Rs. 6 (Rs. both of these will be exercised and the payoff be Rs. 50 = Rs. At expiry. Rs. Thus. 60. 50 or less. 60 – Rs.One of the most popular spread strategies is a bull spread. then the call with an exercise price of shall be exercised for a payoff of Rs. While El and E2 are the respective strike prices of the calls that are long and short. Now if the price rules at Rs. The payoffs resulting from a bull spread strategy are given below. It may be recalled that other things remaining the same. 8. both options are in-the-money and the payoff equals the difference between the exercise prices of the two options. 8 and sell one with an exercise price of Rs. 2. S1 represents the stock price at the time of exercising the calls. the payoff equals the difference between the stock price and the (lower) exercise price. 8 – Rs. 10 with the net profit equal to Rs. 58 – Rs. the purchased call is in-the-money while the call sold expires unexercised. 50 for Rs. 8 – Rs. hence. a call with a lower exercise price has a greater premium. say. 2. . the net being Rs. none of them would be exercised. both being on the same stock and with same expiration date. with the result that the payoff will be nil and net loss would be Rs.

by selling a call against an otherwise naked call. while a spread created with both calls being in-the-money initially would be the most conservative. both options are exercised and the position is closed for the difference between the two exercise prices. One put is purchased and another one is sold which is on the same stock.Payoffs from a Bull Spread (Using Calls) Price of Stock S1 > E2 E1 < S1 < E2 S1 <= E1 *NE = Not Exercised Payoff from Long Call S1 – E 1 S1 – E 1 0 (NE) Payoff from Short Call E2 – S1 0 (NE)* 0 (NE) Bull Spread (Using Calls) Total Payoff E2 – E1 S1 – E1 0 Profit Profit / Loss on Long Call Stock Price E1 E2 Profit / Loss on Short Call Loss Thus. the investor in a bull spread sacrifices an unlimited profit potential in return for the initial cost. A less bullish investor would buy an in-the-money spread for lower gearing. On expiry. if the stock remains below the lower exercise price. with the same expiry date but with a higher exercise price. A spread with one call initially in-then-money and the other one initially out-of-the-money would be relatively less aggressive than a spread with both calls being out-of-the-money. then a small cost would be involved in creating the spread which would be aggressive in nature. A bull spread can also be created using puts. If both the calls are initially out-of-the-money. This results in an overall loss of the initial credit (higher premium received on short put .

the profit function is as shown in the figure. 10 – Rs. none of the options will be exercised and a net profit of Rs. The payoffs associated with a bull spread created using put options are given in the table. the investor has to buy the stock at Rs. Now. both puts expire unexercised leading to no payoffs and a net profit equal to the initial credit. 10 and a net loss equal to Rs. For the stock prices exceeding the higher exercise price. 6 and writes an option identical in all respects except the exercise price that is equal to Rs. For a stock price in between the two exercise prices. when the stock price would be more than Rs. A commitment to buy at Rs. 3. the put with the lower exercise price would expire unexercised resulting in a net profit equal to the initial credit minus the difference between the exercise price and the stock price. 3 = Rs. 40 implies an outward payoff of Rs. 7. 3. Payoffs from a Bull Spread (Using Puts) Price of Stock S1 <= E2 E1 < S1 < E2 Profit S1 >= E2 Payoff from Long Put E1 – S1 0 0 Payoff from Short Put S1 – E2 S1 – E2 Profit / Loss from Short Put 0 Stock Price Total Payoff E1 – E2 S1 – E 2 0 BullE1 Spread E2 (Using Puts) Profit / Loss from Long Put Loss . In general.minus lower premium paid on long put) minus the difference. then both options are in-the-money and can be exercised. the net loss would equal Rs. 3 = Rs. say Rs. for a price of Rs. Suppose an investor buys a put option with an exercise price equal to Rs. 3 will be made. The stock price at the time of exercise is given by S1 and the two options have exercise prices of El and E2 (E2 > El). 44. 50. 50 and to sell at Rs. 6 – Rs. This spread gives an initial credit of Rs. 9. 50 and thus lose Rs. if the stock price is less than Rs. Similarly. If the stock price is between the two exercise prices. In this case. 50. 6 on the option. 40 for Rs. 40.

7 to the investor up front.Example: Type of Option (a) Call (b) Put Exercise Price of option Purchased 60 50 Sold 75 65 Premium on Option Purchased 10 4 Sold 4 11 (a) Call With price of long call. S1 . 65 represents a bull spread.54 = 0 or S1= 54. (b) Put Buying a put option with exercise price equal to Rs. 50 and selling a put option with a greater exercise price of Rs. E1 = 60 and price of a short call.54 0 – 6 = -6 The break-even stock price would be one where net profit is equal to zero. Accordingly. This would result in a positive cash flow of Rs. a stock price greater than Rs. 4 = Rs. 54 would yield profit. E2 = 75. The profit/loss position is as given below. . Thus. 11 – Rs. the profit/loss would be as follows: Stock Price S1 > = E2 E1 < S1 < E2 S1 < = E1 Payoff from Long Call S1 – 60 S1 – 60 0 Payoff from Short Call 75 – S1 0 0 Total Payoff 15 S1 – 60 0 Net Profit / Loss = Payoff – Cost 15 – 6 = 9 S1 – 60 – 6 = S1 .

8 To obtain the break-even price. Assuming that the exercise prices are E1 and E2 with E1 < E2. the payoffs realizable from a bear spread in different circumstances are given in the table below. a bear spread may be created by buying a call with one exercise price and selling another one with a different exercise price. however.S1 E1Stock 1Price –S 0 Long Call Total Payoff E1 – E2 E1 – S1 0 Long Call S1 . S1 = 58.E 2 0 E1 0 E2 Bear Spread (Using Calls) Loss . 58 and a loss would be incurred when it fell short of Rs 58. Profit/Loss Calls) Payoffs from a Bear Spread (Usingfrom Price Profit of Stock S1 >= E2 E1 < S1 < E2 S1 >= E2 Profit/Loss from ShortPayoff from Call Payoff from Short Call E1 .15 Net Profit / Loss = Payoff – Cost 0+7=7 S1 – 65 + 7 = S1 – 58 .Stock Price S1 > = E2 E1 < S1 < E2 S1 < = E1 Payoff from Long Call 0 0 50 – S1 Payoff from Short Call 0 S1 – 65 S1 – 65 Total Payoff 0 S1 – 65 . Unlike in a bull spread. the exercise price of the call option purchased is higher than that of the call option sold. believing that it is more likely to go down than up. we set S1 . A bear spread would involve an initial cash inflow since the premium for the call sold would be greater than for the call bought. The profit profile is shown in figure.58 = 0.15 + 7 = . so that. implying that a profit would result when the stock price exceeded Rs. Bear Spreads In contrast to the bull spreads. bear spreads are used as a strategy when one is bearish of the market. Like a bull spread.

50. the net profit would be obtained by adjusting for the initial cash inflow. If the price were between the two exercise prices. say Rs. were lower than Rs. Payoffs from a Bear Spread (Using Puts) . wherein E1 and E2 are the exercise prices of the option sold and purchased respectively. Bear spreads can also be created by using put options instead of call options. then the call written for Rs. no payoffs are involved. like bull spreads. 50 would be exercised and the investor loses Rs. In return for the profit given up. 60. the investor buys a put with a certain exercise price and chooses to give up some of the profit potential by selling a put with a lower exercise price. 7.Suppose that the exercise prices of two call options are Rs. It may be observed that. written by the investor. the investor buys a put with a high exercise price and sells one with a low exercise price. In this spread. 60. and if the price of the stock exceeded Rs. In each of the cases. If the stock price. 50 and Rs. 57. The profit function is given in figure below. 10 would result. both the calls would be exercised and an outward payoff of Rs. The payoffs from a bear spread created with put options are given in the table below. bear spread limit both the upside profit potential and the downside risk. therefore. In such a case. S1. the investor gets the price of the option sold. then none of the calls will be exercised and. This would require an initial investment because the premium for the put with a higher exercise price would be greater than the premium receivable for the put with the lower exercise price.

6. El = 70 and E2 = 80.S1 Payoff from Short Put 0 0 S1 – E 1 Total Payoff 0 E2 – S1 E2 – E1 Bear Spread (Using Puts) Profit Profit/Loss from Long Put Stock Price E2 E1 Profit/Loss from Short Put Example: Loss Type of Option (a) Call (b) Put (a) Call Exercise Price of option Purchased 80 70 Sold 70 60 Premium on Option Purchased 5 9 Sold 11 5 Here El is the price of call sold and E2 is the price of the call purchased.Price of Stock S1 >= E2 E1 < S1 < E2 S1 >= E2 Payoff from Long Put 0 E 2 . The profit/loss would be as shown below: Stock Price S1 > = E2 E1 < S1 < E2 S1 < = E1 Payoff from Long Call S1 – 80 70 – S1 0 Payoff from Short Call 60 – S1 0 0 Total Payoff . Thus.20 + 6 = .S1 E 2 .20 70 – S1 0 Net Profit / Loss = Payoff – Cost .14 70 – S1 + 6 = 76 – S1 0+6=6 .5 = Rs. Net premium obtained = 11 .

we set 76 – S1 = 0. El. Rs. Butterfly Spreads While bull and bear spreads involve taking positions in two options. profit will result.4 = 6 For the break-even price. If El. This involves buying a call option with a relatively low exercise price. buying another call option with a relatively large exercise price. 4 (= Rs. 56 – S1 = 0. Thus. no call will be exercised. The strategy is obviously meant for an investor who feels that large price changes are unlikely. The price E2 is usually close to the current stock price. and the stock price be less than Rs. with the result that a profit results if the stock price stays close to E2 and a small loss would be incurred if there is a significant price movement either way from it. while for stock prices above this level losses would result.To determine break-even stock price.60 Total Payoff 0 60 – S1 10 Net Profit / Loss = Payoff – Cost 0-4=-4 60 – S1 . Accordingly. (b) Put With El = 60 and E2 = 70. a stock price below Rs. S1 = 56.4 = 56 – S1 10 . while loss will result with prices greater than this. a butterfly spread results from positions in options with three different strike prices. The positions taken in the strategy involve some cost. and a net cost of Rs. 50. 5). Therefore. and selling two call options with a strike price. E3. the profit/loss profile is as given below. 9 – Rs. Thus. With stock prices below Rs. E2 and E3 be Rs. 70 respectively. E2 which is halfway between El and E3. then. 50. 76 would yield profit. the total loss equals the . 60 and Rs. S1 = 76. clearly. Stock Price S1 > = E2 E1 < S1 < E2 S1 < = E1 Payoff from Long Call 0 0 70 – S1 Payoff from Short Call 0 60 – S1 S1 . 56.

Gain would result when the stock price is between Rs. the total loss equals the initial cost. who feels that a significant change in this price is unlikely.) . the amount of gain would decline with an increase in the stock price up to the level of Rs. Similarly. in the next three months. The profit/loss profile for a butterfly spread is given in the figure. 50 and Rs. Payoffs from a Butterfly Spread Price of Stock Payoff from First Long Call S1 < E 1 E1 <= S1 < E2 E2 <= S1 < E3 S1 >= E2 (E1) 0 S1 – E 1 S1 – E 1 S1 – E 1 Payoff from Second Long Call (E3) 0 0 0 S1 – E 3 Payoff from Short Calls (E2) 0 0 2(E2 . 60. An investor. 60.E1 + 2E2 .S1) 2(E2 . 70. or E3 – S1 Since 2E2 = E3 + E1 Butterfly Spread Profit / Loss from Short Calls Profit Profit / Loss from Long Call Profit / Loss from Long Call E E1 3 Stock Price E2 3 3 Example: Loss A certain stock is selling currently at Rs. beyond Rs. when all calls will be exercised.2S1 = 2E2 – E1 – S1.S1) Total Payoff 0 S1 – E1 E3 – S1* 0 S1 .initial cost involved. observes the market prices of 3month calls as tabulated below: Exercise Price Call Price (Rs. and shall be higher as the price moves towards Rs. because the gain on the options with long position will be exactly offset by a corresponding loss on the twin options written. Beyond this price. The payoffs for a butterfly spread are given in the table below. 70. 72.

16 Re. Buying two calls involves a payment of Rs. 70. 75 and above. 73 (iv) Rs. Lets see the payoff function for different levels of stock prices.16. 63 (ii) Rs. Thus. it is clear that when the stock price is less than Rs. 70. Price Total payoff from Calls Cost of Strategy Net Profit / Loss . 17 – Rs. 6 = Rs. profit/loss can be calculated for various given prices as follows. while if the price varied between Rs. and writing two calls yields Rs.S1) 2(70 . 1. then the payoff is Rs. 65 and Rs. 65 and if it is in the range of Rs. 80 The decision of the investor leads to a butterfly spread.S1) Total Payoff 0 S1 – 65 75 – S1 0 From the table. 75—and writes two calls with an exercise price of Rs. 65 and Rs. cost involved with the package of options = Rs. the payoff equal to the price in excess of Rs. 65 or Rs. 17. 8 x 2 = Rs. Accordingly. 68 (iii) Rs. (i) Rs. the payoff will be nil. 70 to Rs. 75. The payoffs associated with this plan are given below. 11+ Rs.65 70 75 11 8 6 The investor decides to go long in two calls—one each with exercise price Rs. Payoffs from a Butterfly Spread Price of Stock Payoff from First Long Call S1 < 65 65 <= S1 < 70 70 <= S1 < 75 S1 >= 75 (E1 = 65) 0 S1 – 65 S1 – 65 S1 – 65 Payoff from Second Long Call (E3 = 75) 0 0 0 S1 – 75 Payoff from Two Short Calls (E2 = 70) 0 0 2(70 . 75 minus the stock price.

it costs to buy a straddle and.63 68 73 80 0 3 2 0 (1) (1) (1) (1) (1) 2 1 (1) COMBINATIONS While spreads involve taking positions in call or put options only.E Payoff from Short Call E .E Straddle E Stock Price Loss . Payoffs from a Straddle Exercise Price Range S1 <= E S1 > E Profit Payoff from Long Call 0 S1 . Important combination strategies include straddles. Since a call and a put are both purchased.S1 0 Total Payoff E – S1 S1 . strips. Straddle A straddle involves buying a call and a put option with the same exercise price and date of expiration. a loss is incurred if the price does not move away from the exercise price since none of them will be exercised. to that extent. The payoff and profit function is respect of a straddle are shown below. combinations represent option trading strategies which involve taking positions in both calls and puts on the same stock. straps and strangles.

or a top straddle represents the reverse position so that it may be created by selling a call and a put with the same expiration date and exercise price. Now. if the stock price at expiration is Rs. 9 while if the price falls to. This is also referred to as a bottom straddle. Suppose that the call costs Rs. 57 then the put option will be exercised and a net profit of Rs. upward or downward. 85 and an expiration date in three months. a straddle write is a very risky strategy to adopt. then none of the options will be exercised and a loss of Rs. 85 in the market. is likely to move significantly. 2. 57 – Rs. or close to the exercise price. 85.for lower prices of the stock. 100 – Rs. Rs. a significant profit is made if the stock price is equal to. 22 will result. This kind of strategy is an obvious one to employ in respect of the stock of a company. The investor can create a straddle by buying a call and a put option both with an exercise price of Rs. in the next three months. 6 would occur. 85 – Rs. which is subjected to a takeover bid. Suppose an investor feels that the price of a certain stock. say. which are potentially unlimited. In a straddle write. A straddle write. The straddle shown above is an example of a straddle purchase. the put option will be exercised and for higher prices. 6 = Rs. If the stock price jumps to Rs 100. . then the call will be exercised resulting in a net profit of (Rs. Hence. 85) – Rs 6 = Rs. but large deviations of stock price from this on either side would cause large losses. 4 and the put Rs. the call option will be exercised.From the profit function depicted in the figure. currently valued at Rs. it is evident that buying a straddle is an appropriate strategy to adopt when large price changes are expected in the stock .

The profit function of a strap are shown below. Since a put option is profitable when the price decreases. A strap consists of a long position in two calls and one put with same exercise price and expiry date. but feels that there is a greater likelihood of the price increasing rather than decreasing. . Here the investor is expecting that a big price movement in the stock price will take place but a decrease in the stock price is more likely than an increase. Strip Profit E Stock Price Loss Straps On the other hand. if the investor is expecting that a big price change would occur in the stock price. the profit function for the strategy.Strips A strip results when a long position in one call is coupled with a long position in two puts. all with the same exercise price and expiration date. the investor will consider the strategy of a strap. two puts are bought in this strategy. shown in the figure below is steeper in the lower than exercise price range and less steep in region of higher prices. Accordingly.

then. a net loss. none of the options is exercised and hence. so that a profit would result if the stock price is lower than the exercise price of the put or if the stock price exceeds the call exercise price. equal to the sum of the premia paid for buying the two options. Profit Payoffs from a Strangle / Loss from Price of Stock Profit S1 <= E1 E1 < S1 < E2 S1 >= E2 Payoff from Put E 1 – S1 0 E1 0 Payoff from Call Call Option Total Payoff E 1 – S1 0 S1 – E 2 E2 0 0 S1 – E2 Stock Price Strangle Profit / Loss from Put Option Loss . an investor buys a put and a call option with the same expiration date but with different exercise prices. is shown below and payoffs for different ranges of the stock price are given in the table. The exercise price of the put is lower than the exercise price of the call. that a strangle is an appropriate strategy for adoption when the price is expected to move sharply. The profit function.Strap Profit E Stock Price Loss Strangles In a strangle. Between the two exercise prices. results. for exercise prices El and E2of put and call respectively. It follows.

than in a straddle. a strangle may be sold. then larger amounts of losses are imminent. CONDORS A condor is an investment strategy which involves four call options or four put options. the downside risk is smaller with a strangle than it is with a straddle if the price is close to the exercise price. in a strangle. if the stock price happens to be between the two exercise prices. However. the stock price has to move farther. However. Long Condor A long condor involving call options is created by buying calls—one with a very low . Also. A short strangle is the choice of an investor who believes that large variations in stock price are unlikely. Similarly. because here as well the investor is betting that a large price change would take place but is not sure as to the direction in which the change would occur. in order that the investor makes a profit. if they do occur. The strangle described above is also called the bottom vertical combination or strangle bought or long strangle.Evidently. It may be long condor or a short condor. a strangle is a similar strategy to a straddle.

and another with a comparatively high exercise price E4. E2. and the other with a price E3 which is lower than and closer to E4.exercise price E1. E3 and E4 are related to each other as in the case of a long condor with call options. The profit function of a long condor is shown below: Long Condor Profit / Loss from Long Call Profit / Loss from Long Call Profit E 1 E4 E2 E3 Stock Price Profit / Loss from Short Call Loss Profit / Loss from Short Call A long condor using put options can be created similarly. E1. and involving selling two calls . E2. and selling two puts—with exercise prices of E2 and E3. and closer to. . by buying one put with exercise price E1 and another one with an exercise price of E4. E3 and E4 are chosen in such a way that E2 – E1 = E4 – E3 and E3 – E1 = 2(E2 – E1). E1. Short Condor A short condor results by reversing the above strategy.and selling two call options—one with a price E2 higher than. The prices E1.

having exercise prices of E1 and E4. with an exercise price of E2 (E2 > El). The table shows that the payoff in respect of this strategy will be the same irrespective of the price of the stock. Figure depicts the profit / loss associated with this policy. and write one call and buy one put. For instance. it is not so in the case of a condor. it may be decided to buy one call and write one put. In the latter case. the profit or loss made is independent of the stock price. and buying two calls with exercise prices of E2 and E3. profit/loss is limited. a box spread may be created in many ways. Short Condor Profit / Loss from Long Call Profit Profit / Loss from Long Call E2 E3 E4 Stock Price E 1 Profit / Loss from Short Call Profit / Loss from Short Call An examination of the profit functions for condors and strangles reveals that while Loss profit/loss potential resulting from large deviations in stock price is very high for a strangle. Payoffs from Box Spreads Stock Price Range Call Bought Bought Payoffs from options Exercise Price = E1 Put Sold Exercise Price = E2 Call Sold Put Total Payoff . With the objective of making a profit regardless of the stock price. with an exercise price equal to E1. BOX SPREADS In a box spread strategy.

none of the call options is exercised and both the puts are exercised. For the price range between E1 and E2. This results in a total payoff of E2 El because the stock bought for E1 is sold for E2. the two call options result in a payoff of E 2 – E1.S1 < =E1 E1 < S1 < E2 S1 > = E2 0 S1 – E1 S1 – E1 S1 – E1 0 0 E 2 – S1 E 2 – S1 0 E2 – S1 E2 – S1 E 2 – S1 E2 – E1 E2 – E1 E2 – E1 When the stock price does not exceed the lower exercise price of E1. Similarly. using the right under long call to buy at this price. stock will be bought at El. when the stock price is E2 or more. and sold for E2. by exercising the right to sell the stock by virtue of the put option. . and buying a call and writing a put with an exercise price of E 2 (E2 being greater than El). With a right to buy the stock at El and the obligation to sell at E2. A box spread can also be constructed by buying a put and writing a call. none of the puts is exercised. with an exercise price El.

13 OPTIONS v/s FUTURES Want to know the line of difference? .

There are certain fundamental differences between a futures and an option contract.

OPTIONS
Only the seller is obligated to perform Premium is paid by the buyer to the seller Loss is restricted while there is unlimited gain potential for the option buyer Options prices are affected not only by prices of the underlying asset but also the time remaining for expiry of the contract and volatility of the underlying asset    

FUTURES
Both the parties are obligated to perform

No premium is paid by any party

There is potential / risk for unlimited gain / loss for the futures buyer

Future prices affected mainly by the underlying asset

Option contract can be exercised any time till the maturity by the buyer  Future contract can be honoured by both the parties only on the date specified

FUTURES & OPTIONS IN INDIA
Indian Scenerio

The Indian Capital Market has witnessed impressive growth and qualitative changes, especially over the last two decades. Derivatives are playing a crucial role in the Capital Markets world-wide. Their introduction in the Indian Capital Market is, the beginning of a new era….. Derivatives are for emerging markets like India. They work as instruments for risk management and tools for market development and serve to enhance market efficiency in areas of risk transfer. Securities and Exchange Board of India (SEBI) after considering the suggestions of the Committee on Derivatives, chaired by Mr. L. C. Gupta & of Mr. J. R. Varma in their reports stipulated the regulatory framework and risk containment measures for derivatives trading in India. In line with SEBI directives, the National Stock Exchange of India Limited (NSE) commenced trading in index futures on June 12, 2000. Trading in Index Options commenced on June 4, 2001. Futures & Options contracts on Index are based on the popular benchmark S&P CNX Nifty. NSE also became the first Exchange to launch trading in options on individual securities from July 2, 2001. Bombay Stock Exchange (BSE) too began trading in index futures in June last year and soon after NSE started its trading in stock options BSE also began its option trading. Options on individual securities are available on 31 securities stipulated by SEBI. As the derivatives market is in its nascent stage in India, it is facing some teething problems. The volume being traded in futures and options is very low. It is as low as 1% of the total volume traded on both the exchanges. Not many brokers are trading in futures and options because they think it is too complicated and there are too many myths attached to it. Only 29 out of 700 BSE members have taken up the membership for dealing in derivatives segment. One of the reasons for depressed volumes is lack of awareness among brokers and investors about the derivative products. Lack of understanding as to how the derivatives in stock markets are to be operated is the major roadblock, in the success of the futures and options market in India. Both BSE and NSE have been taking measures to spread awareness through investor education programs. They have seminars and workshops on a regular basis where they

. The National Stock Exchange is emerging the most-preferred exchange for investors in the newly-launched derivatives products futures and options trading. The experience of world markets shows that derivatives will be the trading instrument in the future.teach people about futures and options. But unfortunately. these are early days. Derivatives trading is here to stay and while volumes on Indian stock exchanges may be dismal now. how to deal in them and try and clear their myths regarding them. Volumes in futures and options trading on NSE have been 10-15 times higher than that on its arch-rival. But it is too early to say much about derivatives in India as it has barely been a year since its introduction. these results are not being reflected much in the market. the Bombay Stock Exchange.

R. B. Business Line) www. D.ace. Mahajan  Futures & Options N.optionbroker. Bagri   Winning in the Options Market Newspaper Articles (Economic Times.tradingfutures.com www.com www. Vohra.com www.BIBLIOGRAPHY  Introduction to Equity Derivatives R.cboe.nseindia. Dogpile)        .com search engines (Google.com www.com www. Business Standard.uiuc.bseindia.

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