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HISTORY OF DERIVATIVES With the opening of the economy to multinationals and the adoption of the liberalized economic policies

, the economy is driven more towards the free market economy. The complex nature of financial structuring itself involves the utilization of multi currency transactions. It exposes the clients, particularly corporate clients to various risks such as exchange rate risk, interest rate risk, economic risk and political risk. With the integration of the financial markets and free mobility of capital, risks also multiplied. For instance, when countries adopt floating exchange rates, they have to face risks due to fluctuations in the exchange rates. Deregulation of interest rate cause interest risks. Again, securitization has brought with it the risk of default or counter party risk. Apart from it, every asset whether commodity or metal or share or currency is subject to depreciation in its value. It may be due to certain inherent factors and external factors like the market condition, Government s policy, economic and political condition prevailing in the country and so on. In the present state of the economy, there is an imperative need of the corporate clients to protect there operating profits by shifting some of the uncontrollable financial risks to those who are able to bear and manage them. Thus, risk management becomes a must for survival since there is a high volatility in the present financial markets.

In this context, derivatives occupy an important place as risk reducing machinery. Derivatives are useful to reduce many of the risks discussed above. In fact, the financial service companies can play a very dynamic role in dealing with such risks. They can ensure that the above risks are hedged by using derivatives like forwards, future, options, swaps etc. Derivatives, thus, enable the clients to transfer their financial risks to he financial service companies. This really protects the clients from unforeseen risks and helps them to get there due operating profits or to keep the project well within the budget costs. To hedge the various risks that one faces in the financial market today, derivatives are absolutely essential. DERIVATIVES IN INDIA In India, all attempts are being made to introduce derivative instruments in the capital market. The National Stock Exchange has been planning to introduce index-based futures. A stiff net worth criteria of Rs.7 to 10 corers cover is proposed for members who wish to enroll for such trading. But, it has not yet received the necessary permission from the securities and Exchange Board of India. In the forex market, there are brighter chances of introducing derivatives on a large scale. Infact, the necessary groundwork for the introduction of derivatives in forex market was prepared by a high-level expert committee appointed by the RBI. It was headed by Mr. O.P. Sodhani. Committee s report was

already submitted to the Government in 1995. As it is, a few derivative products such as interest rate swaps, coupon swaps, currency swaps and fixed rate agreements are available on a limited scale. It is easier to introduce derivatives in forex market because most of these products are OTC products (Overthe-counter) and they are highly flexible. These are always between two parties and one among them is always a financial intermediary. However, there should be proper legislations for the effective implementation of derivative contracts. The utility of derivatives through Hedging can be derived, only when, there is transparency with honest dealings. The players in the derivative market should have a sound financial base for dealing in derivative transactions. What is more important for the success of derivatives is the prescription of proper capital adequacy norms, training of financial intermediaries and the provision of well-established indices. Brokers must also be trained in the intricacies of the derivative-transactions. Now, derivatives have been introduced in the Indian Market in the form of index options and index futures. Index options and index futures are basically derivate tools based on stock index. They are really the risk management tools. Since derivates are permitted legally, one can use them to insulate his equity portfolio against the vagaries of the market.

Every investor in the financial area is affected by index fluctuations. Hence, risk management using index derivatives is of far more importance than risk management using individual security options. Moreover, Portfolio risk is dominated by the market risk, regardless of the composition of the portfolio. Hence, investors would be more interested in using index-based derivative products rather than security based derivative products. There are no derivatives based on interest rates in India today. However, Indian users of hedging services are allowed to buy derivatives involving other currencies on foreign markets. India has a strong dollar- rupee forward market with contracts being traded for one to six month expiration. Daily trading volume on this forward market is around $500 million a day. Hence, derivatives available in India in foreign exchange area are also highly beneficial to the users. RECENT DEVELOPMENTS At present Derivative Trading has been permitted by the SEBI on derivative segment of the BSE and the F&0 segment of the NSE. The natures of derivative contracts permitted are: Ø Index Futures contracts introduced in June, 2000, Ø Index options introduced in June, 2001, and Ø Stock options introduced in July 2001. The minimum contract size of a derivative contract is Rs.2 lakhs. Besides the minimum contract size, there is a stipulation for the lot size of a derivative contract. The lot size refers to number of underlying

during the previous calendar month in the cash segment of the exchange. Ø The Derivatives Exchange/Segment should have arrangements for dissemination of information about trades. which are easily accessible to investors across the country. Ø The Derivative Segment of the Exchange would have a separate Investor Protection Fund.e. But. They are as follows: Ø The Derivatives Exchange/Segment shall have on-line surveillance capability to monitor positions. for option and futures the following wide limits have been fixed. and volumes on a real time basis so as to deter market manipulation.securities in one contract.. Or Ø 10% of the number of shares held by non-promoters. there are market wide limits also. This requirement along with the requirement of minimum contract size from the basis for arriving at the lot size of contract. . The lot size of the underlying individual security should be in multiples of 100 and tractions. Ø The Derivatives Exchange/Segment should have satisfactory system of monitoring investor complaints and preventing irregularities in trading. i. For stock specific products it is of open positions. The market wide limit for index products in NIL. Ø The Derivatives Exchange/Segment should have arbitration and investor grievances redressal mechanism operative from all the four areas/regions of the country. Apart from the above. quantities and quotes on a real time basis through at least two information-vending networks. if any should be rounded of to next higher multiple of 100. Ø 30 times the average number of shares traded daily. ELIGIBILITY CONDITIONS The SEBI has laid down some eligibility conditions for Derivative exchange/Segment and it s clearing Corporation/House. 10% of the free float in terms of number of shares of a company. prices.

Ø The Clearing Corporation/House should have capabilities to segregate initial margins deposited by clearing members for trades on their own account and on account of his client. The concept of value-at-risk shall be used in calculating required level or initial margins. The Clearing Corporations/House shall hold the clients margin money in trust for the client purposes only and should not allow its diversion for any other purpose. the Clearing Corporation/House shall interpose itself between both legs of every trade. which will . Ø In the event of a member defaulting in meeting its liabilities. They are as follows: Ø Investor's money has to be kept separate at all levels and is permitted to be used only against the liability of the Investor and is not available to the trading member or clearing member or even any other investor. Ø The Clearing Corporation/House shall have the capacity to monitor the overall position of Members across both derivatives market and the underlying securities market for those Members who are participating in both. the Clearing Corporation/House shall transfer client positions and assets to another solvent Member or close. Ø The Clearing Corporation/House shall establish facilities for electronic fund transfer (EFT) for swift movement of margin payments. Ø The Trading Member is required to provide every investor with a risk disclosure document.out all open positions.e.. Ø The level of initial margin on Index Futures Contracts shall be related to the risk of loss on the position. becoming the legal counter party to both or alternatively should provide an unconditional guarantee for settlement of all trades. The initial margins should be large enough to cover the one-day loss that can be encountered on the position on 99% of the days.Ø The Clearing Corporation/House shall perform full innovation. INVESTORS PROTECTION The SEBI has taken the following measures to protect the money and interest of investors in the Derivative market. i. Ø The Clearing Corporation/House shall have a separate Trade Guarantee Fund for the trades executed on Derivatives exchange/ segment.

swaps etc. namely. Similarly. options.disclose the risks. all money paid by the Investor towards margins on all open positions is kept in trust with the Clearing House/ Clearing Corporation and in the event of default of the Trading or Clearing Member the amounts paid by the client towards margins are segregated and not utilized towards the default of the member. derivatives are based upon all those major financial instruments. we usually mean only financial derivatives. many commonly used instruments can be called derivatives since they derive their value from an underlying asset. if the cost of materials goes up by 15% the contract price will also go up by 10%. since. extended by the Member. Again. The order will be executed with the identity of the client and without client ID order will not be accepted by the system. it derive its value from the firms underlying assets. Ø They can be designed and traded on the basis of expectations regarding the future price movements of underlying assets. losses suffered by the Investor. a derivative instrument is derived from something backing it. Ø In the derivative markets. This will protects him from the risk of price favour. The investor could also demand the reconfirmation slip with his ID in support of the contract note. if any. equity shares itself is a derivative. Ø They are all off balance sheet instruments and Ø They are used as device for reducing the risks of fluctuations in asset values. derivatives cover a lot of common transactions. when we talk about derivatives. As the word implies. one takes insurance against his house. byelaws and regulation of the derivative segment of the exchanges. as per the rules. on settled/ closed out position are compensated from the Investor Protection Fund. This is also a kind of derivative contract. which are explicitly traded like equity. Thus. However. For instance. forex instruments and commodity based contracts. if any. Thus. if one signs a contract with a building contractor stipulating a condition. DERIVATIVES MEANING OF DERIVATIVES In a broad sense. forward. Ø Investor would get the contract note duly time stamped for receipt of the order and execution of the order. In a strict sense. This something may . debt instruments. futures. The peculiar features of these instruments are that: Ø They can be designed in such a way so as to the varied requirements of the users either by simply using any one of the above instruments or by using a combination of two or more such instruments. associated with the derivatives trading so that investors can take a conscious decision to trade in derivatives. in the event of a default of a member.

but do not actually employ those cash instruments to fund payments . Suppose he buys insurance.be a loan. derivatives are becoming increasingly important in world markets as a tool for risk management. when we use derivatives for hedging. currency . a commodity transaction. All these definitions point out the fact that transactions are carried out on a notional principal. derivatives do not create any new risk. Ø Derivatives are a special type of off-balance sheet instruments in which no principal is ever paid . Similarly. Derivatives are used to separate the risks and transfer them to parties willing to bear these risks. many innovative instruments have been crated by combining two or more of these financial derivatives so as to cater to the specific requirements of users. having an insurance policy reduces the risk of owing a car. DEFINITION OF DERIVATIVES It is very difficult to define the term derivatives in a comprehensive way since many developments have taken place in this field in recent years. It is so because. actual delivery of the underlying asset is not at all essential for settlement purposes. Moreover. a trade flow etc. If he does not take insurance. Ø Derivatives involve payment/receipt of income generated by the underlying asset on a notional principal . (a derivative instrument on the car) he reduces his risk. transferring only the income generated by the underlying asset. Moreover. a currency flow. X owns a car. he runs a big risk. They simply manipulate risks and transfer them to those who are willing to bear these risks. a stock trade. The profit or loss on derivative deal alone is adjusted in the derivative market. hedging through derivatives reduces the risk of owning a specified asset. an asset. let us assume that Mr. some attempts have been made to define the term derivatives . To cite a common example. Ø Derivatives are instruments which make payments calculated using price of interest rate derived from a balance sheet or cash instruments. which may be a share. depending upon the circumstances. an interest rate. Thus. Inspite of this. The kind of hedging that can be obtained by using derivatives is cheaper and more convenient than what could be obtained by using cash instruments. Importance of Derivatives Thus. Derivatives enable a company to hedge this something without changing the flow associated with the business operation. Derivative instruments can be used to minimize risk.

There are some other . Hedging risk through derivatives is not similar to speculation. say 10-15 year risk. all derivative products are low cost products. So. They are as follows: Ø MISCONCEPTION OF DERIVATIVES: There is a wrong feeling that derivatives would bring in financial collapse. Till recently. The gain or loss on a derivative deal is likely to be offset by an equivalent loss or gain in the values of underlying assets. Thus.etc. 'Offsetting of risks' in an important property of hedging transactions. Further. There is an enormous negative publicity in the wake of incidents of financial misadventure. But with the rapid development of the derivative markets. When companies know well that they have to face risk in possessing assets. which stand in their way. derivatives are not only desirable but also necessary to hedge the complex exposures and volatilities that the companies generally face in the financial markets today. INHIBITING FACTORS Though derivatives are very useful for managing various risks. Treasury managers and portfolio managers can hedge all risks without going through the tedious process of hedging each day and amount/share separately. Just as derivatives can be contracted easily. it is better to transfer these risks to those who are ready to bear them. the availability of advanced derivatives market enables companies to concentrate on those management decisions other than funding decisions. there are certain inhibiting factors. Baring had its entire net worth wiped out as a result of its trading and options writing on the Nikkei index futures. Companies can hedge a substantial portion of their balance sheet exposure. Derivatives also offer high liquidity. they have to necessarily go for derivative instruments. with a low margin requirement. it is possible to cover such risks through derivative instruments like swap. All derivative instruments are very simple to operate. Thus. For instance. it may not have been possible for companies to hedge their long term risk. This also does not involve much cost. now. it is also possible for companies to get out of positions in case that market reacts otherwise. But. in speculation one deliberately takes up a risk openly.

could be used as an efficient tool to minimize risks. Ø INBUILT SPECULATIVE MACHANISM: In fact all derivative contracts are structured basically on the basis of the future price movements over which the speculators have on upper hand. is the existence of proper infrastructure. Hence. Ø OFF BALANCE SHEET ITEMS: Invariably. accountants. There has to be effective surveillance. Hence. the institutional infrastructure has to be developed. That is. Indirectly. But the improper handling of these instruments is the main cause for this and one cannot simply blame derivatives for all these misshapennings. There is no doubt that derivatives create leverage and leverage creates increased risk or return. it must be understood that derivatives are not the root cause for all these troubles. Unfortunately. regulators and other look down upon derivatives. there is a feeling that only a few can play this game. price dissemination and regulation of derivative transactions. Showa Shell etc. Derivatives themselves cannot cause such mishaps. Thus. futures etc. Indah Kiat. derivatives possess an inbuilt speculative mechanism. KINDES OF FINANCIAL DERIVATIVES . efficient internal control and strict supervision. swap agreements for substituting fixed interest rate bonds by floating rate bonds or for substituting fixed rate interest bearing asset by floating rate interest paying liability. if properly handled. options. So. It may not be so always.high reward vehicles . There is a prospect of either high return or huge loss in all-derivative instruments. However. To quote a few: Procter and Gamble. The term of the derivative contracts has to be uniform and standardized. one should keep in mind that the very same derivatives. derivatives make one accept the fact that speculation is beneficial. they are 'high risk . derivative must be strongly supported by proper accounting systems. Ø ABSENCE OF PROPER ACCOUNTING SYSTEM: To achieve the desired results. they are all at infancy level as far as derivatives are concerned.similar incidents like this. Ø ABSENCE OF PROPER INFRASTRUCTURE: An important requirement for using derivative instrument like. derivatives are off balance sheet items. At the same time. For instance. Ø LEVERAGING: One of the important characteristic features of derivatives is that they lend themselves to leveraging.

instrument etc. A forward contract refers to an agreement between two parties to exchange an agreed quantity of an asset for cash at certain date in future at a predetermined price specified in that agreement. a cotton dealer. and Ø Swaps Ø FORWARDS: Forwards are the oldest of all the derivatives. x enters into an agreement to buy 50 bales of cotton on December 1at Rs. Example: on June 1. 50.000 on December 1 to y and y has to supply 50 bales of cotton. It is a case of a forward contract where x has to pay Rs.000/per bale from y. In a forward contract. long position & short position take the form of buy & sell in a forward contract. Ø FUTURES: A futures contract is very similar to a forward contract in all respects excepting the fact that it is completely a standardized one. a user (holder) who promises to buy the specified asset at an agreed price at a fixed future date is said to be in the long position . the user who promises to sell at an agreed price at a future date is said to be in short position . Diagram showing Forward Rate Agreement (Spot interest rate FRA rate) . On the other hand. The promised asset may be currency. Thus. the important financial derivatives are the following: Ø Forwards Ø Futures Ø Options. It is legally enforceable and it is always traded on an organized exchange.As already discussed. it is rightly said that a futures contract is nothing but a standardized forward contract. 1. Hence. commodity.

As the very name implies. the trader who promises to buy is said to be in long position and the one who promises to sell is said to be in short position in futures also.) at a predetermined price on or before a specified date in future. risk of heavy fluctuations in the price of assets is very heavy. The term future trading includes both speculative transactions where futures are bought and sold with the objective of making profits from the price changes and also the hedging or protective transactions where futures are bought and sold with view to avoiding unforeseen losses resulting from price fluctuations. Ø SWAPS: Swap is yet another exciting trading instrument. a period or on a specific date in exchange for . during. currency. It is arranged to reap the benefits arising from the fluctuations in the market-either currency market or interest rate market or any other market for that matter. commodity etc. at an agreed price. called the stack price. Clark has defined future trading as a special type of futures contract bought and sold under the rules of organized exchanges. It takes place only in organized futures market and according to well-established standards. As in a forward contract. Infact. Both the parties to the contract must have mutual trust in each other. Option is yet another tool to manage such risks. Ø OPTIONS: In the volatile environment. as an option contract gives the buyer an option to buy or sell an underlying asset (stock. OPTIONS A derivative transaction that gives the option holder the right but not the obligation to buy or sell the underlying asset at a price.Market interest rate payment Payoff table Interest paid by x = Market interest rate Interest received by x = Difference between FRA interest From FRA counter party rate and market interest rate Net interest paid by x = FRA interest rate Source: Journal of the Indian Institute of bankers. bond. The price so predetermined is called the strike price or exercise price . it is a combination of forwards by two counter parties. A future contract is one where there is an agreement between two parties to exchange any assets or currency or commodity for cash at a certain future date.

It means that the writer of a put option is under an obligation to buy the asset at the exercise price provided the option holder exercises his option to sell. which gives the option holder the right to sell an underlying asset at a predetermined price on or before a specified date in future. These instruments can be made according to the requirements of the writer and user. option contracts are highly standardized and so they can be traded only in organized exchanges. which can be. the obligation to sell arises only when the option exercised. which gives the option holder the right to buy a underlying asset (commodities. in case the buyer exercises his option to buy. there are also privately arranged options.) at a predetermined price called exercise price or strike price on or before a specified date in future. foreign exchange. The price at which the underlying asset is traded is called the strike price . TYPES OF OPTIONS Options may fall under any one of following main categories: Ø CALL OPTION Ø PUT OPTION Ø DOUBLE OPTION Ø CALL OPTION: A call option is one. which gives the option holder both the right either to buy or to sell an underlying asset at a predetermined price on or before a specified date in future. the writer of a call option is under an obligation to sell the asset at a specified price. Underlying asset refers to any asset that is traded. It is one of the building blocks of the option contract. . In such a case. it combines the feature of futures as well as forward contracts. Ø DOUBLE OPTION: A double option is one. Thus. traded Over the Counter . Thus. On the other hand. Ø PUT OPTION: A put option is one. Such option instrument cannot be made flexible according to the requirement of the writer as well as the user. FEATURES OF OPTION CONTRACT Ø High flexible: On one hand.payment of a premium is known as option . stock shares etc.

the gain is not equal to the loss. It means that the option holder s profit.30$. the option contract. Ø No Obligation to Buy or Sell: In all option contracts. he can purchases at the rate mentioned in the option i.100= 3. But.05 $ per one hundred rupees. He can exercise this right at any time during the currency of the contract. if the exchanges rate moves in the opposite direction by the same amount and reaches a level of Rs100=3. He gets a payoff at the rate of 0. In short.X exercises his option. the seller is usually referred to as a writer since he is said to write the contract. . Generally this option contract terminates either at the time of exercising the option holder or maturity whichever is earlier. the rupee appreciates within two months by 0. Suppose. then the market price would be Rs. when the value of the underlying assets moves in one direction is not equal to his loss when its value moves in the opposite direction by the same amount. In an option contract. If the option holder does not exercise will be deduction from the total payoff in calculating the net payoff due to the option holder. Rs100=3. he is under an obligation to buy or sell. the writer is in a different position. the option holder has a right to buy or sell underlying assets.05$per every one hundred rupees. However. the buyer has to pay a certain amount at the time of writing the contract for enjoying the right to buy or sell.X purchase a two month call option on rupee at Rs100=3.40$. then the agreement automatically lapses and no settlement is required. the contract will be simply lapsed. in a put option. He is obliged to buy shares. This can be illustrated by means of an illustration: Mr. settlement is made only when the option holder exercises his option. If he does not buy or sell. Ø Settlement: No money or commodity or shares is exchanged when the contract is written. WRITER In an option contract.Ø Down Payment: The option holder must pay a certain amount called premium for holding the right of exercising the option. profit and losses are not symmetrical under an option contract. in no case.e. Suppose the option is not exercised till maturity. If the option holder Mr. So. Ø Non-Linearity: Unlike futures and forward.35$. It is similar to the seller who is said to be in short position in a forward contract. This is considered to be the consideration for the contract. on option contract does not posses the property of linearity.35$.. On the other hands.

but his loss is limited to the premium paid at the rate of 7. the option will not be exercised. it is called as an American option. Off course the option holder suffers a loss.AMERICAN OPTION VS EUROPEAN OPTION In an option contract. All calculation is based on the change in index value. If the spot rate goes up to yen 1 =1. option may be exercised. his net position will be . However.200$ per yen 1. 10/.per point. The option holder gets a profit of Rs100 (10pionts *10). Suppose the spot rate reaches 360.900$.X buys a 3month call option for an index is 350 by paying 10% of the present index value in points at the rate of Rs. For example. On the other hand. When the spot price increases beyond the strike price. CURRENCY OPTIONS Suppose an option contract is entered into between parties to purchase or sell foreign exchange. He incurs a net loss of Rs. the present value of an index is 300. On the other hand. A person Mr.0200-.04 cents per yen 1. However. OPTION TRADING IN SHARES & STOCKS When an option contract is entered into with an option to buy or sell shares or stock. Beyond this level. When the spot rate reaches 380. dollar at the exchange rate of 1 yen = 1.900$ maturity in November.100 or 200 per index point. if the option holder exercises his option now. the writer of the option gets profits as long as the option is not exercised. For instance. the breakeven point is reaches.100-300 (premium 10% on 30 *10).0504 $ (loss). it is knows as share option. As long as the price of pound in the market remains bellows 1. if it can be exercised only at the time of maturity. A person with more money can trade the index at a higher price of Rs. if the option can be exercised at any time between the writing of the contract and its expiration. 350. speculators can play this kind of game only. However.300 and the strike price or exercise price is Rs. it is profitable to exercise the option. the option holder gets profits by exercising his option. This can be illustrated by an example.9200$ per yen 1. exercise of the option becomes profitable. Beyond this index value. it is termed as European option. 200. the spot rate becomes 1. the option price is taken as Rs. Genuine portfolio managers can use this instrument to hedge their risks due to heavy fluctuations in the prices of shares and stocks. Now.0704 (premium) = -. As the spot price increases beyond the strike price level. Now. it is called currency option . his net position will be Rs. the option holder starts making a profit. the option holder will not exercise his option since he will be incurring losses. The spot rate then was also pays a premium of 7.04 cents per yen 1.9704$.10 per point. So long as the index remains below 350. the loss will be limited to the premium paid at the rate of Rs. he will get a profit of . His profit . An option holder buys in September. the breakeven point is reached. Share option transactions are generally index-based.

. On the other hand. For example. OPTION CONTRACT Ø Contract Size Ø Exercise Style Ø Expiry Date Ø Option Class Ø Option Series Ø Premium Ø Settlement Style Ø Strike Price Ø Type Ø Underlying Asset OPTION CONTRACT: The option buyer pays premium to the seller and acquires the right i. the option seller receives the premium and grants the right to the buyer i.9704 $ the writer of the option is also at the break-even point. The person who bought an option contract and keeps the position open without closing out in the market owns a long position.e. The person who sold an option contract and keeps the position open without closing out in the market owns a short position. At the rate 1 yen =1. A short position may be offset or closed out by buying back the same contract in the market.is limited to the premium received i. If spot rate goes beyond this level.he will have to perform the agreement to buy or sell the underlying asset if so requested by the buyer before the option contract expires. the option writer will suffer a net loss. 7. one option contract represents one board lot of the underlying shares (except where there has been a capitalization change). he is in a passive position . to decide whether to buy or sell the underlying asset at the agreed price before the option contract expires. and is referred to as an option holder. the option holder will exercise his option.e. and is referred to as an option writer. GENERAL TERMS OF OPTIONS TRADING Ø CONTRACT SIZE: Refers to the amount of the underlying asset that one option contract represents. . for stock option contracts traded on the Exchange. When the spot rate goes beyond the strike price.04 cents per yen 1.e. A long option position may be offset or closed out by selling the same contract in the market.

Ø EXPIRY DATE: Refers to the date on which that the option contract. It is also known as the EXERCISE PRICE. Ø SETTLEMENT STYLE: Refers to the way the underlying assets change hands on exercise by the option holder. Therefore. For index options traded on the Exchange. . while American style options can be exercised at any time on or before expiry. For Exchange-traded stock options. Physical settlement involves physical delivery of the underlying assets between the holder and the writer while cash settlement involves a cash transfer of the price difference between the strike price and underlying asset. Ø OPTION SERIES: Refers to all option contracts with the same underlying asset. all option contracts of Hong Kong Bank (HKB) represent an option class. For instance. For instance. strike price and type (call/put). will expire. it is quoted on index point s basis. expiry date. Ø PREMIUM: Refers to the price or cost at which the option trades. European style options can only be exercised on the expiry date. Ø OPTION CLASS: Refers to all option contracts with the same underlying asset.Ø EXERCISE STYLE: Refers to when the option contract can be exercised. each series is equivalent to one tradable security or unit. all HKB Call option contracts with April expiry and $180 strike represent an option series. The exercise style for the stock option contracts and index option contracts traded on the Exchange is American style and European style respectively. Ø STRIKE PRICE: Refers to the pre-determined price at which the underlying asset can be bought or sold. it is usually quoted on a per share basis. and hence the right to exercise.

Ø TIME VALUE: The portion of an options premium that is attributed to the option may gain value in the remaining time before it expires. the underlying stock's dividend yield). Put options give the buyer the right to sell the underlying asset. Call options give the buyer the right to buy the underlying asset. Higher dividend yields will mean lower call premiums and higher put premiums. Index. Ø Volatility of Underlying Security The greater the volatility of the underlying the more people are willing to pay for an option's time value. There are five major categories: Equity. For instance. Ø Time to Expiry: All else being equal an option with more time to expiry will have more time value than an option that has less time to expiry. Time value is the value that is attributed to the possibility that the option will increase in value during the time before expiry. Debt and Forex. These two factors affecting opportunity cost have a minimal effect on the options price in comparison to other factors. Ø UNDERLYING ASSET: Refers to the asset to be exchanged if the option is exercised. Time value is higher on volatile securities because there is a possibility of larger profits. A put option on the Hang Seng Index gives the holder the right to sell the index at HK$50 per.e. Ø Time Decay: As illustrated in figure 1 the closer you get to the expiry date the faster an option's time value will .Ø TYPE: Refers to the two basic types of options: CALLS and PUTS. There are two factors that affect the opportunity cost: the risk-free rate of interest and the yield on the underlying (i. The more time there is the more opportunity the underlying asset has to move. the interest that you could have earned is an opportunity cost. a call option on the shares of ABC Company gives the holder the right to buy the shares of ABC Company. Commodity. Ø Opportunity Cost: If you have a sum of money that you could earn interest on and you decided to spend that money on buying a stock. Higher interest rates will mean higher call premiums and lower put premiums.

00 of intrinsic value or the put option is $5.00 in the money.deteriorate. this means that the call option has $5. this concept is called time decay. this means that the put option also has $5. Figure 2. The put option in figure 2 gives the holder the right to sell the stock for $20. The further in the money an option is in the less time value it will command. When an option is more expensive the buyer is risking more money. and a put option with a strike price that is above the stock price is in the money. The call option in figure 2 gives the holder the right to buy the stock for $10. You will pay more money per day of time value for an option that is nearing expiry in comparison to an option that has a long time until expiry. therefore the buyer won't be willing to spend as much money on time value.00 in the money. Figure 1. All other factors being equal a nine month option would lose about 10% of its time value in the first 3 months. The stock is currently trading at $15. Deep in-the-money options are more expensive due to the large amount of intrinsic value. A call option with a strike price that is below the stock price is in the money. Time Decay Curve Chart Ø Time Value & Risk: In-the-Money options are options that have intrinsic value. in the next 3 months it would lose about 30% of the original time value. . and in the last 3 months the option would lose about 60% of its original time value. The stock is currently trading at $15.00 of intrinsic value or the call option is $5.

this is another way of saying the call option is $5. Exercising the put option would be selling the stock for $5.Ø Time Value & Probability of Profitability: Out-of-the-Money is the opposite of in-the-money options. and a put option with strike prices that is below the stock price is out-of-the-money.00 more than the current price.00 less than the current price. The put option in figure 3 gives the holder the right to sell the stock for $10 while the stock is currently trading at $15. The probability of the option transaction being profitable is lower on deep out-of-the-money options anything on expiry. A call option with a strike price that is above the stock price is out-of-the-money. The further out-of-the-money an option is in the less time value it will have.00 out-of-the-money. Figure 3. Exercising the call option would mean buying the stock for $5. this means the put option is $5. When you buy deep out-ofthe-money options the stock has to move a lot in order for it to have any value on expiry.00 out-of-the-money. INTRINSIC VALUE Ø Factors Affecting Intrinsic Value: Intrinsic value is the value that could be realized by exercising an option then immediately liquidating . The call option in figure 3 gives the holder the right to buy the stock for $20 while the stock is currently trading at $15. therefore the buyer won't be willing to spend as much money on time value.

Ø Holder: The holder is the person who bought an option contract. (I. which is currently at or very close to the strike price. At-the-money options have a market price. When you buy a call the most you can lose is the premium you paid for the call. Someone who buys an option they previously wrote is not a holder. There are two factors affecting intrinsic value: the strike price and the underlying security price. . in this example there would be an intrinsic value of $5). Ø Long Call: Buying a call gives you the right to buy the underlying stock at the strike price any time until expiry. which is the same amount.) In-the-money options have an intrinsic value.Underlying Security Price (Note: Intrinsic Value cannot be negative. however they are on the verge of gaining intrinsic value if the underlying stock moves in a favorable direction.Strike Price Put Options: Intrinsic Value = Strike Price . if the above equations produce a negative number the intrinsic value is zero. Figure 4 shows the risk return involved with buying a call with a strike price of $25 for a premium of $5. they are just closing an existing position. Call Options: Intrinsic Value = Underlying Security Price .the position in the underlying. Ø Long Call (Buy a Call): You would buy a call if you think the price of the underlying stock is going to rise (when you are bullish on the underlying stock). Out-of-the-Money options have no intrinsic value. as the option is in the money.e. exercise a call option to buy XYZ at a strike price of $20. then sell XYZ at the current price of $25. At-themoney options don't have intrinsic value either. An option holder is said to be "long" the option they bought. However there is unlimited profit if the underlying stock moves up.

However you are taking on unlimited risk if the underlying stock moves up. In this example the holder of the call option would have a profit of $10 ($15 the value of the option at expiry . Ø Covered Call: A covered call is when you own the underlying stock and you write a call. Figure 6 shows the risk and return involved with writing a covered call with a strike price of $25 for a . The call is covered because if you get assigned and have to sell the underlying stock it is OK because you already own it. Figure 5. Ø Long Call Chart: If the price of the stock rose to $40 by the expiry date the call option would be worth $15 ($40 the stock price . There are two basic types of short calls covered and uncovered (naked). When you write a naked call the most you can make is the premium you receive for writing the call.$5 the premium paid for the option).Figure 4.$25 the strike price).$40 the price you would have to buy the stock for). Ø Naked Call Chart: If the price of the stock rose to $40 by the expiry date the naked call position would be in a loss of $10 ($5 premium you originally received for writing the naked call + $25 the strike price which you are obligated to sell the stock for . If you think that a stock price will stay the same or move up slightly you could write a covered call. Ø Short Call: Writing a call obligates you to sell the underlying stock at the strike price any time until expiry if you are assigned. Figure 5 shows the risk and return involved with writing a naked call with a strike price of $25 for a premium of $5. Ø Naked Call (Uncovered Call): You could write a call if you think the price of the underlying stock is going to stay the same or fall (when you are neutral or bearish on the underlying stock). You short a call when you write (sell) a call that you don't currently own.

A covered call position has the same risk reward profile as writing a naked put. Ø Speculative Put: A speculative put is when you buy a put in hopes that the stock will fall. Figure 6. . Ø Covered Call Chart: If the price of the underlying stock rose to $25 or higher by the expiry date the overall position would have a profit of $6 (this remains the same because any profits on the stock are offset by losses on the short call). Figure 7 shows the risk and return involved with buying a put (speculative put) with a strike price of $25 for a premium of $5.$22 the price paid for the stock + $3 the premium received for writing the call). If the price of the underlying stock fell to $10 your combined loss would be $9 ($10 the current price of the stock . as opposed to buying a put to protect a position in the underlying stock. You can buy a put either to speculate or to protect a position. When you buy a put the most you can lose is the premium you pay for buying the put option. However you are taking on a lot of risk if the underlying stock falls. When you write a covered call there is a maximum amount that you can make. When you buy a put to open a position you are said to be long a put . However you are able to make large profits if the underlying stock falls. Ø Long Put: Buying a put gives you the right to sell the underlying stock at the strike price any time until expiry.premium of $3 at a time when the underlying stock is trading at $22.

In this example the put holder would have a $10 profit ($15 the value of the option at expiry . and you want to protect yourself in case there is a sharp drop in the stock price. Figure 8.$5 the premium paid for the option).$10 current stock price that you could buy the stock for). When you buy a protective put you still have unlimited profit potential while you are able to limit your risk. Ø Speculative put chart: If the price of the stock fell to $10 by the expiry date. Figure 8 shows the risk and return involved with holding a stock and buying a protective put on it. You may want to buy a protective put if you think the underlying stock is going to rise buy you have some short term concerns. the put option would have a value of $15 ($25 strike price that you could sell the stock for . . A protective put is like buying an insurance policy on your stock to protect against the drop in price.Figure 7. Ø Protective Put: A protective put is when you have a position in the underlying stock and you buy a put to protect against a drop in the stock's price.

Ø Short Put: Writing a put obligates you to buy the underlying stock at the strike price any time until expiry if you are assigned. A protective put has the same risk reward profile as buying a call option. Figure 9. If the price of the underlying stock went up to $45 there would be a profit of $10 ($15 the gain on the stock . the put option would have a value of -$20 ($5 current stock price that you could sell the stock for . When you write a put the most you can make is the premium you receive for writing the put option. Ø Short Put Chart: If the price of the stock fell to $5 by the expiry date. You could write a put if you think the price of the underlying stock is going to stay the same or rise (when you are neutral or bullish on the underlying stock). Ø Short Put (Writing a Put): When you write (sell) a put that you don't already own you are said to be "short a put".$5 the premium paid to buy the protective put).Ø Protective Put Chart: If the price of the underlying stock fell to $25 or lower by the expiry date the combined position would have a loss of $10 (this remains the same because the profits on the put option will offset any losses on the stock below the $25 strike price).$25 strike price that you would have to buy the stock for). In this example the put writer would have a $15 loss ($5 the premium received for writing the . However you are taking on the risk of large losses if the underlying stock falls. Figure 9 shows the risk and return involved with writing a put with a strike price of $25 for a premium of $5.

this is called a naked or an uncovered put. When you exercise an option you are actually buying or selling the underlying stock.option . You will get assigned if the person who buys the option from you exercises it. Ø Sell the Options: You can sell an option that you previously bought on or before the expiry date. or sell the stock in the case of a put. If you sell the option you will not need to take a position in the underlying asset. Selling an option is often the best way to close out a position if there is still time remaining before expiry. only the intrinsic value is realized. There are several other methods of covering a short put. Ø Naked Put (Uncovered) vs. and in the case of a put option you would have to buy the stock at the strike price from the put holder. When you write a put you are taking on an obligation to buy the underlying stock at the strike price. Exercising an option would be appropriate in a situation where there is little or no time value. Ø Get Assigned: You can only get assigned if you are short the option. Being assigned is a possibility however you have no control over this. Writing a put has the same risk reward profile as a covered call position. You can cover this obligation by having enough cash to buy the shares at the strike price. and you want to buy the stock in the case of a call. Short Put Covered by Cash: There are two basic types of short puts covered and uncovered (naked). This is because when you sell an option you will sell it for the total price (the intrinsic value + the time value). You can exercise American style option any time on or before the expiry date. When an option is exercised. When you are assigned you must simply fulfill your obligation under the option contract.$20 the value of the option you wrote at expiry). Ø Let the Options Expire: . In the case of a call option you would have to sell the stock at the strike price to the call holder. it is the decision of the other party in the options contract. Ø Exercise the Options: You can only exercise an option if you are long the option (if you own the option). and any time value remaining is lost. If you write a put option that is not covered you are taking on more risk.

and you may be required to specify what type of options strategies you would like to do in the account.An option will expire worthless if the option is either at-the-money or out-of-the-money on expiry. If you have a cash account you will need to open a new account because you cannot trade options in a cash account. however you will first need to get options approval on your account. For example some firms require you to have a minimum balance before writing any naked options. you lose all the money you invested in the option. Registered accounts also have restrictions as to what type of options strategies can be done. If you don't tell them you may find that they won't let you do certain types of strategies. You can also trade options in registered accounts. When you apply for a margin account you will need to specify that you want to trade options. . ANNEXURE HOW OPTIONS WORK: Ø An option is a special contract in which the option owner enjoys the right to buy or sell something without the obligation to do so. If the account application form asks it is important to tell your brokerage firm what type of option strategies you would like to be allowed to do. Letting your options expire worthless is the only viable decision when they are out-of-the-money on expiry. Ø Opening an Account: Before you start trading options you will need to open a margin account. We would recommend for you to check with your brokerage firm to see if they have any additional requirements for trading options. however with a registered account you may also have to apply for options approval on the account. When you let an option expire. Ø Registered Accounts: Options can be traded in registered accounts such as RRSP or RRIF accounts.

For e.and the market price of the call option is Rs30/-. stock options are looked upon. The option becomes worthless after the expiration date. as a speculative vehicle as in any option there is a risk of loss to both the contracting parties.Ø The option to buy under the contract is called Call option and the options to sell are call put option. OPTIONS PRICING: Ø The price of a put or call option depends upon the market behaviour of the equity that underlines the option.(Rs 30 . These options expire on the last Thursday of the month. the exercise price of a call option on the share is Rs 500/. Ø These options have five strike prices stipulated by the exchange and the prices have to be settled in cash. Ø The date on which the option expires or matures is known as expiration date. strike prices. Some of these options can be traded over the counter. In this case. Ø The price at which the option holder can buy or sell the underlying asset is called the striking price or exercise price. Exchange traded options are standardized in terms of quantity. Ø These options are traded on stock exchanges. Ø Options contracts on individual securities on the NSE are in the multiple of 100 and have three months trading cycle.g. Ø The excess of the market price of any options over its intrinsic value is known as time value of an option. .Rs 20). Ø The value of an option expiring immediately is called its intrinsic value. Ø The option holder is the buyer of the option and the option writer is the seller of that option.(Rs520-Rs500/-) and the time value of the option is Rs 10/. expiration date. Ø Generally. mode of settlement trading cycle etc.: the market price of a share is Rs 520/-. Ø The act of buying and selling the underlying Asset as per the option contract is called exercising the option. An option can exercise on or before expiration date. the intrinsic value of the option is Rs 20/. type of options.

In most of the transactions the contract price is the stock market price prevailing at the time the option is written and the premium becomes the variable for the buyer and the seller to bargain. It is also referred to as a striking price. which becomes effective during the period of contract. There are many expiration dates and striking prices offered with option. Ø The contract price remains fixed during the life of the contract. However as per market practice. Ø The amount the buyers pay for the option privilege in purchasing an option is called the premium. which benefit many investors. Sometimes. .Ø The price at which the stock under option may be put or called is the contract price. it may be called as the option money. the contract price can reduce by the amount of any dividend paid or by the value of any right.