ANALYSIS OF DERIVATIVE MARKET IN INDIA
A PROJECT REPORT
Submitted by
RAJ PANDYA
Batch 2010-11
in partial fulfillment for the award of the degree
of
POST GRADUATE DIPLOMA IN MANAGEMENT
(PGDM)
Under the Guidance of
Prof. GITIKA MAYANK
THAKUR INSTITUTE OF MANAGEMENT STUDIES AND RESEARCH
KANDIVILI
MUMBAI
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EXECUTIVE SUMMARY
The project is undertaken to study the derivative market in India. Main objective
behind this is to get the feel of the derivative market in India and to understand the working of
the same. In India, derivative market has developed faster as compared to cash market which is
completely vice-versa when compared to other country.
The project contains study and understanding of the derivative market with respect to
different types of instruments in the derivative market, major reform that took place, How
trading take place, How profits are calculated, Growth of derivatives market in India etc.
I got the exposure of the new market while working on the project. I also understood
working of the market and how it is different from capital market. I also got the knowledge of
how various derivatives instruments were implemented in the market.
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Acknowledgment
Working on the Project with the Anugrah Broking Firm has been a wonderful experience over a
period of the last two months. It was a great privilege working with the Broking Firm and getting
a firsthand knowledge of some of the functions performed by them.
I am grateful to Lect. Geetika Mayank for giving me a chance to do my Final Project Report on
“Equity derivatives” which required extensive study of Derivatives investment.
I feel, I shall always remain indebted to Mr. Balkishan Sharma without whom it is being
impossible to complete my project report .He gave his kind supervision, guidance, timely support
and all other kind of help required in each and every moment of need.
I would also like to thank Prof. Mrinalini Kohojkar, The Director of Thakur Institute of
Management Studies and Research for continuously helping and motivating us to do well
throughout the course.
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COMPANY DETAILS
Name of Company: Anugrah Stock Broking Ltd
Address: Ecospace IT Park, 5th Floor,
Old Nagardas Road, Mogra Village,
Andheri (East), Mumbai – 400069.
Tel No: 91-22-67804700 / 67147800
COMPANY PROFILE
ANUGRAH is one of the leading financial broking house, established in 2003, founded by Mr.
Arvind Kariya and Mr. Paresh Kariya. The company started as broking entity and within a short
span of time it became an established broking house with BSE, NSE, MCX, NCDEX, CDSL DP
and Derivatives segments. Presently ANUGRAH operates from 200+ Business Associates in
India, with Client base over 15000+.
To provide the highest possible quality of service, ANUGRAH provides full access to all our
products and services through multi-channels.
The organization finds its strength in its team of young, talented and confident individuals.
Stringent employee selection process, focus on continuous training and adoption of best
management practices drive the quest to achieving our Success.
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Contents
INTRODUCTION OF THE PROJECT.......................................................................................... 8
OBJECTIVES OF THE PROJECT ................................................................................................ 9
INTRODUCTION TO THE STOCK EXCHANGE .................................................................... 10
Features of the stock exchange ................................................................................................. 10
Functions of stock exchange ..................................................................................................... 11
Who benefits from stock exchange ............................................................................................ 11
FACTORS AFFECTING INDIAN STOCK MARKET .............................................................. 12
Demand & supply ..................................................................................................................... 12
Monetary policy ........................................................................................................................ 12
Repo Rate .................................................................................................................................. 13
Reverse Repo rate ..................................................................................................................... 13
DERIVATIVES – INTRODUCTION .......................................................................................... 15
Definition .................................................................................................................................. 15
Participants in the derivatives market ...................................................................................... 16
Hedger................................................................................................................................... 16
Speculator ............................................................................................................................. 16
Arbitrageurs .......................................................................................................................... 16
Jobber ................................................................................................................................... 16
FORWARD CONTRACTS .......................................................................................................... 17
Limitations of forward markets ................................................................................................. 18
FUTURES CONTRACTS ............................................................................................................ 18
Futures terminology .................................................................................................................. 19
APPLICATION OF FUTURES ................................................................................................. 20
Understanding beta ............................................................................................................... 20
Hedging: Long security, sell futures ..................................................................................... 21
Speculation: Bullish security, buy futures ............................................................................ 22
Speculation: Bearish security, sell futures............................................................................ 22
Arbitrage: Overpriced futures: buy spot, sell futures ........................................................... 22
Arbitrage: Underpriced futures: buy futures, sell spot ......................................................... 23
OPTIONS CONTRACTS ............................................................................................................... 24
Option terminology ................................................................................................................... 24
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Generation of strikes ................................................................................................................. 25
Generation of strikes for stock options ................................................................................. 26
Generation of strikes for Index options ................................................................................ 26
OPTIONS PAYOFFS ................................................................................................................ 26
Payoff profile for buyer of call options: Long call ............................................................... 26
Payoff profile for writer of call options: Short call .............................................................. 28
Payoff profile for buyer of put options: Long put ................................................................. 29
Payoff profile for writer of put options: Short put ................................................................ 30
Other Option Strategies ............................................................................................................ 32
1.
Synthetic Long Call .................................................................................................... 32
2.
Covered Call ............................................................................................................... 34
3.
Bull Call Spread.......................................................................................................... 37
4.
Bear Put Spread .......................................................................................................... 39
5.
Long Straddle ............................................................................................................. 42
6.
Long Strangle ............................................................................................................. 45
7.
Short Straddle ............................................................................................................. 47
8.
Short Strangle ............................................................................................................. 50
APPLICATION OF OPTIONS .................................................................................................. 51
Hedging: Have underlying buy puts ..................................................................................... 51
Speculation: Bullish security, buy calls or sell puts ............................................................. 52
One month calls and puts trading at different strikes ........................................................... 53
Payoff for buyer of call options at various strikes ................................................................ 54
Payoff for writer of put options at various strikes ................................................................ 55
Speculation: Bearish security, sell calls or buy puts ............................................................ 55
One month calls and puts trading at different strikes ........................................................... 56
Payoff for seller of call option at various strikes.................................................................. 57
Payoff for buyer of put options at various strikes ................................................................. 57
RELATION BETWEEN OPEN INTEREST, VOLUME & PRICE ........................................... 58
OPEN INTEREST ..................................................................................................................... 58
CHARGES .................................................................................................................................... 59
WORK AT ANUGRAH STOCK BROKING LTD ..................................................................... 60
Application of Strategies in current scenario ........................................................................... 60
1.
Ratio Bull Call Spread ................................................................................................ 60
2.
Short Straddle ............................................................................................................. 62
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CONCLUSION ............................................................................................................................. 65
BIBLIOGRAPHY ..........................................................................Error! Bookmark not defined.
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INTRODUCTION OF THE PROJECT
Derivatives have vital role to play in enhancing shareholder value by ensuring access to the
cheapest source of funds. Active use of derivatives instruments allows the overall business risk
profile to be modified, thereby providing the potential to improve earning quality by offsetting
undesired risk.
Under my project report, I have studied various trends that come in the way of Derivatives
market. Because impression is usually given that losses arose from derivatives are extremely
complex and difficult to understand financial strategies.
I have found out that derivatives can indeed be used safely and successfully provided a sensible
control and management strategy is established and executed. In spite of that more awareness
should be done and technical expertise knowledge should be more expanded.
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OBJECTIVES OF THE PROJECT





The main objectives of my final project report are as follows:To study the various trends that comes in the way of Derivatives market.
To find out that what would be the future and market potential of derivative market in
India.
To study thoroughly all the concepts related to derivative market.
To study the practical implementation of equity derivative in the market.
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INTRODUCTION TO THE STOCK EXCHANGE
A stock exchange is the place where securities, shares, debentures and bonds of joint stock
companies, central & state govt., semi govt. organizations, local bodies and foreign govt. are
bought and sold.
A stock exchange is the nerve center of capital market. Changes in the capital market are
brought about by a complex set of factors, all operating on the market simultaneously. Such
changes are subject to secular trends set by the economic progress of the nation, and governed by
the factors like general economic situation, financial and monetary policies, tax changes,
political environment, international economic and financial development etc.
A stock exchange provides necessary mobility to capital and directs the flow of capital into
profitable and successful enterprises.
Features of the stock exchange
It is a place where listed securities are bought and sold.
It is an association of persons known as members.
Trading in securities is allowed under rules and regulations of stock exchange.
Membership is must for transacting business.
Investors and speculators, who want to buy and sell securities, can do so through members of
stock exchange i.e. brokers.
There are mainly three participants in stock exchange i.e.
•
Issuer of security (company).
•
Investor of security (Individual, HUF).
•
Intermediaries and products (broker, merchant bankers and shares, bonds, warrants,
derivatives products etc.).
It is the market as well as source for the capital. Corporate and govt. raise resource from the
market.
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Functions of stock exchange
Stock Exchange performs the following functions:
The stock exchange provides appropriate conditions where by purchase and sale of securities
takes place at reasonable and fair prices.
People having surplus funds invest in the securities and these funds used for industrialization
and economic development of country that leads to capital formation.
The stock exchange provides a ready market for the conversion of existing securities into
cash and vice-versa.
The stock exchange acts as the center of providing business information relating to
enterprise whose securities are traded as the listed companies are to present their financial and
other statements to it.
Stock exchange protects the interest of the investors through strict enforcement of rules and
regulations with respect to dealings. Punishments (including fine, suspension or even expulsion
of membership) may be there if broker make any malpractice in dealing with investors like
charging high commissions etc.
Stock exchange acts as the barometer of the country as it measures all the pulls and pressures of
the securities in the market.
The stock exchange provides the linkage between the savings in the household sector and
the investment in corporate economy.
Who benefits from stock exchange
1. Investors: - It provides them liquidity, marketability, safety etc. of investments.
2. Company: - It provides them access to market funds, higher rating and public interest.
3. Brokers: - They receive commission in lieu of services to investors.
4. Economy and Country: - There is large flow of saving, better growth of large number of
industries which finally results in growth of country’s GDP rate which effects the economical
condition of country.
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FACTORS AFFECTING INDIAN STOCK MARKET
Stock market is something where you can never foretell what is going to happen in the market.
You might get huge gain or incur losses when the stock market crashes. There are many factors
affecting stock market. It is very hard to say just one or two factors affect the stock market. So,
let us have a look at the factors that affect stock market.
Demand & supply
This is the first factor that affects share price. When you get to see that more people are buying
stocks, then there is an increase in the price of that particular stock. On the other hand price of
stock falls when more people are selling their stocks. So it is very difficult to predict the Indian
stock market.
Monetary policy
The Indian stock market is largely affected by monetary policy adopted by Reserve Bank of
India (RBI). It includes Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR), Reserve
Repo Rate, Repo rate.
CRR (Cash reserve Ratio) is the amount of Cash (liquid cash like gold) that the banks have to
keep with RBI. This Ratio is basically to secure solvency of the bank and to drain out the
excessive money from the banks.
•
Hike in rate
Less availability of funds
•
Fall in rate
More availability of funds
•
Increase in interest rate
•
Fall in interest rate
•
Customers will borrow less and spends
less
•
Customers will borrow more and
spends more
•
Fall in demand
•
Increase in demand
•
Negative impact on company’s profits
•
Positive impact on company's profits
•
Fall in share price
•
Increase in share price
•
Inflation under control
•
Risk of inflation
SLR (Statutory Liquidity Ratio) is the amount a commercial bank needs to maintain in the form
of cash, or gold or govt. approved securities (Bonds) before providing credit to its customers.
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SLR rate is determined and maintained by the RBI (Reserve Bank of India) in order to control
the expansion of bank credit. Generally this mandatory ration is complied by investing in
Government bonds.
•
Hike in rate
Reduction in bank credit
•
Fall in rate
Expansion in bank credit lending
•
Increase in interest rate
•
Decrease in interest rate
•
Customers will borrow less and spends
less
•
Customer will borrow more and
spends more
•
Fall in demand
•
Raise in demand
•
Decline in company’s profits
•
Increase in company’s profits
•
Fall in share price
•
Increase in share price
•
Control over the inflation
•
Risk of inflation
Impacts on the sectors – Almost all sectors are affected by CRR and SLR rate but banking
sectors are majorly affected by it.
Repo Rate
Repo rate is the rate at which our banks borrow rupees from RBI. This facility is for short term
measure and to fill gaps between demand and supply of money in a bank .when a bank is short of
funds they borrow from bank at repo rate and if bank has a surplus fund then the deposit the
funds with RBI and earn at Reverse repo rate .The current repo rate is 5.25 % (w.e.f 20/04/2010)
Reverse Repo rate
It is the rate which is paid by RBI to banks on Deposit of funds with RBI.A reduction in the repo
rate will help banks to get money at a cheaper rate. When the repo rate increases borrowing from
RBI becomes more expensive. To borrow from RBI bank have to submit liquid bonds /Govt
Bonds as collateral security ,so this facility is a short term gap filling facility and bank does not
use this facility to Lend more to their customers. The current reserve repo rate is 3.75% (w.e.f
20/04/2010).
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Interest rate
 If there is an increase in interest rate it will become more expensive for bank to borrow
money from central bank
 They will pass on this cost on consumers by making credit more expensive
 Consumers will spend less which leads to fall in demand
 Reduction in profits of the company’s leads to fall in stock price
 Expansion of businesses will be obstructed due to less availability of credit
 Negative impact on growth of countries economy
 Almost all sectors are affected by interest rate but banking sectors are majorly affected by
it.
Crude oil
 Rise in oil price has negative impact on stock price.
 Increase in oil price leads to increase in operational cost, transportation cost, and fuel cost
of the companies.
 It leads fall in profit margin of the company
 Buyers become susceptible about the future of the companies that are hugely dependent
on oil.
 This uncertainty restricts the buyers to invest in these companies and as a result the price
of the stocks falls.
 Oil sectors, power sectors, metal sectors are majorly affected by crude oil price.
Financial crisis




Loss of the confidence in countries currency
Causing international investment to withdraw their investment from the country
Leads to crash down of stock market
It is associated with banking panics, and many recessions coincided with these panics.
Currency rate
 Currency rate fluctuations may be considered a lead indicator of what the big investors
may be planning to do as far as their stock market investment are concerned.
 FIIs (foreign institutional investors) decide to invest in the country considering the
currency rate of that country.
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DERIVATIVES – INTRODUCTION
Risk is a characteristic feature of all commodity and capital markets. Prices of all commoditieswhether agricultural like wheat, cotton, rice, coffee or tea, or non agricultural like silver, gold,
etc. are subject to fluctuation over time in keeping with prevailing demand and supply
conditions. Producers or possessors of these commodities obviously cannot be sure of the prices
that their produce or possession may fetch when they have to sell them, in the same way as the
buyers and the processors are not sure what they would have to pay for their buy. Similarly,
prices of shares and debentures or bonds and other securities are also subject to continuous
change. Owners of shares of a company face the risk that the market price of that share may fall
below the price at which they were purchased. In the same way, the foreign exchange rates are
also subject to continuous change. Thus, an importer of a certain piece of machinery is not sure
of the amount he would have to pay in rupee terms when the payments become due.
While examples where risk is seen to exist, can be multiple, it may be observed that parties
involved in all such cases may see the benefits of, and are likely to desire, having some contract
from which forward prices may be fixed and the price risk facing them is eliminated. Derivatives
came into being primarily for the reason of the need to eliminate price risk.
By their very nature, the financial markets are marked by a very high degree of volatility.
Through the use of derivative products, it is possible to partially or fully transfer price risks by
locking-in asset prices. As instruments of risk management, these generally do not influence the
fluctuations in the underlying asset prices. However, by locking in asset prices, derivative
products minimize the impact of fluctuations in asset prices on the profitability and cash flow
situation of risk-averse investors.
Definition
Derivative is a product whose value is derived from the value of one or more basic variables,
called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying
asset can be equity, forex, commodity or any other asset. For example, wheat farmers may wish
to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a
transaction is an example of a derivative. The price of this derivative is driven by the spot price
of wheat which is the "underlying".
As awareness about the usefulness of derivatives as risk management tools has increased, the
markets for derivatives too have grown. Of late, derivatives have assumed a very significant
place in the field of finance and they seem to be driving global financial markets.
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Participants in the derivatives market
Hedger
 These investors have a position (i.e., have bought stocks) in the underlying market but are
worried about a potential loss arising out of a change in the asset price in the future.
 Hedgers participate in the derivatives market to lock the prices at which they will be able
to transact in the future. Thus, they try to avoid price risk through holding a position in
the derivatives market.
 Different hedgers take different positions in the derivatives market based on their
exposure in the underlying market. A hedger normally takes an opposite position in the
derivatives market to what he has in the underlying market.
Speculator
 A Speculator is one who bets on the derivatives market based on his views on the
potential movement of the underlying stock price.
 Speculators take large, calculated risks as they trade based on anticipated future price
movements. They hope to make quick, large gains; but may not always be successful.
 They normally have shorter holding time for their positions as compared to hedgers. If
the price of the underlying moves as per their expectation they can make large profits.
 However, if the price moves in the opposite direction of their assessment, the losses can
also be enormous.
Arbitrageurs
 Arbitrageurs attempt to profit from pricing inefficiencies in the market by making
simultaneous trades that offset each other and capture a risk-free profit.
 An arbitrageur may also seek to make profit in case there is price discrepancy between
the stock price in the cash and the derivatives markets.
Jobber
 A jobber is one who buys and sells equity in large numbers and has half a minute's view
on the market vis-à-vis each transaction.
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 A jobber trades for a profit of 25 to 50 paise which is considered to be good since they
trade in very large volumes.
 But the important thing is that whether a jobber makes a profit or a loss, he should square
up in 30 to 60 seconds; if he doesn't, and allows the price to go up or down by a couple of
rupees, he is speculating and will not succeed.
 The important thing is to exit quickly either way; and re-enter if he thinks he can make a
further gain of 25 to 50 paise. He can do this trade 50 or even 100 times in a day. In the
western countries jobbers are called market-makers.
There are many kinds of derivatives including futures, options, interest rate swaps, and mortgage
derivatives. However in this project we seek to discuss the nature of futures and options and their
trading in the market. To understand the nature of futures and options, let us begin with the idea
of forward contracts.
FORWARD CONTRACTS
A forward contract is an agreement to buy or sell an asset on a specified date for a specified
price. One of the parties to the contract assumes a long position and agrees to buy the underlying
asset on a certain specified future date for a certain specified price. The other party assumes a
short position and agrees to sell the asset on the same date for the same price. Other contract
details like delivery date, price and quantity are negotiated bilaterally by the parties to the
contract. The forward contracts are normally traded outside the exchanges.
The salient features of forward contracts are:
1. They are bilateral contracts and hence exposed to counter - party risk.
2. Each contract is custom designed, and hence is unique in terms of contract size,
expiration date and the asset type and quality.
3. The contract price is generally not available in public domain.
4. On the expiration date, the contract has to be settled by delivery of the asset.
5. If the party wishes to reverse the contract, it has to compulsorily go to the same counterparty, which often results in high prices being charged.
Forward contracts are very useful in hedging and speculation. The classic hedging application
would be suppose an investor owns 100 shares of Reliance Industries. He fears that the market
price of Reliance Industries will fall in near future. He is exposed to the price risk. By using the
equity forward market to sell shares of reliance Industries forward, he can lock on to a price
today and reduce his uncertainty. When there is a fear of price fall in near future you can sell
forward and when there is a fear of price rise in near future you can buy forward.
If a speculator has information or analysis, which forecasts an upturn in a price, then he can go
long on the forward market instead of the cash market. A speculator is one who takes a position
in forwards market without having any position in cash market. The speculator would go long on
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the forward, wait for the price to rise, and then take a reversing transaction to book profits.
Speculators may well be required to deposit a margin upfront. However, this is generally a
relatively small proportion of the value of the assets underlying the forward contract. The use of
forward markets here supplies leverage to the speculator.
Forward contracts can be settled in two ways – Delivery Settlement or Cash Settlement. In
delivery settlement one party delivers the goods and the other party pays the amount that had
been agreed upon when the contract was initiated. In cash settlement the spot price of the
underlying is compared to the contract price and the party with the negative position pays the
difference to the other party.
Limitations of forward markets
Forward markets world-wide are afflicted by several problems:
a. Lack of centralization of trading,
b. Illiquidity, and
c. Counterparty risk
Since the forward contract is a contract between two private parties the contract does not trade in
the open market like an exchange. And because it is not traded publicly, there is no liquidity.
Hence if a party has taken a position in the forward market and wants to reverse his position then
it is very difficult for him to find a buyer for such a contract.
Counterparty risk arises from the possibility of default by any one party to the transaction. When
one of the two sides to the transaction declares bankruptcy, the other suffers. Even when forward
markets trade standardized contracts, and hence avoid the problem of illiquidity, still the
counterparty risk remains a very serious issue.
FUTURES CONTRACTS
A futures contract is functionally similar to a forward contract but differs in detail. While
forward contracts are between two parties who deal directly with and have accountability to each
other for the particular contract, the futures contracts are Standardized contracts, between two
parties who do not necessarily know each other and guaranteed for performance by a clearing
corporation or clearing house.
A clearing house plays a pivotal role in the trading of futures contracts. It acts as an intermediary
for each contract. A clearing house is associated with a futures exchange and is concerned with
matching, processing, registering, confirming, settling, reconciling and guaranteeing the trades
on the futures exchange. Whereas in forward contracts, each party faces the risk that the opposite
party may default, the two parties in a future contract have no worry because of the guarantee of
the clearing house. In fact, once a futures price is agreed upon between the buyer and the seller
and the trade is completed, the clearing house of the exchange becomes the opposite party to
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each one of the parties. Thus, when a investor goes long on futures contract, he/she buys it from
the clearing house and, similarly, when one goes short on futures contract, one actually sells to
clearing house only the clearing house is always neutral; maintaining both long and short
position on an identical number of contracts. The number of outstanding contracts at any point of
time is known as open interest.
An adjunct of the exchange and an intermediary in all the futures transactions, a clearing house
has a number of members. The brokers, who are not members, have to channel their business
through a member only. Since the main function of a clearing house is to eliminate, as far as
possible, the risk of default by either party to a contract, with the possibility that such an
occurrence could wipe out participants from the exchange, it is no surprise that the members of a
clearing house are usually the most financially secure firms of an exchange. In some cases, the
clearing house might have the backing of the government as well.
When a party takes a short position on a futures contract, it is obliged to the clearing corporation
for honouring it on maturity. Similarly, an investor with a long position will seek execution of
the contract through it.
Futures markets were designed to solve the problems that exist in forward markets. A futures
contract may be offset prior to maturity by entering into an equal and opposite transaction. More
than 99% of futures transactions are offset this way.
The standardized items in a futures contract are:
a. Quantity of the underlying
b. Quality of the underlying
c. The date and the month of delivery
d. The units of price quotation and minimum price change
e. Location of settlement
Futures terminology
Spot price: The price at which an asset trades in the spot market.
Futures price: The price at which the futures contract trades in the futures market.
Contract cycle: The period over which a contract trades. The index futures contracts on the NSE
have one month, two months and three months expiry cycles which expire on the last Thursday
of the month. Thus a January expiration contract expires on the last Thursday of January and a
February expiration contract ceases trading on the last Thursday of February. On the Friday
following the last Thursday, a new contract having a three month expiry is introduced for
trading.
Expiry date: It is the date specified in the futures contract. This is the last day on which the
contract will be traded, at the end of which it will cease to exist.
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Contract size: The amount of asset that has to be delivered under one contract. It is also called as
lot size.
Basis: In the context of financial futures, basis can be defined as the futures price minus the spot
price. There will be a different basis for each delivery month for each contract. In a normal
market, basis will be positive. This reflects that futures prices normally exceed spot prices.
Cost of carry: The relationship between futures prices and spot prices can be summarized in
terms of what is known as the cost of carry. This measures the storage cost plus the interest that
is paid to finance the asset less the income earned on the asset.
Initial margin: The amount that must be deposited in the margin account at the time a futures
contract is first entered into is known as initial margin.
Marking-to-market: In the futures market, at the end of each trading day, the margin account is
adjusted to reflect the investor's gain or loss depending upon the futures closing price. This is
called marking-to-market.
Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that
the balance in the margin account never becomes negative. If the balance in the margin account
falls below the maintenance margin, the investor receives a margin call and is expected to top up
the margin account to the initial margin level before trading commences on the next day.
APPLICATION OF FUTURES
Understanding beta
The index model suggested by William Sharpe offers insights into portfolio diversification. It
expresses the excess return on a security or a portfolio as a function of market factors and non
market factors. Market factors are those factors that affect all stocks and portfolios. These would
include factors such as inflation, interest rates, business cycles etc. Non-market factors would be
those factors which are specific to a company, and do not affect the entire market. For example, a
fire breakout in a factory, a new invention, the death of a key employee, a strike in the factory,
etc. The market factors affect all firms. The unexpected change in these factors causes
unexpected changes in the rates of returns on the entire stock market. Each stock however
responds to these factors to different extents. Beta of a stock measures the sensitivity of the
stocks responsiveness to these market factors. Similarly, Beta of a portfolio, measures the
portfolios responsiveness to these market movements. Given stock betas, calculating portfolio
beta is simple. It is nothing but the weighted average of the stock betas.
The index has a beta of 1. Hence the movements of returns on a portfolio with a beta of one will
be like the index. If the index moves up by ten percent, my portfolio value will increase by ten
percent. Similarly if the index drops by five percent, my portfolio value will drop by five
percent. A portfolio with a beta of two, responds more sharply to index movements. If the index
moves up by ten percent, the value of a portfolio with a beta of two will move up by twenty
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percent. If the index drops by ten percent, the value of a portfolio with a beta of two will fall by
twenty percent. Similarly, if a portfolio has a beta of 0.75, a ten percent movement in the index
will cause a 7.5 percent movement in the value of the portfolio. In short, beta is a measure of the
systematic risk or market risk of a portfolio. Using index futures contracts, it is possible to hedge
the systematic risk. With this basic understanding, we look at some applications of index futures.
We look here at some applications of futures contracts. We refer to single stock futures.
However since the index is nothing but a security whose price or level is a weighted average of
securities constituting an index, all strategies that can be implemented using stock futures can
also be implemented using index futures.
Hedging: Long security, sell futures
Futures can be used as an effective risk-management tool. Take the case of an investor who
holds the shares of a company and gets uncomfortable with market movements in the short run.
He sees the value of his security falling from Rs.450 to Rs.390. In the absence of stock futures,
he would either suffer the discomfort of a price fall or sell the security in anticipation of a market
upheaval. With security futures he can minimize his price risk. All he need do is enter into an
offsetting stock futures position, in this case, take on a short futures position. Assume that the
spot price of the security he holds is Rs.390. Two-month futures cost him Rs.402. For this he
pays an initial margin. Now if the price of the security falls any further, he will suffer losses on
the security he holds. However, the losses he suffers on the security, will be offset by the profits
he makes on his short futures position. Take for instance that the price of his security falls to
Rs.350. The fall in the price of the security will result in a fall in the price of futures. Futures will
now trade at a price lower than the price at which he entered into a short futures position. Hence
his short futures position will start making profits. The loss of Rs.40 incurred on the security he
holds, will be made up by the profits made on his short futures position.
Index futures in particular can be very effectively used to get rid of the market risk of a portfolio.
Every portfolio contains a hidden index exposure or a market exposure. This statement is true for
all portfolios, whether a portfolio is composed of index securities or not. In the case of portfolios,
most of the portfolio risk is accounted for by index fluctuations (unlike individual securities,
where only 30- 60% of the securities risk is accounted for by index fluctuations). Hence a
position LONG PORTFOLIO + SHORT NIFTY can often become one-tenth as risky as the
LONG PORTFOLIO position!
Suppose we have a portfolio of Rs. 1 million which has a beta of 1.25. Then a complete hedge is
obtained by selling Rs.1.25 million of Nifty futures.
Warning: Hedging does not always make money. The best that can be achieved using hedging is
the removal of unwanted exposure, i.e. unnecessary risk. The hedged position will make less
profit than the unhedged position, half the time. One should not enter into a hedging strategy
hoping to make excess profits for sure; all that can come out of hedging is reduced risk.
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Speculation: Bullish security, buy futures
Take the case of a speculator who has a view on the direction of the market. He would like to
trade based on this view. He believes that a particular security that trades at Rs.1000 is
undervalued and expects its price to go up in the next two-three months. How can he trade based
on this belief? In the absence of a deferral product, he would have to buy the security and hold
on to it. Assume he buys 100 shares which cost him one lakh rupees. His hunch proves correct
and two months later the security closes at Rs.1010. He makes a profit of Rs.1000 on an
investment of Rs. 1,00,000 for a period of two months. This works out to an annual return of 6
percent.
Today a speculator can take exactly the same position on the security by using futures contracts.
Let us see how this works. The security trades at Rs.1000 and the two-month futures trades at
1006. Just for the sake of comparison, assume that the minimum contract value is 1,00,000. He
buys 100 security futures for which he pays a margin of Rs.20,000. Two months later the
security closes at 1010. On the day of expiration, the futures price converges to the spot price
and he makes a profit of Rs.400 on an investment of Rs.20,000. This works out to an annual
return of 12 percent. Because of the leverage they provide, security futures form an attractive
option for speculators.
Speculation: Bearish security, sell futures
Stock futures can be used by a speculator who believes that a particular security is over-valued
and is likely to see a fall in price. How can he trade based on his opinion? In the absence of a
deferral product, there wasn't much he could do to profit from his opinion. Today all he needs to
do is sell stock futures. Let us understand how this works. Simple arbitrage ensures that futures
on an individual securities move correspondingly with the underlying security, as long as there is
sufficient liquidity in the market for the security. If the security price rises, so will the futures
price. If the security price falls, so will the futures price.
Now take the case of the trader who expects to see a fall in the price of ABC Ltd. He sells one
two-month contract of futures on ABC at Rs.240 (each contact for 100 underlying shares). He
pays a small margin on the same. Two months later, when the futures contract expires, ABC
closes at 220. On the day of expiration, the spot and the futures price converges. He has made a
clean profit of Rs.20 per share. For the one contract that he bought, this works out to be Rs.2000.
Arbitrage: Overpriced futures: buy spot, sell futures
As we discussed earlier, the cost-of-carry ensures that the futures price stay in tune with the spot
price. Whenever the futures price deviates substantially from its fair value, arbitrage
opportunities arise.
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If you notice that futures on a security that you have been observing seem overpriced, how can
you cash in on this opportunity to earn riskless profits?
Say for instance, ABC Ltd. trades at Rs.1000. One- month ABC futures trade at Rs.1025 and
seem overpriced. As an arbitrageur, you can make riskless profit by entering into the following
set of transactions.
1. On day one, borrow funds; buy the security on the cash/spot market at 1000.
2. Simultaneously, sell the futures on the security at 1025.
3. Take delivery of the security purchased and hold the security for a month.
4. On the futures expiration date, the spot and the futures price converge. Now unwind the
position.
5. Say the security closes at Rs.1015. Sell the security.
6. Futures position expires with profit of Rs.10.
7. The result is a riskless profit of Rs.15 on the spot position and Rs.10 on the futures position.
8. Return the borrowed funds.
When does it make sense to enter into this arbitrage? If your cost of borrowing funds to buy the
security is less than the arbitrage profit possible, it makes sense for you to arbitrage. This is
termed as cash-and-carry arbitrage. Remember however, that exploiting an arbitrage opportunity
involves trading on the spot and futures market. In the real world, one has to build in the
transactions costs into the arbitrage strategy.
Arbitrage: Underpriced futures: buy futures, sell spot
Whenever the futures price deviates substantially from its fair value, arbitrage opportunities
arise. It could be the case that you notice the futures on a security you hold seem underpriced.
How can you cash in on this opportunity to earn riskless profits? Say for instance, ABC Ltd.
trades at Rs.1000. One-month ABC futures trade at Rs. 965 and seem underpriced. As an
arbitrageur, you can make riskless profit by entering into the following set of transactions.
1. On day one, sell the security in the cash/spot market at 1000.
2. Make delivery of the security.
3. Simultaneously, buy the futures on the security at 965.
4. On the futures expiration date, the spot and the futures price converge. Now unwind the
position.
5. Say the security closes at Rs.975. Buy back the security.
6. The futures position expires with a profit of Rs.10.
7. The result is a riskless profit of Rs.25 on the spot position and Rs.10 on the futures position.
If the returns you get by investing in riskless instruments is more than the return from the
arbitrage trades, it makes sense for you to arbitrage. This is termed as reverse-cash-and-carry
arbitrage. It is this arbitrage activity that ensures that the spot and futures prices stay in line with
the cost-of-carry. As we can see, exploiting arbitrage involves trading on the spot market. As
more and more players in the market develop the knowledge and skills to do cash-and- carry and
reverse cash-and-carry, we will see increased volumes and lower spreads in both the cash as well
as the derivatives market.
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OPTIONS CONTRACTS
Options are fundamentally different from forward and futures contracts. An option gives the
holder of the option the right to do something. The holder does not have to exercise this right. In
contrast, in a forward or futures contract, the two parties have committed themselves to doing
something. Whereas it costs nothing (except margin requirements) to enter into a futures
contract, the purchase of an option requires an up-front payment.
Option terminology
Index options: These options have the index as the underlying. Some options are European
while others are American. Like index futures contracts, index options contracts are also cash
settled.
Stock options: Stock options are options on individual stoc ks. Options currently trade on over
500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the
specified price.
Buyer of an option: The buyer of an option is the one who by paying the option premium buys
the right but not the obligation to exercise his option on the seller/writer.
Writer of an option: The writer of a call/put option is the one who receives the option premium
and is thereby obliged to sell/buy the asset if the buyer exercises on him. There are two basic
types of options, call options and put options.
Call option: A call option gives the holder the right but not the obligation to buy an asset by a
certain date for a certain price.
Put option: A put option gives the holder the right but not the obligation to sell an asset by a
certain date for a certain price.
Option price/premium: Option price is the price which the option buyer pays to the option seller.
It is also referred to as the option premium.
Expiration date: The date specified in the options contract is known as the expiration date, the
exercise date, the strike date or the maturity.
Strike price: The price specified in the options contract is known as the strike price or the
exercise price.
American options: American options are options that can be exercised at any time upto the
expiration date. Most exchange-traded options are American.
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European options: European options are options that can be exercised only on the expiration
date itself. European options are easier to analyze than American options, and properties of an
American option are frequently deduced from those of its European counterpart.
In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive
cash flow to the holder if it were exercised immediately. A call option on the index is said to be
in-the-money when the current index stands at a level higher than the strike price (i.e. spot price
> strike price). If the index is much higher than the strike price, the call is said to be deep ITM.
In the case of a put, the put is ITM if the index is below the strike price.
At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cash
flow if it were exercised immediately. An option on the index is at-the-money when the current
index equals the strike price (i.e. spot price = strike price).
Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a
negative cash flow if it were exercised immediately. A call option on the index is out-of-themoney when the current index stands at a level which is less than the strike price (i.e. spot price
< strike price). If the index is much lower than the strike price, the call is said to be deep OTM.
In the case of a put, the put is OTM if the index is above the strike price.
Intrinsic value of an option: The option premium can be broken down into two components intrinsic value and time value. The intrinsic value of a call is the amount the option is ITM, if it
is ITM. If the call is OTM, its intrinsic value is zero. Putting it another way, the intrinsic value of
a call is Max[0, (St — K)] which means the intrinsic value of a call is the greater of 0 or (St —
K). Similarly, the intrinsic value of a put is Max[0, K — St],i.e. the greater of 0 or (K — St). K is
the strike price and St is the spot price.
Time value of an option: The time value of an option is the difference between its premium and
its intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only
time value. Usually, the maximum time value exists when the option is ATM. The longer the
time to expiration, the greater is an option's time value, all else equal. At expiration, an option
should have no time value.
Generation of strikes
The exchange has a policy for introducing strike prices and determining the strike price intervals.
Let us look at an example of how the various option strikes are generated by the exchange.
Suppose the Nifty has closed at 2000 and options with strikes 2040, 2030, 2020, 2010, 2000,
1990, 1980, 1970, 1960 are already available. It is further assumed when the Nifty index level is
up to 4000, the exchange commits itself to an inter-strike distance of say 10 and the scheme of
strikes of 4-1-4. If the Nifty closes at around 2020 to ensure strike scheme of 4-1-4, two new
further contracts would be required at 2050 and 2060. Conversely, if Nifty closes at around 1980
to ensure strike scheme of 4-1-4, two new further contracts would be required at 1940 and 1950.
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Generation of strikes for stock options
Price of underlying
Strike Price interval Scheme of strikes to be introduced
(ITM-ATM-OTM)
Less than or equal to Rs.50 2.5
3-1-3
> Rs.50 > Rs.250
5
3-1-3
> Rs.250 > Rs.500
10
3-1-3
> Rs.500 > Rs.1000
20
3-1-3
> Rs.1000 > Rs.2500
30
3-1-3
> Rs.2500
50
3-1-3
Generation of strikes for Index options
Index level
Strike interval Scheme of strikes to be introduced
(ITM-ATM-OTM)
Less than or equal to 2000 50
4-1-4
From 2001 To 4000
100
6-1-6
From 4001 To 6000
100
6-1-6
>6000
100
7-1-7
OPTIONS PAYOFFS
The optionality characteristic of options results in a non-linear payoff for options. In simple
words, it means that the losses for the buyer of an option are limited; however the profits are
potentially unlimited. For a writer, the payoff is exactly the opposite. His profits are limited to
the option premium; however his losses are potentially unlimited. These non-linear payoffs are
fascinating as they lend themselves to be used to generate various payoffs by using combinations
of options and the underlying.
Payoff profile for buyer of call options: Long call
A call option gives the buyer the right to buy the underlying asset at the strike price specified in
the option. The profit/loss that the buyer makes on the option depends on the spot price of the
underlying. If upon expiration, the spot price exceeds the strike price, he makes a profit. Higher
the spot price more is the profit he makes. If the spot price of the underlying is less than the
strike price, he lets his option expire un-exercised. His loss in this case is the premium he paid
for buying the option. Figure gives the payoff for the buyer of a three month call option (often
referred to as long call) with a strike of 2250 bought at a premium of 86.60.
Payoff for investor who went Long Nifty at 2220
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The figure shows the profits/losses from a long position on the index. The investor bought the
index at 2220. If the index goes up, he profits. If the index falls he loses.
Payoff for investor who went Short Nifty at 2220
The figure shows the profits/losses from a short position on the index. The investor sold the
index at 2220. If the index falls, he profits. If the index rises, he loses.
Payoff for buyer of call option
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The figure shows the profits/losses for the buyer of a three-month Nifty 2250 call option. As can
be seen, as the spot Nifty rises, the call option is in-the-money. If upon expiration, Nifty closes
above the strike of 2250, the buyer would exercise his option and profit to the extent of the
difference between the Nifty-close and the strike price. The profits possible on this option are
potentially unlimited. However if Nifty falls below the strike of 2250, he lets the option expire.
His losses are limited to the extent of the premium he paid for buying the option.
Payoff profile for writer of call options: Short call
A call option gives the buyer the right to buy the underlying asset at the strike price specified in
the option. For selling the option, the writer of the option charges a premium. The profit/loss that
the buyer makes on the option depends on the spot price of the underlying. Whatever is the
buyer's profit is the seller's loss. If upon expiration, the spot price exceeds the strike price, the
buyer will exercise the option on the writer. Hence as the spot price increases the writer of the
option starts making losses. Higher the spot price, more is the loss he makes. If upon expiration
the spot price of the underlying is less than the strike price, the buyer lets his option expire unexercised and the writer gets to keep the premium. Figure gives the payoff for the writer of a
three month call option (often referred to as short call) with a strike of 2250 sold at a premium of
86.60.
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Payoff for writer of call option
The figure shows the profits/losses for the seller of a three-month Nifty 2250 call option. As the
spot Nifty rises, the call option is in-the-money and the writer starts making losses. If upon
expiration, Nifty closes above the strike of 2250, the buyer would exercise his option on the
writer who would suffer a loss to the extent of the difference between the Nifty -close and the
strike price. The loss that can be incurred by the writer of the option is potentially unlimited,
whereas the maximum profit is limited to the extent of the up-front option premium of Rs.86.60
charged by him.
Payoff profile for buyer of put options: Long put
A put option gives the buyer the right to sell the underlying asset at the strike price specified in
the option. The profit/loss that the buyer makes on the option depends on the spot price of the
underlying. If upon expiration, the spot price is below the strike price, he makes a profit. Lower
the spot price more is the profit he makes. If the spot price of the underlying is higher than the
strike price, he lets his option expire un-exercised. His loss in this case is the premium he paid
for buying the option. Figure gives the payoff for the buyer of a three month put option (often
referred to as long put) with a strike of 2250 bought at a premium of 61.70.
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Payoff for buyer of put option
The figure shows the profits/losses for the buyer of a three-month Nifty 2250 put option. As can
be seen, as the spot Nifty falls, the put option is in-the-money. If upon expiration, Nifty closes
below the strike of 2250, the buyer would exercise his option and profit to the extent of the
difference between the strike price and Nifty-close. The profits possible on this option can be as
high as the strike price. However if Nifty rises above the strike of 2250, he lets the option expire.
His losses are limited to the extent of the premium he paid for buying the option.
Payoff profile for writer of put options: Short put
A put option gives the buyer the right to sell the underlying asset at the strike price specified in
the option. For selling the option, the writer of the option charges a premium. The profit/loss that
the buyer makes on the option depends on the spot price of the underlying. Whatever is the
buyer's profit is the seller's loss. If upon expiration, the spot price happens to be below the strike
price, the buyer will exercise the option on the writer. If upon expiration the spot price of the
underlying is more than the strike price, the buyer lets his option unexercised and the writer gets
to keep the premium. Figure gives the payoff for the writer of a three month put option (often
referred to as short put) with a strike of 2250 sold at a premium of 61.70.
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Payoff for writer of put option
The figure shows the profits/losses for the seller of a three-month Nifty 2250 put option. As the
spot Nifty falls, the put option is in-the-money and the writer starts making losses. If upon
expiration, Nifty closes below the strike of 2250, the buyer would exercise his option on the
writer who would suffer a loss to the extent of the difference between the strike price and Niftyclose. The loss that can be incurred by the writer of the option is a maximum extent of the strike
price (Since the worst that can happen is that the asset price can fall to zero) whereas the
maximum profit is limited to the extent of the up-front option premium of Rs.61.70 charged by
him.
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Other Option Strategies
1. Synthetic Long Call
An investor purchasing a put while at the same time purchasing an equivalent number of shares
of the underlying stock is establishing a "married put" position - a hedging strategy with a name
from an old IRS ruling.
 Market Opinion
Bullish to Very Bullish
 When to Use
The investor employing the married put strategy wants the benefits of stock ownership
(dividends, voting rights, etc.), but has concerns about unknown, near-term, downside market
risks. Purchasing puts with the purchase of shares of the underlying stock is a directional and
bullish strategy. The primary motivation of this investor is to protect his shares of the underlying
security from a decrease in market price. He will generally purchase a number of put contracts
equivalent to the number of shares held.
 Benefit
While the married put investor retains all benefits of stock ownership, he has "insured" his shares
against an unacceptable decrease in value during the lifetime of the put, and has a limited,
predefined, downside market risk. The premium paid for the put option is equivalent to the
premium paid for an insurance policy. No matter how much the underlying stock decreases in
value during the option's lifetime, the investor has a guaranteed selling price for the shares at the
put's strike price. If there is a sudden, significant decrease in the market price of the underlying
stock, a put owner has the luxury of time to react. Alternatively, a previously entered stop loss
limit order on the purchased shares might be triggered at a time and at a price unacceptable to the
investor. The put contract has conveyed to him a guaranteed selling price, and control over when
he chooses to sell his stock.
 Risk vs. Reward
Maximum Profit: Unlimited
Maximum Loss: Limited (Stock Purchase Price - Strike Price + Premium Paid)
Upside Profit at Expiration: Gains in underlying share value - Premium Paid
Your maximum profit depends only on the potential price increase of the underlying security; in
theory it is unlimited. When the put expires, if the underlying stock closes at the price originally
paid for the shares, the investor's loss would be the entire premium paid for the put.
 Break-Even-Point (BEP)
BEP: Stock Purchase Price + Premium Paid
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 Volatility
If Volatility Increases: Positive Effect
If Volatility Decreases: Negative Effect
Any effect of volatility on the option's total premium is on the time value portion.
 Time Decay
Passage of Time: Negative Effect
The time value portion of an option's premium, which the option holder has "purchased" when
paying for the option, generally decreases, or decays, with the passage of time. This decrease
accelerates as the option contract approaches expiration. A market observer will notice that time
decay for puts occurs at a slightly slower rate than with calls.
EXAMPLE:
Mr. XYZ is bullish about ABC Ltd stock. He buys ABC Ltd. at current market price of Rs.
4900 on 4th July. To protect against fall in the price of ABC Ltd. (his risk),he buys an ABC
Ltd. Put option with a strike price Rs. 4800 (OTM) at a premium of Rs. 125 expiring on
31st July.
Strategy: Buy Stock + Buy Put Option
Buy Stock (Mr. XYZ pays) 4900
Current Market Price of ABC Ltd. (Rs.) 4900
Strike Price (Rs.) 4800
Buy Put (Mr. XYZ pays) 4800
Premium (Rs.) 125
Break Even Point (Rs.) (Put Strike Price + Put
Premium + Stock Price – Put Strike Price)* 5025
* Break even is from the point of view of Mr. XYZ. He has to recover the cost of the Put Option
purchase price + the stock price to break even.
ANALYSIS: This is a low risk strategy. This is a strategy which limits the loss in case of fall in
market but the potential profit remains unlimited when the stock price rises. A good strategy
when you buy a stock for medium or long term, with the aim of protecting any downside risk.
The pay-off resembles a Call Option buy and is therefore called as Synthetic Long Call.
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Synthetic Long Call
300
200
100
0
Payoff
4500
4600
4700
4800
4900
5000
5100
5200
5300
-100
-200
-300
2. Covered Call
The covered call is a strategy in which an investor writes a call option contract while at the same
time owning an equivalent number of shares of the underlying stock. If this stock is purchased
simultaneously with writing the call contract, the strategy is commonly referred to as a "buywrite." If the shares are already held from a previous purchase, it is commonly referred to an
"overwrite." In either case, the stock is generally held in the same brokerage account from which
the investor writes the call, and fully collateralizes, or "covers," the obligation conveyed by
writing a call option contract. This strategy is the most basic and most widely used strategy
combining the flexibility of listed options with stock ownership.
 Market Opinion
Neutral to Bullish on the Underlying Stock
 When to Use
Though the covered call can be utilized in any market condition, it is most often employed when
the investor, while bullish on the underlying stock, feels that its market value will experience
little range over the lifetime of the call contract. The investor desires to either generate additional
income (over dividends) from shares of the underlying stock, and/or provide a limited amount of
protection against a decline in underlying stock value.
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 Benefit
While this strategy can offer limited protection from a decline in price of the underlying stock
and limited profit participation with an increase in stock price, it generates income because the
investor keeps the premium received from writing the call. At the same time, the investor can
appreciate all benefits of underlying stock ownership, such as dividends and voting rights, unless
he is assigned an exercise notice on the written call and is obligated to sell his shares. The
covered call is widely regarded as a conservative strategy because it decreases the risk of stock
ownership.
 Risk vs. Reward
Maximum Profit: Limited
Maximum Loss: Substantial
Upside Profit at Expiration if Assigned: Premium Received + Difference (if any) Between
Strike Price and Stock Purchase Price
Upside Profit at Expiration if Not Assigned: Any Gains in Stock Value + Premium Received
Maximum profit will occur if the price of the underlying stock you own is at or above the call
option's strike price, either at its expiration or when you might be assigned an exercise notice for
the call before it expires. The risk of real financial loss with this strategy comes from the shares
of stock held by the investor. This loss can become substantial if the stock price continues to
decline in price as the written call expires. At the call's expiration, loss can be calculated as the
original purchase price of the stock less its current market price, less the premium received from
initial sale of the call. Any loss accrued from a decline in stock price is offset by the premium
you received from the initial sale of the call option. As long as the underlying shares of stock are
not sold, this would be an unrealized loss. Assignment on a written call is always possible. An
investor holding shares with a low cost basis should consult his tax advisor about the tax
ramifications of writing calls on such shares.
 Break-Even-Point (BEP)
BEP: Stock Purchase Price - Premium Received
 Volatility
If Volatility Increases: Negative Effect
If Volatility Decreases: Positive Effect
Any effect of volatility on the option's price is on the time value portion of the option's premium.
 Time Decay
Passage of Time: Positive Effect
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With the passage of time, the time value portion of the option's premium generally decreases - a
positive effect for an investor with a short option position.
EXAMPLE:
Mr. A bought XYZ Ltd. for Rs 4900 and simultaneously sells a Call option at a strike price
of Rs 5000. Which means Mr. A does not think that the price of XYZ Ltd. will rise above
Rs.5000. However, in case it rises above Rs. 5000, Mr. A does not mind getting exercise at
that price and exiting the stock at Rs. 5000. Mr. A receives a premium of Rs 125 for selling
the Call. Thus net outflow to Mr. A is (Rs. 4900– Rs. 125) = Rs.4775. He reduces the cost of
buying the stock by this strategy.
If the stock price stays at or below Rs. 5000, the Call option will not get exercised and Mr.
A can retain the Rs. 80 premium, which is an extra income. If the stock price goes above Rs
5000, the Call option will get exercised by the Call buyer. The entire position will work like
this:
Strategy: Buy Stock + Sell Call Option
Mr. A buys the stock XYZ Ltd.
Market Price (Rs.) 4900
Call Options Strike Price (Rs.) 5000
Mr. A receives Premium (Rs.) 125
Break Even Point (Rs.) (Stock Price paid – Premium Received) 4775
Covered Call
300
200
100
0
4500
4600
4700
4800
4900
5000
-100
5100
5200
5300
Payoff
-200
-300
-400
-500
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3. Bull Call Spread
Establishing a bull call spread involves the purchase of a call option on a particular underlying
stock, while simultaneously writing a call option on the same underlying stock with the same
expiration month, at a higher strike price. Both the buy and the sell sides of this spread are
opening transactions, and are always the same number of contracts. This spread is sometimes
more broadly categorized as a "vertical spread": a family of spreads involving options of the
same stock, same expiration month, but different strike prices. They can be created with either all
calls or all puts, and be bullish or bearish. The bull call spread, as any spread, can be executed as
a"unit" in one single transaction, not as separate buy and sell transactions. For this bullish
vertical spread, a bid and offer for the whole package can be requested through your brokerage
firm from an exchange where the options are listed and traded.
 Market Opinion
Moderately Bullish to Bullish
 When to Use
Moderately Bullish
An investor often employs the bull call spread in moderately bullish market environments, and
wants to capitalize on a modest advance in price of the underlying stock. If the investor's opinion
is very bullish on a stock it will generally prove more profitable to make a simple call purchase.
Risk Reduction
An investor will also turn to this spread when there is discomfort with either the cost of
purchasing and holding the long call alone, or with the conviction of his bullish market opinion.
 Benefit
The bull call spread can be considered a doubly hedged strategy. The price paid for the call with
the lower strike price is partially offset by the premium received from writing the call with a
higher strike price. Thus, the investor's investment in the long call, and the risk of losing the
entire premium paid for it, is reduced or hedged.
On the other hand, the long call with the lower strike price caps or hedges the financial risk of
the written call with the higher strike price. If the investor is assigned an exercise notice on the
written call and must sell an equivalent number of underlying shares at the strike price, those
shares can be purchased at a predetermined price by exercising the purchased call with the lower
strike price. As a trade-off for the hedge it offers, this written call limits the potential maximum
profit for the strategy.
 Risk vs. Reward
Upside Maximum Profit: Limited (Difference between Strike Prices - Net Debit Paid)
Maximum Loss: Limited (Net Debit Paid)
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A bull call spread tends to be profitable when the underlying stock increases in price. It can be
established in one transaction, but always at a debit (net cash outflow). The call with the lower
strike price will always be purchased at a price greater than the offsetting premium received from
writing the call with the higher strike price. Maximum loss for this spread will generally occur as
the underlying stock price declines below the lower strike price. If both options expire out-ofthe-money with no value, the entire net debit paid for the spread will be lost.
The maximum profit for this spread will generally occur as the underlying stock price rises
above the higher strike price, and both options expire in-the-money. The investor can exercise
the long call, buy stock at its lower strike price, and sell that stock at the written call's higher
strike price if assigned an exercise notice. This will be the case no matter how high the
underlying stock has risen in price. If the underlying stock price is in between the strike prices
when the calls expire, the long call will be in-the-money and worth its intrinsic value. The
written call will be out-of-the-money, and have no value.
 Break-Even-Point (BEP)
BEP: Strike Price of Purchased Call + Net Debit Paid
 Volatility
If Volatility Increases: Effect Varies
If Volatility Decreases: Effect Varies
The effect of an increase or decrease in the volatility of the underlying stock may be noticed in
the time value portion of the options' premiums. The net effect on the strategy will depend on
whether the long and/or short options are in-the-money or out-of-the-money, and the time
remaining until expiration.
 Time Decay
Passage of Time: Effect Varies
The effect of time decay on this strategy varies with the underlying stock's price level in relation
to the strike prices of the long and short options. If the stock price is midway between the strike
prices, the effect can be minimal. If the stock price is closer to the lower strike price of the long
call, losses generally increase at a faster rate as time passes. Alternatively, if the underlying stock
price is closer to the higher strike price of the written call, profits generally increase at a faster
rate as time passes.
EXAMPLE:
Mr. XYZ buys a Nifty Call with a Strike price Rs. 4100 at a premium of Rs. 170.45 and he
sells a Nifty Call option with a strike price Rs. 4400 at a premium of Rs. 35.40. The net
debit here is Rs. 135.05 which is also his maximum loss.
Strategy: Buy a Call with a lower strike (ITM) +Sell a Call with a higher strike (OTM)
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Nifty index Current Value 4900
Buy ITM Call Option Strike Price (Rs.) 4800
Mr. XYZ Pays Premium (Rs.) 225
Sell OTM Call Option
Strike Price (Rs.) 5000
Mr. XYZ Receives Premium (Rs.) 125
Net Premium Paid (Rs.) 100
Break Even Point (Rs.) 4900
Bull Call Spread
150
100
50
0
Payoff
4500
4600
4700
4800
4900
5000
5100
5200
5300
-50
-100
-150
4. Bear Put Spread
Establishing a bear put spread involves the purchase of a put option on a particular underlying
stock, while simultaneously writing a put option on the same underlying stock with the same
expiration month, but with a lower strike price. Both the buy and the sell sides of this spread are
opening transactions, and are always the same number of contracts. This spread is sometimes
more broadly categorized as a "vertical spread": a family of spreads involving options of the
same stock, same expiration month, but different strike prices. They can be created with either all
calls or all puts, and is bullish or bearish. The bear put spread, as any spread; can be executed as
a "package" in one single transaction, not as separate buy and sell transactions. For this bearish
vertical spread, a bid and offer for the whole package can be requested through your brokerage
firm from an exchange where the options are listed and traded.
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 Market Opinion
Moderately Bearish to Bearish
 When to Use
Moderately Bearish
An investor often employs the bear put spread in moderately bearish market environments, and
wants to capitalize on a modest decrease in price of the underlying stock. If the investor's opinion
is very bearish on a stock it will generally prove more profitable to make a simple put purchase.
Risk Reduction
An investor will also turn to this spread when there is discomfort with either the cost of
purchasing and holding the long put alone, or with the conviction of his bearish market opinion.
 Benefit
The bear put spread can be considered a doubly hedged strategy. The price paid for the put with
the higher strike price is partially offset by the premium received from writing the put with a
lower strike price. Thus, the investor's investment in the long put and the risk of losing the entire
premium paid for it, is reduced or hedged.
On the other hand, the long put with the higher strike price caps or hedges the financial risk of
the written put with the lower strike price. If the investor is assigned an exercise notice on the
written put, and must purchase an equivalent number of underlying shares at its strike price, he
can sell the purchased put with the higher strike price in the marketplace. The premium received
from the put's sale can partially offset the cost of purchasing the shares from the assignment. The
net cost to the investor will generally be a price less than current market prices. As a trade-off for
the hedge it offers, this written put limits the potential maximum profit for the strategy.
 Risk vs. Reward
Downside Maximum Profit: Limited (Difference between Strike Prices - Net Debit Paid)
Maximum Loss: Limited (Net Debit Paid)
A bear put spread tends to be profitable if the underlying stock decreases in price. It can be
established in one transaction, but always at a debit (net cash outflow). The put with the higher
strike price will always be purchased at a price greater than the offsetting premium received from
writing the put with the lower strike price.
Maximum loss for this spread will generally occur as underlying stock price rises above the
higher strike price. If both options expire out-of-the-money with no value, the entire net debit
paid for the spread will be lost.
The maximum profit for this spread will generally occur as the underlying stock price declines
below the lower strike price, and both options expire in-the-money. This will be the case no
matter how low the underlying stock has declined in price. If the underlying stock is in between
the strike prices when the puts expire, the purchased put will be in-the-money, and be worth its
intrinsic value. The written put will be out-of-the-money, and have no value.
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 Break-Even-Point (BEP)
BEP: Strike Price of Purchased Put - Net Debit Paid
 Volatility
If Volatility Increases: Effect Varies
If Volatility Decreases: Effect Varies
The effect of an increase or decrease in either the volatility of the underlying stock may be
noticed in the time value portion of the options' premiums. The net effect on the strategy will
depend on whether the long and/or short options are in-the-money or out-of-the-money, and the
time remaining until expiration.
 Time Decay
Passage of Time: Effect Varies
The effect of time decay on this strategy varies with the underlying stock's price level in relation
to the strike prices of the long and short options. If the stock price is midway between the strike
prices, the effect can be minimal. If the stock price is closer to the higher strike price of the
purchased put, losses generally increase at a faster rate as time passes. Alternatively, if the
underlying stock price is closer to the lower strike price of the written put, profits generally
increase at a faster rate as time passes.
EXAMPLE:
Nifty is presently at 4900. Mr. XYZ expects Nifty to fall. He buys one Nifty ITM Put with a
strike price Rs. 5000 at a premium of Rs. 125 and sells one Nifty OTM Put with strike price
Rs. 4800 at a premium Rs.75.
Strategy: BUY A PUT with a higher strike (ITM) + SELL A PUT with a lower strike
(OTM)
Nifty index Current Value
Buy ITM Put Option Strike Price (Rs.) 5000
Mr. XYZ pays Premium (Rs.) 125
Sell OTM Put Option Strike Price (Rs.) 4800
Mr. XYZ receives Premium (Rs.) 75
Net Premium Paid (Rs.)
Break Even Point (Rs.)
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Bear Put Spread
200
150
100
50
Payoff
0
4500
4600
4700
4800
4900
5000
5100
5200
5300
-50
-100
5. Long Straddle
The long straddle is simply the simultaneous purchase of a long call and a long put on the same
underlying security with both options having the same expiration and same strike price. Because
the position includes both a long call and a long put, the investor in a straddle should have a
complete understanding of the risks and rewards associated with both long calls and long puts.
**Since the straddle involves two trades, a commission charge is likely for the purchase (and any
subsequent sale) of each position -- one commission for the call and one commission for the put.
 Market Opinion
Increasing volatility and large price swings in the underlying security. Potentially profit from a
big move, either up or down, in the underlying price during the life of the options.
 When to Use
Purchasing only long calls or only long puts is primarily a directional strategy. The long straddle
however, consisting of both long calls and long puts is not a directional strategy, rather it is one
where the investor feels large price swings are forthcoming but is unsure of the direction. This
strategy may prove beneficial when the investor feels large price movement, either up or down,
is imminent but is uncertain of the direction.
An instance of when a straddle may be considered is when the investor believes there is news
forthcoming. An example may be when one is anticipating news regarding a drug in trials from a
biotechnology company. The investor feels the news surrounding the drug will introduce large
price swings in the underlying but is unsure of whether this news will have a positive or negative
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impact on the price. If the news is positive, this may positively impact the price of the security. If
the news is disappointing, the stock could decline considerably. The risk is the stock remaining
at the strike price of the straddle until expiration.
 Benefit
A long straddle benefits when the price of the underlying moves above or below the break even
points. If a large price movement occurs outside of this range, significant profits can be realized.
If an increase in the implied volatility of the options outpaces time value erosion, likewise the
position could realize a profit.
 Risk vs. Reward
Maximum Profit: Theoretically unlimited to the upside; limited profits on the down side as the
stock can only decline to zero.
Maximum Loss: Limited and predetermined, but potentially significant, equal to the sum of the
two premiums paid (call premium plus put premium). Maximum loss occurs should the
underlying price equal the strike price of the options at expiration.
Upside Profit at Expiration: (Stock Price at expiration – total premium paid) – strike price.
Assuming Stock Price above BEP at expiration.
Downside Profit at Expiration: Strike price - (Stock price at expiration + total premium paid).
Assuming stock price is below BEP at expiration.
The maximum profit on the upside is theoretically unlimited as there is no theoretical limit on
how high a stock price can rise. The maximum downside profit is limited by the stock's potential
decrease to no less than zero. Though the potential loss is predetermined and limited in dollar
amount, it can be as much as 100% of the premiums initially paid for the straddle. Whatever
your motivation for purchasing the straddle is, weigh the potential reward against the potential
loss of the entire premium paid.
 Break-Even-Point (BEP)
BEP: Two break-even prices:
Strike Price + sum of call premium and put premium
Strike price – sum of call premium and put premium
 Volatility
If Volatility Increases: Positive Effect
If Volatility Decreases: Negative Effect
Any effect of volatility on the option's total premium is on the time value portion.
 Time Decay
Passage of Time: Negative Effect
The time value portion of an option's premium, which the option holder has "purchased" when
paying for the options, generally decreases, or decays, with the passage of time. This decrease
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accelerates as the option contract approaches expiration. A market observer will notice that time
decay for puts occurs at a slightly slower rate than with calls.
EXAMPLE:
Suppose Nifty is at 4900 on 27th April. An investor, Mr. A enters a long straddle by buying
a May Rs 4900 Nifty Put for Rs. 90 and a May Rs. 4900 Nifty Call for Rs. 100. The net
debit taken to enter the trade is Rs 190, which is also his maximum possible loss.
Strategy: Buy Put + Buy Call
Nifty index Current Value 4900
Call and Put Strike Price (Rs.) 4900
Mr. A pays Total Premium (Call + Put) (Rs.) 190
Break Even Point (Rs.) 5090(U) (Rs.) 4710(L)
Long Straddle
400
300
200
100
Payoff
0
4500
4600
4700
4800
4900
5000
5100
5200
5300
5400
-100
-200
-300
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6. Long Strangle
The long strangle is simply the simultaneous purchase of a long call and a long put on the same
underlying security with both options having the same expiration but where the put strike price is
lower than the call strike price. Because the position includes both a long call and a long put, the
investor using a long strangle should have a complete understanding of the risks and rewards
associated with both long calls and long puts.
**Since the strangle involves two trades, a commission charge is likely for the purchase (and any
subsequent sale) of each position; one commission for the call and one commission for the put
and commission charges may significantly impact the breakeven and the potential profit/loss of
the strategy.
 Comparable Strategy
The long strangle is similar to the long straddle. However, while the straddle uses the same strike
price for the call and the put, the strangle uses different strikes. In the case of the strangle, the put
strike is below the call strike. As a result, whereas the straddle expires worthless only if the stock
price equals the strike price, the long strangle expires worthless if the underlying price is at or
between the strike prices at expiration. The strangle will generally provide more leverage when
compared to a straddle as it is normally less expensive to purchase a strangle than a straddle.
 Market Opinion
Increasing volatility and extremely large price swings in the underlying security. Potentially
profit from a large move, either up or down, in the underlying price during the life of the options.
 When to Use
Purchasing only long calls or only long puts is primarily a directional strategy. The long strangle
however, consisting of both long calls and long puts is a not a directional strategy, rather one
where the investor feels extremely large price swings are forthcoming but is unsure of the
direction. This strategy may prove beneficial when the investor feels large price movement,
either up or down, is about to happen but uncertain of the direction.
An instance of when a strangle may be considered is when an earnings announcement is
forthcoming. The investor feels the projected announcement will introduce large price swings in
the underlying. If the earnings announcement and future outlook is positive, this may positively
impact the price of the security. If the earnings announcement and outlook is negative, or fails to
impress investors, the stock could decline considerably. The risk is the stock remains stable or
between the strike price of the call and strike price of the put until expiration. Another risk is that
the stock's move does not produce a corresponding option price increase that is enough to cover
the two premiums paid for the position. Declining implied volatility will also negatively impact
this strategy.
 Benefit
A long strangle benefits when the price of the underlying moves above or below the break even
points. If a large price movement occurs outside of this range, significant profits can be realized.
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If an increase in the implied volatility of the options outpaces time value erosion, likewise the
position could realize a profit.
 Risk vs. Reward
Maximum Profit: Theoretically unlimited to the upside; limited profits on the down side as the
stock can only decline to zero.
Maximum Loss: Limited and predetermined, but potentially significant, equal to the sum of the
two premiums paid (call premium plus put premium). Maximum loss occurs if the underlying
price is between the strike price of the call and put options at expiration.
Upside Profit at Expiration: (Stock Price at expiration – total premium paid) – call strike price.
Assuming Stock Price above BEP at expiration.
Downside Profit at Expiration: Put strike price - (Stock price at expiration + total premium
paid).
Assuming stock price is below BEP at expiration.
The maximum profit on the upside is theoretically unlimited as there is no theoretical limit on
how high a stock price can rise. The maximum downside profit is limited by the stock's potential
decrease to no less than zero. Though the potential loss is predetermined and limited in dollar
amount, it can be as much as 100% of the premiums initially paid for the strangle. Whatever
your motivation for purchasing the strangle is, weigh the potential reward against the potential
loss of the entire premium paid.
 Break-Even-Point (BEP)
BEP: Two break-even prices:
Call strike price + sum of call premium and put premium
Put strike price – sum of call premium and put premium
 Volatility
If Volatility Increases: Positive Effect
If Volatility Decreases: Negative Effect
Any effect of volatility on the option's total premium is on the time value portion.
 Time Decay
Passage of Time: Negative Effect
The time value portion of an option's premium, which the option holder has "purchased" when
paying for the options, generally decreases, or decays, with the passage of time. This decrease
accelerates as the option contract approaches expiration. A market observer will notice that time
decay for puts occurs at a slightly slower rate than with calls.
EXAMPLE:
Suppose Nifty is at 4900 in May. An investor, Mr. A, executes a Long Strangle by buying a
Rs. 4800 Nifty Put for a premium of Rs. 100 and a Rs 5000 Nifty Call for Rs 125. The net
debit taken to enter the trade is Rs. 225, which is also his maximum possible loss.
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Strategy: Buy OTM Put + Buy OTM Call
Nifty index Current Value 4900
Buy Call Option Strike Price (Rs.) 5000
Mr. A pays Premium (Rs.) 125
Break Even Point (Rs.) 5225
Buy Put Option Strike Price (Rs.) 4800
Mr. A pays Premium (Rs.) 100
Break Even Point (Rs.) 4575
Long Strangle
200
150
100
50
0
4500
4600
4700
4800
4900
5000
5100
5200
5300
5400
Payoff
-50
-100
-150
-200
-250
7. Short Straddle
A trader establishes a short straddle by simultaneously selling a put option and a call option at
the same strike price and expiration date. A short straddle is a bet that implied volatility will
decrease or that the price of the underlying will not move substantially during the life of the
options. If the price of the underlying asset increases or decreases quickly during the life of the
option then the position will incur a loss. Otherwise the profit will be equal to the amount of
premium collected when the position is established.
As opposed to its high volatility counterpart, the long straddle, the short straddle is a high risk,
low volatility, limited return options strategy. The short straddle involves selling one at the
money call and put short at the same strike price and expiration date with the expectation that the
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stock will remain relatively neutral until the expiration of both options. The short straddle is a
play on the time decay, or theta, of an option.
 When to use
When you are bearish on volatility and think market prices will remain stable.
 Volatility
An increase in volatility is a negative for the spread. The impact will depend to a large part on
both the amount of time left until expiration and the price of XYZ relative to the strike price.
Because an increase in volatility can have a large negative impact, it is important that the implied
volatilities of XYZ's options be near historic highs before an investor consider writing a straddle!
 Break Even Point
Breakeven on the Downside (*b1) = Strike Price - Call Premium - Put Premium
Breakeven on the Upside (*b2) = Strike Price + Call Premium + Put Premium
Risk = Unlimited on when stock moves above or below breakeven points.
A short straddle will always have a maximum profit potential equaling the premiums received
from selling the straddle
Maximum Profit Potential = Call Premium + Put Premium
For more precision, we can use the following formula to determine the gain or loss at expiration.
Profit/Loss at Expiration = Call Premium + Put Premium - Absolute Value(Security Closing
Price - Strike Price)
Straddles are a neutral strategy with a high range of risk and limited reward.
 How it works?
You are looking at a stock not expected to show short-term volatility. The short straddle requires
you to buy the call option and the put option at the current strike price. If the stock stays put, you
make money. If it moves in either direction you have less profit or face a big loss.
 Payoff
It's a double win, if the price stays the same.
 Drawback
If the stock moves big, either up or down, you could lose big. For a less-risky strategy, a long
butterfly has the same objectives, but less risk.
The short strangle is similar to the short straddle and does the opposite of the long strangle. The
short strangle is a medium to high risk, limited reward, low volatility options strategy. The
strategy is to sell OTM puts and OTM calls, with the same expiration date but different strike
prices, which are equidistant from the current price of the underlying security.
 Always remember
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Anything can happen and be prepared if it does. Being short an option is very dangerous if the
underlying goes against you dramatically. Remember our discussion on option deltas; once a
stock moves above its call strike, the delta starts to increase dramatically and especially so when
the stock is closer to expiration. Think about buy stopping the security if it moves above the call
strike price. You will at least be able to hedge some of the potential losses. Conversely, if the
security would move below the put strike, you may want to consider shorting the stock to offset
potential downside risk of the strangle.
EXAMPLE:
Suppose Nifty is at 4900 on 27th April. An investor, Mr. A, enters into a short straddle by selling
a May Rs 4900 Nifty Put for Rs. 90 and a May Rs. 4900 Nifty Call for Rs. 100. The net credit
received is Rs. 190, which is also his maximum possible profit.
Strategy: Sell Put + Sell Call
Nifty index Current Value 4900
Call and Put Strike Price (Rs.) 4900
Mr. A receives Total Premium (Call + Put) (Rs.) 190
Break Even Point (Rs.)*5090 (U) (Rs.)*4710 (L)
* From buyer’s point of view
Short Straddle
300
200
100
0
4500
4600
4700
4800
4900
5000
5100
5200
5300
5400
Payoff
-100
-200
-300
-400
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8. Short Strangle
The short strangle, also known as sell strangle, is a neutral strategy in options trading that
involves the simultaneous selling of a slightly out-of-the-money put and a slightly out-of-themoney call of the same underlying stock and expiration date.
The short strangle option strategy is a limited profit, unlimited risk options trading strategy that
is taken when the options trader thinks that the underlying stock will experience little volatility in
the near term. Short strangles are credit spreads as a net credit is taken to enter the trade.
The short strangle is similar to the short straddle and does the opposite of the long strangle. The
short strangle is a medium to high risk, limited reward, low volatility options strategy. The
strategy is to sell OTM puts and OTM calls, with the same expiration date but different strike
prices, which are equidistant from the current price of the underlying security.
Risk = Unlimited on when stock moves above or below breakeven points.
 Breakeven point(s)
There are 2 break-even points for the short strangle position. The breakeven points can be
calculated using the following formulae.
Upper Breakeven Point=Strike Price of Short Call+ Net Premium Received
Lower Breakeven Point=Strike Price of Short Put-Net Premium Received
 Gain/Loss Scenarios
1) When the security is trading above the put strike and below the call strike, both options that
were shorted expire worthless. Profit = put premium received + call premium received
2) Profit/Loss Scenario - Security Moves Higher than Call Strike = Call Premium + Put
Premium - Security Closing Price + Call Strike
3) Profit/Loss Scenario - Security Moves Lower than Put Strike = Call Premium + Put Premium
- Put Strike + Security Closing Price
Always remember, anything can happen and be prepared if it does. Being short an option is very
dangerous if the underlying goes against you dramatically. Remember our discussion on option
deltas; once a stock moves above its call strike, the delta starts to increase dramatically and
especially so when the stock is closer to expiration. Think about buy stopping the security if it
moves above the call strike price. You will at least be able to hedge some of the potential losses.
Conversely, if the security would move below the put strike, you may want to consider shorting
the stock to offset potential downside risk of the strangle.
EXAMPLE:
Suppose Nifty is at 4900 in May. An investor, Mr. A, executes a Short Strangle by selling a Rs.
4800 Nifty Put for a premium of Rs. 100 and a Rs. 5000 Nifty Call for Rs 125. The net credit is
Rs. 225, which is also his maximum possible gain.
Strategy: Sell OTM Put + Sell OTM Call
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Nifty index Current Value 4900
Sell Call Option Strike Price (Rs.) 5000
Mr. A receives Premium (Rs.) 125
Break Even Point (Rs.) 5225
Sell Put Option Strike Price (Rs.) 4800
Mr. A receives Premium (Rs.) 100
Break Even Point (Rs.) 4575
Short Strangle
250
200
150
100
50
Payoff
0
4500
4600
4700
4800
4900
5000
5100
5200
5300
5400
-50
-100
-150
-200
APPLICATION OF OPTIONS
We look here at some applications of options contracts. We refer to single stock options here.
However since the index is nothing but a security whose price or level is a weighted average of
securities constituting the index, all strategies that can be implemented using stock futures can
also be implemented using index options.
Hedging: Have underlying buy puts
Owners of stocks or equity portfolios often experience discomfort about the overall stock market
movement. As an owner of stocks or an equity portfolio, sometimes you may have a view that
stock prices will fall in the near future. At other times you may see that the market is in for a few
days or weeks of massive volatility, and you do not have an appetite for this kind of volatility.
The union budget is a common and reliable source of such volatility: market volatility is always
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enhanced for one week before and two weeks after a budget. Many investors simply do not want
the fluctuations of these three weeks. One way to protect your portfolio from potential downside
due to a market drop is to buy insurance using put options.
Index and stock options are a cheap and easily implementable way of seeking this insurance. The
idea is simple. To protect the value of your portfolio from falling below a particular level, buy
the right number of put options with the right strike price. If you are only concerned about the
value of a particular stock that you hold, buy put options on that stock. If you are concerned
about the overall portfolio, buy put options on the index. When the stock price falls your stock
will lose value and the put options bought by you will gain, effectively ensuring that the total
value of your stock plus put does not fall below a particular level. This level depends on the
strike price of the stock options chosen by you. Similarly when the index falls, your portfolio
will lose value and the put options bought by you will gain, effectively ensuring that the value of
your portfolio does not fall below a particular level. This level depends on the strike price of the
index options chosen by you. Portfolio insurance using put options is of particular interest to
mutual funds who already own well-diversified portfolios. By buying puts, the fund can limit its
downside in case of a market fall.
Speculation: Bullish security, buy calls or sell puts
There are times when investors believe that security prices are going to rise. For instance, after a
good budget, or good corporate results, or the onset of a stable government. How does one
implement a trading strategy to benefit from an upward movement in the underlying security?
Using options there are two ways one can do this:
1. Buy call options; or
2. Sell put options
We have already seen the payoff of a call option. The downside to the buyer of the call option is
limited to the option premium he pays for buying the option. His upside however is potentially
unlimited. Suppose you have a hunch that the price of a particular security is going to rise in a
month’s time. Your hunch proves correct and the price does indeed rise, it is this upside that you
cash in on. However, if your hunch proves to be wrong and the security price plunges down,
what you lose is only the option premium. Having decided to buy a call, which one should you
buy? Given that there are a number of one-month calls trading, each with a different strike price,
the obvious question is: which strike should you choose?
Let us take a look at call options with different strike prices. Assume that the current price level
is 1250, risk-free rate is 12% per year and volatility of the underlying security is 30%. The
following options are available:
1. A one month call with a strike of 1200.
2. A one month call with a strike of 1225.
3. A one month call with a strike of 1250.
4. A one month call with a strike of 1275.
5. A one month call with a strike of 1300.
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Which of these options you choose largely depends on how strongly you feel about the
likelihood of the upward movement in the price, and how much you are willing to lose should
this upward movement not come about. There are five one-month calls and five one-month puts
trading in the market. The call with a strike of 1200 is deep in-the-money and hence trades at a
higher premium. The call with a strike of 1275 is out-of-the-money and trades at a low premium.
The call with a strike of 1300 is deep-out-of-money. Its execution depends on the unlikely event
that the underlying will rise by more than 50 points on the expiration date.
Hence buying this call is basically like buying a lottery. There is a small probability that it may
be in-the-money by expiration, in which case the buyer will make profits. In the more likely
event of the call expiring out-of-the-money, the buyer simply loses the small premium amount of
Rs.27.50.As a person who wants to speculate on the hunch that prices may rise, you can also do
so by selling or writing puts. As the writer of puts, you face a limited upside and an unlimited
downside. If prices do rise, the buyer of the put will let the option expire and you will earn the
premium. If however your hunch about an upward movement proves to be wrong and prices
actually fall, then your losses directly increase with the falling price level. If for instance the
price of the underlying falls to 1230 and you've sold a put with an exercise of 1300, the buyer of
the put will exercise the option and you'll end up losing Rs.70. Taking into account the premium
earned by you when you sold the put, the net loss on the trade is Rs.5.20.Having decided to write
a put, which one should you write? Given that there are a number of one-month puts trading,
each with a different strike price, the obvious question is: which strike should you choose? This
largely depends on how strongly you feel about the likelihood of the upward movement in the
prices of the underlying. If you write an at-the-money put, the option premium earned by you
will be higher than if you write an out-of-the-money put. However the chances of an at-themoney put being exercised on you are higher as well.
One month calls and puts trading at different strikes
The spot price is 1250. There are five one-month calls and five one-month puts trading in the
market. The call with a strike of 1200 is deep in-the-money and hence trades at a higher
premium. The call with a strike of 1275 is out-of-the-money and trades at a low premium. The
call with a strike of 1300 is deep-out-of-money. Its execution depends on the unlikely event that
the price of underlying will rise by more than 50 points on the expiration date. Hence buying this
call is basically like buying a lottery. There is a small probability that it may be in-the-money by
expiration in which case the buyer\ will profit. In the more likely event of the call expiring outof-the-money, the buyer simply loses the small premium amount of Rs. 27.50. Figure 4.10 shows
the payoffs from buying calls at different strikes. Similarly, the put with a strike of 1300 is deep
in-the-money and trades at a higher premium than the at-the-money put at a strike of 1250. The
put with a strike of 1200 is deep out-of-the-money and will only be exercised in the unlikely
event that underlying falls by 50 points on the expiration date.
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Figure shows the payoffs from writing puts at different strikes.
Underlying Strike price of option Call Premium(Rs.) Put Premium(Rs.)
1250
1250
1250
1250
1250
1200
1225
1250
1275
1300
80/10
63.65
49.45
37.50
27.50
18.15
26.50
37.00
49.80
64.80
In the example in Figure, at a price level of 1250, one option is in-the-money and one is out-ofthe-money. As expected, the in-the-money option fetches the highest premium of Rs.64.80
whereas the out-of-the-money option has the lowest premium of Rs. 18.15.
Payoff for buyer of call options at various strikes
The figure shows the profits/losses for a buyer of calls at various strikes. The in-the-money
option with a strike of 1200 has the highest premium of Rs.80.10 whereas the out-of-the-money
option with a strike of 1300 has the lowest premium of Rs.27.50.
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Payoff for writer of put options at various strikes
The figure shows the profits/losses for a writer of puts at various strikes. The in-the- money
option with a strike of 1300 fetches the highest premium of Rs.64.80 whereas the out-of-themoney option with a strike of 1200 has the lowest premium of Rs. 18.15.
Speculation: Bearish security, sell calls or buy puts
Do you sometimes think that the market is going to drop? That you could make a profit by
adopting a position on the market? Due to poor corporate results, or the instability of the
government, many people feel that the stocks prices would go down. How does one implement a
trading strategy to benefit from a downward movement in the market? Today, using options, you
have two choices:
1. Sell call options; or
2. Buy put options
We have already seen the payoff of a call option. The upside to the writer of the call option is
limited to the option premium he receives upright for writing the option. His downside however
is potentially unlimited. Suppose you have a hunch that the price of a particular security is going
to fall in a month’s time. Your hunch proves correct and it does indeed fall, it is this downside
that you cash in on. When the price falls, the buyer of the call lets the call expire and you get to
keep the premium. However, if your hunch proves to be wrong and the market soars up instead,
what you lose is directly proportional to the rise in the price of the security.
Having decided to write a call, which one should you write? Table 4.2 gives the premiums for
one month calls and puts with different strikes. Given that there are a number of one-month calls
Thakur Institute of Management Studies and Research
Page 55
trading, each with a different strike price, the obvious question is: which strike should you
choose? Let us take a look at call options with different strike prices. Assume that the current
stock price is 1250, risk-free rate is 12% per year and stock volatility is 30%. You could write
the following options:
1. A one month call with a strike of 1200.
2. A one month call with a strike of 1225.
3. A one month call with a strike of 1250.
4. A one month call with a strike of 1275.
5. A one month call with a strike of 1300.
Which of these options you write largely depends on how strongly you feel about the likelihood
of the downward movement of prices and how much you are willing to lose should this
downward movement not come about. There are five one-month calls and five one-month puts
trading in the market. The call with a strike of 1200 is deep in-the-money and hence trades at a
higher premium. The call with a strike of 1275 is out-of-the-money and trades at a low premium.
The call with a strike of 1300 is deep-out-of-money. Its execution depends on the unlikely event
that the stock will rise by more than 50 points on the expiration date. Hence writing this call is a
fairly safe bet. There is a small probability that it may be in-the-money by expiration in which
case the buyer exercises and the writer suffers losses to the extent that the price is above 1300. In
the more likely event of the call expiring out-of- the-money, the writer earns the premium
amount ofRs.27.50.
As a person who wants to speculate on the hunch that the market may fall, you can also buy puts.
As the buyer of puts you face an unlimited upside but a limited downside. If the price does fall,
you profit to the extent the price falls below the strike of the put purchased by you. If however
your hunch about a downward movement in the market proves to be wrong and the price actually
rises, all you lose is the option premium. If for instance the security price rises to 1300 and
you've bought a put with an exercise of 1250, you simply let the put expire. If however the price
does fall to say 1225 on expiration date, you make a neat profit of Rs.25.
Having decided to buy a put, which one should you buy? Given that there are a number of onemonth puts trading, each with a different strike price, the obvious question is: which strike
should you choose? This largely depends on how strongly you feel about the likelihood of the
downward movement in the market. If you buy an at-the-money put, the option premium paid by
you will be higher than if you buy an out-of-the-money put. However the chances of an at-themoney put expiring in-the-money are higher as well.
One month calls and puts trading at different strikes
The spot price is 1250. There are five one-month calls and five one-month puts trading in the
market. The call with a strike of 1200 is deep in-the-money and hence trades at a higher
premium. The call with a strike of 1275 is out-of-the-money and trades at a low premium. The
call with a strike of 1300 is deep-out-of- money. Its execution depends on the unlikely event that
the price will rise by more than 50 points on the expiration date. Hence writing this call is a fairly
safe bet. There is a small probability that it may be in-the-money by expiration in which case the
Thakur Institute of Management Studies and Research
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buyer exercises and the writer suffers losses to the extent that the price is above 1300. In the
more likely event of the call expiring out-of-the-money, the writer earns the premium amount of
Rs.27.50. Figure 4.12 shows the payoffs from writing calls at different strikes. Similarly, the put
with a strike of 1300 is deep in-the-money and trades at a higher premium than the at-the-money
put at a strike of 1250. The put with a strike of 1200 is deep out-of-the-money and will only be
exercised in the unlikely event that the price falls by 50 points on the expiration date. The choice
of which put to buy depends upon how much the speculator expects the market to fall.
Underlying
1250
1250
1250
1250
1250
Strike price of option
1200
1225
1250
1275
1300
Call Premium(Rs.)
80.10
63.65
49.45
37.50
27.50
Put Premium(Rs.)
18.15
26.50
37.00
49.80
64.80
Payoff for seller of call option at various strikes
The figure shows the profits/losses for a seller of calls at various strike prices. The in-the-money
option has the highest premium of Rs.80.10 whereas the out-of-the-money option has the lowest
premium of Rs. 27.50.
Payoff for buyer of put options at various strikes
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The figure shows the profits/losses for a buyer of puts at various strike prices. The in-the-money
option has the highest premium of Rs.64.80 whereas the out-of-the-money option has the lowest
premium of Rs. 18.50.
RELATION
BETWEEN
VOLUME & PRICE
OPEN
INTEREST,
OPEN INTEREST
 Open Interest is the total number of outstanding contracts that are held by market
participants at the end of the day.
 It can also be defined as the total number of futures contracts or option contracts that
have not yet been exercised (squared off), expired, or fulfilled by delivery.
 Open interest measures the flow of money into the futures & options market. For each
seller of a futures contract there must be a buyer of that contract. Thus a seller and a
buyer combine to create only one contract.
 Therefore, to determine the total open interest for any given market we need only to
know the totals from one side or the other, buyers or sellers, not the sum of both.
Price
Increase
Increase
Increase
Decrease
Decrease
Decrease
Open Interest
Increase
Decrease
Decrease
Increase
Decrease
Decrease
Volume
Increase
Increase
Decrease
Increase
Increase
Decrease
Trend
Strong Uptrend
Covering Short Position
Weak Uptrend
Strong Downtrend
Liquidating Long Position
Weak Downtrend
Thakur Institute of Management Studies and Research
View
Bullish
Bullish
Bearish
Bearish
Bearish
Bullish
Action
Go Long
Go Long
Go Short
Go Short
Go Short
Go Long
Page 58
CHARGES
The maximum brokerage chargeable by a trading member in relation to trades affected in the
contracts admitted to dealing on the F&O segment of NSE is fixed at 2.5% of the contract value
in case of index futures and stock futures. In case of index options and stock options it is 2.5% of
notional value of the contract [(Strike Price + Premium) * Quantity)], exclusive of statutory
levies. The transaction charges payable to the exchange by the trading member for the trades
executed by him on the F&O segment are fixed at the rate of Rs. 2 per lac of turnover (0.002%)
subject to a minimum of Rs.1 lac per year. However for the transactions in the options subsegment the transaction charges are levied on the premium value at the rate of 0.05% (each side)
instead of on the strike price as levied earlier. Further to this, trading members have been advised
to charge brokerage from their clients on the Premium price (traded price) rather than Strike
price. The trading members contribute to Investor Protection Fund of F&O segment at the rate of
Re. 1/- per Rs. 100 crores of the traded value (each side).
Thakur Institute of Management Studies and Research
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WORK AT ANUGRAH STOCK BROKING LTD
Application of Strategies in current scenario
1. Ratio Bull Call Spread
Date
900
8-Jun-10
9-Jun-10
10-Jun-10
11-Jun-10
14-Jun-10
15-Jun-10
16-Jun-10
17-Jun-10
18-Jun-10
21-Jun-10
22-Jun-10
23-Jun-10
24-Jun-10
Short Nifty Call 18 Lots (Strike Price 5200) Premium Received
900@33.30 = 29970
Premium
Days Profit/Loss
Rs.
Total Profit/Loss
33.3
21.3
12
10800
10800
25
-3.7
-3330
7470
39.3
-14.3 -12870
-5400
35.35
3.95
3555
-1845
64.65
-29.3 -26370
-28215
71
-6.35
-5715
-33930
68.05
2.95
2655
-31275
102.5
-34.45 -31005
-62280
77.5
25
22500
-39780
154.6
-77.1 -69390
-109170
125.25
29.35
26415
-82755
130.9
-5.65
-5085
-87840
120.1
10.8
9720
-78120
Long Nifty Call 5 Lots (Strike Price 5000) Premium Paid 250@120 = 30000
Date
Premium Days Profit/Loss
Rs.
Total Profit/Loss
120
250
8-Jun-10
94
-26
-6500
-6500
9-Jun-10
108.3
14.3
3575
-2925
10-Jun-10
150.3
42
10500
7575
11-Jun-10
157
6.7
1675
9250
14-Jun-10
220
63
15750
25000
15-Jun-10
238
18
4500
29500
16-Jun-10
234.4
-3.6
-900
28600
17-Jun-10
287.05
52.65 13162.5
41762.5
18-Jun-10
261
-26.05 -6512.5
35250
21-Jun-10
354
93
23250
58500
22-Jun-10
323
-31
-7750
50750
23-Jun-10
333.8
10.8
2700
53450
24-Jun-10
321.4
-12.4
-3100
50350
Thakur Institute of Management Studies and Research
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Net
Profit/Loss
4300
4545
2175
7405
-3215
-4430
-2675
-20517.5
-4530
-50670
-32005
-34390
-27770
Nifty
Close
4987.1
5000.3
5078.6
5119.35
5197.7
5222.35
5233.35
5274.85
5262.6
5353.3
5316.55
5323.15
5320.6
Profit if closing
today
NIL
75
19650
29837.5
49425
35472.5
28322.5
1347.5
9310
-49645
-25757.5
-30047.5
-28390
Analysis:
The strategy ratio bull call spread was implemented with a view that the market (NIFTY Index)
would be range bound between 5000 to 5200. To gain the maximum out of these strategy 18 lots
of Nifty Call with strike price of 5200 were sold at a premium of Rs.33.30 amounting to
Rs.29970 (18*50*33.33). With this position the writer of the option would lose money if the
market goes up more than 5200. Against the money received from this position we enter into
another position of buying 5 lots of Nifty Call with strike price of 5000 at a premium of Rs.120
(5*50*120). This means that if the market crosses 5000 mark we would gain. In this strategy
there was no initial cost as the money received from selling the calls was used in buying the calls
for different strike price. The trick over here is to correctly get the ratio of Long and Short right.
This strategy was actually used by the clients of Anugrah and the brokers had taken positions for
their clients, but they exited their position within two days as their views about the markets
changed but we were asked to track this position till the expiry to understand how this position
would make losses if the original range was broken and the market shooted up much more.
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2. Short Straddle
Short Nifty Call 1 Lot (Strike Price 5000) Premium Received 50@120 = 6000
Date
Premium
Days Profit/Loss
Rs.
Total Profit/Loss
50
120
8-Jun-10
94
26
1300
1300
9-Jun-10
108.3
-14.3
-715
585
10-Jun-10
150.3
-42
-2100
-1515
11-Jun-10
157
-6.7
-335
-1850
14-Jun-10
220
-63
-3150
-5000
15-Jun-10
238
-18
-900
-5900
16-Jun-10
234.4
3.6
180
-5720
17-Jun-10
287.05
-52.65 -2632.5
-8352.5
18-Jun-10
261
26.05
1302.5
-7050
21-Jun-10
354
-93
-4650
-11700
22-Jun-10
323
31
1550
-10150
23-Jun-10
333.8
-10.8
-540
-10690
24-Jun-10
321.4
12.4
620
-10070
Short Nifty Put 1 Lot (Strike Price 5000) Premium Received 50@101.80 =
5090
Date
Premium Days Profit/Loss
Rs.
Total Profit/Loss
101.8
50
8-Jun-10
131.9
-30.1 -1505
-1505
9-Jun-10
105.1
26.8
1340
-165
10-Jun-10
63
42.1
2105
1940
11-Jun-10
49.05
13.95 697.5
2637.5
14-Jun-10
18.5
30.55 1527.5
4165
15-Jun-10
13.4
5.1
255
4420
16-Jun-10
11.55
1.85
92.5
4512.5
17-Jun-10
5
6.55 327.5
4840
18-Jun-10
3.95
1.05
52.5
4892.5
21-Jun-10
1.9
2.05 102.5
4995
22-Jun-10
1.26
0.64
32
5027
23-Jun-10
0.55
0.71
35.5
5062.5
24-Jun-10
0.05
0.5
25
5087.5
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Net
Profit/Loss
-205
420
425
787.5
-835
-1480
-1207.5
-3512.5
-2157.5
-6705
-5123
-5627.5
-4982.5
Nifty
Breakeven Close
Downside Upside
5221.8
4778.2
4987.1
208.9
234.7
5000.3
222.1
221.5
5078.6
300.4
143.2
5119.35
341.15 102.45
5197.7
419.5
24.1
5222.35
444.15
-0.55
5233.35
455.15 -11.55
5274.85
496.65 -53.05
5262.6
484.4
-40.8
5353.3
575.1 -131.5
5316.55
538.35 -94.75
5323.15
544.95 -101.3
5320.6
542.4
-98.8
If today is expiry
Profit on Profit on
Net
SC
SP
Profit
6000
5985
2070
32.5
-3885
-5117.5
-5667.5
-7742.5
-7130
-11665
-9827.5
-10157.5
-10030
4445
5090
5090
5090
5090
5090
5090
5090
5090
5090
5090
5090
5090
10445
11075
7160
5122.5
1205
-27.5
-577.5
-2652.5
-2040
-6575
-4737.5
-5067.5
-4940
Thakur Institute of Management Studies and Research
Page 63
Analysis:
The strategy short straddle was implemented with a view that the market (NIFTY Index) would
be range bound between 4778 to 5222. To gain the maximum out of this strategy 1 lot of Nifty
Call with strike price of 5000 were sold at a premium of Rs.120 amounting to Rs.6000 (50*120)
and 1 lot of Nifty put with strike price of 5000 at a premium of Rs.101.80 amounting to Rs.5090
(50*101.80). With this position the writer of the option would lose money if the market goes up
more than 5221 or goes down below 4778. In this strategy there was no initial cost as the money
received from selling the calls and put for same strike price. The trick over here is to get the
maximum in the range bound market. This strategy was actually used by the clients of Anugrah
and the brokers had taken positions for their clients, but they exited their position within two
days as their views about the markets changed but we were asked to track this position till the
expiry to understand how this position would make losses if the original range was broken and
the market shooted up much more.
Thakur Institute of Management Studies and Research
Page 64
CONCLUSION
My two months summer internship with Anugrah was very knowledgeable. My experience about
derivatives studies is very pleasant and will definitely help me in my career. Thus I conclude that
my training has helped me in relating what I am studying now in my finance specialization
through subjects such as SAPM & Derivative.
Thakur Institute of Management Studies and Research
Page 65
REFERENCE




Option Strategies Module- NCFM
Derivatives Dealers Module- NCFM
Derivative And Financial Innovation –Manish Bhansal
NSE India.com
Thakur Institute of Management Studies and Research
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