HISTORY OF DERIVATIVES
With the opening of the economy to multinationals and the adoption of the liberalized economic policies, the economy is driven more towards the free market economy. The complex nature of financial structuring itself involves the utilization of multi currency transactions. It exposes the clients, particularly corporate clients to various risks such as exchange rate risk, interest rate risk, economic risk and political risk.
With the integration of the financial markets and free mobility of capital, risks also multiplied. For instance, when countries adopt floating exchange rates, they have to face risks due to fluctuations in the exchange rates. Deregulation of interest rate cause interest risks. Again, securitization has brought with it the risk of default or counter party risk. Apart from it, every asset—whether commodity or metal or share or currency—is subject to depreciation in its value. It may be due to certain inherent factors and external factors like the market condition, Government’s policy, economic and political condition prevailing in the country and so on.
In the present state of the economy, there is an imperative need of the corporate clients to protect there operating profits by shifting some of the uncontrollable financial risks to those who are able to bear and manage them. Thus, risk management becomes a must for survival since there is a high volatility in the present financial markets.
In this context, derivatives occupy an important place as risk reducing machinery. Derivatives are useful to reduce many of the risks discussed above. In fact, the financial service companies can play a very dynamic role in dealing with such risks. They can ensure that the above risks are hedged by using derivatives like forwards, future, options, swaps etc. Derivatives, thus, enable the clients to transfer their financial risks to he financial service companies. This really protects the clients from unforeseen risks and helps them to get there due operating profits or to keep the project well within the budget costs. To hedge the various risks that one faces in the financial market today, derivatives are absolutely essential.
DERIVATIVES IN INDIA
In India, all attempts are being made to introduce derivative instruments in the capital market. The National Stock Exchange has been planning to introduce index-based futures. A stiff net worth criteria of Rs.7 to 10 corers cover is proposed for members who wish to enroll for such trading. But, it has not yet received the necessary permission from the securities and Exchange Board of India.
In the forex market, there are brighter chances of introducing derivatives on a large scale. Infact, the necessary groundwork for the introduction of derivatives in forex market was prepared by a high-level expert committee appointed by the RBI. It was headed by Mr. O.P. Sodhani. Committee’s report was already submitted to the Government in 1995. As it is, a few derivative products such as interest rate swaps, coupon swaps, currency swaps and fixed rate agreements are available on a limited scale. It is easier to introduce derivatives in forex market because most of these products are OTC products (Over-the-counter) and they are highly flexible. These are always between two parties and one among them is always a financial intermediary.
However, there should be proper legislations for the effective implementation of derivative contracts. The utility of derivatives through Hedging can be derived, only when, there is transparency with honest dealings. The players in the derivative market should have a sound financial base for dealing in derivative transactions. What is more important for the success of derivatives is the prescription of proper capital adequacy norms, training of financial intermediaries and the provision of well-established indices. Brokers must also be trained in the intricacies of the derivative-transactions.
Now, derivatives have been introduced in the Indian Market in the form of index options and index futures. Index options and index futures are basically derivate tools based on stock index. They are really the risk management tools. Since derivates are permitted legally, one can use them to insulate his equity portfolio against the vagaries of the market.
Every investor in the financial area is affected by index fluctuations. Hence, risk management using index derivatives is of far more importance than risk management using individual security options. Moreover, Portfolio risk is dominated by the market risk, regardless of the composition of the portfolio. Hence, investors would be more interested in using index-based derivative products rather than security based derivative products.
There are no derivatives based on interest rates in India today. However, Indian users of hedging services are allowed to buy derivatives involving other currencies on foreign markets. India has a strong dollar- rupee forward market with contracts being traded for one to six month expiration. Daily trading volume on this forward market is around $500 million a day. Hence, derivatives available in India in foreign exchange area are also highly beneficial to the users.
RECENT DEVELOPMENTS
At present Derivative Trading has been permitted by the SEBI on derivative segment of the BSE and the F&0 segment of the NSE. The natures of derivative contracts permitted are:
Ø Index Futures contracts introduced in June, 2000,
Ø Index options introduced in June, 2001, and
Ø Stock options introduced in July 2001.
The minimum contract size of a derivative contract is Rs.2 lakhs. Besides the minimum contract size, there is a stipulation for the lot size of a derivative contract. The lot size refers to number of underlying securities in one contract. The lot size of the underlying individual security should be in multiples of 100 and tractions, if any should be rounded of to next higher multiple of 100. This requirement along with the requirement of minimum contract size from the basis for arriving at the lot size of contract.
Apart from the above, there are market wide limits also. The market wide limit for index products in NIL. For stock specific products it is of open positions. But, for option and futures the following wide limits have been fixed.
Ø 30 times the average number of shares traded daily, during the previous calendar month in the cash segment of the exchange.
Or
Ø 10% of the number of shares held by non-promoters, i.e., 10% of the free float in terms of number of shares of a company.
ELIGIBILITY CONDITIONS
The SEBI has laid down some eligibility conditions for Derivative exchange/Segment and it’s clearing Corporation/House. They are as follows:
Ø The Derivatives Exchange/Segment shall have on-line surveillance capability to monitor positions, prices, and volumes on a real time basis so as to deter market manipulation.
Ø The Derivatives Exchange/Segment should have arrangements for dissemination of information about trades, quantities and quotes on a real time basis through at least two information-vending networks, which are easily accessible to investors across the country.
Ø The Derivatives Exchange/Segment should have arbitration and investor grievances redressal mechanism operative from all the four areas/regions of the country.
Ø The Derivatives Exchange/Segment should have satisfactory system of monitoring investor complaints and preventing irregularities in trading.
Ø The Derivative Segment of the Exchange would have a separate Investor Protection Fund.
Ø The Clearing Corporation/House shall perform full innovation, i.e., the Clearing Corporation/House shall interpose itself between both legs of every trade, becoming the legal counter party to both or alternatively should provide an unconditional guarantee for settlement of all trades.
Ø The Clearing Corporation/House shall have the capacity to monitor the overall position of Members across both derivatives market and the underlying securities market for those Members who are participating in both.
Ø The level of initial margin on Index Futures Contracts shall be related to the risk of loss on the position. The concept of value-at-risk shall be used in calculating required level or initial margins. The initial margins should be large enough to cover the one-day loss that can be encountered on the position on 99% of the days.
Ø The Clearing Corporation/House shall establish facilities for electronic fund transfer (EFT) for swift movement of margin payments.
Ø In the event of a member defaulting in meeting its liabilities, the Clearing Corporation/House shall transfer client positions and assets to another solvent Member or close- out all open positions.
Ø The Clearing Corporation/House should have capabilities to segregate initial margins deposited by clearing members for trades on their own account and on account of his client. The Clearing Corporations/House shall hold the clients’ margin money in trust for the client purposes only and should not allow its diversion for any other purpose.
Ø The Clearing Corporation/House shall have a separate Trade Guarantee Fund for the trades executed on Derivatives exchange/ segment.
INVESTORS PROTECTION
The SEBI has taken the following measures to protect the money and interest of investors in the Derivative market. They are as follows:
Ø Investor's money has to be kept separate at all levels and is permitted to be used only against the liability of the Investor and is not available to the trading member or clearing member or even any other investor.
Ø The Trading Member is required to provide every investor with a risk disclosure document, which will disclose the risks, associated with the derivatives trading so that investors can take a conscious decision to trade in derivatives.
Ø Investor would get the contract note duly time stamped for receipt of the order and execution of the order. The order will be executed with the identity of the client and without client ID order will not be accepted by the system. The investor could also demand the reconfirmation slip with his ID in support of the contract note. This will protects him from the risk of price favour, if any, extended by the Member.
Ø In the derivative markets, all money paid by the Investor towards margins on all open positions is kept in trust with the Clearing House/ Clearing Corporation and in the event of default of the Trading or Clearing Member the amounts paid by the client towards margins are segregated and not utilized towards the default of the member. However, in the event of a default of a member, losses suffered by the Investor, if any, on settled/ closed out position are compensated from the Investor Protection Fund, as per the rules, byelaws and regulation of the derivative segment of the exchanges.
DERIVATIVES
MEANING OF DERIVATIVES
In a broad sense, many commonly used instruments can be called derivatives since they derive their value from an underlying asset. For instance, equity shares itself is a derivative, since, it derive its value from the firms underlying assets. Similarly, one takes insurance against his house. Again, if one signs a contract with a building contractor stipulating a condition, if the cost of materials goes up by 15% the contract price will also go up by 10%. This is also a kind of derivative contract. Thus, derivatives cover a lot of common transactions.
In a strict sense, derivatives are based upon all those major financial instruments, which are explicitly traded like equity, debt instruments, forex instruments and commodity based contracts. Thus, when we talk about derivatives, we usually mean only financial derivatives, namely, forward, futures, options, swaps etc. The peculiar features of these instruments are that:
Ø They can be designed in such a way so as to the varied requirements of the users either by simply using any one of the above instruments or by using a combination of two or more such instruments.
Ø They can be designed and traded on the basis of expectations regarding the future price movements of underlying assets.
Ø They are all off –balance sheet instruments and
Ø They are used as device for reducing the risks of fluctuations in asset values.
As the word implies, a derivative instrument is derived from “something” backing it. This something may be a loan, an asset, an interest rate, a currency flow, a stock trade, a commodity transaction, a trade flow etc. Derivatives enable a company to hedge ‘this something’ without changing the flow associated with the business operation.
DEFINITION OF DERIVATIVES
It is very difficult to define the term derivatives in a comprehensive way since many developments have taken place in this field in recent years.
Moreover, many innovative instruments have been crated by combining two or more of these financial derivatives so as to cater to the specific requirements of users, depending upon the circumstances. Inspite of this, some attempts have been made to define the term ‘derivatives’.
Ø “Derivatives involve payment/receipt of income generated by the underlying asset on a notional principal”.
Ø “Derivatives are a special type of off-balance sheet instruments in which no principal is ever paid”.
Ø “Derivatives are instruments which make payments calculated using price of interest rate derived from a balance sheet or cash instruments, but do not actually employ those cash instruments to fund payments”.
All these definitions point out the fact that transactions are carried out on a notional principal, transferring only the income generated by the underlying asset.
Importance of Derivatives
Thus, derivatives are becoming increasingly important in world markets as a tool for risk management. Derivative instruments can be used to minimize risk. Derivatives are used to separate the risks and transfer them to parties willing to bear these risks. The kind of hedging that can be obtained by using derivatives is cheaper and more convenient than what could be obtained by using cash instruments. It is so because, when we use derivatives for hedging, actual delivery of the underlying asset is not at all essential for settlement purposes. The profit or loss on derivative deal alone is adjusted in the derivative market.
Moreover, derivatives do not create any new risk. They simply manipulate risks and transfer them to those who are willing to bear these risks. To cite a common example, let us assume that Mr. X owns a car. If he does not take insurance, he runs a big risk. Suppose he buys insurance, (a derivative instrument on the car) he reduces his risk. Thus, having an insurance policy reduces the risk of owing a car. Similarly, hedging through derivatives reduces the risk of owning a specified asset, which may be a share, currency etc.
Hedging risk through derivatives is not similar to speculation. The gain or loss on a derivative deal is likely to be offset by an equivalent loss or gain in the values of underlying assets. 'Offsetting of risks' in an important property of hedging transactions. But, in speculation one deliberately takes up a risk openly. When companies know well that they have to face risk in possessing assets, it is better to transfer these risks to those who are ready to bear them. So, they have to necessarily go for derivative instruments.
All derivative instruments are very simple to operate. Treasury managers and portfolio managers can hedge all risks without going through the tedious process of hedging each day and amount/share separately.
Till recently, it may not have been possible for companies to hedge their long term risk, say 10-15 year risk. But with the rapid development of the derivative markets, now, it is possible to cover such risks through derivative instruments like swap. Thus, the availability of advanced derivatives market enables companies to concentrate on those management decisions other than funding decisions.
Further, all derivative products are low cost products. Companies can hedge a substantial portion of their balance sheet exposure, with a low margin requirement.
Derivatives also offer high liquidity. Just as derivatives can be contracted easily, it is also possible for companies to get out of positions in case that market reacts otherwise. This also does not involve much cost.
Thus, derivatives are not only desirable but also necessary to hedge the complex exposures and volatilities that the companies generally face in the financial markets today.
INHIBITING FACTORS
Though derivatives are very useful for managing various risks, there are certain inhibiting factors, which stand in their way. They are as follows:
Ø MISCONCEPTION OF DERIVATIVES:
There is a wrong feeling that derivatives would bring in financial collapse. There is an enormous negative publicity in the wake of incidents of financial misadventure. For instance, Baring had its entire net worth wiped out as a result of its trading and options writing on the Nikkei index futures. There are some other similar incidents like this. To quote a few: Procter and Gamble, Indah Kiat, Showa Shell etc. However, it must be understood that derivatives are not the root cause for all these troubles. Derivatives themselves cannot cause such mishaps. But the improper handling of these instruments is the main cause for this and one cannot simply blame derivatives for all these misshapennings.
Ø LEVERAGING:
One of the important characteristic features of derivatives is that they lend themselves to leveraging. That is, they are 'high risk - high reward vehicles’. There is a prospect of either high return or huge loss in all-derivative instruments. So, there is a feeling that only a few can play this game. There is no doubt that derivatives create leverage and leverage creates increased risk or return. At the same time, one should keep in mind that the very same derivatives, if properly handled, could be used as an efficient tool to minimize risks.
Ø OFF BALANCE SHEET ITEMS:
Invariably, derivatives are off balance sheet items. For instance, swap agreements for substituting fixed interest rate bonds by floating rate bonds or for substituting fixed rate interest bearing asset by floating rate interest paying liability. Hence, accountants, regulators and other look down upon derivatives.
Ø ABSENCE OF PROPER ACCOUNTING SYSTEM:
To achieve the desired results, derivative must be strongly supported by proper accounting systems, efficient internal control and strict supervision. Unfortunately, they are all at infancy level as far as derivatives are concerned.
Ø INBUILT SPECULATIVE MACHANISM:
In fact all derivative contracts are structured basically on the basis of the future price movements over which the speculators have on upper hand. Indirectly, derivatives make one accept the fact that speculation is beneficial. It may not be so always. Thus, derivatives possess an inbuilt speculative mechanism.
Ø ABSENCE OF PROPER INFRASTRUCTURE:
An important requirement for using derivative instrument like, options, futures etc. is the existence of proper infrastructure. Hence, the institutional infrastructure has to be developed. There has to be effective surveillance, price dissemination and regulation of derivative transactions. The term of the derivative contracts has to be uniform and standardized.
KINDES OF FINANCIAL DERIVATIVES
As already discussed, the important financial derivatives are the following:
Ø Forwards
Ø Futures
Ø Options, and
Ø Swaps
Ø FORWARDS:
Forwards are the oldest of all the derivatives. A forward contract refers to an agreement between two parties to exchange an agreed quantity of an asset for cash at certain date in future at a predetermined price specified in that agreement. The promised asset may be currency, commodity, instrument etc.
Example: on June 1, x enters into an agreement to buy 50 bales of cotton on December 1at Rs. 1,000/- per bale from y, a cotton dealer. It is a case of a forward contract where x has to pay Rs. 50,000 on December 1 to y and y has to supply 50 bales of cotton.
In a forward contract, a user (holder) who promises to buy the specified asset at an agreed price at a fixed future date is said to be in the ‘long position’. On the other hand, the user who promises to sell at an agreed price at a future date is said to be in ‘short position’. Thus, ‘long position & ‘short position’ take the form of ‘buy & sell’ in a forward contract.
Ø FUTURES:
A futures contract is very similar to a forward contract in all respects excepting the fact that it is completely a standardized one. Hence, it is rightly said that a futures contract is nothing but a standardized forward contract. It is legally enforceable and it is always traded on an organized exchange.
Diagram showing Forward Rate Agreement
(Spot interest rate – FRA rate)
Market interest rate payment
Payoff table
Interest paid by ‘x’ = Market interest rate
Interest received by ‘x’ = Difference between FRA interest
From FRA counter party rate and market interest rate
Net interest paid by ‘x’ = FRA interest rate
Source: Journal of the Indian Institute of bankers.
Clark has defined future trading “as a special type of futures contract bought and sold under the rules of organized exchanges.” The term ‘future trading’ includes both speculative transactions where futures are bought and sold with the objective of making profits from the price changes and also the hedging or protective transactions where futures are bought and sold with view to avoiding unforeseen losses resulting from price fluctuations.
A future contract is one where there is an agreement between two parties to exchange any assets or currency or commodity for cash at a certain future date, at an agreed price. Both the parties to the contract must have mutual trust in each other. It takes place only in organized futures market and according to well-established standards.
As in a forward contract, the trader who promises to buy is said to be in ‘long position’ and the one who promises to sell is said to be in ‘short position’ in futures also.
Ø SWAPS:
Swap is yet another exciting trading instrument. Infact, it is a combination of forwards by two counter parties. It is arranged to reap the benefits arising from the fluctuations in the market-either currency market or interest rate market or any other market for that matter.
Ø OPTIONS:
In the volatile environment, risk of heavy fluctuations in the price of assets is very heavy. Option is yet another tool to manage such risks.
As the very name implies, as an option contract gives the buyer an option to buy or sell an underlying asset (stock, bond, currency, commodity etc.) at a predetermined price on or before a specified date in future. The price so predetermined is called the ‘strike price’ or ‘exercise price’.
OPTIONS
A derivative transaction that gives the option holder the right but not the obligation to buy or sell the underlying asset at a price, called the stack price, during, a period or on a specific date in exchange for payment of a premium is known as ‘option’. Underlying asset refers to any asset that is traded. The price at which the underlying asset is traded is called the ‘strike price’. It is one of the building blocks of the option contract.
TYPES OF OPTIONS
Options may fall under any one of following main categories:
Ø CALL OPTION
Ø PUT OPTION
Ø DOUBLE OPTION
Ø CALL OPTION:
A call option is one, which gives the option holder the right to buy a underlying asset (commodities, foreign exchange, stock shares etc.) at a predetermined price called ‘exercise price’ or strike price on or before a specified date in future. In such a case, the writer of a call option is under an obligation to sell the asset at a specified price, in case the buyer exercises his option to buy. Thus, the obligation to sell arises only when the option exercised.
Ø PUT OPTION:
A put option is one, which gives the option holder the right to sell an underlying asset at a predetermined price on or before a specified date in future. It means that the writer of a put option is under an obligation to buy the asset at the exercise price provided the option holder exercises his option to sell.
Ø DOUBLE OPTION:
A double option is one, which gives the option holder both the right either to buy or to sell an underlying asset at a predetermined price on or before a specified date in future.
FEATURES OF OPTION CONTRACT
Ø High flexible:
On one hand, option contracts are highly standardized and so they can be traded only in organized exchanges. Such option instrument cannot be made flexible according to the requirement of the writer as well as the user. On the other hand, there are also privately arranged options, which can be, traded ‘Over the Counter’. These instruments can be made according to the requirements of the writer and user. Thus, it combines the feature of ‘futures’ as well as forward contracts.
Ø Down Payment:
The option holder must pay a certain amount called ‘premium’ for holding the right of exercising the option. This is considered to be the consideration for the contract. If the option holder does not exercise will be deduction from the total payoff in calculating the net payoff due to the option holder.
Ø Settlement:
No money or commodity or shares is exchanged when the contract is written. Generally this option contract terminates either at the time of exercising the option holder or maturity whichever is earlier. So, settlement is made only when the option holder exercises his option. Suppose the option is not exercised till maturity, then the agreement automatically lapses and no settlement is required.
Ø Non-Linearity:
Unlike futures and forward, on option contract does not posses the property of linearity. It means that the option holder’s profit, when the value of the underlying assets moves in one direction is not equal to his loss when its value moves in the opposite direction by the same amount. In short, profit and losses are not symmetrical under an option contract. This can be illustrated by means of an illustration:
Mr.X purchase a two month call option on rupee at Rs100=3.35$. Suppose, the rupee appreciates within two months by 0.05 $ per one hundred rupees, then the market price would be Rs.100= 3.40$. If the option holder Mr.X exercises his option, he can purchases at the rate mentioned in the option i.e., Rs100=3.35$. He gets a payoff at the rate of 0.05$per every one hundred rupees. On the other hands, if the exchanges rate moves in the opposite direction by the same amount and reaches a level of Rs100=3.30$, the option contract, the gain is not equal to the loss.
Ø No Obligation to Buy or Sell:
In all option contracts, the option holder has a right to buy or sell underlying assets. He can exercise this right at any time during the currency of the contract. But, in no case, he is under an obligation to buy or sell. If he does not buy or sell, the contract will be simply lapsed.
WRITER
In an option contract, the seller is usually referred to as a “writer” since he is said to write the contract. It is similar to the seller who is said to be in ‘short position’ in a forward contract. However, in a put option, the writer is in a different position. He is obliged to buy shares. In an option contract, the buyer has to pay a certain amount at the time of writing the contract for enjoying the right to buy or sell.
AMERICAN OPTION VS EUROPEAN OPTION
In an option contract, if the option can be exercised at any time between the writing of the contract and its expiration, it is called as an American option. On the other hand, if it can be exercised only at the time of maturity, it is termed as European option.
OPTION TRADING IN SHARES & STOCKS
When an option contract is entered into with an option to buy or sell shares or stock, it is knows as share option. Share option transactions are generally index-based. All calculation is based on the change in index value. For example, the present value of an index is 300. A person Mr.X buys a 3month call option for an index is 350 by paying 10% of the present index value in points at the rate of Rs.10 per point. Now, the option price is taken as Rs.300 and the strike price or exercise price is Rs. 350.
So long as the index remains below 350, the option holder will not exercise his option since he will be incurring losses. Now, the loss will be limited to the premium paid at the rate of Rs. 10/- per point. As the spot price increases beyond the strike price level, exercise of the option becomes profitable. Suppose the spot rate reaches 360, option may be exercised.
The option holder gets a profit of Rs100 (10pionts *10). However, his net position will be Rs.100-300 (premium 10% on 30 *10). He incurs a net loss of Rs. 200. When the spot rate reaches 380, the break-even point is reaches. Beyond this index value, the option holder starts making a profit.
A person with more money can trade the index at a higher price of Rs.100 or 200 per index point. However, speculators can play this kind of game only. Genuine portfolio managers can use this instrument to hedge their risks due to heavy fluctuations in the prices of shares and stocks.
CURRENCY OPTIONS
Suppose an option contract is entered into between parties to purchase or sell foreign exchange, it is called ‘currency option’. This can be illustrated by an example. An option holder buys in September, dollar at the exchange rate of 1 yen = 1.900$ maturity in November. The spot rate then was also pays a premium of 7.04 cents per yen 1. As long as the price of pound in the market remains bellows 1.900$, the option will not be exercised. Off course the option holder suffers a loss, but his loss is limited to the premium paid at the rate of 7.04 cents per yen 1. When the spot price increases beyond the strike price, it is profitable to exercise the option. For instance, the spot rate becomes 1.9200$ per yen 1, if the option holder exercises his option now, he will get a profit of .200$ per yen 1. However, his net position will be .0200-.0704 (premium) = -.0504 $ (loss). If the spot rate goes up to yen 1 =1.9704$, the break-even point is reached. Beyond this level, the option holder gets profits by exercising his option.
On the other hand, the writer of the option gets profits as long as the option is not exercised. His profit is limited to the premium received i.e., 7.04 cents per yen 1. When the spot rate goes beyond the strike price, the option holder will exercise his option. At the rate 1 yen =1.9704 $ the writer of the option is also at the break-even point. If spot rate goes beyond this level, the option writer will suffer a net loss.
OPTION CONTRACT
Ø Contract Size
Ø Exercise Style
Ø Expiry Date
Ø Option Class
Ø Option Series
Ø Premium
Ø Settlement Style
Ø Strike Price
Ø Type
Ø Underlying Asset
OPTION CONTRACT:
The option buyer pays premium to the seller and acquires the right i.e. to decide whether to buy or sell the underlying asset at the agreed price before the option contract expires.
On the other hand, the option seller receives the premium and grants the right to the buyer i.e. he is in a passive position - he will have to perform the agreement to buy or sell the underlying asset if so requested by the buyer before the option contract expires.
The person who bought an option contract and keeps the position open without closing out in the market owns a long position, and is referred to as an option holder. A long option position may be offset or closed out by selling the same contract in the market.
The person who sold an option contract and keeps the position open without closing out in the market owns a short position, and is referred to as an option writer. A short position may be offset or closed out by buying back the same contract in the market.
GENERAL TERMS OF OPTIONS TRADING
Ø CONTRACT SIZE:
Refers to the amount of the underlying asset that one option contract represents. For example, for stock option contracts traded on the Exchange, one option contract represents one board lot of the underlying shares (except where there has been a capitalization change).
Ø EXERCISE STYLE:
Refers to when the option contract can be exercised. European style options can only be exercised on the expiry date, while American style options can be exercised at any time on or before expiry. The exercise style for the stock option contracts and index option contracts traded on the Exchange is American style and European style respectively.
Ø EXPIRY DATE:
Refers to the date on which that the option contract, and hence the right to exercise, will expire.
Ø OPTION CLASS:
Refers to all option contracts with the same underlying asset. For instance, all option contracts of Hong Kong Bank (HKB) represent an option class.
Ø OPTION SERIES:
Refers to all option contracts with the same underlying asset, expiry date, strike price and type (call/put). Therefore, each series is equivalent to one tradable security or unit. For instance, all HKB Call option contracts with April expiry and $180 strike represent an option series.
Ø PREMIUM:
Refers to the price or cost at which the option trades. For Exchange-traded stock options, it is usually quoted on a per share basis. For index options traded on the Exchange, it is quoted on index point’s basis.
Ø SETTLEMENT STYLE:
Refers to the way the underlying assets change hands on exercise by the option holder. Physical settlement involves physical delivery of the underlying assets between the holder and the writer while cash settlement involves a cash transfer of the price difference between the strike price and underlying asset.
Ø STRIKE PRICE:
Refers to the pre-determined price at which the underlying asset can be bought or sold. It is also known as the EXERCISE PRICE.
Ø TYPE:
Refers to the two basic types of options: CALLS and PUTS. Call options give the buyer the right to buy the underlying asset. Put options give the buyer the right to sell the underlying asset.
Ø UNDERLYING ASSET:
Refers to the asset to be exchanged if the option is exercised. There are five major categories: Equity, Index, Commodity, Debt and Forex. For instance, a call option on the shares of ABC Company gives the holder the right to buy the shares of ABC Company. A put option on the Hang Seng Index gives the holder the right to sell the index at HK$50 per.
Ø TIME VALUE:
The portion of an options premium that is attributed to the option may gain value in the remaining time before it expires. Time value is the value that is attributed to the possibility that the option will increase in value during the time before expiry.
Ø Time to Expiry:
All else being equal an option with more time to expiry will have more time value than an option that has less time to expiry. The more time there is the more opportunity the underlying asset has to move.
Ø Volatility of Underlying Security
The greater the volatility of the underlying the more people are willing to pay for an option's time value. Time value is higher on volatile securities because there is a possibility of larger profits.
Ø Opportunity Cost:
If you have a sum of money that you could earn interest on and you decided to spend that money on buying a stock, the interest that you could have earned is an opportunity cost. There are two factors that affect the opportunity cost: the risk-free rate of interest and the yield on the underlying (i.e. the underlying stock's dividend yield). Higher interest rates will mean higher call premiums and lower put premiums. Higher dividend yields will mean lower call premiums and higher put premiums. These two factors affecting opportunity cost have a minimal effect on the options price in comparison to other factors.
Ø Time Decay:
As illustrated in figure 1 the closer you get to the expiry date the faster an option's time value will deteriorate; this concept is called time decay. You will pay more money per day of time value for an option that is nearing expiry in comparison to an option that has a long time until expiry. All other factors being equal a nine month option would lose about 10% of its time value in the first 3 months, in the next 3 months it would lose about 30% of the original time value, and in the last 3 months the option would lose about 60% of its original time value.
Figure 1.
Time Decay Curve Chart
Ø Time Value & Risk:
In-the-Money options are options that have intrinsic value. A call option with a strike price that is below the stock price is in the money, and a put option with a strike price that is above the stock price is in the money.
The call option in figure 2 gives the holder the right to buy the stock for $10. The stock is currently trading at $15, this means that the call option has $5.00 of intrinsic value or the call option is $5.00 in the money.
The put option in figure 2 gives the holder the right to sell the stock for $20. The stock is currently trading at $15, this means that the put option also has $5.00 of intrinsic value or the put option is $5.00 in the money.
Figure 2.
The further in the money an option is in the less time value it will command. Deep in-the-money options are more expensive due to the large amount of intrinsic value. When an option is more expensive the buyer is risking more money, therefore the buyer won't be willing to spend as much money on time value.
Ø Time Value & Probability of Profitability:
Out-of-the-Money is the opposite of in-the-money options. A call option with a strike price that is above the stock price is out-of-the-money, and a put option with strike prices that is below the stock price is out-of-the-money.
The call option in figure 3 gives the holder the right to buy the stock for $20 while the stock is currently trading at $15. Exercising the call option would mean buying the stock for $5.00 more than the current price, this is another way of saying the call option is $5.00 out-of-the-money.
The put option in figure 3 gives the holder the right to sell the stock for $10 while the stock is currently trading at $15. Exercising the put option would be selling the stock for $5.00 less than the current price; this means the put option is $5.00 out-of-the-money.
Figure 3.
The further out-of-the-money an option is in the less time value it will have. When you buy deep out-of-the-money options the stock has to move a lot in order for it to have any value on expiry. The probability of the option transaction being profitable is lower on deep out-of-the-money options anything on expiry, therefore the buyer won't be willing to spend as much money on time value.
INTRINSIC VALUE
Ø Factors Affecting Intrinsic Value:
Intrinsic value is the value that could be realized by exercising an option then immediately liquidating the position in the underlying.
(I.e. exercise a call option to buy XYZ at a strike price of $20, then sell XYZ at the current price of $25; in this example there would be an intrinsic value of $5).
There are two factors affecting intrinsic value: the strike price and the underlying security price.
Call Options: Intrinsic Value = Underlying Security Price - Strike Price
Put Options: Intrinsic Value = Strike Price - Underlying Security Price
(Note: Intrinsic Value cannot be negative, if the above equations produce a negative number the intrinsic value is zero.)
In-the-money options have an intrinsic value, which is the same amount, as the option is in the money.
At-the-money options have a market price, which is currently at or very close to the strike price. At-the-money options don't have intrinsic value either, however they are on the verge of gaining intrinsic value if the underlying stock moves in a favorable direction.
Out-of-the-Money options have no intrinsic value.
Ø Holder:
The holder is the person who bought an option contract. Someone who buys an option they previously wrote is not a holder, they are just closing an existing position. An option holder is said to be "long" the option they bought.
Ø Long Call:
Buying a call gives you the right to buy the underlying stock at the strike price any time until expiry.
Ø Long Call (Buy a Call):
You would buy a call if you think the price of the underlying stock is going to rise (when you are bullish on the underlying stock).
Figure 4 shows the risk return involved with buying a call with a strike price of $25 for a premium of $5. When you buy a call the most you can lose is the premium you paid for the call. However there is unlimited profit if the underlying stock moves up.
Figure 4.
Ø Long Call Chart:
If the price of the stock rose to $40 by the expiry date the call option would be worth $15 ($40 the stock price - $25 the strike price). In this example the holder of the call option would have a profit of $10 ($15 the value of the option at expiry - $5 the premium paid for the option).
Ø Short Call:
Writing a call obligates you to sell the underlying stock at the strike price any time until expiry if you are assigned.
You short a call when you write (sell) a call that you don't currently own. There are two basic types of short calls covered and uncovered (naked).
Ø Naked Call (Uncovered Call):
You could write a call if you think the price of the underlying stock is going to stay the same or fall (when you are neutral or bearish on the underlying stock).
Figure 5 shows the risk and return involved with writing a naked call with a strike price of $25 for a premium of $5. When you write a naked call the most you can make is the premium you receive for writing the call. However you are taking on unlimited risk if the underlying stock moves up.
Figure 5.
Ø Naked Call Chart:
If the price of the stock rose to $40 by the expiry date the naked call position would be in a loss of $10 ($5 premium you originally received for writing the naked call + $25 the strike price which you are obligated to sell the stock for - $40 the price you would have to buy the stock for).
Ø Covered Call:
A covered call is when you own the underlying stock and you write a call. The call is covered because if you get assigned and have to sell the underlying stock it is OK because you already own it. If you think that a stock price will stay the same or move up slightly you could write a covered call.
Figure 6 shows the risk and return involved with writing a covered call with a strike price of $25 for a premium of $3 at a time when the underlying stock is trading at $22. When you write a covered call there is a maximum amount that you can make. However you are taking on a lot of risk if the underlying stock falls.
Figure 6.
Ø Covered Call Chart:
If the price of the underlying stock rose to $25 or higher by the expiry date the overall position would have a profit of $6 (this remains the same because any profits on the stock are offset by losses on the short call). If the price of the underlying stock fell to $10 your combined loss would be $9 ($10 the current price of the stock - $22 the price paid for the stock + $3 the premium received for writing the call).
A covered call position has the same risk reward profile as writing a naked put.
Ø Long Put:
Buying a put gives you the right to sell the underlying stock at the strike price any time until expiry.
When you buy a put to open a position you are said to be “long a put”. You can buy a put either to speculate or to protect a position.
Ø Speculative Put:
A speculative put is when you buy a put in hopes that the stock will fall, as opposed to buying a put to protect a position in the underlying stock.
Figure 7 shows the risk and return involved with buying a put (speculative put) with a strike price of $25 for a premium of $5. When you buy a put the most you can lose is the premium you pay for buying the put option. However you are able to make large profits if the underlying stock falls.
Figure 7.
Ø Speculative put chart:
If the price of the stock fell to $10 by the expiry date, the put option would have a value of $15 ($25 strike price that you could sell the stock for - $10 current stock price that you could buy the stock for). In this example the put holder would have a $10 profit ($15 the value of the option at expiry - $5 the premium paid for the option).
Ø Protective Put:
A protective put is when you have a position in the underlying stock and you buy a put to protect against a drop in the stock's price. A protective put is like buying an insurance policy on your stock to protect against the drop in price. You may want to buy a protective put if you think the underlying stock is going to rise buy you have some short term concerns, and you want to protect yourself in case there is a sharp drop in the stock price.
Figure 8 shows the risk and return involved with holding a stock and buying a protective put on it. When you buy a protective put you still have unlimited profit potential while you are able to limit your risk.
Figure 8.
Ø Protective Put Chart:
If the price of the underlying stock fell to $25 or lower by the expiry date the combined position would have a loss of $10 (this remains the same because the profits on the put option will offset any losses on the stock below the $25 strike price). If the price of the underlying stock went up to $45 there would be a profit of $10 ($15 the gain on the stock - $5 the premium paid to buy the protective put).
A protective put has the same risk reward profile as buying a call option.
Ø Short Put:
Writing a put obligates you to buy the underlying stock at the strike price any time until expiry if you are assigned.
Ø Short Put (Writing a Put):
When you write (sell) a put that you don't already own you are said to be "short a put". You could write a put if you think the price of the underlying stock is going to stay the same or rise (when you are neutral or bullish on the underlying stock).
Figure 9 shows the risk and return involved with writing a put with a strike price of $25 for a premium of $5. When you write a put the most you can make is the premium you receive for writing the put option. However you are taking on the risk of large losses if the underlying stock falls.
Figure 9.
Ø Short Put Chart:
If the price of the stock fell to $5 by the expiry date, the put option would have a value of -$20 ($5 current stock price that you could sell the stock for - $25 strike price that you would have to buy the stock for). In this example the put writer would have a $15 loss ($5 the premium received for writing the option - $20 the value of the option you wrote at expiry).
Writing a put has the same risk reward profile as a covered call position.
Ø Naked Put (Uncovered) vs. Short Put Covered by Cash:
There are two basic types of short puts covered and uncovered (naked).
When you write a put you are taking on an obligation to buy the underlying stock at the strike price. You can cover this obligation by having enough cash to buy the shares at the strike price. There are several other methods of covering a short put. If you write a put option that is not covered you are taking on more risk, this is called a naked or an uncovered put.
Ø Sell the Options:
You can sell an option that you previously bought on or before the expiry date. Selling an option is often the best way to close out a position if there is still time remaining before expiry. This is because when you sell an option you will sell it for the total price (the intrinsic value + the time value). If you sell the option you will not need to take a position in the underlying asset.
Ø Exercise the Options:
You can only exercise an option if you are long the option (if you own the option). You can exercise American style option any time on or before the expiry date. When an option is exercised, only the intrinsic value is realized, and any time value remaining is lost. When you exercise an option you are actually buying or selling the underlying stock. Exercising an option would be appropriate in a situation where there is little or no time value, and you want to buy the stock in the case of a call, or sell the stock in the case of a put.
Ø Get Assigned:
You can only get assigned if you are short the option. You will get assigned if the person who buys the option from you exercises it. Being assigned is a possibility however you have no control over this; it is the decision of the other party in the options contract. When you are assigned you must simply fulfill your obligation under the option contract. In the case of a call option you would have to sell the stock at the strike price to the call holder, and in the case of a put option you would have to buy the stock at the strike price from the put holder.
Ø Let the Options Expire:
An option will expire worthless if the option is either at-the-money or out-of-the-money on expiry. Letting your options expire worthless is the only viable decision when they are out-of-the-money on expiry. When you let an option expire, you lose all the money you invested in the option.
Ø Opening an Account:
Before you start trading options you will need to open a margin account. If you have a cash account you will need to open a new account because you cannot trade options in a cash account.
When you apply for a margin account you will need to specify that you want to trade options, and you may be required to specify what type of options strategies you would like to do in the account. If the account application form asks it is important to tell your brokerage firm what type of option strategies you would like to be allowed to do. If you don't tell them you may find that they won't let you do certain types of strategies.
You can also trade options in registered accounts, however with a registered account you may also have to apply for options approval on the account. We would recommend for you to check with your brokerage firm to see if they have any additional requirements for trading options. For example some firms require you to have a minimum balance before writing any naked options.
Ø Registered Accounts:
Options can be traded in registered accounts such as RRSP or RRIF accounts, however you will first need to get options approval on your account. Registered accounts also have restrictions as to what type of options strategies can be done.
ANNEXURE
HOW OPTIONS WORK:
Ø An option is a special contract in which the option owner enjoys the right to buy or sell something without the obligation to do so.
Ø The option to buy under the contract is called Call option and the options to sell are call put option.
Ø The option holder is the buyer of the option and the option writer is the seller of that option.
Ø The price at which the option holder can buy or sell the underlying asset is called the striking price or exercise price.
Ø The date on which the option expires or matures is known as expiration date. The option becomes worthless after the expiration date.
Ø The act of buying and selling the underlying Asset as per the option contract is called exercising the option. An option can exercise on or before expiration date.
Ø These options are traded on stock exchanges. Some of these options can be traded over the counter. Exchange traded options are standardized in terms of quantity, expiration date, strike prices, type of options, mode of settlement trading cycle etc.
Ø Options contracts on individual securities on the NSE are in the multiple of 100 and have three months trading cycle. These options expire on the last Thursday of the month.
Ø These options have five strike prices stipulated by the exchange and the prices have to be settled in cash.
Ø The value of an option expiring immediately is called its intrinsic value.
Ø The excess of the market price of any options over its intrinsic value is known as time value of an option.
For e.g.: the market price of a share is Rs 520/-, the exercise price of a call option on the share is Rs 500/- and the market price of the call option is Rs30/-. In this case, the intrinsic value of the option is Rs 20/- (Rs520-Rs500/-) and the time value of the option is Rs 10/- (Rs 30 - Rs 20).
OPTIONS PRICING:
Ø The price of a put or call option depends upon the market behaviour of the equity that underlines the option.
Ø Generally, stock options are looked upon, as a speculative vehicle as in any option there is a risk of loss to both the contracting parties.
Ø The price at which the stock under option may be put or called is the contract price. It is also referred to as a striking price.
Ø The contract price remains fixed during the life of the contract. However as per market practice, the contract price can reduce by the amount of any dividend paid or by the value of any right, which becomes effective during the period of contract.
Ø The amount the buyers pay for the option privilege in purchasing an option is called the premium. Sometimes, it may be called as the option money. In most of the transactions the contract price is the stock market price prevailing at the time the option is written and the premium becomes the variable for the buyer and the seller to bargain. There are many expiration dates and striking prices offered with option, which benefit many investors.
With the opening of the economy to multinationals and the adoption of the liberalized economic policies, the economy is driven more towards the free market economy. The complex nature of financial structuring itself involves the utilization of multi currency transactions. It exposes the clients, particularly corporate clients to various risks such as exchange rate risk, interest rate risk, economic risk and political risk.
With the integration of the financial markets and free mobility of capital, risks also multiplied. For instance, when countries adopt floating exchange rates, they have to face risks due to fluctuations in the exchange rates. Deregulation of interest rate cause interest risks. Again, securitization has brought with it the risk of default or counter party risk. Apart from it, every asset—whether commodity or metal or share or currency—is subject to depreciation in its value. It may be due to certain inherent factors and external factors like the market condition, Government’s policy, economic and political condition prevailing in the country and so on.
In the present state of the economy, there is an imperative need of the corporate clients to protect there operating profits by shifting some of the uncontrollable financial risks to those who are able to bear and manage them. Thus, risk management becomes a must for survival since there is a high volatility in the present financial markets.
In this context, derivatives occupy an important place as risk reducing machinery. Derivatives are useful to reduce many of the risks discussed above. In fact, the financial service companies can play a very dynamic role in dealing with such risks. They can ensure that the above risks are hedged by using derivatives like forwards, future, options, swaps etc. Derivatives, thus, enable the clients to transfer their financial risks to he financial service companies. This really protects the clients from unforeseen risks and helps them to get there due operating profits or to keep the project well within the budget costs. To hedge the various risks that one faces in the financial market today, derivatives are absolutely essential.
DERIVATIVES IN INDIA
In India, all attempts are being made to introduce derivative instruments in the capital market. The National Stock Exchange has been planning to introduce index-based futures. A stiff net worth criteria of Rs.7 to 10 corers cover is proposed for members who wish to enroll for such trading. But, it has not yet received the necessary permission from the securities and Exchange Board of India.
In the forex market, there are brighter chances of introducing derivatives on a large scale. Infact, the necessary groundwork for the introduction of derivatives in forex market was prepared by a high-level expert committee appointed by the RBI. It was headed by Mr. O.P. Sodhani. Committee’s report was already submitted to the Government in 1995. As it is, a few derivative products such as interest rate swaps, coupon swaps, currency swaps and fixed rate agreements are available on a limited scale. It is easier to introduce derivatives in forex market because most of these products are OTC products (Over-the-counter) and they are highly flexible. These are always between two parties and one among them is always a financial intermediary.
However, there should be proper legislations for the effective implementation of derivative contracts. The utility of derivatives through Hedging can be derived, only when, there is transparency with honest dealings. The players in the derivative market should have a sound financial base for dealing in derivative transactions. What is more important for the success of derivatives is the prescription of proper capital adequacy norms, training of financial intermediaries and the provision of well-established indices. Brokers must also be trained in the intricacies of the derivative-transactions.
Now, derivatives have been introduced in the Indian Market in the form of index options and index futures. Index options and index futures are basically derivate tools based on stock index. They are really the risk management tools. Since derivates are permitted legally, one can use them to insulate his equity portfolio against the vagaries of the market.
Every investor in the financial area is affected by index fluctuations. Hence, risk management using index derivatives is of far more importance than risk management using individual security options. Moreover, Portfolio risk is dominated by the market risk, regardless of the composition of the portfolio. Hence, investors would be more interested in using index-based derivative products rather than security based derivative products.
There are no derivatives based on interest rates in India today. However, Indian users of hedging services are allowed to buy derivatives involving other currencies on foreign markets. India has a strong dollar- rupee forward market with contracts being traded for one to six month expiration. Daily trading volume on this forward market is around $500 million a day. Hence, derivatives available in India in foreign exchange area are also highly beneficial to the users.
RECENT DEVELOPMENTS
At present Derivative Trading has been permitted by the SEBI on derivative segment of the BSE and the F&0 segment of the NSE. The natures of derivative contracts permitted are:
Ø Index Futures contracts introduced in June, 2000,
Ø Index options introduced in June, 2001, and
Ø Stock options introduced in July 2001.
The minimum contract size of a derivative contract is Rs.2 lakhs. Besides the minimum contract size, there is a stipulation for the lot size of a derivative contract. The lot size refers to number of underlying securities in one contract. The lot size of the underlying individual security should be in multiples of 100 and tractions, if any should be rounded of to next higher multiple of 100. This requirement along with the requirement of minimum contract size from the basis for arriving at the lot size of contract.
Apart from the above, there are market wide limits also. The market wide limit for index products in NIL. For stock specific products it is of open positions. But, for option and futures the following wide limits have been fixed.
Ø 30 times the average number of shares traded daily, during the previous calendar month in the cash segment of the exchange.
Or
Ø 10% of the number of shares held by non-promoters, i.e., 10% of the free float in terms of number of shares of a company.
ELIGIBILITY CONDITIONS
The SEBI has laid down some eligibility conditions for Derivative exchange/Segment and it’s clearing Corporation/House. They are as follows:
Ø The Derivatives Exchange/Segment shall have on-line surveillance capability to monitor positions, prices, and volumes on a real time basis so as to deter market manipulation.
Ø The Derivatives Exchange/Segment should have arrangements for dissemination of information about trades, quantities and quotes on a real time basis through at least two information-vending networks, which are easily accessible to investors across the country.
Ø The Derivatives Exchange/Segment should have arbitration and investor grievances redressal mechanism operative from all the four areas/regions of the country.
Ø The Derivatives Exchange/Segment should have satisfactory system of monitoring investor complaints and preventing irregularities in trading.
Ø The Derivative Segment of the Exchange would have a separate Investor Protection Fund.
Ø The Clearing Corporation/House shall perform full innovation, i.e., the Clearing Corporation/House shall interpose itself between both legs of every trade, becoming the legal counter party to both or alternatively should provide an unconditional guarantee for settlement of all trades.
Ø The Clearing Corporation/House shall have the capacity to monitor the overall position of Members across both derivatives market and the underlying securities market for those Members who are participating in both.
Ø The level of initial margin on Index Futures Contracts shall be related to the risk of loss on the position. The concept of value-at-risk shall be used in calculating required level or initial margins. The initial margins should be large enough to cover the one-day loss that can be encountered on the position on 99% of the days.
Ø The Clearing Corporation/House shall establish facilities for electronic fund transfer (EFT) for swift movement of margin payments.
Ø In the event of a member defaulting in meeting its liabilities, the Clearing Corporation/House shall transfer client positions and assets to another solvent Member or close- out all open positions.
Ø The Clearing Corporation/House should have capabilities to segregate initial margins deposited by clearing members for trades on their own account and on account of his client. The Clearing Corporations/House shall hold the clients’ margin money in trust for the client purposes only and should not allow its diversion for any other purpose.
Ø The Clearing Corporation/House shall have a separate Trade Guarantee Fund for the trades executed on Derivatives exchange/ segment.
INVESTORS PROTECTION
The SEBI has taken the following measures to protect the money and interest of investors in the Derivative market. They are as follows:
Ø Investor's money has to be kept separate at all levels and is permitted to be used only against the liability of the Investor and is not available to the trading member or clearing member or even any other investor.
Ø The Trading Member is required to provide every investor with a risk disclosure document, which will disclose the risks, associated with the derivatives trading so that investors can take a conscious decision to trade in derivatives.
Ø Investor would get the contract note duly time stamped for receipt of the order and execution of the order. The order will be executed with the identity of the client and without client ID order will not be accepted by the system. The investor could also demand the reconfirmation slip with his ID in support of the contract note. This will protects him from the risk of price favour, if any, extended by the Member.
Ø In the derivative markets, all money paid by the Investor towards margins on all open positions is kept in trust with the Clearing House/ Clearing Corporation and in the event of default of the Trading or Clearing Member the amounts paid by the client towards margins are segregated and not utilized towards the default of the member. However, in the event of a default of a member, losses suffered by the Investor, if any, on settled/ closed out position are compensated from the Investor Protection Fund, as per the rules, byelaws and regulation of the derivative segment of the exchanges.
DERIVATIVES
MEANING OF DERIVATIVES
In a broad sense, many commonly used instruments can be called derivatives since they derive their value from an underlying asset. For instance, equity shares itself is a derivative, since, it derive its value from the firms underlying assets. Similarly, one takes insurance against his house. Again, if one signs a contract with a building contractor stipulating a condition, if the cost of materials goes up by 15% the contract price will also go up by 10%. This is also a kind of derivative contract. Thus, derivatives cover a lot of common transactions.
In a strict sense, derivatives are based upon all those major financial instruments, which are explicitly traded like equity, debt instruments, forex instruments and commodity based contracts. Thus, when we talk about derivatives, we usually mean only financial derivatives, namely, forward, futures, options, swaps etc. The peculiar features of these instruments are that:
Ø They can be designed in such a way so as to the varied requirements of the users either by simply using any one of the above instruments or by using a combination of two or more such instruments.
Ø They can be designed and traded on the basis of expectations regarding the future price movements of underlying assets.
Ø They are all off –balance sheet instruments and
Ø They are used as device for reducing the risks of fluctuations in asset values.
As the word implies, a derivative instrument is derived from “something” backing it. This something may be a loan, an asset, an interest rate, a currency flow, a stock trade, a commodity transaction, a trade flow etc. Derivatives enable a company to hedge ‘this something’ without changing the flow associated with the business operation.
DEFINITION OF DERIVATIVES
It is very difficult to define the term derivatives in a comprehensive way since many developments have taken place in this field in recent years.
Moreover, many innovative instruments have been crated by combining two or more of these financial derivatives so as to cater to the specific requirements of users, depending upon the circumstances. Inspite of this, some attempts have been made to define the term ‘derivatives’.
Ø “Derivatives involve payment/receipt of income generated by the underlying asset on a notional principal”.
Ø “Derivatives are a special type of off-balance sheet instruments in which no principal is ever paid”.
Ø “Derivatives are instruments which make payments calculated using price of interest rate derived from a balance sheet or cash instruments, but do not actually employ those cash instruments to fund payments”.
All these definitions point out the fact that transactions are carried out on a notional principal, transferring only the income generated by the underlying asset.
Importance of Derivatives
Thus, derivatives are becoming increasingly important in world markets as a tool for risk management. Derivative instruments can be used to minimize risk. Derivatives are used to separate the risks and transfer them to parties willing to bear these risks. The kind of hedging that can be obtained by using derivatives is cheaper and more convenient than what could be obtained by using cash instruments. It is so because, when we use derivatives for hedging, actual delivery of the underlying asset is not at all essential for settlement purposes. The profit or loss on derivative deal alone is adjusted in the derivative market.
Moreover, derivatives do not create any new risk. They simply manipulate risks and transfer them to those who are willing to bear these risks. To cite a common example, let us assume that Mr. X owns a car. If he does not take insurance, he runs a big risk. Suppose he buys insurance, (a derivative instrument on the car) he reduces his risk. Thus, having an insurance policy reduces the risk of owing a car. Similarly, hedging through derivatives reduces the risk of owning a specified asset, which may be a share, currency etc.
Hedging risk through derivatives is not similar to speculation. The gain or loss on a derivative deal is likely to be offset by an equivalent loss or gain in the values of underlying assets. 'Offsetting of risks' in an important property of hedging transactions. But, in speculation one deliberately takes up a risk openly. When companies know well that they have to face risk in possessing assets, it is better to transfer these risks to those who are ready to bear them. So, they have to necessarily go for derivative instruments.
All derivative instruments are very simple to operate. Treasury managers and portfolio managers can hedge all risks without going through the tedious process of hedging each day and amount/share separately.
Till recently, it may not have been possible for companies to hedge their long term risk, say 10-15 year risk. But with the rapid development of the derivative markets, now, it is possible to cover such risks through derivative instruments like swap. Thus, the availability of advanced derivatives market enables companies to concentrate on those management decisions other than funding decisions.
Further, all derivative products are low cost products. Companies can hedge a substantial portion of their balance sheet exposure, with a low margin requirement.
Derivatives also offer high liquidity. Just as derivatives can be contracted easily, it is also possible for companies to get out of positions in case that market reacts otherwise. This also does not involve much cost.
Thus, derivatives are not only desirable but also necessary to hedge the complex exposures and volatilities that the companies generally face in the financial markets today.
INHIBITING FACTORS
Though derivatives are very useful for managing various risks, there are certain inhibiting factors, which stand in their way. They are as follows:
Ø MISCONCEPTION OF DERIVATIVES:
There is a wrong feeling that derivatives would bring in financial collapse. There is an enormous negative publicity in the wake of incidents of financial misadventure. For instance, Baring had its entire net worth wiped out as a result of its trading and options writing on the Nikkei index futures. There are some other similar incidents like this. To quote a few: Procter and Gamble, Indah Kiat, Showa Shell etc. However, it must be understood that derivatives are not the root cause for all these troubles. Derivatives themselves cannot cause such mishaps. But the improper handling of these instruments is the main cause for this and one cannot simply blame derivatives for all these misshapennings.
Ø LEVERAGING:
One of the important characteristic features of derivatives is that they lend themselves to leveraging. That is, they are 'high risk - high reward vehicles’. There is a prospect of either high return or huge loss in all-derivative instruments. So, there is a feeling that only a few can play this game. There is no doubt that derivatives create leverage and leverage creates increased risk or return. At the same time, one should keep in mind that the very same derivatives, if properly handled, could be used as an efficient tool to minimize risks.
Ø OFF BALANCE SHEET ITEMS:
Invariably, derivatives are off balance sheet items. For instance, swap agreements for substituting fixed interest rate bonds by floating rate bonds or for substituting fixed rate interest bearing asset by floating rate interest paying liability. Hence, accountants, regulators and other look down upon derivatives.
Ø ABSENCE OF PROPER ACCOUNTING SYSTEM:
To achieve the desired results, derivative must be strongly supported by proper accounting systems, efficient internal control and strict supervision. Unfortunately, they are all at infancy level as far as derivatives are concerned.
Ø INBUILT SPECULATIVE MACHANISM:
In fact all derivative contracts are structured basically on the basis of the future price movements over which the speculators have on upper hand. Indirectly, derivatives make one accept the fact that speculation is beneficial. It may not be so always. Thus, derivatives possess an inbuilt speculative mechanism.
Ø ABSENCE OF PROPER INFRASTRUCTURE:
An important requirement for using derivative instrument like, options, futures etc. is the existence of proper infrastructure. Hence, the institutional infrastructure has to be developed. There has to be effective surveillance, price dissemination and regulation of derivative transactions. The term of the derivative contracts has to be uniform and standardized.
KINDES OF FINANCIAL DERIVATIVES
As already discussed, the important financial derivatives are the following:
Ø Forwards
Ø Futures
Ø Options, and
Ø Swaps
Ø FORWARDS:
Forwards are the oldest of all the derivatives. A forward contract refers to an agreement between two parties to exchange an agreed quantity of an asset for cash at certain date in future at a predetermined price specified in that agreement. The promised asset may be currency, commodity, instrument etc.
Example: on June 1, x enters into an agreement to buy 50 bales of cotton on December 1at Rs. 1,000/- per bale from y, a cotton dealer. It is a case of a forward contract where x has to pay Rs. 50,000 on December 1 to y and y has to supply 50 bales of cotton.
In a forward contract, a user (holder) who promises to buy the specified asset at an agreed price at a fixed future date is said to be in the ‘long position’. On the other hand, the user who promises to sell at an agreed price at a future date is said to be in ‘short position’. Thus, ‘long position & ‘short position’ take the form of ‘buy & sell’ in a forward contract.
Ø FUTURES:
A futures contract is very similar to a forward contract in all respects excepting the fact that it is completely a standardized one. Hence, it is rightly said that a futures contract is nothing but a standardized forward contract. It is legally enforceable and it is always traded on an organized exchange.
Diagram showing Forward Rate Agreement
(Spot interest rate – FRA rate)
Market interest rate payment
Payoff table
Interest paid by ‘x’ = Market interest rate
Interest received by ‘x’ = Difference between FRA interest
From FRA counter party rate and market interest rate
Net interest paid by ‘x’ = FRA interest rate
Source: Journal of the Indian Institute of bankers.
Clark has defined future trading “as a special type of futures contract bought and sold under the rules of organized exchanges.” The term ‘future trading’ includes both speculative transactions where futures are bought and sold with the objective of making profits from the price changes and also the hedging or protective transactions where futures are bought and sold with view to avoiding unforeseen losses resulting from price fluctuations.
A future contract is one where there is an agreement between two parties to exchange any assets or currency or commodity for cash at a certain future date, at an agreed price. Both the parties to the contract must have mutual trust in each other. It takes place only in organized futures market and according to well-established standards.
As in a forward contract, the trader who promises to buy is said to be in ‘long position’ and the one who promises to sell is said to be in ‘short position’ in futures also.
Ø SWAPS:
Swap is yet another exciting trading instrument. Infact, it is a combination of forwards by two counter parties. It is arranged to reap the benefits arising from the fluctuations in the market-either currency market or interest rate market or any other market for that matter.
Ø OPTIONS:
In the volatile environment, risk of heavy fluctuations in the price of assets is very heavy. Option is yet another tool to manage such risks.
As the very name implies, as an option contract gives the buyer an option to buy or sell an underlying asset (stock, bond, currency, commodity etc.) at a predetermined price on or before a specified date in future. The price so predetermined is called the ‘strike price’ or ‘exercise price’.
OPTIONS
A derivative transaction that gives the option holder the right but not the obligation to buy or sell the underlying asset at a price, called the stack price, during, a period or on a specific date in exchange for payment of a premium is known as ‘option’. Underlying asset refers to any asset that is traded. The price at which the underlying asset is traded is called the ‘strike price’. It is one of the building blocks of the option contract.
TYPES OF OPTIONS
Options may fall under any one of following main categories:
Ø CALL OPTION
Ø PUT OPTION
Ø DOUBLE OPTION
Ø CALL OPTION:
A call option is one, which gives the option holder the right to buy a underlying asset (commodities, foreign exchange, stock shares etc.) at a predetermined price called ‘exercise price’ or strike price on or before a specified date in future. In such a case, the writer of a call option is under an obligation to sell the asset at a specified price, in case the buyer exercises his option to buy. Thus, the obligation to sell arises only when the option exercised.
Ø PUT OPTION:
A put option is one, which gives the option holder the right to sell an underlying asset at a predetermined price on or before a specified date in future. It means that the writer of a put option is under an obligation to buy the asset at the exercise price provided the option holder exercises his option to sell.
Ø DOUBLE OPTION:
A double option is one, which gives the option holder both the right either to buy or to sell an underlying asset at a predetermined price on or before a specified date in future.
FEATURES OF OPTION CONTRACT
Ø High flexible:
On one hand, option contracts are highly standardized and so they can be traded only in organized exchanges. Such option instrument cannot be made flexible according to the requirement of the writer as well as the user. On the other hand, there are also privately arranged options, which can be, traded ‘Over the Counter’. These instruments can be made according to the requirements of the writer and user. Thus, it combines the feature of ‘futures’ as well as forward contracts.
Ø Down Payment:
The option holder must pay a certain amount called ‘premium’ for holding the right of exercising the option. This is considered to be the consideration for the contract. If the option holder does not exercise will be deduction from the total payoff in calculating the net payoff due to the option holder.
Ø Settlement:
No money or commodity or shares is exchanged when the contract is written. Generally this option contract terminates either at the time of exercising the option holder or maturity whichever is earlier. So, settlement is made only when the option holder exercises his option. Suppose the option is not exercised till maturity, then the agreement automatically lapses and no settlement is required.
Ø Non-Linearity:
Unlike futures and forward, on option contract does not posses the property of linearity. It means that the option holder’s profit, when the value of the underlying assets moves in one direction is not equal to his loss when its value moves in the opposite direction by the same amount. In short, profit and losses are not symmetrical under an option contract. This can be illustrated by means of an illustration:
Mr.X purchase a two month call option on rupee at Rs100=3.35$. Suppose, the rupee appreciates within two months by 0.05 $ per one hundred rupees, then the market price would be Rs.100= 3.40$. If the option holder Mr.X exercises his option, he can purchases at the rate mentioned in the option i.e., Rs100=3.35$. He gets a payoff at the rate of 0.05$per every one hundred rupees. On the other hands, if the exchanges rate moves in the opposite direction by the same amount and reaches a level of Rs100=3.30$, the option contract, the gain is not equal to the loss.
Ø No Obligation to Buy or Sell:
In all option contracts, the option holder has a right to buy or sell underlying assets. He can exercise this right at any time during the currency of the contract. But, in no case, he is under an obligation to buy or sell. If he does not buy or sell, the contract will be simply lapsed.
WRITER
In an option contract, the seller is usually referred to as a “writer” since he is said to write the contract. It is similar to the seller who is said to be in ‘short position’ in a forward contract. However, in a put option, the writer is in a different position. He is obliged to buy shares. In an option contract, the buyer has to pay a certain amount at the time of writing the contract for enjoying the right to buy or sell.
AMERICAN OPTION VS EUROPEAN OPTION
In an option contract, if the option can be exercised at any time between the writing of the contract and its expiration, it is called as an American option. On the other hand, if it can be exercised only at the time of maturity, it is termed as European option.
OPTION TRADING IN SHARES & STOCKS
When an option contract is entered into with an option to buy or sell shares or stock, it is knows as share option. Share option transactions are generally index-based. All calculation is based on the change in index value. For example, the present value of an index is 300. A person Mr.X buys a 3month call option for an index is 350 by paying 10% of the present index value in points at the rate of Rs.10 per point. Now, the option price is taken as Rs.300 and the strike price or exercise price is Rs. 350.
So long as the index remains below 350, the option holder will not exercise his option since he will be incurring losses. Now, the loss will be limited to the premium paid at the rate of Rs. 10/- per point. As the spot price increases beyond the strike price level, exercise of the option becomes profitable. Suppose the spot rate reaches 360, option may be exercised.
The option holder gets a profit of Rs100 (10pionts *10). However, his net position will be Rs.100-300 (premium 10% on 30 *10). He incurs a net loss of Rs. 200. When the spot rate reaches 380, the break-even point is reaches. Beyond this index value, the option holder starts making a profit.
A person with more money can trade the index at a higher price of Rs.100 or 200 per index point. However, speculators can play this kind of game only. Genuine portfolio managers can use this instrument to hedge their risks due to heavy fluctuations in the prices of shares and stocks.
CURRENCY OPTIONS
Suppose an option contract is entered into between parties to purchase or sell foreign exchange, it is called ‘currency option’. This can be illustrated by an example. An option holder buys in September, dollar at the exchange rate of 1 yen = 1.900$ maturity in November. The spot rate then was also pays a premium of 7.04 cents per yen 1. As long as the price of pound in the market remains bellows 1.900$, the option will not be exercised. Off course the option holder suffers a loss, but his loss is limited to the premium paid at the rate of 7.04 cents per yen 1. When the spot price increases beyond the strike price, it is profitable to exercise the option. For instance, the spot rate becomes 1.9200$ per yen 1, if the option holder exercises his option now, he will get a profit of .200$ per yen 1. However, his net position will be .0200-.0704 (premium) = -.0504 $ (loss). If the spot rate goes up to yen 1 =1.9704$, the break-even point is reached. Beyond this level, the option holder gets profits by exercising his option.
On the other hand, the writer of the option gets profits as long as the option is not exercised. His profit is limited to the premium received i.e., 7.04 cents per yen 1. When the spot rate goes beyond the strike price, the option holder will exercise his option. At the rate 1 yen =1.9704 $ the writer of the option is also at the break-even point. If spot rate goes beyond this level, the option writer will suffer a net loss.
OPTION CONTRACT
Ø Contract Size
Ø Exercise Style
Ø Expiry Date
Ø Option Class
Ø Option Series
Ø Premium
Ø Settlement Style
Ø Strike Price
Ø Type
Ø Underlying Asset
OPTION CONTRACT:
The option buyer pays premium to the seller and acquires the right i.e. to decide whether to buy or sell the underlying asset at the agreed price before the option contract expires.
On the other hand, the option seller receives the premium and grants the right to the buyer i.e. he is in a passive position - he will have to perform the agreement to buy or sell the underlying asset if so requested by the buyer before the option contract expires.
The person who bought an option contract and keeps the position open without closing out in the market owns a long position, and is referred to as an option holder. A long option position may be offset or closed out by selling the same contract in the market.
The person who sold an option contract and keeps the position open without closing out in the market owns a short position, and is referred to as an option writer. A short position may be offset or closed out by buying back the same contract in the market.
GENERAL TERMS OF OPTIONS TRADING
Ø CONTRACT SIZE:
Refers to the amount of the underlying asset that one option contract represents. For example, for stock option contracts traded on the Exchange, one option contract represents one board lot of the underlying shares (except where there has been a capitalization change).
Ø EXERCISE STYLE:
Refers to when the option contract can be exercised. European style options can only be exercised on the expiry date, while American style options can be exercised at any time on or before expiry. The exercise style for the stock option contracts and index option contracts traded on the Exchange is American style and European style respectively.
Ø EXPIRY DATE:
Refers to the date on which that the option contract, and hence the right to exercise, will expire.
Ø OPTION CLASS:
Refers to all option contracts with the same underlying asset. For instance, all option contracts of Hong Kong Bank (HKB) represent an option class.
Ø OPTION SERIES:
Refers to all option contracts with the same underlying asset, expiry date, strike price and type (call/put). Therefore, each series is equivalent to one tradable security or unit. For instance, all HKB Call option contracts with April expiry and $180 strike represent an option series.
Ø PREMIUM:
Refers to the price or cost at which the option trades. For Exchange-traded stock options, it is usually quoted on a per share basis. For index options traded on the Exchange, it is quoted on index point’s basis.
Ø SETTLEMENT STYLE:
Refers to the way the underlying assets change hands on exercise by the option holder. Physical settlement involves physical delivery of the underlying assets between the holder and the writer while cash settlement involves a cash transfer of the price difference between the strike price and underlying asset.
Ø STRIKE PRICE:
Refers to the pre-determined price at which the underlying asset can be bought or sold. It is also known as the EXERCISE PRICE.
Ø TYPE:
Refers to the two basic types of options: CALLS and PUTS. Call options give the buyer the right to buy the underlying asset. Put options give the buyer the right to sell the underlying asset.
Ø UNDERLYING ASSET:
Refers to the asset to be exchanged if the option is exercised. There are five major categories: Equity, Index, Commodity, Debt and Forex. For instance, a call option on the shares of ABC Company gives the holder the right to buy the shares of ABC Company. A put option on the Hang Seng Index gives the holder the right to sell the index at HK$50 per.
Ø TIME VALUE:
The portion of an options premium that is attributed to the option may gain value in the remaining time before it expires. Time value is the value that is attributed to the possibility that the option will increase in value during the time before expiry.
Ø Time to Expiry:
All else being equal an option with more time to expiry will have more time value than an option that has less time to expiry. The more time there is the more opportunity the underlying asset has to move.
Ø Volatility of Underlying Security
The greater the volatility of the underlying the more people are willing to pay for an option's time value. Time value is higher on volatile securities because there is a possibility of larger profits.
Ø Opportunity Cost:
If you have a sum of money that you could earn interest on and you decided to spend that money on buying a stock, the interest that you could have earned is an opportunity cost. There are two factors that affect the opportunity cost: the risk-free rate of interest and the yield on the underlying (i.e. the underlying stock's dividend yield). Higher interest rates will mean higher call premiums and lower put premiums. Higher dividend yields will mean lower call premiums and higher put premiums. These two factors affecting opportunity cost have a minimal effect on the options price in comparison to other factors.
Ø Time Decay:
As illustrated in figure 1 the closer you get to the expiry date the faster an option's time value will deteriorate; this concept is called time decay. You will pay more money per day of time value for an option that is nearing expiry in comparison to an option that has a long time until expiry. All other factors being equal a nine month option would lose about 10% of its time value in the first 3 months, in the next 3 months it would lose about 30% of the original time value, and in the last 3 months the option would lose about 60% of its original time value.
Figure 1.
Time Decay Curve Chart
Ø Time Value & Risk:
In-the-Money options are options that have intrinsic value. A call option with a strike price that is below the stock price is in the money, and a put option with a strike price that is above the stock price is in the money.
The call option in figure 2 gives the holder the right to buy the stock for $10. The stock is currently trading at $15, this means that the call option has $5.00 of intrinsic value or the call option is $5.00 in the money.
The put option in figure 2 gives the holder the right to sell the stock for $20. The stock is currently trading at $15, this means that the put option also has $5.00 of intrinsic value or the put option is $5.00 in the money.
Figure 2.
The further in the money an option is in the less time value it will command. Deep in-the-money options are more expensive due to the large amount of intrinsic value. When an option is more expensive the buyer is risking more money, therefore the buyer won't be willing to spend as much money on time value.
Ø Time Value & Probability of Profitability:
Out-of-the-Money is the opposite of in-the-money options. A call option with a strike price that is above the stock price is out-of-the-money, and a put option with strike prices that is below the stock price is out-of-the-money.
The call option in figure 3 gives the holder the right to buy the stock for $20 while the stock is currently trading at $15. Exercising the call option would mean buying the stock for $5.00 more than the current price, this is another way of saying the call option is $5.00 out-of-the-money.
The put option in figure 3 gives the holder the right to sell the stock for $10 while the stock is currently trading at $15. Exercising the put option would be selling the stock for $5.00 less than the current price; this means the put option is $5.00 out-of-the-money.
Figure 3.
The further out-of-the-money an option is in the less time value it will have. When you buy deep out-of-the-money options the stock has to move a lot in order for it to have any value on expiry. The probability of the option transaction being profitable is lower on deep out-of-the-money options anything on expiry, therefore the buyer won't be willing to spend as much money on time value.
INTRINSIC VALUE
Ø Factors Affecting Intrinsic Value:
Intrinsic value is the value that could be realized by exercising an option then immediately liquidating the position in the underlying.
(I.e. exercise a call option to buy XYZ at a strike price of $20, then sell XYZ at the current price of $25; in this example there would be an intrinsic value of $5).
There are two factors affecting intrinsic value: the strike price and the underlying security price.
Call Options: Intrinsic Value = Underlying Security Price - Strike Price
Put Options: Intrinsic Value = Strike Price - Underlying Security Price
(Note: Intrinsic Value cannot be negative, if the above equations produce a negative number the intrinsic value is zero.)
In-the-money options have an intrinsic value, which is the same amount, as the option is in the money.
At-the-money options have a market price, which is currently at or very close to the strike price. At-the-money options don't have intrinsic value either, however they are on the verge of gaining intrinsic value if the underlying stock moves in a favorable direction.
Out-of-the-Money options have no intrinsic value.
Ø Holder:
The holder is the person who bought an option contract. Someone who buys an option they previously wrote is not a holder, they are just closing an existing position. An option holder is said to be "long" the option they bought.
Ø Long Call:
Buying a call gives you the right to buy the underlying stock at the strike price any time until expiry.
Ø Long Call (Buy a Call):
You would buy a call if you think the price of the underlying stock is going to rise (when you are bullish on the underlying stock).
Figure 4 shows the risk return involved with buying a call with a strike price of $25 for a premium of $5. When you buy a call the most you can lose is the premium you paid for the call. However there is unlimited profit if the underlying stock moves up.
Figure 4.
Ø Long Call Chart:
If the price of the stock rose to $40 by the expiry date the call option would be worth $15 ($40 the stock price - $25 the strike price). In this example the holder of the call option would have a profit of $10 ($15 the value of the option at expiry - $5 the premium paid for the option).
Ø Short Call:
Writing a call obligates you to sell the underlying stock at the strike price any time until expiry if you are assigned.
You short a call when you write (sell) a call that you don't currently own. There are two basic types of short calls covered and uncovered (naked).
Ø Naked Call (Uncovered Call):
You could write a call if you think the price of the underlying stock is going to stay the same or fall (when you are neutral or bearish on the underlying stock).
Figure 5 shows the risk and return involved with writing a naked call with a strike price of $25 for a premium of $5. When you write a naked call the most you can make is the premium you receive for writing the call. However you are taking on unlimited risk if the underlying stock moves up.
Figure 5.
Ø Naked Call Chart:
If the price of the stock rose to $40 by the expiry date the naked call position would be in a loss of $10 ($5 premium you originally received for writing the naked call + $25 the strike price which you are obligated to sell the stock for - $40 the price you would have to buy the stock for).
Ø Covered Call:
A covered call is when you own the underlying stock and you write a call. The call is covered because if you get assigned and have to sell the underlying stock it is OK because you already own it. If you think that a stock price will stay the same or move up slightly you could write a covered call.
Figure 6 shows the risk and return involved with writing a covered call with a strike price of $25 for a premium of $3 at a time when the underlying stock is trading at $22. When you write a covered call there is a maximum amount that you can make. However you are taking on a lot of risk if the underlying stock falls.
Figure 6.
Ø Covered Call Chart:
If the price of the underlying stock rose to $25 or higher by the expiry date the overall position would have a profit of $6 (this remains the same because any profits on the stock are offset by losses on the short call). If the price of the underlying stock fell to $10 your combined loss would be $9 ($10 the current price of the stock - $22 the price paid for the stock + $3 the premium received for writing the call).
A covered call position has the same risk reward profile as writing a naked put.
Ø Long Put:
Buying a put gives you the right to sell the underlying stock at the strike price any time until expiry.
When you buy a put to open a position you are said to be “long a put”. You can buy a put either to speculate or to protect a position.
Ø Speculative Put:
A speculative put is when you buy a put in hopes that the stock will fall, as opposed to buying a put to protect a position in the underlying stock.
Figure 7 shows the risk and return involved with buying a put (speculative put) with a strike price of $25 for a premium of $5. When you buy a put the most you can lose is the premium you pay for buying the put option. However you are able to make large profits if the underlying stock falls.
Figure 7.
Ø Speculative put chart:
If the price of the stock fell to $10 by the expiry date, the put option would have a value of $15 ($25 strike price that you could sell the stock for - $10 current stock price that you could buy the stock for). In this example the put holder would have a $10 profit ($15 the value of the option at expiry - $5 the premium paid for the option).
Ø Protective Put:
A protective put is when you have a position in the underlying stock and you buy a put to protect against a drop in the stock's price. A protective put is like buying an insurance policy on your stock to protect against the drop in price. You may want to buy a protective put if you think the underlying stock is going to rise buy you have some short term concerns, and you want to protect yourself in case there is a sharp drop in the stock price.
Figure 8 shows the risk and return involved with holding a stock and buying a protective put on it. When you buy a protective put you still have unlimited profit potential while you are able to limit your risk.
Figure 8.
Ø Protective Put Chart:
If the price of the underlying stock fell to $25 or lower by the expiry date the combined position would have a loss of $10 (this remains the same because the profits on the put option will offset any losses on the stock below the $25 strike price). If the price of the underlying stock went up to $45 there would be a profit of $10 ($15 the gain on the stock - $5 the premium paid to buy the protective put).
A protective put has the same risk reward profile as buying a call option.
Ø Short Put:
Writing a put obligates you to buy the underlying stock at the strike price any time until expiry if you are assigned.
Ø Short Put (Writing a Put):
When you write (sell) a put that you don't already own you are said to be "short a put". You could write a put if you think the price of the underlying stock is going to stay the same or rise (when you are neutral or bullish on the underlying stock).
Figure 9 shows the risk and return involved with writing a put with a strike price of $25 for a premium of $5. When you write a put the most you can make is the premium you receive for writing the put option. However you are taking on the risk of large losses if the underlying stock falls.
Figure 9.
Ø Short Put Chart:
If the price of the stock fell to $5 by the expiry date, the put option would have a value of -$20 ($5 current stock price that you could sell the stock for - $25 strike price that you would have to buy the stock for). In this example the put writer would have a $15 loss ($5 the premium received for writing the option - $20 the value of the option you wrote at expiry).
Writing a put has the same risk reward profile as a covered call position.
Ø Naked Put (Uncovered) vs. Short Put Covered by Cash:
There are two basic types of short puts covered and uncovered (naked).
When you write a put you are taking on an obligation to buy the underlying stock at the strike price. You can cover this obligation by having enough cash to buy the shares at the strike price. There are several other methods of covering a short put. If you write a put option that is not covered you are taking on more risk, this is called a naked or an uncovered put.
Ø Sell the Options:
You can sell an option that you previously bought on or before the expiry date. Selling an option is often the best way to close out a position if there is still time remaining before expiry. This is because when you sell an option you will sell it for the total price (the intrinsic value + the time value). If you sell the option you will not need to take a position in the underlying asset.
Ø Exercise the Options:
You can only exercise an option if you are long the option (if you own the option). You can exercise American style option any time on or before the expiry date. When an option is exercised, only the intrinsic value is realized, and any time value remaining is lost. When you exercise an option you are actually buying or selling the underlying stock. Exercising an option would be appropriate in a situation where there is little or no time value, and you want to buy the stock in the case of a call, or sell the stock in the case of a put.
Ø Get Assigned:
You can only get assigned if you are short the option. You will get assigned if the person who buys the option from you exercises it. Being assigned is a possibility however you have no control over this; it is the decision of the other party in the options contract. When you are assigned you must simply fulfill your obligation under the option contract. In the case of a call option you would have to sell the stock at the strike price to the call holder, and in the case of a put option you would have to buy the stock at the strike price from the put holder.
Ø Let the Options Expire:
An option will expire worthless if the option is either at-the-money or out-of-the-money on expiry. Letting your options expire worthless is the only viable decision when they are out-of-the-money on expiry. When you let an option expire, you lose all the money you invested in the option.
Ø Opening an Account:
Before you start trading options you will need to open a margin account. If you have a cash account you will need to open a new account because you cannot trade options in a cash account.
When you apply for a margin account you will need to specify that you want to trade options, and you may be required to specify what type of options strategies you would like to do in the account. If the account application form asks it is important to tell your brokerage firm what type of option strategies you would like to be allowed to do. If you don't tell them you may find that they won't let you do certain types of strategies.
You can also trade options in registered accounts, however with a registered account you may also have to apply for options approval on the account. We would recommend for you to check with your brokerage firm to see if they have any additional requirements for trading options. For example some firms require you to have a minimum balance before writing any naked options.
Ø Registered Accounts:
Options can be traded in registered accounts such as RRSP or RRIF accounts, however you will first need to get options approval on your account. Registered accounts also have restrictions as to what type of options strategies can be done.
ANNEXURE
HOW OPTIONS WORK:
Ø An option is a special contract in which the option owner enjoys the right to buy or sell something without the obligation to do so.
Ø The option to buy under the contract is called Call option and the options to sell are call put option.
Ø The option holder is the buyer of the option and the option writer is the seller of that option.
Ø The price at which the option holder can buy or sell the underlying asset is called the striking price or exercise price.
Ø The date on which the option expires or matures is known as expiration date. The option becomes worthless after the expiration date.
Ø The act of buying and selling the underlying Asset as per the option contract is called exercising the option. An option can exercise on or before expiration date.
Ø These options are traded on stock exchanges. Some of these options can be traded over the counter. Exchange traded options are standardized in terms of quantity, expiration date, strike prices, type of options, mode of settlement trading cycle etc.
Ø Options contracts on individual securities on the NSE are in the multiple of 100 and have three months trading cycle. These options expire on the last Thursday of the month.
Ø These options have five strike prices stipulated by the exchange and the prices have to be settled in cash.
Ø The value of an option expiring immediately is called its intrinsic value.
Ø The excess of the market price of any options over its intrinsic value is known as time value of an option.
For e.g.: the market price of a share is Rs 520/-, the exercise price of a call option on the share is Rs 500/- and the market price of the call option is Rs30/-. In this case, the intrinsic value of the option is Rs 20/- (Rs520-Rs500/-) and the time value of the option is Rs 10/- (Rs 30 - Rs 20).
OPTIONS PRICING:
Ø The price of a put or call option depends upon the market behaviour of the equity that underlines the option.
Ø Generally, stock options are looked upon, as a speculative vehicle as in any option there is a risk of loss to both the contracting parties.
Ø The price at which the stock under option may be put or called is the contract price. It is also referred to as a striking price.
Ø The contract price remains fixed during the life of the contract. However as per market practice, the contract price can reduce by the amount of any dividend paid or by the value of any right, which becomes effective during the period of contract.
Ø The amount the buyers pay for the option privilege in purchasing an option is called the premium. Sometimes, it may be called as the option money. In most of the transactions the contract price is the stock market price prevailing at the time the option is written and the premium becomes the variable for the buyer and the seller to bargain. There are many expiration dates and striking prices offered with option, which benefit many investors.
