Presented
by Lavita
Derivatives
Derivatives
Commodity
Derivatives
Financial
Derivatives
Tangible
Commodities
Intangible
Commodities
Real
Estate
Foreign
Exchange
Equity
Derivatives
Debt
Derivatives
Index products
Derivatives on
Securities
Interest rate
Products
IRF & IRS
GOI Secs,
Bonds,
T-bills
? Quantity of the underlying
? Quality of the underlying (not required in
financial futures)
? The date and month of delivery
? The units of price quotation (not the price
itself) and minimum change in price (tick-size)
? Location of Settlement
? Basis convergence at maturity
Forwards Vs. Futures
Standardised Terms in Futures
Genesis – The Inter linkages
Forwards
Futures
Options
Standardised
& Traded on
Exchange
Attach
A Right
The Global Derivatives Industry :
Chronology of Instruments
1874 Commodity Futures
1972 Currency Futures
1973 Equity Options
1975 Interest Futures
1981 Currency Swaps
1982 Index Futures, Interest Rates Swaps,
Currency Options
1983 Option on Index, Options on Futures
Introduction of Products
CHOICES
1. Index Futures
2. Options on Index
3. Options on Stocks
4. Futures on Stocks
Sensex Futures – 9
th
June, 2000 Friday
Sensex Options – 1
st
June, 2001 Friday
Stock Options – 9
th
July, 2001 Monday
Stock futures – 9
th
Nov, 2001 Friday
Interest Rate Futures – 24
th
June, 2003 Tuesday
Derivatives Session Timings
Trading
Session
9.30 15.30
Position
Transfer
15.30 15.45
Closing
Session
15.45 16.00
Option
Exercise
16.00 16.30
Margin
Session
16.30 16.45
Query
Session
16.45 17.30
End of Day 17.30
-
Futures / Options
Contracts Duration
July
Aug
Sept
Oct
1 month (Near)
2 month (Middle)
3 month (Far)
3 month (Far)
2 month (Middle)
1 month (Near)
Expires
All Contracts in Derivatives expires on
Last Thursday of every Month
Frequently used terms in
derivatives market..
Positions:
? Long position- Outstanding/unsettled
purchase position at any point of time.
? Short position - Outstanding/ unsettled
sales position at any point of time.
? Open position - Outstanding/unsettled
long or short position at any point of
time.
product terminology
? Contract Size - The value of the contract at a specific
level of Index or stock. It is index level*multiplier.
? Multiplier - It is a pre-determined value, used to arrive
at the contract size. It is price per index point.
? Tick Size - It is the minimum difference between two
quotes of similar nature.
? Contract Month - The month in which the contract will
expire.
Frequently used terms in derivatives mkt..
? Expiry Day - The last day on which the contract is
available for trading.
? Open interest - Total outstanding long or short
positions in the market at any specific point in time.
As total long positions for market would be equal to
total short positions, for calculation of open Interest,
only one side of the contracts is counted.
? Volume - No. of contracts traded during a specific
period of time. During a day, during a week or during
a month.
Do V have any OPTION here!
Options are deferred delivery contracts that
give the buyers the right, but not the
obligation, to buy or sell a specified
underlying at a set price on or before a
specified date.
What R my OPTIONS
Deferred delivery contracts
Give the buyer a right
Not the obligation
To buy or
Sell
A specified underlying
At a set price
On or
Before a specified date
Options
Deferred delivery contracts
Give the buyer the right
Not the obligation
To Buy or
Sell
A specified underlying
At a set price
On or
Before a specified date
1, 2, 3 months +
Cash settlement
Call Options
Put Option
Any Asset
Strike Price
European Option
American Option
Any Party, here
Option Seller - One who gives/writes the
option. He has an obligation to perform, in
case option buyer desires to exercise his
option.
Option Buyer - One who buys the option. He
has right to exercise the option but no
obligation.
Options - Salient Features
Call Option - Right to buy
Put Option - Right to sell
American Option
can be exercised anytime on or before the
expiration date
European Option
can be exercised only on the expiration date
Options - Terminology
Strike Price or Exercise Price
Expiration Date
Exercise date
Option Premium
Intrinsic Value
Time Value
In the money
Out of the money
At the money
Call Option
? Right to BUY a specified underlying at a
set price on or before an expiration date.
? The holder of a RIL May 450 call option
has the right to buy (or go long) 100 RIL
shares at a price of 450 anytime between
purchase and expiration.
Put Option
? Right to SELL a specified underlying at a
set price on or before an expiration date.
? The holder of a RIL May 450 put option
has the right to sell (or go short) a RIL
share at a price of 450 anytime between
purchase and expiration.
Call Buyer V/s Seller
? Call Buyer
– Pays premium
– Has right to
exercise resulting
in a long position
in the underlying
– Time works against
buyer
? Call Seller
– Collects premium
– Has obligation if
assigned resulting
in a short position
in the underlying
– Time works in
favor of seller
Put Buyer V/s Seller
? Put Buyer
– Pays premium
– Has right to
exercise resulting
in a short position
in the underlying
– Time works against
buyer
? Put Seller
– Collects premium
– Has obligation if
assigned resulting
in a long position
in the underlying
– Time works in
favor of seller
Assignment
? When holder of an option exercises the
right, a randomly selected option seller is
obligated to be assigned into the
underlying contract.
TRADE OPTIONS
? RIL – Cash 550
? UR View –RIL to move to 650 in month
? What to do buy RIL
? Hold on – Huge Investment outlay & then
? If view is wrong, so
Buy RIL call 550 , Premium 5
Presented
by Lavita
Economic Payoff
Structure
Options
Asymmetrical risk and return
Buyer - Has limited loss potential - but unlimited
profit potential.
Seller - Has limited profit potential but unlimited
loss potential
Risk
Expiration Day Payoff diagrams
? Help Determine Risk / Reward Tradeoffs
? Help Determine Break-even Levels
? Help Determine Maximum Profit / Loss
? Make Option Strike Prices Readily
Observable
Position of Call option buyer
Trader’s rights- Buy underlying at strike
price.
Trader’s obligations- Nil.
Premium paid or received - Paid.
Margin requirements - No.
Risk profile - Limited, to the extent of the
premium paid.
Profit potential - Unlimited, if prices go up.
Breakeven point - Strike price + Premium.
Position of Call option seller
Trader’s rights- Nil.
Trader’s obligations- Sell underlying at
strike price.
Premium paid or received - Received.
Margin requirements - Yes.
Risk profile - Unlimited, if prices go up.
Profit potential - Limited , to the extent of
the premium received.
Breakeven point - Strike price + Premium.
Economic Payoff for Call Option
-20
-15
-10
-5
0
5
10
15
20
8
0
8
2
8
4
8
6
8
8
9
0
9
2
9
4
9
6
9
8
1
0
0
1
0
2
1
0
4
1
0
6
1
0
8
1
1
0
1
1
2
1
1
4
1
1
6
1
1
8
1
2
0
Asset Price
G
a
i
n
/
L
o
s
s
Buy Call
Sell Call
Strike Rate-100 & Premium-5
-20
-15
-10
-5
0
5
10
15
20
90 95 100 105 110 115 120
Price
P
r
o
f
i
t
/
L
o
s
s
Buyer
Writer
Pay-off-Call option
Hedge/Trade using PUT OPTIONS
? RIL Stock– Cash 550
? UR View –RIL to move to 500 in month
? What to do - Sell RIL
? Hold on – Loss on Stock –
purpose defeated & then
? If view is wrong, so
Buy RIL put 550 , Premium 10
Position of Put option buyer
Trader’s rights- Sell underlying at strike price.
Trader’s obligations- Nil.
Premium paid or received - Paid.
Margin requirements - No.
Risk profile - Limited, to the extent of the
premium paid.
Profit potential - Unlimited*, if prices go down
(BEP = Strike price - Premium).
* Practically, Put option buyer’s profit is limited as
the price of the asset can not go below zero (Max.
profit = Strike price – Premium paid).
Position of Put option seller
Trader’s rights - Nil.
Trader’s obligations- Buy underlying at strike
price.
Premium paid or received - Received.
Margin requirements - Yes.
Risk profile - Unlimited*, if prices go down.
Profit potential - Limited, to the extent of the
premium received (BEP = Strike price - Premium)
* Practically, Put option seller’s risk is limited as the
price of the asset can not go below zero (Maximum loss =
Strike price – Premium received).
Economic Payoff for Put Option
-20
-15
-10
-5
0
5
10
15
20
8
0
8
2
8
4
8
6
8
8
9
0
9
2
9
4
9
6
9
8
1
0
0
1
0
2
1
0
4
1
0
6
1
0
8
1
1
0
1
1
2
1
1
4
1
1
6
1
1
8
1
2
0
Asset Price
G
a
i
n
/
L
o
s
s
Buy Put
Sell Put
Strike Rate-100 & Premium-5
-15
-10
-5
0
5
10
15
5800 5900 6000 6100 6200 6300 6400
Price
P
r
o
f
i
t
/
L
o
s
s
Buyer
Writer
Pay-off-Put option
Options - Parameters
? Strike Price
? Market Price
? Premium
? Break Even Analysis
? When to Exercise to reduce losses on
Premium Account.
Option Class and Series
All options of the same type (calls or puts)
and same expiration are referred to as an
Option Class.
An option series consists of all the options
of a given class with the same expiration
date and strike price. In other words, an
option series refers to a particular contract
that is traded.
HOW OPTIONS ARE TRADED ?
Options Pay-off - ITM
In-the-Money
In-the-Money options are those where the
strike price is better than the market price.
It is profitable for the option holder to
exercise.
Options with Intrinsic value
Options Pay-off - ATM
At-the-Money
At-the Money options are those where
strike price and market price are the same.
Intrinsic value is NIL
Some Time value possible.
Options Pay-off - OTM
Out-of-the-Money
Out-of-the Money options are those where
strike price is worse than the market price.
It is not profitable for the option holder to
exercise.
Intrinsic value is NIL
Some Time value possible.
Option Valuation
Option Premium = Intrinsic + Time
Value Value
Option Premium >= 0
Intrinsic Value >= 0
Time Value >= 0
Intrinsic Value
Value of an Option were it to be exercised now.
Difference between Exercise/Strike Price and
Spot Price
Intrinsic value of an option is the value to the
extent an option is in-the-money (at any point in
time).
Only ITM options have intrinsic value.
Intrinsic value cannot be negative
For a Call Option
S
t
- X
For a Put Option
X - S
t
S
t
= Spot price at time t
X = Strike Price
Time Value
The magnitude of the options’ time value reflects the
potential of the option to gain intrinsic value during its
life
Amount buyers are willing to pay for the possibility that,
at some time prior to expiration, the option may become
profitable
Difference between Option Premium and Intrinsic Value
Cannot be negative
For a Call Option
C - [Max(0,S
t
- X)] C = Call Option Premium
For a Put Option P = Put Option Premium
P - [Max(0,X - S
t
)] S
t
= Spot price at time t
Max for ATM option
Value of option (Premium)
Maximum Time
Value Premium
40 45 50 55 60
P
R
E
M
I
U
M
Call option
price curve
Stock Price
Strike Price 5
10
Intrinsic Value
Behavior of time value of option
Rate of decay of option time value is not linear. Time
value premium decreases at an accelerated rate as the
option approaches maturity.
3 2 1 0
Time
Value
Premium
Time to maturity
Option Time Value Decay
Sensex Call 5500 at sensex 5500
0
10
20
30
40
50
60
9 8 7 6 5 4 3 2 1 0
Time to Expiration
T
i
m
e
V
a
l
u
e
Time Value
Option Valuation
Call Option
P
c
= MAX (0, S - X)
Put Option
P
p
= MAX (0, X - S)
P
c
= Premium/value of call option
P
p =
Premium/value of put option
S
=
Spot price of asset at maturity
X = Strike price of option
Value of option (Premium)
35 40 45 50 55 60 65
35 40 45 50 55 60 65
out-of-the-money calls
in-the-money puts
in-the-money calls
out-of-the-money puts
at-the-money calls and puts
Cash price = 50 being constant & move the Strikes
Strike Prices
At-The-Money-Strike
Out-Of-The-Money Puts In-The-Money-Puts
5700 5800 5900 6000 6100 6200 6300
5700 5800 5900 6000 6100 6200 6300
In-The-Money-Calls Out-Of-The-Money-Calls
At-The-Money-Strike
Intrinsic value and options
Market Scenarios Call option Put options
Market price > strike
price
In-the-money Out-of-the-money
Market price = strike
price
At-the-money * At-the-money*
Market price < Strike
price
Out-of-the-money In-the-money
* When market price is very near to the strike price, option is
called near the money option.
* Only in-the-money options have intrinsic value.
Option Positions Can be closed by the
following ways
? By taking a reverse position in the
market.
? Ex: XYZ bought a Reliance May call
option of 450 strike. The above position
can be closed by selling the same series
in the market
Option Positions Can be closed by the
following ways
? By exercising the option before maturity.
? Ex: XYZ bought a Reliance May call
option of 450 strike. He can exercise the
option on any day before the maturity
during the exercise session. The Option
will be closed at the closing price of the
underlying on the exercise day.
Option Positions Can be closed by the
following ways
? By carrying the position till maturity.
? Ex: XYZ bought a Reliance May call
option of 450 strike and XYZ intends to
carry the position till maturity. On the
maturity, If this is position is in the money
it will be closed automatically at the
closing price of the underlying on the
maturity day.
Option Pricing Models
Black-Scholes Model
P
ce
= S*N(d1) - K e
-Rf.T
* N(d2)
Normal Distribution Function
Binomial (Cox-Ross-Rubenstein) Model
P
pe
= K e
-Rf.T
* N(-d2) - S*N(-d1)
Binomial Distribution Function
Factors affecting Option
Values
Current Price of the underlying asset (S)
Exercise Price of the option(X)
Time to Expiry (T)
Volatility of prices of the underlying asset
(s)
Interest Rates (R
f
)
Dividend
Presented
by Lavita
Option Greeks
Measuring Option
Price Sensitivity
Delta (
Derivative of the option pricing formula with
reference to the asset price (S)
Measures the estimated change in the option
premium for a unit change in Price of underlying (S)
It is also called Hedge Ratio.
If underlying increases by 10 points, a call option
whose delta is 0.3 would increase only 3 points.
Delta
In-the-money option: Higher Deltas (.8)
At-the-money option: Average Deltas (.5)
Out-of-the-money option: Lower Deltas (.2)
Delta
Deep In-the-money options
Delta converges to 1.00
Premium will typically move bit-by-bit with
underlying
Deep Out-of-the-money options
Delta converges to Zero
Premium will generally be very unresponsive to
movement in underlying
Sensex 6000 Call
0
0.2
0.4
0.6
0.8
1
5700 5800 5900 6000 6100 6200 6300
Underlying Prices
D
e
l
t
a
Gamma (
Second derivative of the option pricing
formula with reference to the asset price (S)
Measures the estimated change in the delta
of the option for a unit change in price of
the underlying (S)
Vega (
Derivative of the option pricing formula
with reference to the volatility of the asset
returns (s)
Measures the estimated change in the
option premium for a unit change in
Volatility of the underlying (s)
Historical Vs. Implied Volatility.
If the implied volatility is 20%. The call
premium is 2.00 and vega is 0.12, the
premium would increase to 2.12 when
implied volatility moves up to 21%.
Theta
Derivative of the option pricing formula
with reference to time to option expiry (T)
Measures the estimated change in the
option premium for a unit change in T.
Time decay works in favour of the seller of
the Option.
Assume a premium of 1.00 and a theta of
0.04. The premium is expected to reduced
to 0.96 as one day passes.
Rho (
Derivative of the option pricing formula
with reference to the risk free rate (R
f
)
Measures the estimated change in the
option premium for a unit change in risk
free interest rate. R
f
Factors affecting Option
Prices
Effect of an increase in each pricing factor on the option value,
holding other factors constant
Sl. No. Pricing Factors Call
option
Put option
1. Current Asset Price (S) Increase Decrease
2. Strike price (K) Decrease Increase
3. Volatility of underlying
price (s)
Increase Increase
4. Time to expiration (t) Increase Increase
5. Interest rate ( r ) Increase Decrease
Why do I invest in Options?
Options offer flexibility to the buyer in form of
right to buy or sell and perform hedging..
They can be as conservative or as speculative as
one's investment strategy dictates.
High leverage - Less Investment (in form of
premium) and More Return on Investment.
Large profit potential & Pre-known limited risk
for Option buyer
One can insure his equity portfolio against a
decline in the market by way of buying a
protective put/ writing covered call by paying a
relatively small premium
Basic Options Strategies- I
? Covered Call Strategy – Value Creation
Long Stock
– Sell Covered Call
• Receives Premium
• If exercised, your position is covered
• If not Exercised then Premium is all yours
Basic Options Strategies- II
? Protective Put Strategy –Value Preservation
Long Stock
– Buy Protective Put
• Pays Premium
• If exercised, your portfolio value gets preserved
• If not Exercised then Premium is gone
CAN WE USE
BOTH STRATEGIES TOGETHER?
Key Points
Options can be a very effective tool to take
advantage of a rising or falling underlying. The
following points may be kept in mind while
purchasing options:
The time value of option premiums decay towards
expiration, so market timing is very important.
Choose an option month that allows enough time for
the anticipated move in the underlying.
In-the-money calls are initially more responsive to
underlying price changes than out-ot-the-money calls.
Choose a strike price level that offers a good
risk/reward ratio given the expected price movement.
SENSEX Options
Trading Mechanism
Contract Design:
Multiplier
Contract size
Tick size
Expiration month and date
Open Interest, Volume, Position
Product Specification
SENSEX Options
? Underlying Asset – Sensex
? Contract Multiplier – 100
? Contracts available – 1,2,3 months
? Tick Size – 0.1 Sensex points
INR 10
? Price (Premium) Quotations – Sensex pts
? Trading Hours – 9:30 am –3:30 pm
? Exercise Style – European
Product Specification
SENSEX Options
? Settlement Type - Cash
? Strike Price Interval – 50 Sensex Pts
– Minimum 5 Stike Prices available at any pt in time
• 2 ITM, 2 OTM & 1 ATM
? Last Trading Day – Last Thursday
? Expiration Day - Last Thursday
? Final Settlement – Last Trading Day, The
Closing Value of Sensex = Final Settlement
Price of the expiring Options Contract
? Exercise Session , All ITM deemed exercised
Stock Options
Strike Price Intervals
Sr. No. Price of the Strike Price
Underlying (Rs.) I nterval (Rs.)
? 1. Less than or equal to Rs. 50 Rs. 2
? 2. > Rs. 50 to < Rs. 150 Rs. 5
? 3. > Rs. 150 to < Rs. 250 Rs. 10
? 4. > Rs. 250 to < Rs. 500 Rs. 20
? 5. > Rs. 500 to < Rs. 1000 Rs. 30
? 6. > Rs. 1000 Rs. 50
Product Specification
Stock Options
? Underlying Asset – Stock
? Contract Multiplier –Stock specific mkt lot
? Strike Price Interval – Minimum 5 Stike Prices
available at any pt in time
• 2 ITM, 2 OTM & 1 ATM
? Contracts available – 1,2,3 months
? Tick Size – 0.01
? Price (Premium) Quotations – Rs. per share
? Trading Hours – 9:30 am –3:30 pm
? Exercise Style – American
Product Specification
Stock Options
? Settlement Type - Cash
? Strike Price Interval –Minimum 5 Stike Prices
available at any pt in time
• 2 ITM, 2 OTM & 1 ATM
? Last Trading Day – Last Thursday
? Expiration Day - Last Thursday
? Final Settlement – Last Trading Day, The
Closing Value of Stock = Final Settlement Price
of the expiring Futures Contract
? Exercise Session , All ITM deemed exercised
Operators in the derivatives
market..
? Hedgers - Operators, who want to transfer
a risk component of their portfolio.
? Speculators - Operators, who intentionally
take the risk from hedgers in pursuit of
profit.
? Arbitrageurs - Operators who operate in
the different markets simultaneously, in
pursuit of profit and eliminate mis-pricing.
MARK
TO MARKET
TRADING SYSTEM
INVESTOR
DEPOSITS
ADDTIONAL
MARGIN MARKED
TO MARKET
INVESTOR
WITHDRAWS
ADDITIONAL
MARGIN MARKED
TO MARKET
GAINS CREDITED
TO
INVESTORS A/C
LOSS DEBITED
TO
INVESTOR A/C
MARK
TO MARKET
INVESTOR
CLEARING
CORPORATION
MARGINS
CONFIRMATION
CONFIRMATION
ORDER
CONFIRMATION
ORDER
MARGINS
Broker
Why do we need derivatives..
? Price discovery.
? Hedging.
? Stability in the underlying market.
? Transaction Cost
? Speed of Execution
Future
Multiple indices trading on the same
exchange ......................
.........even the same index with different
contract designs.
Hedge funds
Books & Visitations
Options, Futures & Other Derivatives by J C Hull
Options Trading Strategies by McMilan
Derivatives by Edward Ma
Futures and Options by Vohra & Bagri
Futures & Options by R Mahajanhttp://www.bseindia.comhttp://www.cme.comhttp://www.cboe.comhttp://www.cbot.comhttp://www.LIFFE.comhttp://www.numa.comhttp://www.jpmorgan.com
FORWARD
your
FUTURE
with lots of
OPTIONS
doc_564465119.ppt
by Lavita
Derivatives
Derivatives
Commodity
Derivatives
Financial
Derivatives
Tangible
Commodities
Intangible
Commodities
Real
Estate
Foreign
Exchange
Equity
Derivatives
Debt
Derivatives
Index products
Derivatives on
Securities
Interest rate
Products
IRF & IRS
GOI Secs,
Bonds,
T-bills
? Quantity of the underlying
? Quality of the underlying (not required in
financial futures)
? The date and month of delivery
? The units of price quotation (not the price
itself) and minimum change in price (tick-size)
? Location of Settlement
? Basis convergence at maturity
Forwards Vs. Futures
Standardised Terms in Futures
Genesis – The Inter linkages
Forwards
Futures
Options
Standardised
& Traded on
Exchange
Attach
A Right
The Global Derivatives Industry :
Chronology of Instruments
1874 Commodity Futures
1972 Currency Futures
1973 Equity Options
1975 Interest Futures
1981 Currency Swaps
1982 Index Futures, Interest Rates Swaps,
Currency Options
1983 Option on Index, Options on Futures
Introduction of Products
CHOICES
1. Index Futures
2. Options on Index
3. Options on Stocks
4. Futures on Stocks
Sensex Futures – 9
th
June, 2000 Friday
Sensex Options – 1
st
June, 2001 Friday
Stock Options – 9
th
July, 2001 Monday
Stock futures – 9
th
Nov, 2001 Friday
Interest Rate Futures – 24
th
June, 2003 Tuesday
Derivatives Session Timings
Trading
Session
9.30 15.30
Position
Transfer
15.30 15.45
Closing
Session
15.45 16.00
Option
Exercise
16.00 16.30
Margin
Session
16.30 16.45
Query
Session
16.45 17.30
End of Day 17.30
-
Futures / Options
Contracts Duration
July
Aug
Sept
Oct
1 month (Near)
2 month (Middle)
3 month (Far)
3 month (Far)
2 month (Middle)
1 month (Near)
Expires
All Contracts in Derivatives expires on
Last Thursday of every Month
Frequently used terms in
derivatives market..
Positions:
? Long position- Outstanding/unsettled
purchase position at any point of time.
? Short position - Outstanding/ unsettled
sales position at any point of time.
? Open position - Outstanding/unsettled
long or short position at any point of
time.
product terminology
? Contract Size - The value of the contract at a specific
level of Index or stock. It is index level*multiplier.
? Multiplier - It is a pre-determined value, used to arrive
at the contract size. It is price per index point.
? Tick Size - It is the minimum difference between two
quotes of similar nature.
? Contract Month - The month in which the contract will
expire.
Frequently used terms in derivatives mkt..
? Expiry Day - The last day on which the contract is
available for trading.
? Open interest - Total outstanding long or short
positions in the market at any specific point in time.
As total long positions for market would be equal to
total short positions, for calculation of open Interest,
only one side of the contracts is counted.
? Volume - No. of contracts traded during a specific
period of time. During a day, during a week or during
a month.
Do V have any OPTION here!
Options are deferred delivery contracts that
give the buyers the right, but not the
obligation, to buy or sell a specified
underlying at a set price on or before a
specified date.
What R my OPTIONS
Deferred delivery contracts
Give the buyer a right
Not the obligation
To buy or
Sell
A specified underlying
At a set price
On or
Before a specified date
Options
Deferred delivery contracts
Give the buyer the right
Not the obligation
To Buy or
Sell
A specified underlying
At a set price
On or
Before a specified date
1, 2, 3 months +
Cash settlement
Call Options
Put Option
Any Asset
Strike Price
European Option
American Option
Any Party, here
Option Seller - One who gives/writes the
option. He has an obligation to perform, in
case option buyer desires to exercise his
option.
Option Buyer - One who buys the option. He
has right to exercise the option but no
obligation.
Options - Salient Features
Call Option - Right to buy
Put Option - Right to sell
American Option
can be exercised anytime on or before the
expiration date
European Option
can be exercised only on the expiration date
Options - Terminology
Strike Price or Exercise Price
Expiration Date
Exercise date
Option Premium
Intrinsic Value
Time Value
In the money
Out of the money
At the money
Call Option
? Right to BUY a specified underlying at a
set price on or before an expiration date.
? The holder of a RIL May 450 call option
has the right to buy (or go long) 100 RIL
shares at a price of 450 anytime between
purchase and expiration.
Put Option
? Right to SELL a specified underlying at a
set price on or before an expiration date.
? The holder of a RIL May 450 put option
has the right to sell (or go short) a RIL
share at a price of 450 anytime between
purchase and expiration.
Call Buyer V/s Seller
? Call Buyer
– Pays premium
– Has right to
exercise resulting
in a long position
in the underlying
– Time works against
buyer
? Call Seller
– Collects premium
– Has obligation if
assigned resulting
in a short position
in the underlying
– Time works in
favor of seller
Put Buyer V/s Seller
? Put Buyer
– Pays premium
– Has right to
exercise resulting
in a short position
in the underlying
– Time works against
buyer
? Put Seller
– Collects premium
– Has obligation if
assigned resulting
in a long position
in the underlying
– Time works in
favor of seller
Assignment
? When holder of an option exercises the
right, a randomly selected option seller is
obligated to be assigned into the
underlying contract.
TRADE OPTIONS
? RIL – Cash 550
? UR View –RIL to move to 650 in month
? What to do buy RIL
? Hold on – Huge Investment outlay & then
? If view is wrong, so
Buy RIL call 550 , Premium 5
Presented
by Lavita
Economic Payoff
Structure
Options
Asymmetrical risk and return
Buyer - Has limited loss potential - but unlimited
profit potential.
Seller - Has limited profit potential but unlimited
loss potential
Risk
Expiration Day Payoff diagrams
? Help Determine Risk / Reward Tradeoffs
? Help Determine Break-even Levels
? Help Determine Maximum Profit / Loss
? Make Option Strike Prices Readily
Observable
Position of Call option buyer
Trader’s rights- Buy underlying at strike
price.
Trader’s obligations- Nil.
Premium paid or received - Paid.
Margin requirements - No.
Risk profile - Limited, to the extent of the
premium paid.
Profit potential - Unlimited, if prices go up.
Breakeven point - Strike price + Premium.
Position of Call option seller
Trader’s rights- Nil.
Trader’s obligations- Sell underlying at
strike price.
Premium paid or received - Received.
Margin requirements - Yes.
Risk profile - Unlimited, if prices go up.
Profit potential - Limited , to the extent of
the premium received.
Breakeven point - Strike price + Premium.
Economic Payoff for Call Option
-20
-15
-10
-5
0
5
10
15
20
8
0
8
2
8
4
8
6
8
8
9
0
9
2
9
4
9
6
9
8
1
0
0
1
0
2
1
0
4
1
0
6
1
0
8
1
1
0
1
1
2
1
1
4
1
1
6
1
1
8
1
2
0
Asset Price
G
a
i
n
/
L
o
s
s
Buy Call
Sell Call
Strike Rate-100 & Premium-5
-20
-15
-10
-5
0
5
10
15
20
90 95 100 105 110 115 120
Price
P
r
o
f
i
t
/
L
o
s
s
Buyer
Writer
Pay-off-Call option
Hedge/Trade using PUT OPTIONS
? RIL Stock– Cash 550
? UR View –RIL to move to 500 in month
? What to do - Sell RIL
? Hold on – Loss on Stock –
purpose defeated & then
? If view is wrong, so
Buy RIL put 550 , Premium 10
Position of Put option buyer
Trader’s rights- Sell underlying at strike price.
Trader’s obligations- Nil.
Premium paid or received - Paid.
Margin requirements - No.
Risk profile - Limited, to the extent of the
premium paid.
Profit potential - Unlimited*, if prices go down
(BEP = Strike price - Premium).
* Practically, Put option buyer’s profit is limited as
the price of the asset can not go below zero (Max.
profit = Strike price – Premium paid).
Position of Put option seller
Trader’s rights - Nil.
Trader’s obligations- Buy underlying at strike
price.
Premium paid or received - Received.
Margin requirements - Yes.
Risk profile - Unlimited*, if prices go down.
Profit potential - Limited, to the extent of the
premium received (BEP = Strike price - Premium)
* Practically, Put option seller’s risk is limited as the
price of the asset can not go below zero (Maximum loss =
Strike price – Premium received).
Economic Payoff for Put Option
-20
-15
-10
-5
0
5
10
15
20
8
0
8
2
8
4
8
6
8
8
9
0
9
2
9
4
9
6
9
8
1
0
0
1
0
2
1
0
4
1
0
6
1
0
8
1
1
0
1
1
2
1
1
4
1
1
6
1
1
8
1
2
0
Asset Price
G
a
i
n
/
L
o
s
s
Buy Put
Sell Put
Strike Rate-100 & Premium-5
-15
-10
-5
0
5
10
15
5800 5900 6000 6100 6200 6300 6400
Price
P
r
o
f
i
t
/
L
o
s
s
Buyer
Writer
Pay-off-Put option
Options - Parameters
? Strike Price
? Market Price
? Premium
? Break Even Analysis
? When to Exercise to reduce losses on
Premium Account.
Option Class and Series
All options of the same type (calls or puts)
and same expiration are referred to as an
Option Class.
An option series consists of all the options
of a given class with the same expiration
date and strike price. In other words, an
option series refers to a particular contract
that is traded.
HOW OPTIONS ARE TRADED ?
Options Pay-off - ITM
In-the-Money
In-the-Money options are those where the
strike price is better than the market price.
It is profitable for the option holder to
exercise.
Options with Intrinsic value
Options Pay-off - ATM
At-the-Money
At-the Money options are those where
strike price and market price are the same.
Intrinsic value is NIL
Some Time value possible.
Options Pay-off - OTM
Out-of-the-Money
Out-of-the Money options are those where
strike price is worse than the market price.
It is not profitable for the option holder to
exercise.
Intrinsic value is NIL
Some Time value possible.
Option Valuation
Option Premium = Intrinsic + Time
Value Value
Option Premium >= 0
Intrinsic Value >= 0
Time Value >= 0
Intrinsic Value
Value of an Option were it to be exercised now.
Difference between Exercise/Strike Price and
Spot Price
Intrinsic value of an option is the value to the
extent an option is in-the-money (at any point in
time).
Only ITM options have intrinsic value.
Intrinsic value cannot be negative
For a Call Option
S
t
- X
For a Put Option
X - S
t
S
t
= Spot price at time t
X = Strike Price
Time Value
The magnitude of the options’ time value reflects the
potential of the option to gain intrinsic value during its
life
Amount buyers are willing to pay for the possibility that,
at some time prior to expiration, the option may become
profitable
Difference between Option Premium and Intrinsic Value
Cannot be negative
For a Call Option
C - [Max(0,S
t
- X)] C = Call Option Premium
For a Put Option P = Put Option Premium
P - [Max(0,X - S
t
)] S
t
= Spot price at time t
Max for ATM option
Value of option (Premium)
Maximum Time
Value Premium
40 45 50 55 60
P
R
E
M
I
U
M
Call option
price curve
Stock Price
Strike Price 5
10
Intrinsic Value
Behavior of time value of option
Rate of decay of option time value is not linear. Time
value premium decreases at an accelerated rate as the
option approaches maturity.
3 2 1 0
Time
Value
Premium
Time to maturity
Option Time Value Decay
Sensex Call 5500 at sensex 5500
0
10
20
30
40
50
60
9 8 7 6 5 4 3 2 1 0
Time to Expiration
T
i
m
e
V
a
l
u
e
Time Value
Option Valuation
Call Option
P
c
= MAX (0, S - X)
Put Option
P
p
= MAX (0, X - S)
P
c
= Premium/value of call option
P
p =
Premium/value of put option
S
=
Spot price of asset at maturity
X = Strike price of option
Value of option (Premium)
35 40 45 50 55 60 65
35 40 45 50 55 60 65
out-of-the-money calls
in-the-money puts
in-the-money calls
out-of-the-money puts
at-the-money calls and puts
Cash price = 50 being constant & move the Strikes
Strike Prices
At-The-Money-Strike
Out-Of-The-Money Puts In-The-Money-Puts
5700 5800 5900 6000 6100 6200 6300
5700 5800 5900 6000 6100 6200 6300
In-The-Money-Calls Out-Of-The-Money-Calls
At-The-Money-Strike
Intrinsic value and options
Market Scenarios Call option Put options
Market price > strike
price
In-the-money Out-of-the-money
Market price = strike
price
At-the-money * At-the-money*
Market price < Strike
price
Out-of-the-money In-the-money
* When market price is very near to the strike price, option is
called near the money option.
* Only in-the-money options have intrinsic value.
Option Positions Can be closed by the
following ways
? By taking a reverse position in the
market.
? Ex: XYZ bought a Reliance May call
option of 450 strike. The above position
can be closed by selling the same series
in the market
Option Positions Can be closed by the
following ways
? By exercising the option before maturity.
? Ex: XYZ bought a Reliance May call
option of 450 strike. He can exercise the
option on any day before the maturity
during the exercise session. The Option
will be closed at the closing price of the
underlying on the exercise day.
Option Positions Can be closed by the
following ways
? By carrying the position till maturity.
? Ex: XYZ bought a Reliance May call
option of 450 strike and XYZ intends to
carry the position till maturity. On the
maturity, If this is position is in the money
it will be closed automatically at the
closing price of the underlying on the
maturity day.
Option Pricing Models
Black-Scholes Model
P
ce
= S*N(d1) - K e
-Rf.T
* N(d2)
Normal Distribution Function
Binomial (Cox-Ross-Rubenstein) Model
P
pe
= K e
-Rf.T
* N(-d2) - S*N(-d1)
Binomial Distribution Function
Factors affecting Option
Values
Current Price of the underlying asset (S)
Exercise Price of the option(X)
Time to Expiry (T)
Volatility of prices of the underlying asset
(s)
Interest Rates (R
f
)
Dividend
Presented
by Lavita
Option Greeks
Measuring Option
Price Sensitivity
Delta (
Derivative of the option pricing formula with
reference to the asset price (S)
Measures the estimated change in the option
premium for a unit change in Price of underlying (S)
It is also called Hedge Ratio.
If underlying increases by 10 points, a call option
whose delta is 0.3 would increase only 3 points.
Delta
In-the-money option: Higher Deltas (.8)
At-the-money option: Average Deltas (.5)
Out-of-the-money option: Lower Deltas (.2)
Delta
Deep In-the-money options
Delta converges to 1.00
Premium will typically move bit-by-bit with
underlying
Deep Out-of-the-money options
Delta converges to Zero
Premium will generally be very unresponsive to
movement in underlying
Sensex 6000 Call
0
0.2
0.4
0.6
0.8
1
5700 5800 5900 6000 6100 6200 6300
Underlying Prices
D
e
l
t
a
Gamma (
Second derivative of the option pricing
formula with reference to the asset price (S)
Measures the estimated change in the delta
of the option for a unit change in price of
the underlying (S)
Vega (
Derivative of the option pricing formula
with reference to the volatility of the asset
returns (s)
Measures the estimated change in the
option premium for a unit change in
Volatility of the underlying (s)
Historical Vs. Implied Volatility.
If the implied volatility is 20%. The call
premium is 2.00 and vega is 0.12, the
premium would increase to 2.12 when
implied volatility moves up to 21%.
Theta
Derivative of the option pricing formula
with reference to time to option expiry (T)
Measures the estimated change in the
option premium for a unit change in T.
Time decay works in favour of the seller of
the Option.
Assume a premium of 1.00 and a theta of
0.04. The premium is expected to reduced
to 0.96 as one day passes.
Rho (
Derivative of the option pricing formula
with reference to the risk free rate (R
f
)
Measures the estimated change in the
option premium for a unit change in risk
free interest rate. R
f
Factors affecting Option
Prices
Effect of an increase in each pricing factor on the option value,
holding other factors constant
Sl. No. Pricing Factors Call
option
Put option
1. Current Asset Price (S) Increase Decrease
2. Strike price (K) Decrease Increase
3. Volatility of underlying
price (s)
Increase Increase
4. Time to expiration (t) Increase Increase
5. Interest rate ( r ) Increase Decrease
Why do I invest in Options?
Options offer flexibility to the buyer in form of
right to buy or sell and perform hedging..
They can be as conservative or as speculative as
one's investment strategy dictates.
High leverage - Less Investment (in form of
premium) and More Return on Investment.
Large profit potential & Pre-known limited risk
for Option buyer
One can insure his equity portfolio against a
decline in the market by way of buying a
protective put/ writing covered call by paying a
relatively small premium
Basic Options Strategies- I
? Covered Call Strategy – Value Creation
Long Stock
– Sell Covered Call
• Receives Premium
• If exercised, your position is covered
• If not Exercised then Premium is all yours
Basic Options Strategies- II
? Protective Put Strategy –Value Preservation
Long Stock
– Buy Protective Put
• Pays Premium
• If exercised, your portfolio value gets preserved
• If not Exercised then Premium is gone
CAN WE USE
BOTH STRATEGIES TOGETHER?
Key Points
Options can be a very effective tool to take
advantage of a rising or falling underlying. The
following points may be kept in mind while
purchasing options:
The time value of option premiums decay towards
expiration, so market timing is very important.
Choose an option month that allows enough time for
the anticipated move in the underlying.
In-the-money calls are initially more responsive to
underlying price changes than out-ot-the-money calls.
Choose a strike price level that offers a good
risk/reward ratio given the expected price movement.
SENSEX Options
Trading Mechanism
Contract Design:
Multiplier
Contract size
Tick size
Expiration month and date
Open Interest, Volume, Position
Product Specification
SENSEX Options
? Underlying Asset – Sensex
? Contract Multiplier – 100
? Contracts available – 1,2,3 months
? Tick Size – 0.1 Sensex points
INR 10
? Price (Premium) Quotations – Sensex pts
? Trading Hours – 9:30 am –3:30 pm
? Exercise Style – European
Product Specification
SENSEX Options
? Settlement Type - Cash
? Strike Price Interval – 50 Sensex Pts
– Minimum 5 Stike Prices available at any pt in time
• 2 ITM, 2 OTM & 1 ATM
? Last Trading Day – Last Thursday
? Expiration Day - Last Thursday
? Final Settlement – Last Trading Day, The
Closing Value of Sensex = Final Settlement
Price of the expiring Options Contract
? Exercise Session , All ITM deemed exercised
Stock Options
Strike Price Intervals
Sr. No. Price of the Strike Price
Underlying (Rs.) I nterval (Rs.)
? 1. Less than or equal to Rs. 50 Rs. 2
? 2. > Rs. 50 to < Rs. 150 Rs. 5
? 3. > Rs. 150 to < Rs. 250 Rs. 10
? 4. > Rs. 250 to < Rs. 500 Rs. 20
? 5. > Rs. 500 to < Rs. 1000 Rs. 30
? 6. > Rs. 1000 Rs. 50
Product Specification
Stock Options
? Underlying Asset – Stock
? Contract Multiplier –Stock specific mkt lot
? Strike Price Interval – Minimum 5 Stike Prices
available at any pt in time
• 2 ITM, 2 OTM & 1 ATM
? Contracts available – 1,2,3 months
? Tick Size – 0.01
? Price (Premium) Quotations – Rs. per share
? Trading Hours – 9:30 am –3:30 pm
? Exercise Style – American
Product Specification
Stock Options
? Settlement Type - Cash
? Strike Price Interval –Minimum 5 Stike Prices
available at any pt in time
• 2 ITM, 2 OTM & 1 ATM
? Last Trading Day – Last Thursday
? Expiration Day - Last Thursday
? Final Settlement – Last Trading Day, The
Closing Value of Stock = Final Settlement Price
of the expiring Futures Contract
? Exercise Session , All ITM deemed exercised
Operators in the derivatives
market..
? Hedgers - Operators, who want to transfer
a risk component of their portfolio.
? Speculators - Operators, who intentionally
take the risk from hedgers in pursuit of
profit.
? Arbitrageurs - Operators who operate in
the different markets simultaneously, in
pursuit of profit and eliminate mis-pricing.
MARK
TO MARKET
TRADING SYSTEM
INVESTOR
DEPOSITS
ADDTIONAL
MARGIN MARKED
TO MARKET
INVESTOR
WITHDRAWS
ADDITIONAL
MARGIN MARKED
TO MARKET
GAINS CREDITED
TO
INVESTORS A/C
LOSS DEBITED
TO
INVESTOR A/C
MARK
TO MARKET
INVESTOR
CLEARING
CORPORATION
MARGINS
CONFIRMATION
CONFIRMATION
ORDER
CONFIRMATION
ORDER
MARGINS
Broker
Why do we need derivatives..
? Price discovery.
? Hedging.
? Stability in the underlying market.
? Transaction Cost
? Speed of Execution
Future
Multiple indices trading on the same
exchange ......................
.........even the same index with different
contract designs.
Hedge funds
Books & Visitations
Options, Futures & Other Derivatives by J C Hull
Options Trading Strategies by McMilan
Derivatives by Edward Ma
Futures and Options by Vohra & Bagri
Futures & Options by R Mahajanhttp://www.bseindia.comhttp://www.cme.comhttp://www.cboe.comhttp://www.cbot.comhttp://www.LIFFE.comhttp://www.numa.comhttp://www.jpmorgan.com
FORWARD
your
FUTURE
with lots of
OPTIONS
doc_564465119.ppt