Wollega University

Banking & Finance Program

CHAPTER SIX

OPTIONS AND FUTURES TRADING

 Derivatives
Introduction
The individuals and firms who wish to avoid or reduce risk can deal with
the others who are willing to accept the risk for a price.

A common place where such transactions take place is called the

‘derivative market’. The financial assets commonly traded in the derivatives
market are used to change the risk characteristics of underlying asset or
liability position, they are referred to as ‘derivative financial instruments’ or
simply ‘derivatives’.

Derivative assets get their name from the fact that their value derives from
some other asset. The underlying asset may be equity, commodity or
currency.

Thus, since their value derives from some underlying instrument and have
no intrinsic value of their own. The best- known derivative assets are futures
and options are the focus of this chapter.
 OPTIONS TRADING
An option is a derivative financial instrument that specifies a contract
between two parties for a future transaction to buy or sell an asset at a
specific time for an agreed price.

An option is a contract that gives the buyer the right, but not the obligation,
to buy or sell an underlying asset at a specific price on or before a certain
date. An option, just like a stock or bond, is a security. It is also a binding
contract with strictly defined terms and properties.

Example:- Mr. X discovers a house that he would love to purchase.

Unfortunately, he won't have the cash to buy it for another three months. Mr.
X talks to the owner and negotiate a deal that gives him an option to buy the
house in three months for a price of Birr 200,000. The owner agrees, but for
this option, X pays a price of Birr 3,000 as an advance.
Now, consider two theoretical situations that might arise:
1. As a result, the market value of the house skyrockets to Birr
500,000. But the owner sold you the option, he is obligated to sell
you the house for Birr 200,000. In the end, you stand to make a
profit of Birr 2,]97,000.
(Birr 500,000-200,000=300,000-3,000=2,97,000).
2. Mr. X now considers that house is worthless, say Birr 175,000. On
the upside, because he bought an option, he is under no obligation
to go through with the sale. Of course, he still lose the Birr 3,000
price of the option.
Generally speaking, stock options are considered as speculative
vehicle. As found in any option, there is a risk of loss to the
contracting parties.
 Cont’d
There are three parties in the option trading namely, the
option seller, buyer and broker.
The option seller is also called as the option writer. He is a
person who grants the other person the option to buy.
So, he becomes bound to respond to the buyer’s
decision.
Option Buyer: The person who has received the right and
thus has a decision to make is the option buyer. He must
pay a price to the option writer to induce him to the
option.
Option Broker: The broker spots the option buyer and the
seller and receives a commission or fee for it.
 TYPES OF OPTIONS
There are two types of options. These are:
1) Put Option
2) Call Option
 Put Option
A put gives the holder the right to sell an asset at a certain price within a
specific period of time. Puts are very similar to having a short position on
a stock. Buyer of puts hope that the price of the stock will fall before the
option expires.
Example: Mr. Girma expects XY company stock price to decline from its
current level of Rs. 350 per share during the next two months. So, Girma
could buy a put option to sell the 200 shares at Rs. 365 which is the
striking price. Mr. Girma, the buyer of the option induces the Writer John
to sign the contract and to assume the risk.

The Contract for the Put Option Contains:

 The name of the company shares to be sold
 Number of shares to be sold
 The selling price or striking price
 Expiration date of option
 Call Option
A call gives the holder the right to buy an asset at a certain price
within a specific period of time. Calls are similar to having a long
position on a stock. Buyers of calls hope that the stock will
increase substantially before the option expires.

Example: Mr. “X” owns 100 shares of ABC Ltd. and he gives “Z”
the right to buy those 100 shares at any time during the next 3
months at a price of Rs.130. The price of Rs. 130 is known as
striking price or exercise price. For providing this option, Mr. X
charges Rs. 10 per share from Z. Then Z has to pay Rs. 1000
(100*10) to X to make him sign the contract.
If the price rises beyond Rs. 130 per share, Mr. X? gets profit. If
the price of the stock falls, the loss of “Z” could be limited to
only Rs. 1000(100*10).

The contract for a call option gives the particulars of:

 The name of the company whose shares to be bought.
 Number of shares to be bought
 The purchase price (Exercise or striking price)
 The expiration date of the contract
 Factors Determining The Options Value
A) Stock Volatility:
Buyers of option view volatile stocks favorably because
their chances of getting profit are more. If at all there is
a loss, it can be limited to the amount of premium.
On the other hand, the seller dislikes volatility as it can
work against him. The probability of rise and fall in
prices affects the owner of the stock. As a result, Option
sellers demand higher prices for writing options on
volatile stocks.
 Factors…..cont’d
B)Expiration date or Option Period:
The expiration date of the option considerably affects the
premium. If the period of the option is longer, the buyer will
have better chances of making a profit. If extended the
periods of time which sellers suffer.
In other words, longer the option period, higher will be the
option price.
C) Striking Prices:
The price at which stock may be put or called is the strike price.
It is also referred to as the contract price. During the life of
the contract, the striking price remains fixed. As an
exemption to this general rule, the amount of any dividend
paid during the option period will reduce the striking price.
 Factors…..cont’d
D) Dividends:
Dividends are one of the important factors which affects option value.
Generally, stocks paying higher dividends do not increase very much in
price.
Naturally, option writers prefer to write options on high dividend stocks as
they collect dividends in addition to their premium income. So, buyers and
sellers agree to lower premiums for high dividend paying stocks.
E) Interest Rates:
When the interest rates are higher, the value of the striking price would
be lower and at the same time the call price would be higher.
At higher interest rates, holding bonds would fetch higher income in the
form of interest.
As a result, an option writer demands a higher price for writing at a time
when interest rates are higher.
 American vs. European Options
Options can be either American-Style Options or European-
Style Options. Their only difference is that:
American option may be exercised anytime before the
expiration date of option, so for example if option is of 31st
December 2010 then American option can be exercised any time
before 31st December 2010.
Whereas, European option can be exercised only on the
expiration date of option, in case of above example if it is a
European option then it can be exercised only on 31st December
and not before that.
 In other words American style option is more flexible than
European style option as it can be exercised anytime unlike
European option which can be exercised only at particular date.
 Advantages of Options Trading:
i)Flexibility: Option investing can be used in a wide variety of
strategies, from minimum-risk to high risk. It is flexible enough to
let you take the benefits from any market condition, whether the
stocks are up or down.
ii)Low capital requirements. Options allow you to take a position
with very low capital requirements. Someone can do a lot in the
options market with $1,000 but not so much with $1,000 in the
stock market.
iii)Hedging: Options investing allows the investors to protect their
positions against any price fluctuations when it is not
advantageous to modify the underlying position.
Iv)Limited Risk. Risk is limited to the option premium (except when
writing options for a security that is not already owned).
v)Unique Strategies. Options allow you to create unique strategies
to take advantage of different characteristics of the market - like
volatility and time decay.
 Disadvantages of Options Trading
a. Costs. The costs of trading options including both commission is
significantly higher on a percentage basis than trading the underlying
stock, and these costs can drastically eat into any profits.
b. Time decay: Option trading is time-sensitive in nature and leads to the
result that most options trading expire worthless. This is only applied to
the traders that purchase options.
c. Complexity. Options are very complex and require a great deal of
observation and maintenance.
d) Less information. Options can be a pain when it is harder to get quotes
or other standard analytical information like the implied volatility.
e) Options not available for all stocks. Although options are available on a
good number of stocks, this still limits the number of possibilities available
to the investor.
f) Less Liquidity: With the wide range of prices available, some will suffer
from very low liquidity making trading difficult.
 FUTURES TRADING
A futures contract is an agreement to buy or sell an asset at a certain time
in the future for a certain price. A forward or futures contract, however,
imposes a firm obligation to go through the transaction.
Example: A farmer growing cotton enters into contract to sell his harvest at
a future date to avoid the risk of change in price by that date. Such
transactions take place through the forward or future markets.
How futures differ from options:
a) In options, the delivery is optional for buyer but obligatory for seller of
the option.
b) In option, the buyer pays the seller a premium in the beginning itself,
while there is no premium paid on the future contract.
c) Future contract can be performed only at the settlement date, but not
before that. The buyer of the options has a right to exercise the option
either at expiration date or prior to that.
 Forward Contract
In a forward contract, two parties agree to buy or sell an asset on
some future date at an agreed price and quantity. At the time of
signing the deal, the forward contract does not involve any
money transaction.

The forward contract is intended to safeguard and eliminate the

price risk at a future date. But the forward market lacks
centralization of trading, liquidity and counter parties risk. As it
involves no third party guarantee. In order to solve these
problems of forward contracts, future markets are designed.
 Differences Between Futures and Forwards
Future contract Forward contract
1.Traded at organized stock 1. Forward contracts are private
exchanges. agreements.
2.Standardized contract in terms of 2. Chance for negotiation for
size, time and price. privately by parties.
3. No money exchanges hands
3.All participants required to
until delivery.
deposit margins.
4. Trading is mostly unregulated.
4.Trading is regulated. 5. Price fixation is may not be
5.Price fixation is transparent and transparent and is not publicly
publicly disclosed. disclosed.
6.In a futures contract wishes to 6. No secondary market to
transfer his obligation to another transfer the obligation.
party.
 WHO TRADES FUTURES

Hedgers: Hedgers typically include producers and

consumers of a commodity or the owner of an asset.
Hedgers buy or sell futures contracts to protect themselves
against the risk of price changes.
Example: A farmer may sell his crop ‘wheat’ in futures and
the investor may sell his stock index futures. By doing so,
they can shield themselves against risk of unexpected price
changes.
 Cont’d
 Speculators: Speculators play a very important role in
the proper functioning of the futures market. They buy or
sell futures contracts in an attempt to earn a profit.
 Speculators do not have a prior position that they want to
hedge against price fluctuation. Rather they are willing to
assume the risk of price fluctuation in the hope of
profiting from them.