Financial Derivatives and Risk Management

DR. PRADIPTA KUMAR SANYAL

Holding Period Yield
=( Price of Stock in 2021- Price of Stock 2020)/ Price of Stock 2020+
Dividend

Capital Gain Revenue Gain

HPY = HPR-1

HPR = Price of Stock 2021/ Price of Stock 2020

Natural Logarithm = Ln

Total Risk Unsystematic Risk-----------------Diversification through

Portfolio

Derivatives Instruments to
Unsystematic Risk Zone Reduce Systematic Risk

Systematic Risk Zone

Systematic Risk = Market Risk ---------------Derivatives--------------------
----------Hedging (Reducing the Risk Associated with Market)
No of Stocks
Hedge- Reducing Risk
Hedging – The Process to reduce the market Risk / Systematic Risk
Financial Market/ Security Market

Stock Market/ Derivative Market Debt Market/ Commodity

Cash Market/ Futures / Options/ Swaps Money Market
Spot Market/
Equity market

Derivative Instruments

Futures Options Swaps

 Derivative / Financial Derivative

Concept in Mathematics
X ---- Independent
Y ------------------- Dependent
Change in Y/ Change in X
Y = f( X)-----------------------Linear Relationship

Y = a+bX ------------------------------- Regression Line

Concept in Financial Derivatives

Change in Derivative Market/ Change in equity Market (Cash/ Spot)

Change in Derivative Market/ Change in Underlying Assets

Underlying Assets Stocks(Equity)/ Indices/ Currency/

Commodity

Definition of Financial Derivatives

Derivative is instrument which derives its value from an underlying
asset. Derivative is an agreement between two parties.

Example
Suppose RIL is trading at Rs 2572/- in Cash Market/ Spot/ Equity. You
want to buy 100 shares of RIL after one month however you have an
understanding that the price of RIL is most likely to increase by Rs
200/- within 1 months’ time.
Currently you don’t have money to buy RIL right now however you
want to buy the stock after one month.
How you can hedge the risk associated with market fluctuation likely to
have after month.

Solution
To hedge the risk associated with the equity market, the investor can
enter into a contract with Derivative market.

70% RIL= 2785 – 24.11.2022

RIL = 2585 10% RIL =1500
1.10.2020 20% RIL = 2385 24.11.2022

Entering into Derivative Contract, the investor is freezing the buying

price of RIL @1500/- in the Derivative Market.

Suppose for each share of RIL buyer has to pay Rs 2/- as a commission
to the seller.
Profit / Loss to Buyer
If the Price of RIL reaches to Rs 2000/- as per the buyer’s expectation
then following pay off will happen to the buyer

The buyer will have a notional profit of Rs 500/- = Rs 2000- Rs 1500

Buyer Net Profit = 500 – Brokerage ( Rs 2) = 500- 2=Rs 498
For 100 shares = 498*100 = 49800

If the price is likely to fall to Rs 1200/- in the spot market/cash market

after one month
Profit or loss to buyer
Buyer Loss = 1200-1500=-300
Total Loss =-300-2=-302
Seller Profit/Loss
Profit of the Seller = 1500-1200=300
Total Profit = 300+2= 302

Derivative ----------------------------Hedge------------Hedging
Hedging is the process through which price fluctuations (Price
Volatility) in the cash/spot/equity market can be hedged by entering into
a contract in the derivative market.
 Participants in the Derivative Market

Hedger Speculator Arbitrageur

Hedger wants to Hedge Speculator Arbitrageur

his risk Speculates about the who takes the
fluctuation in price advantage of
Price difference

Commonly Used Derivative Contracts

Forward Contract Futures Contract Option Contract

OTC (Over the Counter)

 Exchange Traded Contract

OTC Derivative Contract

1. This Contract are available in the OTC Market

2. In OTC the contracts are not standardized. ( no specification)

3. Though OTC contract are now a days regulated, however it may

not give full protection of the contract if there will be any breach
of contract.
Exchange Traded Derivatives
1. These Contract are available in Exchanges (NSE/BSE)
2. Exchange traded contracts are standardized contracts.
(Specification)
3. Exchange Traded Contract are well regulated by the Exchanges
and it gives full supports if there will be any breach of contract.

Mechanism is Case of OTC Contract

OTC Platform-
Bank/Financial Institution
 Buyer of a Derivative Seller of a
Contract Derivative Contract

Exchange Traded Contract

Exchange (BSE/NSE)

Buyer of a Derivative Seller of a Derivative

Contract Contract

Forward Contract- Salient Features

1. Forward Contract are OTC Contract
2. Forward Contracts are Customized Contract.
3. Forward Contracts are having two parties. (Buyer of
the Contract and Seller of the contract)
4. Hedger and Speculator are also involved in forward
contract.
Forward contract are mostly being entered into for hedging the risk
associated with fluctuations in dollar versus home currency (Indian
Currency) (Exchange Rate Volatility)
 Example
TCS earns most of its revenue in dollar and the company earns a
good amount revenue in the month of September however the same
revenue will get transferred to India in the month of December. TCS
is expecting a higher volatility in exchange rate during the month of
December so wants to hedge the price fluctuation in dollar vs Rupee
during the month of September.
Total Revenue of the Company during Sept = 1000 $
September Dollar Vs Rupee----------------------- 1 $ = Rs 70
December Dollar Vs Rupee ------------------------1 $ = Rs 69
So to hedge risk associated with the fluctuation in the dollar vs rupee
, TCS enters in a forward derivative contract and fix the price at Rs
70 per dollar.

Futures Contract - Salient Features

1. Exchange Traded Contract
2. Futures Contract are standardized contract

Terminology
Spot Price- Is the price which is available in spot market/cash
market/equity market.
Future Price- Future Price is the price which is available in the future
market.
Contract Cycle- Three Months Cycle is available in derivative contract
of the Indian Exchanges
Near Month Contract – for October 2020 near month expiry is 26th
October
Next Month Contract- for October 2020 is 29th November 2020.

Far Month Contract – for October 2020 is 30th December 2020

2000
B
1500
A
C
1200

Basis = Future Price – Spot Price

Positive Basis = Spot Price > Future Price Backwardation

Negative Basis = Future Price > Spot Price Contango
(Normal))

Contract Size ( Bharati Airtel) = 1851(lot Size)

Future Price (Bharati Airtel ) = 421.90 (29th October 2020)
Contract Value (Bharati Airtel- Near Month Contract 29th October 2020-
expiry) = 1851* 421.90 = Rs
Basis (Bharati Airtel)= F.P – S.P = 421.90 – 420.70 = 1.20
 COST OF CARRY
Example
Reliance is Trading at 851.30 (Spot Price(So))n – 8th March 2013
Reliance is Trading at 854.70 (Future Price (Fo) with near month
contract expiry is 28th March 2013

FP = So* (1+r)t
854.70 = 851.30 *(1+r)t
Finding out the “r” solving the above equation will determine our Cost
of Carry

Cost of Acquisition in the Spot Market = Spot Price of the Stock +

Amount of Interest

1. Future Price < Cost of Acquisition in Spot Market = Invest in

Future Market
2. Future Price > Cost of Acquisition in Spot Market = Invest in Spot
Market

Practical Example on Cost of Carry – Britannia Ltd

Spot Price
3787.25
Future Price
3797.05
Risk Free Rate of Interest – Treasury Bill Rate (T-Bill) = 3.3 ( 91 day)
Expiry – 29th of October

Novation- Is a process through which a trade gets executed in NSE

Derivative segment

NSCCL – National Securities Clearing Corporation Limited

NEAT – National Exchange Automated Trading

BOLT – BSE Online Trading
Replacement of Human Outcry system

Value At Risk ( VaR)

Essentially makes us understand how much volatility a stock /index has
during a specified period of time.
If stock /Index has 99% VaR then it indicates that stock/ Index has a
movement of 1% on either side from its last close.

Calculation of Initial Margin and Maintenance Margin along with

Market to Market
Stock – Reliance Industries Ltd
Spot Price = Rs 2176.70
Future Price = Rs 2178.20
Lot Size = 505
Initial Margin is assumed to 8% of Contract Value (99% VaR)
Maintenance Margin is assumed to 5 % of Contract Value (5% of
Contract Value)
Contract Value = Lot Size * FP = 505*2178.20
Initial Margin = Contract Value * 8%
Maintenance Margin = Contract Value * 5%
Mark to market means Profit/ Loss on daily basis which is based
movement of Future Price.

Date FP Initial Maintenance Mark

Margin Margin to
Rs Rs Rs Market (Rs)

16-10-2020 2178.20 87999 54999 Nil

20-10-2020 1200 48480 (87999-48480)

= 39519

(Loss)

25-10-2020 2500 101000 101000-

87999

= 13001
Enhanced Eligibility Criteria for Stock to be included in F & O Segment of NSE

1. Average Daily Market Capitalization

2. Average Daily Traded Value

3. Market Wide Position Limit in the Security

4. Quarter Sigma Value

5. Average Daily Deliverable Value

1. Average Daily Market Capitalization and Average Daily Traded Values

are Calculated on very 16th Day of the month

Arbitrage opportunity

Equilibrium Price

Cash Price + Interest = 851.30+ 2.80 = 854.10

FP = 854.70 > Equilibrium Price

Hedging Strategies related Futures Trading

Short Hedge Long Hedge

Shorting the Underlying Assets Buying a Derivative Contract

Selling the Derivative Contract

Long Hedge

It’s mean long on a contract (Buy Derivative Contract). The investor is bullish on

the stock / Index thereby he is expecting that stock / Index will move upward or

will have a bullish trend. So he wants hedge the risk associated with the upward

movement of the stock /Index thereby freezing at current price.

2000

+500

Stock A= 1500 -500 1000

Short Hedge ( I want to Sell Stock /Index by Entering into Contract)

It’s mean short on a contract (Sell Derivative Contract). The investor is bearish on

the stock / Index thereby he is expecting that stock / Index will move downward or

will have a bearish trend. So he wants hedge the risk associated with the

downward movement of the stock /Index thereby freezing at current price.

-500 2000

Stock = 1500
 +500

1000

Redefining Basis from the perspective of Hedge

B1 = F1- S1, - time when then the contract is entered into

B2 = F2 – S2 - time when the contract is expiring

B2 = F2=S2 - Convergence of future price and spot price on
the date of expiry

CROSS Hedge
Cross Hedge contract happens when a contract is entered into to hedge
the original asset. These types of contracts are entered because of the
non-availability of contract of original asset.

Suppose Asset A is available in Cash Market however Asset A is not

available in the F&O segment. Investor expecting the price of Asset A is
likely to go up. How to hedge price fluctuation of asset A in the cash
market through derivative market?

Investor would enter into a contract in the F&O segment with a similar
asset as the original asset is not available in F&O segment. There by any
profit out of the similar will pass on to the original asset. This type of
arrangement is known as CROSS HEDGE.
 Simple Regression

Change in Y---------------Dependent
------------------------
Change in X--------------------Independent

Delta Y
---------
Delta X

Y = a +b X + e (e =unexplained Variable)
Return of ACC = a+ b Return of Index +e
b = Coefficient of the Independent = 1.2
Y R Square = 89%
R Square = Coefficient of Determination, how much Dependent is
explained by the Independent Variable.
b
 a X

Y = a+b X
Y = 0+1.2X
Y = 2+1.2X

Assignment -1
How to Calculate Hedge Effective and Minimum Variance Hedge
Ratio
1. Identify a stock traded in both Cash and future Market of NSE
2. Download historical data of the cash price and future price of
the stock
3. Covert the data into return series (Holding Period Return )
Current Price
--------------------------
Previous Price

Current Price – Previous Price

Derivative Assignement-1
Steps to follow
1. Visit NSE Website
 2. Download historical data of the stock that you
have chosen
3. Link- https://www.nseindia.com/get-
quotes/equity?symbol=ACC

Hedging with Futures

What about hedging a stock in the equity market through buying/selling
Index futures (Nifty 50 Futures) in the futures market?

Y = a +b X + e (e =unexplained Variable)
Return of a Stock = a+ b Return of Index +e
R stock = α+β *R index+ e

Hedging with Index Futures

Example
An investor is bullish on Infosys and wants to buy 500 shares @ of
2800/-
So the total value of Portfolio = 500 *2800 = 140,00,000
Beta of Infosys to Market = .60
Futures Index Price = 6000 per contract
Lot Size = 50
Contract Value = 6000*50 = 300000
How many number contracts required to hedge the portfolio of the
Investor?
 Portfolio Value
N = β * ----------------------
Contract Value
140,00,000
N= .6 *------------------------ = 28
3,00,000

Assignment -2 (in Continuity)

Practically we need to Hedge a stock with Index
1. Choose a stock
2. choose Nifty 50 as the Index
3. Download atleast a year daily close data/ Last
Traded Price of the stock and Nifty 50.
4. Convert the above the data into Return Series
Return = Ln ( Today’s Price/ Yesterday Price)
5. Run Regression applying Excel Data Analysis
tool pack to Calculate Beta and R Square
6. Dependent Variable = Return of Stock
Independent Variable = Return of Nifty 50

Option Contract
 1. The buyer of the Contract has the Option to come out of the
contract.
2. The buyer has the right to execute / perform the contract, however
he/ she doesn’t have the obligation to the perform the contract.

Option Contract

Call Option Contract Put Option Contract

( Right to Buy) ( Right to Sell)

Call Option gives the buyer of the option contract to buy a contract
Put Option gives the buyer of the option contract to sell a contract
 Parties to Option Contract

Buyer of the Contract Writer of the Option

- Buy(Call) the Contract
Writer
- Sell(Put) the Contract

Suppose X is the buyer of RIL then he is going to buy the contract from
the writer. Writer will sell the contract to the buyer.

Suppose X is now seller of RIL. Then he is going to sell the contract to

the writer and now the writer will buy the RIL Contract from X

Option Price – Essentially it mean Option Premium. It is also as known

as LTP (Last Traded Price) . (Refer Option Chain in NSE)

Option Chain – Option Chain gives us a clear practical understanding

about all information related to Option Contract ( Contract on Index/
Contract on Stock)
OI – Open Interest – No of Contract outstanding / not executed at any
point in time.
Volume- No of Trade being executed at any particular point in time.

IV- implied Volatility- Implied volatility mean the amount of volatility

an Index/ Stock has at any point in time.

Volatility
(Fluctuations in the Prices/ Changes in Prices of Index / Stock)

Historical Volatility Implied Volatility

(HV is calculated on Past Data (Current Volatility)
This is Historical Standard Deviation) ( How much Volatility a
Stock/ Index has currently)
LTP – Last Traded Price is also known as Option Premium. It is the
price at which the option can be bought at the time of entering into the
option contract.

Bid Qty – Buy quantity

Ask Qty – Sell Quantity
The Difference between Ask and Bid is known as Spread
Positive Spread = Ask – Bid (Ask> Bid)
Negative Spread = Bid – Ask (Ask< Bid)
Spread percentage = (Ask- Bid)/ Bid
Strike Price= The Price at which option contract can be entered into.
Strike price is also known as Exercise Price.

Expiration Date- Is the date on which an option contract is going to

mature, depends on month of expiry (Near month Contract/ Next Month
Contract/ Far Month Contract.)

American vs. European Option

American can be exercised at any point in time during the contract
period (time between date of entering into option and expiry date);
however in case of European Option Contract, the buyer can execute the
contract only on the date of Expiry. So he does not have the flexibility to
execute the contract any point of time.

In- the Money Option

Example
Strike Price (Price at which Option Contract Can be exercised) of a
Stock = 2500
Spot Price (is the price at which the same stock is traded in the spot
market/ Cash Market/ Equity market) = 2400
Buyer’s position
As a buyer of Contract what would be my buying option

In the above case of Price Difference the option is said to be Out-of-the-

Money, meaning thereby that Option contract does not have implication
or in other words we can option contract can be entered into because of
the higher in comparison to Cash Price.
So as a Buyer I would to like buy from Cash Price/ Spot Price.

However if we reverse the prices (now Spot Price = 2500, Strike Price =
2400), then

More Examples on In the Money/ At the Money /Out of the Money

RIL = Cash Market = 1500

RIL = Derivative Market = 1550
As a buyer is it in the Money/ At the Money or Out of the money
As the buyer is not entering into the contract because the price is higher
in derivative market, so we can say Call Option is said to be out of the
money.
If We take the above case from Seller then the seller would like to enter
into the contract because he is going to sell it at a higher price in the
derivative market and the Put Option is said to be in the money.
Option Status Call Option Put Option

In the Money Spot Price>Strike Price Strike Price > Spot price

At the money Spot Price= Strike price Spot Price= Strike Price

Out of the Money Spot Price< Strike Price Strike Price < Spot Price

Intrinsic Value of an Option

Option Premium

Intrinsic Value(I V) Time Value

(Spot Price- Strike Price) (Option Premium – I V)

Option Premium = Intrinsic Value + Time Value

Example
Reliance Industries (17.11.2020 , 10.49 am)
Spot Price = 2006
Strike Price = 1700
LTP ( Option Premium ) = 330
Intrinsic Value = 2006 – 1700 = 306
Time Value = 330- 306 = 24

Basic Option Trading Strategies

1. Long on Call – A Long Position in Call Option ( Buying a Call)

Example ( SP = Spot Price , EP = Exercise Price, LTP
=Premium= Rs 5)
SP 0 = Rs 85 (Current Spot Price)
EP0= Rs 80 (Current Exercise Price)
Option Premium = Rs 5
Intrinsic Value = SP – EP = 85 – 80 = Rs 5
Time Value = 5- 5 = 0
Whether the Call is in the money or Not?

Call is in the Money as SP> EP

As Call is in the Money B is going to enter into the Contract.

A is Writer of the Option
B is the Buyer of the Option
Profit / Loss on Call Option OR Pay off Matrix on Call
Date SP EP Premium Intrinsic Time Profit /
Value Value Loss
11.1.2022 85 80 5 5 0 (85-80)-
5=0
20.1.2022 86 80 5 6 1 (86-80)-
5=1
22.1.2022 90 80 5 10 5 (90-80)-
5=5
24.1.2022 78 80 5 0 -5(Option
Premium)
26.1.2022 75 80 5 0 0 -5

On 24.1.2022 as the Cash Price went below 80 (SK), the buyer of

the Call Option will not execute the Contract (as he does not have
obligation to perform the Contract) and he will buy the stock from
the Cash Market. The maximum potential loss the buyer will have
in the derivative market is the amount of premium he already paid
to the writer
2. Long PUT - Long on Put (Right to Sell)
Example (SP = Spot Price , SK = Strike Price, LTP =Premium= Rs
5)
SP 0 = Rs 85
SK0= Rs 80
Whether the Put is in the money? (Shall the Investor Buy the
Put?)
Condition - Strike Price > Spot price
SP 0 = Rs 80
SK0= Rs 85
Now Put is in the money as the Condition being satisfied.
LTP = Option Premium = Option Value = Rs 5
 LONG on PUT (Right to Sell/ Selling the Stock)
Date SP (Cash SK/EP Premium Intrinsic Time Profit /
Market) Value Value Loss
Derivative
(Pantaloons)
(Central)

18.11.2 80 85 5 5 0 (85-80)-5=0
020

20.11.2 86 85 5 0 5 -5 (Option
020 Premium
that you
already
Paid)

22.11.2 90 85 5 0 5 -5(Option
020 Premium
that you
already
Paid)

24.11.2 78 85 5 7 2 (85-78)-5=2
020

26.11.2 75 85 5 0 0 85-75=10-
020 5=5

Call is in the Money – When an Investor is buying the stock in

the Derivatives/Option Market (Spot Price>Strike Price- as you
always try to at the lower price)
Put is in the Money- When an Investor wants to sell in the
Option Market (Strike Price > Spot price- as you always wants to
sell at a higher price)

Buyer Exchange Writer

Long (Buy) on Call Short ( Sell) on Call

Long (Buy) on Put Short ( Sell) on Put

Particulars In the Money Particulars In the Money

Buyer= A Writer = B

Long on Call Spot > Strike Short on Call Strike> Spot

(Writer)
Long on Put Strike > Spot Short on Put Spot > Strike
 Short on Call (Selling a Call Option)
Writer of the Call Option will sell the Contract to the Buyer of the
call option
Writer of the call Option is Bearish on the Stock or in other words
the writer expects that the price of the Stock will fall and he will
have profit. It is assumed that the writer already in possession of
the stock and expect that stock price will fall. So, his expectation is
opposite of the buyer’s expectation.
Date SP SK Premium Intrinsic Time Profit /
Value Value Loss
18.11.2020 85 80 5 5 0 (80-85)
=-5+5=0
20.11.2020 86 80 5 6 1 (80-86)
=-6+5=-1
22.11.2020 90 80 5 10 5 (80-90)=-
10+5=-5
24.11.2020 78 80 5 0 80-
78=2+5=7
26.11.2020 75 80 5 0 0 =80-
75=5+5=10
 Short on Put
It means we as writer will sell the Put Option. Writer expects that the
price of the Stock will go up and he is in possession of the stock,
however the buyer of the Put thinks that the price will fall in cash
market. So the buyer will make profit from the contract as he fixed the
price @ 85.
Prospective of Writer of a Put Option
Date SP (Cash SK/EP Premium Intrinsic Time Profit /
Market) Value Value Loss
Derivative
(Pantaloons)
(Central)

18.11.2 80 85 5 5 0 80-85
020
=-5+5=0

20.11.2 86 85 5 0 5 Profit=
020 LTP= 5

22.11.2 90 85 5 0 5 Profit=LTP
020 =5

24.11.2 78 85 5 7 2 78-85=-
020 7+5=-2

26.11.2 75 85 5 10 0 75-85=-
020 10+5=-5
 Advanced Option Trading Strategies
1.
Single Stock and Single Option Strategy

PUT Single Stock Call Single Stock

Single Option Single Option

Protective Covered
Put Put Protective Call Covered
Strategy Call

Protective Put
1. Single Stock
2. Put Contract
 Put – Call Parity
Drink Pepsi Be Cool
STOCK + PUT = Bond + Call
Buying a Stock and Put Contract equals to Buying Bond
and Call Option Contract
An Investor may be bullish on stock and would like go
long (Buy) with an understanding that the stock has 80%
probability of going up, however he is not ignoring the
20% probability that stock may go down or may go
against his anticipation. Now to protect the 20% chance
of stock falling down he would like to enter into Put
contract in the derivative market.
Stock Price = Rs 1200
Strike Price = Rs 1200
Option Value = Rs 50 (LTP/ Premium)
After One Month
Stock Price = Rs 900
Strike Price = Rs 1200
Profit or Loss
Cash Market = Profit / Loss = -300 (900- 1200)
Profit or Loss in Derivative = +1200
Option Premium Paid = -50
 ----------------
Net Profit = 1150
Put – Call Parity

SIP PEPSI BE COOL

SIP PEPSI BE COOL
Stock PUT Bond Call

S + P = B + C
Protective Put Fiduciary Call
To Satisfy Put – Call Parity the Following Conditions
must be considered
1. It should be European
2. The Strike of Put and Call should be equal
3. The Present Value of the Bond equals to the Strike
Price of Put/ Call
Bond= Deep Discount Bond / Zero Coupon Bond
Deep Discount Bond or a Zero Coupon (Interest)
Bond is a kind of issued at value lower than the Face
Value. This bond does not carry any rate of interest
however rate of interest is implied in the bond.
 Face value of the Bond = 100
Issue Price of the bond = Rs 90
Maturity Value = Rs 100
Interest = Rs 10
Strike Price Put = 100, Strike Price of Call = 100,
Value of Bond on Maturity = 100
Put – Call Parity (3 months Contract)
Situations Market S P = B C
price
I 200 200 0 = 100 100
II 150 150 0 = 100 50
III 80 80 20 = 100 0
IV 70 70 30 = 100 0

Protective Put
Reliance Industries as on 26.11.2020 = Spot = 1943(MP)
Diagram - 1
 2100
80% Prob
1943(Market Price) Put Contract (Re.90) 1900
20% Prob
1700
(Single Step Binominal Tree)
Suppose the Stock went against your anticipation, then
what would be profit / loss? (ignore Premium)

Investor’s Position
- Long on Stock ( He/ She wants to Buy the
Stock)
- Long on Put ( He wants to have a long Put
Contract)
- The Investor has Bullish Market
Covered Put (As Investor you are Short on Stock)
Investor’s Position
- Short on Stock ( He/ She wants to Sell the
Stock)
- Short on Put ( He wants to have a Short Put
Contract)
 - The Investor has Bearish Market view
- Suppose he bought the stock @1500 (few
months back)
Spot Price = 1943
Diagram -2
2100
20% Prob
1943(Market Price) Put Contract (Rs 90) 1900
80% Prob
1700
(Single Step Binominal Tree)
if the stock goes down to 1700 as per his anticipation then
what would his profit or loss (Ignore Premium)

Covered Call
Investor’s Position
- Long on Stock ( He/ She wants to Buy the
Stock)
- Short on Call ( He wants to have a Short Call
Contract)
 - The Investor has Neutral to Moderately
Bullish Market
Spot Price = 1943
Diagram -3
2100
50% Prob
1900(Market Price) Short on Call Contract (Re.90)1900

50% Prob
1700
(Single Step Binominal Tree)
if the stock goes down to 1700 as per his anticipation then
what would his profit or loss (Ignore Premium)
Total Collection from Call
Premium = 90
Price = 1900
Cost of the stock = 1943 (CMP) - the price which he
bought the stock
Protective Call
Investor’s Position
- Short on Stock ( He/ She wants to Sell the
Stock)
 - Long on Call ( He wants to have a Buy Call
Contract)
- The Investor has Bearish Market

Spot Price = 1943(MP)

Diagram -4
2100
20% Prob
1943(Market Price) long on Call Contract (Re.90)1900

80% Prob
1700
(Single Step Binominal Tree)
if the stock goes down to 1700 as per his anticipation then
what would his profit or loss (Ignore Premium)

Multiple Option Strategies

Multiple Option Strategies

Spread Strategies
 Bull Spread Bear Spread
Bull Spread
- Market is Bullish ( there has been a rally in the
Market) Bull Call Spread
- Bull Spread
Bull Put Spread
Bull Call Spread
- Buy Call Option
- Sell a Call Option
- Date of expiry of both the contract has to be
same.
- Strike Price of Call Option Sold > Strike Price
of Call Option Bought
- Call Option Sold has lower premium than call
option bought
Example from Option Chain dated – 27.11.2020
Date of Expiry = 31st December 2020
Reliance Industries = 1935
Call Position Strike Price Premium
Short on Call (K2) 1950 83
Long on Call (K1) 1700 268
Net Cash Inflow/ Out flow -185 (net outflow of
premium)
If the Market Price < Strike Price of Long on Call
Situation on the Date of Expiry
1. Then the investor will buy the stock from the spot
market as the market price less. Then he will forego
the contract and the net outflow would be only the
premium.
2. If the K1< Market < K2
1700< 1935< 1950
if the above situation prevails on the date of expiry then
the investor will buy the call from the option market
(1700) , however the call sold will lapse.
3. if K1<K2< Market Price
1700< 1950< 2100
Both the Call will be exercised.

Bull Put Spread

- A Put Option Bought
- A Put Option Sold
- Maturity of the Option to be same.
 - Strike Price of Put Sold > Strike Price of Put
Bought
- Premium on Put Sold > Premium on Put
Bought
Date- 1.12.2020
Reliance Industries
Spot Price = 1935
Strike Price of Put being sold (K2) = 2400 LTP = 452
Strike Price of Put being Bought (K1) = 1950 LTP = 84
Net Flow of Premium = 183- 84 = 99
1. If Market Price(MP) > K2
(K1<K2< MP = 1950<2400< 2500)
Neither of the Derivatives will be exercised as you
get a higher price in the cash market.
2. If the Market Price is Between K1 K2
(K1< MP< K2 = 1950 < 2000< 2400)
K2 will be exercised
K1 will not be exercised as you can sell the stock in
the spot @ 2000
3. if the MP< K1 < K2
(1900< 1950< 2400)
 then both the Put Option will be exercised

Bear Spread
- Market is moderately Bearish
Bear Spread

Call Bear Spread Put Bear Spread

Call Bear Spread

- A Call Option is bought (K2)
- A Call Option Sold ( K1)
- The Stock should be same
- Expiry Date has be Same
Strike Price of Call Sold (K1)< Strike of Call Bought(K2)
Call Sold Strike Price = 1750 LTP = 252
Call Bought Strike price = 1900 LTP =104
1. If MP < K1< K2
 So Both Option will expiry as the investor is getting
a cheaper from the Spot Market
2. If the Market price is between K 1 and K2
(K1< MP< K2)
Call Option Sold will be exercised
Call Option Bought will expire
3. if K1<K2< MP
Both Contracts will be exercise as you are getting
Bear Put Spread
- A Put Option Bought
- A Put Option Sold
- The Date of Expiry is to same.
- Strike Price (Exercise Price) of Put Option
Sold < Strike Price of Put Option Bought.
Example from Option Chain dt- 2.12.2020

Spot Price RIL = 1943

Strike Price @ Put Sold = 1950 LTP =77
Strike Price @ Put Bought = 2100 LTP = 176
Premium of Put Sold < Premium of Put Bought
Net Cash out flow on Premium = 77 -176 = -99
Situation 1
K1<K2< MP
Both the Put will not be exercised as the Investor can sell
the stock in spot market @ MP (2200)
Situation 2
K 2= Put Option Bought
K1 = Put Option Sold
Put Option Sold < MP < Put Option Bought
Put Option Bought (K2) will exercised as The Investor
will get higher value then the market value.
Put Option Sold (K1) will lapse as the price is less than
Market Price, so the Investor will sell the stock at Market
Price.
Situation 3
MP < Put Option Sold (K1) <Put Option Bought (K2)
So the Investor will sell the stock in the Derivative market
(by exercising both the contracts) as he/she will get
higher price.
Option Trading Strategy using :
Multiple Options of Different Types
 Straddle Strangle
Long Straddle
- Buy a Call
- Buy a Put
- With Same Strike Price
Investor has an expectation that price will go up so one
way he is bullish on the Market and buying a CALL
In other way he also thinks that market may fall and he is
also bearish on market and he is buying a PUT
Spot Price of RIL = 1943
Call Buy @ 1900 LTP = 107
PUT Buy @ 2000 LTP = 106
Total LTP Payment = 107+ 106 = 213
On the Date of Expiry Spot < 1900
If market falls below 1900 the investor will not exercise,
as he can buy the stock from spot at lower price
In case Put he will exercise the Put as he can sell the
stock at a higher through the Put Contract.
Situation 2
If the Spot Price is 2300
Butterfly Spread
- Three Different Call Option with three
Different Strike Prices
- Buying a Call Option with Relatively Low
Strike price (K1)
- Buying a call with relatively higher Strike
price (K3)
- Buying another Call option with a strike
between ( K1 and K3) i.e., K2
Long Call Butterfly
- Sell Two At-the – Money Call Option
- Buy 1 In-the- Money Call Option
- Buy 1 Out- of the-Money Call Option
- Investor is expecting that the market would be
range bound
Example
RIL Spot = 1945
1. Sell Two RIL Call at ATM 1945 LTP = 75
2. Buy One RIL Call at ITM = 1900 LTP = 104
 3. Buy One RIL Call at OTM = 2000 LTP = 56
Net Gain / Loss on Premium = (75*2) – (104+56)
= 150 – 160 = -10
Calculation As per formula
Upper Break Even = 2000 – 10 = 1990
Lower Break Even = 1900 + 10 = 1910
Strangle Strategy

Long Strangle Short Strangle

Long Strangle
- One OTM Put
- One OTM Call
- Same expiration and Same Strike
Short Strangle
- One Put Sell at OTM
- One Call Sell at OTM
 - Same Expiration and Same Strike Price
Strategies to be Remember
1. Long on Call
2. Short on Call
3. Long on Put
4. Short on Put
5. Protective Put and Covered Put
6. Protective Call and Covered Call
7. Bull Spread
8. Bear Spread
9. Straddle
10. Strangle
(For theoretical and Practical Understanding, Pl follows
the NCFM Course Material - Derivatives Strategies.pdf
along with this note)

Black Scholes Model

Black – Scholes Model is used to calculate the theoretical
price (LTP/Premium) of an Option. Once the Theoretical
Price is being calculated by applying Black Scholes
model then it is compared with the price available in the
market to understand whether the Option is under/
overvalued, so that an investment decision can be taken.

European Call Option Using Black Scholes Model

Formula
C = S0 N (d1) – Ke-rt N(d2)

C = Theoretical Price of European Call

S0 = Spot Price
N= Normal Distribution
K = Strike Price
r = Rate of Return / Risk Free Rate of Return
t = Time
D1, D2=
e = Exponential Value = 2.7183

d1 = LN (So/K)+(r+σ2 /2)T / σ Square Root T

d2 = LN (So/K)+(r-σ2 /2)T / σ Square Root T

European Put Applying Black Scholes Model

 Put = P = Ke-rt N(-d2) - S0 N (-d1)
d2 = d1 – Sigma *Sqrt (t)
Assignment -3
You have to take 2 stocks of your choice which are
available both on Cash and Derivative Markets and
Calculate:
1. Volatility Calculation
2. European Call and Put ( 2*10) = 20 Marks