Options and Futures

Derivatives

Derivatives are financial contracts which derive their values from the underlying assets or securities. Some examples are:

Options Futures Swaps

Option

An option is the right, but not the obligation to buy or sell something on a specified date at a specified price. In the securities market, an option is a contract between two parties to buy or sell specified number of shares at a later date for an agreed price.

Three parties are involved in the option trading, the option seller, buyer and the broker.

Process

The option seller or writer is a person who grants someone else the option to buy or sell. He receives a premium on its price. The option buyer pays a price to the option writer to induce him to write the option. The securities broker acts as an agent to find the option buyer and the seller, and receives a commission or fee for it.

Call Options

The call option that gives the right to buy. The contract gives the particulars of:

The name of the company whose shares are to be bought or the underlying asset. The number of shares to be purchased. The purchase price or the exercise price or the strike price of the shares to be bought. The expiration date, the date on which the contract or the option expires.

Put Options

Put option gives its owner the right to sell (or put) an asset or security to someone else. Like the call option the contract contains:
Strongly efficient market All information is reflected on prices. Semi strong efficient market All public information is reflected on security prices Weakly efficient market All historical information is reflected on security

The name of the company whose shares are to be sold. The number of shares to be sold. The selling price or the striking price. The expiration date of the option.

Factors Affecting the Value of Call Option

The market price of the underlying asset

The striking price

5.
6.

Interest rates
Dividends

Intrinsic Value and Time Value

Call option intrinsic value or expiration value = Stock price Striking price Put option intrinsic value or expiration value = Striking price Stock price Time value = Premium Intrinsic value

Gain or Loss of Call Buyer

When the market price exceeds the strike price by just enough to cover the premium, the profit is zero for the buyer if he exercises the option.

This is the point of no profit and no loss and hence known as break-even point.
If there is a rise in the price of the stock beyond the break-even point, the call buyer gains profit.

Call Buyers Position

Market price of optioned stock

Loss of Premium Break-even Rs 55

Call Writers Gain or Loss

When the market price is lower than the strike price, the call buyer may not exercise his option, hence the premium is the only profit the call writer can gain.

If the price increases further it would be a loss to the call writer.

Writing a Call
Option profit 25 20 15 10 5 Premium gain 0 5 10 15 20 25 10 20 30 40 60 70 80 90 100 Intrinsic value Market price of optioned stock

Exercise Price (Rs 50)

Break-even Rs 55

Loss line to call writer

Put Buyers Position

Put buyer gains in the bearish market when the price falls. When the price increases, the put buyer has to pay the premium alone and his liability is limited to the premium amount he has paid.

Put Buyers Gain or Loss

10 Break-even Rs 45 30 Exercise Price Rs 50 Price of the optioned stock

70

90 Premium loss

10

20

Put Writers Position

The gains of the put buyer are the losses of the put writer. If the market price increases the put writer will gain the premium because the put buyer may not be willing to sell the shares at the lower rate i.e., the strike price is lower than the market price.

Writing a Put
30 20 Break-even Rs 45 Strike Price Rs 50 10 Intrinsic value Premium gain 0 20 5 40 60 80 Price of the optioned stock

15 Loss line of put writer 25

35

Profits in Stocks, Bonds and Options

Bond Return
Profit Rs

30
20 10

Return Stock Price at Termination 80 90 100

40

50

60 10 20 30 LOSS Rs

Exercise Price = 70

Stock Return
PROFIT Rs 30 20 10 Stock Price at Termination

40

50

60 10 20 30 LOSS Rs

80

90

100

Exercise Price = 70

Selling the Stock Short

40

50

60 10 20 30 LOSS Rs

80

90

100

Investment in Calls

Protective buy the stock and buy a put Covered call writing own the stock and sell a call Artificial convertible bonds buy bonds and buy calls

The Black-Scholes Option Pricing Model

ln(P/S) + (R + 0.5 2 )T d1 = T d 2 = d1 T

where V = Current value of the option P = Current price of the underlying share N(d1), N(d2) = Areas under a standard normal function S = Striking price of the option R = Risk free rate of interest T = Option period = Standard deviation e = Exponential function

Futures

Futures is a financial contract which derives its value from the underlying asset. There are commodity futures and financial futures. In the financial futures, there are foreign currencies, interest rate, stock futures and market index futures. Market index futures are directly related with the stock market.

In a forward contract, two parties agree to buy or sell some underlying asset on some future date at a stated price and quantity. The forward contract involves no money transaction at the time of signing the deal. Forward contract safeguards and eliminates the price risk at a future date. But the forward market has the problem of: (a) lack of centralisation of trading (b) liquidity (c) counterparty risk

Forward and Futures

Future Market
The three distinct features of the future markets are:

Standardised contracts Centralised trading Settlement through clearing houses to avoid counterparty risk

Benefits of the Index Based Futures

Liquidity: The index based futures attract a much more substantial order flow and have greater liquidity in the market. Information: Information flow is more in the index than in the case of securities. The insiders are privileged to have more information in securities. Settlement: In the settlement, stocks have to be delivered either in the physical mode or in the depository mode. No such delivery is needed in the index based futures. They are settled through cash.

Less volatile: The changes that occur in index values are less compared to the price changes that occur in the individual securities. This leads to lower prices for the index futures and can work with lower margins. Manipulation: The securities in the index are carefully selected, keeping the liquidity considerations and as such are hard to manipulate. But security prices could be manipulated more easily than the index. Beneficial to the mutual funds.