CONTENTS

Derivatives – an overviewFutures contractHedging in futuresSpeculating in futuresArbitrage in futuresOptionsOptions strategiesDerivatives productsOpen interestFutures price = spot price + cost of carry

DERIVATIVESThe word “DERIVATIVES” is derived from the word itself derived of aunderlying asset. It is a future image or copy of a underlying asset whichmay be shares, stocks, commodities, stock indices, etc.

Derivatives is a financial product (shares, bonds) any act which isconcerned with lending and borrowing (bank) does not have its valueborrow the value from underlying asset/ basic variables.

Derivatives is derived from the following products:

A. SharesB. DebunturesC. Mutual fundsD. GoldE. SteelF. Interest rateG. Currencies.

Derivatives is a type of market where two parties are entered into acontract one is bullish and other is bearish in the market having oppositeviews regarding the market. There cannot be a derivatives having sameviews about the market. In short it is like a INSURANCE market whereinvestors cover their risk for a particular position.

Derivatives are financial contracts of pre-determined fixed duration,whose values are derived from the value of an underlying primaryfinancial instrument, commodity or index, such as: interest rates,exchange rates, commodities, and equities.

Derivatives are risk shifting instruments. Initially, they were used toreduce exposure to changes in foreign exchange rates, interest rates, orstock indexes or commonly known as risk hedging. Hedging is the mostimportant aspect of derivatives and also its basic economic purpose.There has to be counter party to hedgers and they are speculators.Speculators don’t look at derivatives as means of reducing risk but it’s abusiness for them. Rather he accepts risks from the hedgers in pursuit ofprofits. Thus for a sound derivatives market, both hedgers andspeculators are essential.

Derivatives trading has been a new introduction to the Indian markets. Itis, in a sense promotion and acceptance of market economy, that hasreally contributed towards the growing awareness of risk and hence thegradual introduction of derivatives to hedge such risks.

Initially derivatives was launched in America called Chicago. Then in 1999,RBI introduced derivatives in the local currency Interest Rate markets,which have not really developed, but with the gradual acceptance of theALM guidelines by banks, there should be an instrumental product inhedging their balance sheet liabilities.

The first product which was launched by BSE and NSE in the derivativesmarket was index futures

BACKGROUND

Consider a hypothetical situation in which ABC trading company has toimport a raw material for manufacturing goods. But this raw material isrequired only after 3 months. However in 3 months the prices of rawmaterial may go up or go down due to foreign exchange fluctuations andat this point of time it can not be predicted whether the prices would goup or come down. Thus he is exposed to risks with fluctuations in forexrates. If he buys the goods in advance then he will incur heavy interestand storage charges. However, the availability of derivatives solves theproblem of importer. He can buy currency derivatives. Now any loss dueto rise in raw material prices would be offset by profits on the futurescontract and vice versa. Hence the company can hedge its risk throughthe use of derivatives

DEFINATIONS

According to JOHN C. HUL “ A derivatives can be defined as a financialinstrument whose value depends on (or derives from) the values of other,more basic underlying variables.”

According to ROBERT L. MCDONALD “A derivative is simply a financialinstrument (or even more simply an agreement between two people)which has a value determined by the price of something else.

With Securities Laws (Second Amendment) Act,1999, Derivatives has beenincluded in the definition of Securities. The term Derivative has beendefined in Securities Contracts (Regulations) Act, as:-

A Derivative includes: -

a. a security derived from a debt instrument, share, loan, whethersecured or unsecured, risk instrument or contract for differences orany other form of security;

b. contract which derives its value from the prices, or index of prices,of underlying securities.

Derivatives were developed primarily to manage, offset or hedge againstrisk but some were developed primarily to provide the potential for highreturns.

INTRODUCTION TO FUTURE MARKETFutures markets were designed to solve the problems that exit inforward markets. A futures con tract is an agreement between twoparties to buy or sell an asset at a certain time in the future at a certainprice. There is a multilateral contract between the buyer and seller for aunderlying asset which may be financial instrument or physicalcommodities. But unlike forward contracts the future contracts arestandardized and exchange traded.

PURPOSE

The primary purpose of futures market is to provide an efficient andeffective mechanism for management of inherent risks, withoutcounter-party risk.

It is a derivative instrument and a type of forward contract The futurecontracts are affected mainly by the prices of the underlying asset. As itis a future contract the buyer and seller has to pay the margin to trade inthe futures market

It is essential that both the parties compulsorily discharge theirrespective obligations on the settlement day only, even though thepayoffs are on a daily marking to market basis to avoid default risk.Hence, the gains or losses are netted off on a daily basis and eachmorning starts with a fresh opening value. Here both the parties face an

equal amount of risk and are also required to pay upfront margins to theexchange irrespective of whether they are buyers or sellers. Index basedfinancial futures are settled in cash unlike futures on individual stockswhich are very rare and yet to be launched even in the US. Most of thefinancial futures worldwide are index based and hence the buyer nevercomes to know who the seller is, both due to the presence of the clearingcorporation of the stock exchange in between and also due to secrecyreasons

EXAMPLE

The current market price of INFOSYS COMPANY is Rs.1650.

There are two parties in the contract i.e. Hitesh and Kishore. Hitesh isbullish and kishore is bearish in the market. The initial margin is 10%.paid by the both parties. Here the Hitesh has purchased the one monthcontract of INFOSYS futures with the price of Rs.1650.The lot size ofinfosys is 300 shares.

Suppose the stock rises to 2200.

Profit

202200

10

01400 1500 1600 1700 1800 1900

-10

-20

Loss

Unlimited profit for the buyer(Hitesh) = Rs.1,65,000 [(2200-1650*3oo)]and notional profit for the buyer is 500.

Unlimited loss for the buyer because the buyer is bearish in the market

Suppose the stock falls to Rs.1400

Profit

20

10

01400 1500 1600 1700 1800 1900

-10

-20

Loss

Unlimited profit for the seller = Rs.75,000.[(1650-1400*300)] andnotional profit for the seller is 250.

Unlimited loss for the seller because the seller is bullish in the market.

Finally, Futures contracts try to "bet" what the value of an index orcommodity will be at some date in the future. Futures are often used bymutual funds and large institutions to hedge their positions when themarkets are rocky. Also, Futures contracts offer a high degree of leverage,or the ability to control a sizable amount of an asset for a cash outlay,which is distantly small in proportion to the total value of contract

MARGIN

Margin is money deposited by the buyer and the seller to ensure theintegrity of the contract. Normally the margin requirement has beendesigned on the concept of VAR at 99% levels. Based on the value at riskof the stock/index margins are calculated. In general margin rangesbetween 10-50% of the contract value.

PURPOSE

The purpose of margin is to provide a financial safeguard to ensure thattraders will perform on their contract obligations.

TYPES OF MARGIN

INITIAL MARGIN:

It is a amount that a trader must deposit before trading any futures. Theinitial margin approximately equals the maximum daily price fluctuationpermitted for the contract being traded. Upon proper completion of allobligations associated with a traders futures position, the initial margin isreturned to the trader.

OBJECTIVEThe basic aim of Initial margin is to cover the largest potential loss in oneday. Both buyer and seller have to deposit margins. The initial margin isdeposited before the opening of the position in the Futures transaction.

MAINTENANCE MARGIN:

It is the minimum margin required to hold a position. Normally themaintenance is lower than initial margin. This is set to ensure that thebalance in the margin account never becomes negative. If the balance inthe margin account falls below the maintenance margin, the investorreceives a margin call to top up the margin account to the initial levelbefore trading commencing on the next level.

ILLUSTRATION

On MAY 15th two traders, one buyer and seller take a position on JuneNSE S and P CNX nifty futures at 1300 by depositing the initial margin ofRs.50,000with a maintenance margin of 12%. The lot size of niftyfutures =200.suppose on MAY 16thThe price of futures settled at Rs.1950. As the buyer is bullish andthe seller is bearish in the market. The profit for the buyer will be 10,000[(1350-1300)*200]Loss for the seller will be 10,000[(1300-1350)]

Net Balance of Buyer = 60,000(50,000 is the margin +10,000 profit forthe buyer)Net Balance of Seller = 40,000(50,000 is the margin -10,000 loss for theseller)

Suppose on may 17th nifty futures settled at 1400.Profit of buyer will be 10,000[(1450-1350)*200]Loss of seller will be 10,000[(1350-1400)*200]

Net balance of Buyer =70,000(50, 000 is the margin +20,000 profit forthe buyer)Net Balance of Seller = 30,000(50,000 is the margin -20,000 loss for theseller)

As the sellers balance dropped below the maintenance margin i.e. 12% of1400*200=33600 While the initial margin was 50,000.Thus the sellermust deposit Rs.20,000 as a margin call.Now the nifty futures settled at Rs.1390.

Loss for Buyer will be 2,000 [(1390-1400)*200]Profit for Seller will be 2,000 [(1390-1400)*200]

Net balance of Buyer =68,000(70,000 is the margin -2000 loss for thebuyer)Net Balance of Seller = 52,000(50,000 is the margin +2000 profit for theseller)

Therefore in this way each account each account is credited or debitedaccording to the settlement price on a daily basis. Deficiencies in marginrequirements are called for the broker, through margin calls. Till now theconcept of maintenance margin is not used in India.

ADDITIONAL MARGIN:

In case of sudden higher than expected volatility, additional margin maybe called for by the exchange. This is generally imposed when theexchange fears that the markets have become too volatile and may resultin some crisis, like payments crisis, etc. This is a preemptive move byexchange to prevent breakdown.

CROSS MARGINING:This is a method of calculating margin after taking into accountcombined positions in Futures, options, cash market etc. Hence, the totalmargin requirement reduces due to cross-Hedges.

MARK-TO-MARKET MARGIN:

It is a one day market which fluctuates on daily basis and on every scripproper evaluation is done. E.g. Investor has purchase the SATYAMFUTURES. and pays the Initial margin. Suddenly script of SATYAM fallsthen the investor is required to pay the mark-to-market margin alsocalled as variation margin for trading in the future contract

HEDGERS :

Hedgers are the traders who wish to eliminate the risk of price change towhich trhey are already exposed.It is a mechanism by which theparticipants in the physical/ cash markets can cover their price risk.Hedgers are those persons who don’t want to take the risk therefore theyhedge their risk while taking position in the contract. In short it is a wayof reducing risks when the investor has the underlying security.

PURPOSE:

“TO REDUCE THE VOLATILITY OF A PORTFOLIO, BY REDUCING THE RISK”

Figure 1.1

Hedgers

Existing SYSTEMNew

Approach Peril &Prize ApproachPeril &Prize1) Difficult to 1) No Leverage 1)Fix price today to buy 1)Additionaloffload holding available risk latter by paying premium.cost is onlyduring adverse reward dependant 2)For Long, buy ATM Putpremium.market conditions on market prices Option. If market goes up,as circuit filters long position benefit elselimit to curtail losses. exercise the option.

3)Sell deep OTM call optionwith underlying shares, earnpremium + profit with

increase prcie

AdvantagesAvailability of Leverage

STRATEGY:

The basic hedging strategy is to take an equal and opposite position inthe futures market to the spot market. If the investor buys the scrip in thespot market but suddenly the market drops then the investor hedge theirrisk by taking the short position in the Index futures

HEDGING AND DIVERSIFICATION:

Hedging is one of the principal ways to manage risk, the other beingdiversification. Diversification and hedging do not have have cost in cashbut have opportunity cost. Hedging is implemented by adding anegatively and perfectly correlated asset to an existing asset. Hedgingeliminates both sides of risk: the potential profit and the potential loss.Diversification minimizes risk for a given amount of return (or,alternatively, maximizes return for a given amount of risk). Diversificationis affected by choosing a group of assets instead of a single asset(technically, by adding positively and imperfectly correlated assets).

ILLUSTRATION

Ram enters into a contract with Shyam that he sells 50 pens to Shyam forRs.1000. The cost of manufacturing the pen for Ram is only Rs. 400 andhe will make a profit of Rs 600 if the sale is completed.

COST SELLING PRICE PROFIT400 1000 600

However, Ram fears that Shyam may not honour his contract. So heinserts a new clause in the contract that if Shyam fails to honour thecontract he will have to pay a penalty of Rs.400. And if Shyam honoursthe contract Ram will offer a discount of Rs 100 as incentive.

Shyam defaults Shyam honors400 (Initial Investment) 600 (Initial profit)400 (penalty from Shyam (-100) discount given to Shyam- (No gain/loss) 500 (Net gain)

Finally if Shyam defaults Ram will get a penalty of Rs 400 but Ram willrecover his initial investment. If Shyam honors the bill the ram will get aprofit of 600 deducting the discount of Rs.100 and net profit for ram isRs.500. Thus Ram has hedged his risk against default and protected hisinitial investment.

Now let’s see how investor hedge their risk in the market

Example:

Say you have bought 1000 shares of XYZ Company but in the short termyou expect that the market would go down due to some news. Then, tominimize your downside risk you could hedge your position by buying aPut Option. This will hedge your downside risk in the market and yourloss of value in XYZ will be set off by the purchase of the Put Option.

Therefore hedging does not remove losses .The best that can be achievedusing hedging is the removal of unwanted exposure, i.e.unnessary risk.The hedging position will make less profits than the un-hedged position,half the time. One should not enter into a hedging strategy hoping tomake excess profits for sure; all that can come out of hedging is reducerisk.

HEDGING WITH OPTIONS:

Options can be used to hedge the position of the underlying asset. Herethe options buyers are not subject to margins as in hedging throughfutures. Options buyers are however required to pay premium which aresometimes so high that makes options unattractive.

ILLUSTRATION:

With a market price of ACC Rs.600 the investor buys the 50 shares ofACC.Now the investor excepts that price will fall by 100.So he decided tobuy the put Option b y paying the premium of Rs.25. Thus the investorhas hedge their risk by purchasing the put Option. Finally stock falls by100 the loss of investor is restricted t the premium paid of Rs.2500 asinvestor recovered Rs.75 a share by buying ACC put.

HEDGING STRATEGIES:

LONG SECURITY, SELL NIFTY FUTURES:

Under this investor takes a long position on the security and sellsome amount of

Nifty Futures. This offsets the hidden Nifty exposure that is inside everylong- security position. Thus the position LONG SECURITY, SELL NIFTY isa pure play on the performance of the security, without any extra riskfrom fluctuations of the market index. Finally the investor has “HEDGEDAWAY” his index exposure.

EXAMPLE:

LONG SECURITY, SELL FUTURESHere stock futures can be used as an effective risk

–management tool. In this case the investor buys the shares of thecompany but suddenly the rally goes down. Thus to maximize the riskthe Hedger enters into a future contract and takes a short position.However the losses suffers in the security will be offset by the profits hemakes on his short future position.

Spot Price of ACC = 390Market action = 350Loss = 40Strategy = BUY SECURITY, SELL FUTURESTwo month Futures= 390Premium = 12Short position = 390Future profit = 40(390-350)

As the fall in the price of the security will result in a fall in the price ofFutures. Now the Futures will trade at a price lower then the price atwhich the hedger entered into a short position.

Finally the loss of Rs.40 incurred on the security hedger holds, will bemade up the profits made on his short futures position.

HAVE STOCK, BUY PUTS:

This is one of the simplest ways to take on hedge. Here the investorbuys 100 shares of HLL.The spot price of HLL is 232 suddenly theinvestor worries about the fall of price. Therefore the solution is buyput options on HLL.

The investor buys put option with a strike of Rs.240. The premiumcharged is Rs.10.Here the investor has two possible scenarios threemonths later.

1) IF PRICE RISES

Market action: 215Loss : 17(232-15)Strike price : 240Premium : 08Profit : 17(240-215-8)

Thus loss he suffers on the stock will be offset by the profit theinvestor earns on the put option bought.

2) IF PRICE RISES:

Market share : 250Loss : 10Short position : 250(spot market)

Thus the investor has a limited loss(determined by the strike priceinvestor chooses) and an unlimited profit.

HAVE PORTFOLIO, SHORT NIFTY FUTURES:

Here the investor are holding the portfolio of stocks and sellingnifty futures. In the case of portfolios, most of the portfolio risk isaccounted for by index fluctuations. Hence a position LONGPORTFOLIO+ SHORT NIFTY can often become one-tenth as risky asthe LONG PORTFOLIO position.

Let us assume that an investor is holding a portfolio of followingscrips as given below on 1st May, 2001.

Company Beta Amount of Holding ( inRs)

Infosys 1.55 400,000.00Global Tele 2.06 200,000.00Satyam Comp 1.95 175,000.00HFCL 1.9 125,000.00Total Value of Portfolio 1,000,000.00

Trading Strategy to be followed

The investor feels that the market will go down in the next two monthsand wants to protect him from any adverse movement. To achieve thisthe investor has to go short on 2 months NIFTY futures i.e he has to sellJune Nifty. This strategy is called Short Hedge.

Formula to calculate the number of futures for hedging purposes is

Beta adjusted Value of Portfolio / Nifty Index level

Beta of the above portfolio

=(1.55*400,000)+(2.06*200,000)+(1.95*175,000)+(1.9*125,000)/1,000,000

=1.61075 (round to 1.61)

Applying the formula to calculate the number of futures contracts

Assume NIFTY futures to be 1150 on 1st May 2001

= (1,000,000.00 * 1.61) / 1150

= 1400 Units

Since one Nifty contract is 200 units, the investor has to sell 7 Niftycontracts.

Short Hedge

Stock Market Futures Market1st May Holds Rs 1,000,000.00

in stock portfolioSell 7 NIFTY futurescontract at 1150.

25th June Stock portfolio fall by6% to Rs 940,000.00

NIFTY futures falls by4.5% to 1098.25

Profit / Loss Loss: -Rs 60,000.00 Profit: 72,450.00Net Profit: + Rs15,450.00

SPECULATORS:

If hedgers are the people who wish to avoid price risk, speculators arethose who are willing to take such risk. speculators are those who do nothave any position and simply play with the others money. They only havea particular view on the market, stock, commodity etc. In short,speculators put their money at risk in the hope of profiting from ananticipated price change. Here if speculators view is correct he earnsprofit. In the event of speculator not being covered, he will loose theposition. They consider various factors such as demand supply, marketpositions, open interests, economic fundamentals and other data to taketheir positions.

SPECULATION IN THE FUTURES MARKET

Speculation is all about taking position in the futures marketwithout having the underlying. Speculators operate in the marketwith motive to make money. They take:Naked positions - Position in any future contract.Spread positions - Opposite positions in two future contracts. Thisis a conservative speculative strategy.

Speculators bring liquidity to the system, provide insurance to thehedgers and facilitate the price discovery in the market.

Figure 1.2

Speculators

Existing SYSTEMNew

Approach Peril &Prize ApproachPeril &Prize1) Deliver based 1) Both profit & 1)Buy &Sell stocks1)MaximumTrading, margin loss to extent of on delivery basisloss possibletrading& carry price change. 2) Buy Call &Put topremiumforward transactions. by payingpaid2) Buy Index Futures premium

hold till expiry. AdvantagesGreater Leverage as to pay only the premium.

Greater variety of strike price options at a given time.

ILLUSTRATION:

Here the Speculator believes that stock market will going to appreciate.

Current market price of PATNI COMPUTERS = 1500

Strategy: Buy February PATNI futures contract at 1500

Lot size = 100 shares

Contract value = 1,50,000 (1500*100)

Margin = 15000 (10% of 150000)

Market action = rise to 1550

Future Gain:Rs. 5000 [(1550-1500)*100]

Market action = fall to 1400

Future loss: Rs.-10000 [(1400-1500)*100]

Thus the Speculator has a view on the market and accept the risk inanticipating of profiting from the view. He study the market and play thegame with the stock market

TYPES:

POSITION TRADERS:

These traders have a view on the market an hold positions over a periodof as days until their target is met.

DAY TRADERS:

. Day traders square off the position during the curse of the trading dayand book the profits.

SCALPERS:

Scalpers in anticipation of making small profits trade a number of timesthroughout the day.

SPECULATING WITH OPTIONS:

A speculator has a definite outlook about future price, therefore he canbuy put or call option depending upon his perception about future price.If speculator has a bullish outlook, he will buy calls or sell (write) put. Incase of bearish perception, the speculator will put r write calls. Ifspeculator’s view is correct he earns profit. In the event of speculator notbeing covered, he will loose the position. A Speculator will buy call or putif his price outlook in a particular direction is very strong but if is eitherneutral or not so strong. He would prefer writing call or put to earnpremium in the event of price situations.

ILLUSTRATION:

Here if speculator excepts that ZEE TELEFILMS stock price will rise frompresent level of Rs.1050 then he buys call by paying premium. If priceshave gone up then he earns profit otherwise he losses call premiumwhich he pays to buy the call. if speculator sells that ZEE TELEFILMS stockwill come down then he will buy put on the stale price until he can writeeither call or put.

Finally Speculators provide depth an liquidity to the futures market an intheir absence; the price protection sought the hedger would be verycostly.

STRATEGIES:

BULLISH SECURITY,SELL FUTURES:

Here the Speculator has a view on the market. The Speculator is bullish inthe market. Speculator buys the shares of the company an makes the

profit. At the same time the Speculator enters into the future contract i.e.buys futures and makes profit.

Spot Price of RELIANCE = 1000Value = 1000*100shares = 1,00,000Market action = 1010Profit = 1000Initial margin = 20,000Market action = 1010Profit = 400(investment of Rs.20,000)

This shows that with a investment of Rs.1,00,000 for a period of 2months the speculator makes a profit of 1000 and got a annual return of6% in the spot market but in the case of futures the Speculator makes aprofit of Rs.400 on the investment of Rs.20,000 and got return of 12%.

Thus because of leverage provided security futures form an attractiveoption for speculator.

BULLISH STOCK, BUY CALLS OR BUY PUTS:

Under this strategy the speculator is bullish in the market. He could doany of the following:

BUY STOCK

ACC spot price : 150No of shares : 200Price : 150*200 = 30,000Market action : 160Profit : 2,000Return : 6.6% returns over 2months

BUY CALL OPTION:

Strike price : 150Premium : 8Lot size : 200 sharesMarket action :160Profit : (160-150-8)*200 = 400Return : 25% returns over 2months

This shows that investor can earn more in the call option because it gives25% returns over a investment of 2months as compared to 6.6% returnsover a investment in stocks

BEARISH SECURITY,SELL FUTURES:

In this case the stock futures is overvalued and is likely to see a fall inprice. Here simple arbitrage ensures that futures on an individualsecurities more correspondingly with the underlying security as long asthere is sufficient liquidity in the market for the security. If the securityprice rises the future price will also rise and vice-versa.

Two month Futures on SBI = 240Lot size = 100sharesMargin = 24Market action = 220Future profit = 20(240-220)

Finally on the day of expiration the spot and future price converges theinvestor makes a profit because the speculator is bearish in the marketand all the future stocks need to sell in the market.

BULLISH INDEX, LONG NIFTY FUTURES:

Here the investor is bullish in the index. Using index futures, an investorcan “BUY OR SELL” the entire index trading on one single security. Once aperson is LONG NIFTY using the futures market, the investor gains if theindex rises and loss if the index falls.

1st July = Index will rise

Buy nifty July contract = 960

Lot =200

14th July nifty risen= 967.35

Nifty July contract= 980

Short position =980

Profit = 4000(200*20)

ARBITRAGEURS:

Ar bi t r age i s t he concept of si mul t aneous buyi ng of secur i t i es i n onemar ket wher e t he pr i ce i s l ow and sel l i ng i n anot her mar ket wher e t hepr i ce i s hi gher .

Ar bi t r ageur s t hr i ve on mar ket i mper f ect i ons. Ar bi t r ageur i s i nt el l i gentand knowl edgeabl e per son and r eady t o t ake t he r i sk He i s basi cal l y r i skaver se. He ent er s i nt o t hose cont r act s wer e he can ear n r i sk l esspr of i t s. When mar ket s ar e i mper f ect , buyi ng i n one mar ket andsi mul t aneousl y sel l i ng i n ot her mar ket gi ves r i sk l ess pr of i t .Ar bi t r ageur s ar e al ways i n t he l ook out f or such i mper f ect i ons.

In the futures market one can take advantages of arbitrage opportunitiesby buying from lower priced market and selling at the higher pricedmarket.

JM Morgan introduced EQUITY DERIVATIVES FUND called as ARBITRAGEFUND where the investor buys the shares in the cash market and sell theshares in the future market.

ARBITRAGEURS IN FUTURES MARKET

Arbitrageurs facilitate the alignment of prices among different marketsthrough operating in them simultaneously.

Figure 1.3

Arbitrageurs

Existing SYSTEMNew

Approach Peril &Prize ApproachPeril &Prize1) Buying Stocks in 1) Make money 1) B Group more 1)Risk freeone and selling in whichever way the promising as stillgame.another exchange. Market moves. in weeklysettlementforward transactions. 2) Cash &Carry2) If Future Contract arbitragecontinuesmore or less than Fair price

Fair Price = Cash Price + Cost of Carry.

Example:

Current market price of ONGC in BSE= 500

Current market price of ONGC in NSE= 510

Lot size = 100 shares

Thus the Arbitrageur earns the profit of Rs.1000(10*100)

STRATEGIES:

BUY SPOT, SELL FUTURES:

In this the investor observing that futures have beenoverpriced, how can the investor cash in this opportunity to earn risk lessprofits. Say for i nst ance ACC = 1000 and One month ACC futures = 1025.

This shows that futures have been overpriced and therefore as anArbitrageur, investor can make r i sk l ess pr of i t s ent er i ng i nt o t hef ol l owi ng set f t r ansact i ons.

On day one, borrow funds, buy security on the spot market at 1000Simultansely, sell the futures on the security at1025Take delivery of the security purchased and hold the security for amonthon the futures expiration date, the spot and futures converge . Nowunwind the positionSa y the security closes at Rs.1015. Sell the securityFutures position expires with the profit f Rs.10The result is a risk less profit of Rs.15 on the spot position andRs.10 on the futures positionReturn the Borrow funds.

Finally if the cost of borrowing funds to buy the security is less than thearbitrage profit possible, it makes sense for the investor to enter into thearbitrage. This is termed as cash – and- carry arbitrage.

BUY FUTURES, SELL SPOT:

In this the investor observing that futures have been underpriced, how can the investor cash in this opportunity to earn risk lessprofits. Say for i nst ance ACC = 1000 and One month ACC futures = 965.

This shows that futures have been under priced and therefore as anArbitrageur, investor can make r i sk l ess pr of i t s ent er i ng i nt o t hef ol l owi ng set f t r ansact i ons.

On day one, sell the security on the spot market at 1000Mae delivery of the securitySimultansely, buy the futures on the security at 965

On the futures expiration date, the spot and futures converge .Now unwind the positionSa y the security closes at Rs.975. Sell the securityFutures position expires with the profit f Rs.10The result is a risk less profit of Rs.25 the spot position and Rs.10on the futures position

Finally if the returns get investing in risk less instruments is less thanthe return from the arbitrage it makes sense for the investor to enterinto the arbitrage. This is termed as reverse cash – and- carry arbitrage.

ARBITRAGE WITH NIFTY FUTURES:

Arbitrage is the opportunity of taking advantage of the price differencebetween two markets. An arbitrageur will buy at the cheaper market andsell at the costlier market. It is possible to arbitraged between NIFTY inthe futures market and the cash market. If the futures price is any of theprices given below other than the equilibrium price then the strategy tobe followed is

CASE-1

Spot Price of INFOSEYS = 1650

Future Price Of INFOSEYS = 1675

In this case the arbitrageur will buy INFOSEYS in the cash market atRs.1650 and sell in the futures at Rs.1675 and finally earn risk free profitOf Rs.25.

CASE-2

Future Price Of ACC = 675

Spot Price of ACC = 700

In this case the arbitrageur will buy ACC in the Future market at Rs.675and sell in the Spot at Rs.700 and finally earn risk free profit Of Rs.25.

INTRODUCTION TO OPTIONS

It is a interesting tool for small retail investors. An option is a contract,which gives the buyer (holder) the right, but not the obligation, to buy orsell specified quantity of the underlying assets, at a specific (strike) priceon or before a specified time (expiration date). The underlying may bephysical commodities like wheat/ rice/ cotton/ gold/ oil or financialinstruments like equity stocks/ stock index/ bonds etc.

MONTHLY OPTIONS :The exchange trade option with one month maturity and the contractusually expires on last Thursday of every month.

PROBLEMS WITH MONTHLY OPTIONS

Investors often face a problem when hedging using the three-monthlycycle options as thepremium paid for hedging is very high. Also the trader has to pay moremoney to take a long or short position which results into iiliquidity in themarket.Thus to overcome the problem the BSE introduced WEEKLYOPTIONS

WEEKLY OPTIONS:The exchange trade option with one or weak maturity and the contractexpires on last Friday of every weak

ADVANTAGES

Weekly Options are advantageous to many to investors, hedgersand traders.

The premium paid for buying options is also much lower as theyhave shorter time to maturity.The trader will also have to pay lesser money to take a long orshort position.the trader can take a larger position in the market with limited loss.On account of low cost, the liquidity will improve, as moreparticipants would come in.Weekly Options would lead to better price discovery andimprovement in market depth, resulting in better price discoveryand improvement in market efficiency

TYPES OF OPTION:

CALL OPTIONA call option gives the holder (buyer/ one who is long call), the right tobuy specified quantity of the underlying asset at the strike price on orbefore expiration date. The seller (one who is short call) however, has theobligation to sell the underlying asset if the buyer of the call optiondecides to exercise his option to buy. To acquire this right the buyerpays a premium to the writer (seller) of the contract.ILLUSTRATION

Suppose in this option there are two parties one is Mahesh (call buyer)who is bullish in the market and other is Rakesh (call seller) who isbearish in the market.The current market price of RELIANCE COMPANY is Rs.600 and premiumis Rs.25

1. CALL BUYER

Here the Mahesh has purchase the call option with a strike price ofRs.600.The option will be excerised once the price went above 600. Thepremium paid by the buyer is Rs.25.The buyer will earn profit once theshare price crossed to Rs.625(strike price + premium). Suppose the stockhas crossed Rs.660 the option will be exercised the buyer will purchasethe RELIANCE scrip from the seller at Rs.600 and sell in the market atRs.660.

Profit

30

20

10

0590 600 610 620 630 640

-10

-20

-30

Loss

Unlimited profit for the buyer = Rs.35{(spot price – strike price) –premium}Limited loss for the buyer up to the premium paid.

2. CALL SELLER:

In another scenario, if at the tie of expiry stock price falls below Rs. 600say suppose the stock price fall to Rs.550 the buyer will choose not toexercise the option.

Profit

30

20

10

0590 600 610 620 630 640

-10

-20

-30

Loss

Profit for the Seller limited to the premium received = Rs.25Loss unlimited for the seller if price touches above 600 say 630 then theloss of Rs.30

Finally the stock price goes to Rs.610 the buyer will not exercise theoption because he has the lost the premium of Rs.25.So he will buy theshare from the seller at Rs.610.

Thus from the above example it shows that option contracts are formedso to avoid the unlimited losses and have limited losses to the certainextent

Thus call option indicates two positions as follows:LONG POSITION

If the investor expects price to rise i.e. bullish in the market he takes along position by buying call option.

SHORT POSITIONIf the investor expects price to fall i.e. bearish in the market he takes ashort position by selling call option.

PUT OPTIONA Put option gives the holder (buyer/ one who is long Put), the right tosell specified quantity of the underlying asset at the strike price on orbefore a expiry date. The seller of the put option (one who is short Put)however, has the obligation to buy the underlying asset at the strike priceif the buyer decides to exercise his option to sell.

ILLUSTRATION

Suppose in this option there are two parties one is Dinesh (put buyer)who is bearish in the market and other is Amit(put seller) who is bullishin the market.

The current market price of TISCO COMPANY is Rs.800 and premium isRs.2 0

1) PUT BUYER(Dinesh):

Here the Dinesh has purchase the put option with a strike price ofRs.800.The option will be excerised once the price went below 800. The

premium paid by the buyer is Rs.20.The buyer’s breakeven point isRs.780(Strike price – Premium paid). The buyer will earn profit once theshare price crossed below to Rs.780. Suppose the stock has crossedRs.700 the option will be exercised the buyer will purchase the RELIANCEscrip from the market at Rs.700and sell to the seller at Rs.800

Profit

20

10

0600 700 800 900 1000 1100

-10

-20

Loss

Unlimited profit for the buyer = Rs.80 {(Strike price – spot price) –premium}Loss limited for the buyer up to the premium paid = 20

2). PUT SELLER(Amit):

In another scenario, if at the time of expiry, market price of TISCO is Rs.900. the buyer of the Put option will choose not to exercise his option tosell as he can sell in the market at a higher rate.

profit

20

10

0600 700 800 900 1000 1100

-10

-20

Loss

Unlimited loses for the seller if stock price below 780 say 750 thenunlimited losses for the seller because theseller is bullish in the market = 780 - 750 = 30

Limited profit for the seller up to the premium received = 20

Thus Put option also indicates two positions as follows:

LONG POSITIONIf the investor expects price to fall i.e. bearish in the market he takes along position by buying Put option.

SHORT POSITIONIf the investor expects price to rise i.e. bullish in the market he takes ashort position by selling Put option

CALL OPTIONS PUT OPTIONSOption buyer oroption holder

Buys the right to buythe underlying asset atthe specified price

Buys the right to sellthe underlying asset atthe specified price

Option seller oroption writer

Has the obligation tosell the underlyingasset (to the optionholder) at the specified

Has the obligation tobuy the underlyingasset (from the optionholder) at the specified

price price.

FACTORS AFFECTING OPTION PREMIUM

THE PRICE OF THE UNDERLYING ASSET: (S)Changes in the underlying asset price can increase or decrease thepremium of an option. These price changes have opposite effects on callsand puts.

For instance, as the price of the underlying asset rises, the premium of acall will increase and the premium of a put will decrease. A decrease inthe price of the underlying asset’s value will generally have the oppositeeffect

Premium of thePremium of thePrice of the CALL Price of CALLUnderlying Underlyingasset asset

Premium of thePremium of the

PUTPUT

THE SRIKE PRICE: (K)The strike price determines whether or not an option has any intrinsicvalue. An option’s premium generally increases as the option gets furtherin the money, and decreases as the option becomes more deeply out ofthe money.

Time until expiration: (t)An expiration approaches, the level of an option’s time value, for putsand calls, decreases.

Volatility:Volatility is simply a measure of risk (uncertainty), or variability of anoption’s underlying. Higher volatility estimates reflect greater expectedfluctuations (in either direction) in underlying price levels. Thisexpectation generally results in higher option premiums for puts andcalls alike, and is most noticeable with at- the- money options.

Interest rate: (R1)This effect reflects the “COST OF CARRY” – the interest that might be paidfor margin, in case of an option seller or received from alternativeinvestments in the case of an option buyer for the premium paid.Higher the interest rate, higher is the premium of the option as the costof carry increases.

PLAYERS IN THE OPTION MARKET:a)Developmental institutionsb)Mutual Fundsc)Domestic & Foreign Institutional Investorsd)Brokerse)Retail Participants

FUTURES V/S OPTIONS

RIGHT OR OBLIGATION :Futures are agreements/contracts to buy or sell specified quantity of theunderlying assets at a price agreed upon by the buyer & seller, on orbefore a specified time. Both the buyer and seller are obligated tobuy/sell the underlying asset.

In case of options the buyer enjoys the right & not the obligation, to buyor sell the underlying asset.

RISKFutures Contracts have symmetric risk profile for both the buyer as wellas the seller.

While options have asymmetric risk profile. In case of Options, for a buyer(or holder of the option), the downside is limited to the premium (optionprice) he has paid while the profits may be unlimited. For a seller orwriter of an option, however, the downside is unlimited while profits arelimited to the premium he has received from the buyer.

PRICES:

The Futures contracts prices are affected mainly by the prices of theunderlying asset.

While the prices of options are however, affected by prices of theunderlying asset, time remaining for expiry of the contract & volatility ofthe underlying asset.

COST:

It costs nothing to enter into a futures contract whereas there is a cost ofentering into an options contract, termed as Premium.

STRIKE PRICE:

In the Futures contract the strike price moves while in the optioncontract the strike price remains constant .

Liquidity:

As Futures contract are more popular as compared to options. Also thepremium charged is high in the options. So there is a limited Liquidity inthe options as compared to Futures. There is no dedicated trading andinvestors in the options contract.

Price behaviour:

The trading in future contract is one-dimensional as the price of futuredepends upon the price of the underlying only. While trading in option istwo-dimensional as the price of the option depends upon the price andvolatility of the underlying.

PAY OFF:

As options contract are less active as compared to futures which resultsinto non linear pay off. While futures are more active has linear pay off .

OPTION STRATAGIES:

1. BULL CALL SPREAD:This strategy is used when investor is bullish in the market but to alimited upside .The Bull Call Spread consists of the purchase of a lowerstrike price call an sale of a higher strike price call, of the same month.However, the total investment is usually far less than that required topurchase the stock.

Current price of PATNI COMPUTERS is Rs. 1500

Here the investor buys one month call of 1490 at 25 ticks per contractand sell one month call of 1510 and receive 15 ticks per contract.

Premium = 10 ticks per contract(25 paid- 15 received)

Lot size = 600 shares

BREAK- EVEN- POINT= 1490+10=1500

Possible outcomes at expiration:

i. BREAK- EVEN- POINT:

On expiration if the stock of PATNI COMPUTERS is 1500 then the optionwill close at Breakeven. The call of 1490 will have an intrinsic value of 0while the 1510 call option sold will expire worthless and also reduce thepremium received.

ii. BETWEEN STRIKE PRICE AND BREAK- EVEN- POINT :

If the index is between1490 an 1500 then the 1490 call option will havean intrinsic value of 5 which is less than premium paid result in loss of5.While 1510 call option sold will not expire which will reduce the lossthrough receiving the net premium.

If the index is between 1500 and 1510 then the 1490 call option willhave an intrinsic value of 10 i.e. deep in the money While 1510 calloption sold will have no intrinsic value the premium receive generateprofit .

iii. AT STRIKE:

If the index is at 1490, the 1490 call option will have no intrinsic valueand expire worthless. While 1510 call sold result in Rs.10 loss i.e. deepout the money.

If the index is at 1510, the 1490 call option will have an intrinsic value of10 i.e. deep in the money. While 1510 call sold will have no intrinsic valueand expire worthless and profit is the premium received of Rs. 10

iv. ABOVE HIGHER PRICE:

IF the PATNI COMPUTERS is above 1510, the 1490 call option will be inthe money of Rs.10 while the 1510 option i.e. strike prices-premiumpaid.

v. BELOW PRICE:

IF the underlying stock is below 1490, both the 1490 call option and1510 option sold result in loss to the premium paid.

The pay-off table:

PATNI COMPUTERSAT EXPIRATION

1485

(belowlowerprice)

1490

(Atthelowerprice)

1495

(Betweenlowerstrike&BEP

1500

(At BEP)

1510

Intrinsic value of1490 long call atexpiration (a)

0 0 5 10 20

Premium paid (b) 25 25 25 25 25Intrinsic value of1510 short call atexpiration (c)

0 0 0 0 0

Premium received (d) 15 15 15 15 15profit/loss(a-c)-(b-d)

-10 -10 -5 0 10

PATNI COMPUTERSAT EXPIRATION

1495

(belowhigherprice)

1510

(Atthehigherprice)

1505

(Betweenhigherstrike&BEP

1500

(At BEP)

1520

(AboveBEP

Intrinsic value of1510 short call atexpiration (a)

0 0 0 0 10

Premium paid (b) 15 15 15 15 15Intrinsic value of1490 long call atexpiration (c)

5 20 15 10 30

Premium received (d) 25 25 25 25 25profit/loss(c-a)-( d- b)

-5 10 5 0 10

Profit

20

10

01490 1500 1510 1520 1530 1540

-10

-20

Loss

2.BEAR PUT SPREAD:It is implemented in the bearish market with a limited downside. The Bearput Spread consists of the purchase a higher strike price put and sale ofa lower strike price put, of the same month. It provides high leverageover a limited range of stock prices. However, the total investment isusually far less than that required to buy the stock shares.

Current price of INFOSYS TECHNOLOGIES is Rs. 4500

Here the investor buys one month put of 5510(higher price) at 55 ticksper contract and sell one month put of 4490 (lower price) and receive 45ticks per contract.

Premium = 10 ticks per contract(55 paid- 45 received)

Lot size = 200 shares

BREAK- EVEN- POINT= 5510-10 = 5500.

Possible outcomes at expiration:

i. BREAK- EVEN- POINT:

On expiration if the stock of PATNI COMPUTERS is 5500 then the optionwill close at Breakeven. The put purchase of 5510 is 10 result inno-profit no loss situation to the premium paid while the 4490 putoption sold will expire worthless and also reduce the premium received.

ii. BETWEEN STRIKE PRICE AND BREAK- EVEN- POINT :

If the index is between 5510 an 5500 then the 5510 put option will havean intrinsic value of 5 which is less than premium paid result in loss of5.While 4490 call option sold will not expire which will reduce the loss ofRs.10 through receiving the net premium.

If the index is between 5500 and 4490 then the 5510 put option willhave an intrinsic value of 15 i.e. deep in the money While 4490 putoption sold will have no intrinsic value the premium receive will generateprofit .

iii. AT STRIKE:

If the index is at 5510, the 5510 put option will have an intrinsic valueof 0 and expire worthless. While 4490 will also have no intrinsic value anput sold result in reducing the loss as the premium received

If the index is at 4490 the 5510 put option will have maximum profitdeep in the money. While 4490 put sold will have no intrinsic value andexpire worthless and profit is the premium received between the strikeprice an premium paid.

iv. ABOVE STRIKE PRICE:

IF the INFOSYS TECHNOLOGIES is above 5510, the 5510 put option willhave no intrinsic value. while the 4490 put option sold result inmaximum loss to the premium received.

If the underlying stock is above 4490 but below 5510, the 4490 putoption will have no intrinsic value. while the 5510 put option sold resultin the maximum profit strike price - premium

v. BELOW STRIKE PRICE:

IF the underlying stock is below 5510, the 5510 option purchase whilebe in the money and 4490 option sold will be assigned (strike price –premium paid) = profit .

The pay-off table:

INFOSYS ATEXPIRATION

5520

(Abovestrike)

5510

(Atthestrike)

5505

(Betweenlowerstrike&BEP

5500

(At BEP)

4480

Intrinsic value of5510 long put atexpiration (a)

0 0 5 10 30

Premium paid (b) 55 55 55 55 55Intrinsic value of4490 short put atexpiration (c)

0 0 0 0 10

Premium received(d)

45 45 45 45 45

profit/loss(a-c)-(b-d)

-10 -10 -5 0 10

INFOSYS ATEXPIRATION

5505

(Abovestrike)

4490

(Atthestrike)

4495

(Betweenstrike&BEP

5500

(At BEP)

4480

(belowstrikeprice)

Intrinsic value of4490 short put atexpiration (a)

0 0 0 0 10

Premium received(b)

45 45 45 45 45

Intrinsic value of5510 long put atexpiration (c)

5 30 15 10 30

Premium paid (d) 55 55 55 55 55profit/loss[(c-a)-( d- b)]

-5 20 15 0 10

Profit

20

10

03000 3500 4000 4500 5000 5500

6000 6500 7000-10

-20

Loss

3. BULL PUT SPREAD.This strategy is opposite of Bear put spread. Here the investor ismoderately bullish in the market to provide high leverage over a limitedrange of stock prices. The investor buys a lower strike put and selling ahigher strike put with the same expiration dates. The strategy has bothlimited profit potential and limited downside risk.

The current price of RELIANCE CAPITAL is Rs.1290

Here the investor buys one month put of 1300 (lower price) at 25 ticksper contract and sell one month put of 1310 (higher price) and receive15 ticks per contract.

Premium = 10 ticks per contract (25 paid- 15 received)

Lot size = 600 shares

BREAK- EVEN- POINT= 1300-10 = 1290

Possible outcomes at expiration:

i. BREAK- EVEN- POINT:

On expiration if the stock of RELIANCE CAPITAL is 1290, the 1300 putoption will have an intrinsic value of 10 while the 1310 put option soldwill have an intrinsic value of 30.

ii. BETWEEN STRIKE PRICE AND BREAK- EVEN- POINT:

If the underlying index is between 1290 an 1300, the 1300 put optionthe buyer will have an intrinsic value of 5 while the 1310 option sold willhave an intrinsic value of 15

If the underlying index is between 1300 and 1310, the 1300 put optionthe buyer will have no intrinsic value and expire worthless, while the1310 option sold will have an intrinsic value of 5.

iii. AT STRIKE:

If the index is at1300, the 1300 put option will have an intrinsic value of0 and expire worthless. While 1310 will have an intrinsic value of 10

If the index is at 1310 the 1300 put option will have an intrinsic value of0 (deep out the money and expire worthless. While 1310 will also haveno intrinsic value and profit of seller is limited t the premium received

iv. ABOVE STRIKE PRICE:

If the index is above1300 say 1310, the 1300 put option buyer has lostthe premium while the 1310 put option seller receive premium to thelimited profit

If the index is above 1310, say 1320 the 1290 put option buyer willhave maximum loss results in deep out the money while the 1310 putoption will have the limited profit.

v. BELOW STRIKE PRICE:

If the index is below 1300 say (1290) , the 1300 put option buyerwill have an intrinsic value of 10 while the 1310 put option sold receiveonly premium as the profit is limited for the seller.

OPTION PAYOFF

Profit

Loss

4.BEAR CALL SPREAD:This strategy is best implemented in a moderately bearish or stablemarket to provide high leverage over a limited range of stock prices. Herethe investor buys a higher strike call and sells a lower strike call with thesame expiration dates. However, the total investment is usually far lessthan that required to buy the stock or futures contract. The strategy hasboth limited profit potential and limited downside risk.

Current price of ACC is Rs. 1500

Here the investor buys one month call of 1510 at 25 ticks per contractand sell one month call of 1490 and receive 15 ticks per contract.

Premium = 10 ticks per contract (25 paid - 15 received)

Lot size = 600 shares

BREAK- EVEN- POINT= 1510+10=1520

Possible outcomes at expiration:

i. BREAK- EVEN- POINT:

On expiration if the stock of PATNI COMPUTERS is 1520 then the optionwill close at Breakeven. The call of 1510 will have an intrinsic value of 10while the 1490 call option sold will expire worthless and also reduce thepremium with the premium outflow.

ii. BETWEEN STRIKE PRICE AND BREAK- EVEN- POINT :

If the index is between 1490 and 1500 then the 1510 call option will haveno intrinsic value and expire worthless, While 1490 call option sold willnot expire which will reduce the loss through receiving the net premium.

If the index is between 1500 and 1510 then the 1510 call option willhave an intrinsic value of 0, while 1490 call option sold will have nointrinsic value the premium receive generate profit .

iii. AT STRIKE:

If the index is at 1510 the 1510 call option will have no intrinsic valueand expire worthless. While 1490 call sold receive only premium

If the index is at 1490, the 1510 call option will have no intrinsic valueresult in deep out the money, While 1490 call sold will have no intrinsicvalue and expire worthless

iv. ABOVE HIGHER PRICE :

IF the underlying stock is above 1510 say 1520, the 1510 call option willbe in the money of Rs.10 while the 1490 option will incur loss to thepremium receive

IF the underlying stock is above 1490 say Below1510, the 1510 calloption will not be exercised while the 1490 option will incur loss to thepremium receive because seller is bearish in the market.

v. BELOW STRIKE PRICE :

IF the underlying stock is below 1510, the 1510 call option will result indeep out the money and 1490 option sold result in loss to the premiumpaid.

OPTION PAYOFF

Profit

Loss

5). STRADDLE:In this strategy the investor purchase and sell the call as well as the putoption of the same strike price, the same expiration date, and the sameunderlying. In this strategy the investor is neutral in the market.

This strategy is often used by the SPECULATORS who believe that assetprices will move in one direction or other significantly or will remain fairlyconstant.

TYPES:

LONG STRADDLE:Here the investor takes a long position(buy) on the call and put with thesame strike price and same expiration date. In this the investor isbeneficial if the price of the underlying stock move substantially in eitherdirection. If prices fall the put option will be profitable an if the prices

rises the call option will give gains. Profit potential in this strategy isunlimited ,While the loss is limited up to the premium paid. This willoccur if the spot price at expiration is same as the strike price of theoptions.

SHORT STRADDLE:This strategy is reverse of long straddle. Here the investor write(sell) thecall as well as the put in equal number for the same strike price an sameexpiration. This strategy is normally used when the prices of theunderlying stock is stable but the investor start suffering losses if themarket substantially moves in either direction .

Detailed example of a long straddle

Current market price of BAJAJ AUTO is Rs.600

Here the investor buys one month call of strike price 600 at 20 ticks percontract and two month put of strike price 600 for 15 ticks per contract.

Premium Paid = 35 ticks

Lot size = 400 shares

Lower Break- Even- Point = 600 – 35 = 565

Higher Break- Even- Point = 600 + 35 = 635

i. AT BREAK- EVEN- POINT:

If the stock is at 565 or at 635, this option strategy will be at Break-Even- Point. At 565 the 600 call will have no intrinsic value an expireworthless but the 600 put will have an intrinsic value of 35.

At 635 the 600 call will have an intrinsic value of 35, while the put 600will expire worthless.

ii. BELOW STRIKE PRICE AND BELOW LOWER BEP:

If the stock price goes to 550 then the 600 call will have no intrinsicvalue and expire worthless while 600 put will have an intrinsic value of 50.

iii. ABOVE STRIKE PRICE AND ABOVE LOWER BEP:

If the stock price touches 650 the 600 call will have an intrinsic value of50, while 600 put will have no intrinsic value an will expire worthless.

iv. BETWEEN LOWER BEP AND HIGHER BEP:

If the stock prices goes to 6oo then the both call and put option willexpire worthless which results in the loss of 35(premium).

The pay-off table:BAJAJ AUTO ATEXPIRATION

550

(BELOWSTRIKEAN DBELOWBEP )

600

(Atthestrike)

618

(BETWEENSTRIKE &HIGHERBEP

635

(At BEP)

650

(ABOVESTRIKEAN DABOVEHIGHERBEP

Intrinsic value of600 long call atexpiration (a)

0 0 18 35 30

Premium paid (b) 20 20 20 20 20Intrinsic value of600 long put atexpiration (c)

50 0 0 0 10

Premium paid (d) 15 15 15 15 15

profit/loss(a+c)-(b+ d)

15 -15 -17 0 5

Profit

40

30

20

10BEP

BAJAJ AUTO ATEXPIRATION

550

(BELOWSTRIKEAN DBELOWBEP )

600

(Atthestrike)

583

(BETWEENSTRIKE &LOWERBEP

565

(AtLOWERBEP)

650

(ABOVESTRIKEAN DABOVEHIGHERBEP

Intrinsic value of600 long call atexpiration (a)

0 0 0 0 30

Premium paid (b) 20 20 20 20 20Intrinsic value of600 long put atexpiration (c)

50 0 17 35 10

Premium paid (d) 15 15 15 15 15

profit/loss(a+c)-(b+ d)

15 -15 -18 0 5

550 560 570 580 590 600 610620 630 640 650

-10

-20

-30

-40

Loss

6. STRANGLE:In this strategy the investor is neutral in the market which involves thepurchase of a higher call and a lower put that are slightly out of themoney with different strike price and with the different expiration date.The premiums are lower as compared to straddle also the risk is moreinvolved as compare to straddle which not leads to the profit.

TYPES

1) LONG STRANGLE:

Here the investor purchases a higher call and a lower put withdifferent strike price and with the different expiration date. A longstrangle strategy is used to profit from a volatile price an loss from stableprices.

2)SHORT STRANGLE:

In this the investor sells a higher call and a lower put with different strikeprice and with the different expiration date. A short strangle strategy isused to profit from a stable prices an loss starts when price is volatile.

Detailed example of a short strangle

Current market price of BSE INDEX is Rs.4000

Here the investor sells a two month call of strike price 4050 for 20 ticksper contract and two month put of strike price 3950 for 15 ticks percontract.

Premium Received = 35 ticks

Lot size = 300 shares

Lower Break- Even- Point = 3950 – 35 = 3915

Higher Break- Even- Point = 4050 + 35 = 4085

On Expiration:

i. AT BREAK EVEN POINT:

If the stock is at 3915 or at 4085, this option strategy will be at Break-Even- Point. At 3915 the 4050 call will have no intrinsic value and expireworthless but the 3950 put will have an intrinsic value of 35

At 4085 the 4050 call will have an intrinsic value of 35, while the put 400will have no intrinsic value and expire worthless.

ii. BELOW STRIKE PRICE AND BELOW LOWER BEP:

If the stock price goes to 3900 then the 4050 call will have no intrinsicvalue and expire worthless while 3950 put will have an intrinsic value of50.

iii. ABOVE STRIKE PRICE AND ABOVE LOWER BEP:

If the stock price touches 4100 the 4050 call will have an intrinsic valueof 50, while 3950 put will have no intrinsic value and will expireworthless.

iv. BETWEEN LOWER BEP AND HIGHER BEP:

If the stock prices goes to 4000 then the both call and put option willexpire worthless and limited profit up to the premium received.

v. AT STRIKE PRICE:

If the price is settled at 4050 then 4050 call and 3950 put will havelimited profit upto the premium received

The pay-off table:

BSE INDEX ATEXPIRATION

3900

(BELOWSTRIKEAN DBELOWBEP )

4050

(Atthestrike)

4070

(BETWEENSTRIKE &HIGHERBEP)

4085

(AtHIGHERBEP)

4100

(ABOVESTRIKEAN DABOVEHIGHERBEP

Intrinsic value of4050 Short call atexpiration (a)

0 0 20 35 50

Premium Receive(b) 20 20 20 20 20Intrinsic value of3950 short put atexpiration (c)

50 0 0 0 0

Premium Receive(d)

15 15 15 15 15

profit/loss(a+c)-(b15 -35 -15 0 15

+ d)

BSE INDEX ATEXPIRATION

3900

(BELOWSTRIKEAN DBELOWBEP )

3950

(Atthestrike)

3930

(BETWEENSTRIKE &LOWERBEP

3915

(AtLOWERBEP)

(ABOVELOWERSTRIKEAN DABOVELOWERBEP

Intrinsic value of600 Short call atexpiration (a)

0 0 0 0 0

Premium Receive(b) 20 20 20 20 20Intrinsic value of400 short put atexpiration (c)

50 0 20 35 0

Premium Receive(d)

15 15 15 15 15

profit/loss(a+c)-(b+ d)

15 -35 -15 0 -35

Profit

20

10

03900 3925 3950 3975 4000 4025

4050 4075 4100-10

-20

LossBreak – Even - Point

7) COVERED CALL:

Under this strategy investors buys the shares which shows that theyare bullish in the market but suddenly they are scared about the marketfalls thus they sells the call option. Here the seller is usually negative orneutral on the direction of the underlying security. This strategy is bestimplemented in a bullish to neutral market where a slow rise in themarket price of the underlying stock is anticipated.

Thus if price rises he will not participate in the rally. However he hasnow reduced loss by the amount of premium received, if pricesfalls.Finally if prices remains unchanged obtains the maximum profitpotential.

EXAMPLE:

Portfolio: 100 shares purchased at Rs.300Components: Sell a two month Reliance call of 300 strike at 25Net premium: 25 ticksPremium received: Rs.2500 (25*100, the multiplier)Break-even-point: Rs.275:Rs.300-25 (Premium received)

Possible outcomes at expiration:

If the stock closes at 300, the 300 call option will not exercised and sellerwill receive the premium.If the stock ends at 275, the 300 call option expires worthless equilant tothe premium received results into no profit no loss.If the stock ends above 300, the 300 call option is exercised and callwriter receives the premium results into the maximum profit potential.

The payoff diagram of a covered call with long stock + short call = shortput

Profit:

50

25

0250 275 300 325 350

-25

Break- Even-

-50

Loss

8) COVERED PUT:

Here the writer sell stock as well as put because he overall moderatebearish on the market and profit potential is limited to the premiumreceived plus the difference between the original share price of the shortposition and strike price of the put. The potential loss on this position,however is substantial if price increases above the original share price ofthe short position. In this case the short stock will suffer losses which willbe offset by the premium received.

Profit:

Premium Received

Lower

Loss

9) UNCOVERED CALL:

This strategy is reverse of the covered call. There is no opposite positionin the naked call. A call option writer (seller) is uncovered if the shares ofthe underlying security represented by the option is not owned by theoption writer.

break- even-

The object of an uncovered call writer is to realize income by writing(selling) option without committing capital to the ownership of theunderlying shares.

This shows that the seller has one sided position in the contract for thisthe seller must deposit and maintain sufficient margin with the broker toassure that the stock can be purchased for delivery if option is exercised.

RISKS INVOLVED IN WRITING UNCOVERED CALL OPTION ARE ASFOLLOWS:-

If the market price of the stock rises sharply the calls could beexercised, while as far as the obligation is concerned the sellermust buy the stock more than the option strike price, which resultsin a substantial loss.

The rise of buying uncovered calls is similar to that of selling stockalthough, as an option writer, the risk is cushioned somewhat bythe amount of premium received.

ILLUSTRATION:

Portfolio: Write reliance call of 65 strike

Net premium: 6

Lot size: 100 shares

Market action: price settled at 55

Therefore the option will not be assigned because the seller has nostock position and price decline has no effect on the profit of thepremium received.

Suppose the price settled at Rs.75 the option assigned and the sellerhas to cover the position at a net loss of Rs.400 [1000 (loss oncovering call)- 600(premium income)]

Finally the loss is unlimited to the increase in the stock price andprofit is limited to the declining stable stock price.

10) PROTECTIVE PUT:

Under this strategy the investor purchases the stock along with theput option because the investor is bearish in the market. This strategy

enables the holder of the stock to gain protection from a surprisedecline in the price as well as protect unrealized profits. Till theoption expires, no matter what the price of underlying is, the optionbuyer will be able to sell the stock at strike price of put option.

SCENARIO

Price of HLL: 200

Components: Buy a one-month put of strike 200

Net premium: 10 ticks per contract

Premium paid: 1000 (10*100 multiplier)

Break-even-point: 210 (Rs.200+10, Premium paid)

Here the investor pays an additional margin of Rs.10 along with theprice of Rs.210 combining a share with a put option is referred as aProtective Put.

Possible outcomes at expiration

AT BREAK-EVEN-POINT:Previously if the price rises to 200 the investor will gain but now theinvestor pays an margin of Rs.10. If price rises to Rs.210 then only theinvestor will gain.

BELOW STRIKE PRICE:In case of fall in the stock price the loss is limited to Rs.18. This meansthat he maximum loss that the investor would have to bear is limited tothe extent of premium paid.If the price falls at 190 the investor will sell at 200.

ABOVE STRIKE PRICE :In case of rise in prices then the put option will expire worthless and theinvestor will benefit from rise in the stock price.

Finally uncertainty is the biggest curse of the market and a protective puthelps override the uncertainty in the markets. Protective put removes theuncertainty by limiting the investor loss at Rs.10. In this case no matterwhat happens to the investor is protected by the loss of Rs.10. The putoption makes the investor life by telling the investor in advance howmuch it stands to loss. This is also referred to as PORTFOLIO INSURANCE

because it helps the investor by insuring the value of investment just likeany other asset for which the investor would purchase insurance.

profit:

20

10

0180 190 200 210 220

-10

-20

Loss

PRICING OF AN OPTION

DELTA

A measure of change in the premium of an option corresponding to achange in the price of the underlying asset.

Change in option premiumDelta = --------------------------------

Change in underlying price

FACTORS AFFECTING DELTA OPTION:

Strike priceRisk free interest rateVolatilityUnderlying priceTime to maturity

Break- Even-

ILUSTRATION

The investor has buys the call option in the future contract for the strikeprice of Rs.19. The premium charged for the strike price of 19 at 0.80The delta for this option is 0.5.Here if the price of the option rises to20.A rise of 1. then the premium will increase by 0.5 x 1.00 = 0.50. The newoption premium will be 0.80 + 0.50 = Rs 1.30.

Here in the money call option will increase the delta by 1.which will makethe value more and expensive while at the money option have the deltato 0.5 and finally out the money call option will have the delta very closeto 0 as the change in underlying price is not likely to make them valuableor cheap and reverse for the put option

Delta is positive for a bullish position (long call and short put) as thevalue of the position increases with rise in the price of the underlying.Delta is negative for a bearish position (short call and long put) as thevalue of the position decreases with rise in the price of the underlying.

Delta varies from 0 to 1 for call options and from –1 to 0 for put options.Some people refer to delta as 0 to 100 numbers.

ADVANTAGE

The delta is advantageous for the option buyer because it can tell himmuch of an option and accordingly buyer can expect his short termmovements by the underlying stock. This can help the option of an buyerwhich call/put option should be bought.

GAMMA

A measure of change in the delta that may occur corresponding to therise or fall in the price of the underlying asset.

Gamma = change in option delta

__________________

change in underlying price

The gamma of an option tells you how much the delta of an option wouldincrease or decrease for a unit change in the price of the underlying. Forexample, assume the gamma of an option is 0.04 and its delta is 0.5. Fora unit change in the price of the underlying, the delta of the option wouldchange to 0.5 + 0.04 = 0.54. The new delta of the option at changedunderlying price is 0.54; so the rate of change in the premium hasincreased. suppose the delta changed to 0.5-0.04 = 0.46 thus the rate ofpremium will decreased .

In simple terms if delta is velocity, then gamma is acceleration. Delta tellsyou how much the premium would change; gamma changes delta andtells you how much the next premium change would be for a unit pricechange in the price of the underlying.

Gamma is positive for long positions (long call and long put) and negativefor short positions (short call and short put). Gamma does not mattermuch for options with long maturity. However for options with shortmaturity, gamma is high and the value of the options changes very fastwith swings in the underlying prices

THETA:

A measure of change in the value of an option corresponding to its timeto maturity. It is a measure of time decay (or time shrunk). Theta isgenerally used to gain an idea of how time decay is affecting yourportfolio.

Change in an option premiumTheta = --------------------------------------

Change in time to expiry

Theta is usually negative for an option as with a decrease in time, theoption value decreases. This is due to the fact that the uncertaintyelement in the price decreases.

ILLUSTRATION

Suppose the theta of Infosys 30-day call option with a strike price ofRs3,900 is 4.5 when Infosys is quoting at Rs3,900, volatility is 50% andthe risk-free interest rate is 8%. This means that if the price of Infosysand the other parameters like volatility remain the same and one daypasses, the value of this option would reduce by Rs.4.5.

ADVANTAGE

Theta is always positive for the seller of an option, as the value of theposition of the seller increases as the value of the option goes down withtime.

DISADVANTAGE

Theta is always negative for the buyer of an option, as the value of theoption goesdown each day if his view is not realized.

In simple words theta tells how much value the option would lose afterone day, with all the other parameters remaining the same.

VEGA

The extent of extent of change that may occur in the option premium,given a change in the volatility of the underlying instrument.

Change in an option premiumVega = -----------------------------------------

Change in volatility

ILLUSTRATION

Suppose the Vega of an option is 0.6 and its premium is Rs15 when volatilityof theunderlying is 35%. As the volatility increases to 36%, the premium of theoptionwould change upward to Rs15.6.Vega is positive for a long position (long call and long put) and negative fora short position (short call and short put).

ADVANTAGE

Simply put, for the buyer it is advantageous if the volatility increases after hehasbought the option.

DISADVANTAGE

For the seller any increase in volatility is dangerous as the probability of hisoption getting in the money increases with any rise in volatility.

In simple words Vega indicates how much the option premium would changefor a unit change in annual volatility of the underlying.

DERIVATIVES PRODUCTS OFFERED BY BSE

SENSEX FUTURES

A financial derivative product enabling the investor to buy or sellunderlying sensex on a future date at a future price decided by themarket forces

First financial derivative product in India.

Useful primarily for Hedging the index based portfolios and also forexpressing the views on the market

SENSEX OPTIONS:

A financial derivative product enabling the investor to buy or sellcall or put options (to be exercised on a future date) on the underlyingsensex at a premium decided by the market forces

Useful primarily for Hedging the Sensex based portfolios and also forexpressing the views on the market.

STOCK FUTURES:

A financial derivative product enabling the investor to buy or sellunderlying stock on a future date at a price decided by the marketforces

Available on ____ individual stocks approved by SEBI

Useful primarily for Hedging, Arbitrage and for expressing the viewson the market.

STOCK OPTIONS:

A financial derivative product enabling the investor to buy or sellcall options(to be exercised at a future date) on the underlying stockat a premium decided by the market forces

Available on ____ individual stocks approved by SEBI

Useful primarily for Hedging, Arbitrage and for expressing the views onthe market.

CONTRACT SPECIFICATIONS

PARTICULARS SENSEX FUTURES ANDOPTIONS

STOCK FUTURES ANDOPTIONS

Underlying Asset Sensex Corresponding stockin the cash market

Contract Multiplier 50 times the sensex(futures)

100 times the sensex(options)

Stock specific E.g.market lot of RIL is600, Infosys is 100 &so on

Contract Months 3 nearest serialmonths (futures)

1, 2 and 3months(options)

1, 2 and 3 months

Tick size 0.1 point 0.01*Price Quotation Sensex point Rupees per shareTrading Hours 9:30a.m. to 3:30p.m. 9:30a.m. to 3:30p.m.Settlement value In case of sensex

options the closingvalue of the sensex

In case of stockoptions the closingvalue of the

on the expiry day respectative in thecash segment of BSE

Exercise Notice Time In case of sensexoptions Specified time(exercise session) onthe last trading day ofthe contract. All in themoney options woulddeem to be exercisedunless communicatedotherwise by theparticipant.

In case of stockoptions Specified time(exercise session) onthe last trading day ofthe contract. All in themoney options woulddeem to be exercisedunless communicatedotherwise by theparticipant.

Last Trading Day Last Thursday of thecontract month. If it isa holiday, theimmediatelypreceding businessday

Last Thursday of thecontract month. If it isa holiday, theimmediatelypreceding businessday

Final Settlement On the last tradingday, the closing valueof the Sensex wouldbe the finalsettlement price ofthe expiringfutures/optioncontract.

The difference issettled in cash on theexpiration day on thebasis of the closingvalue of therespectativeunderlying scrip inthe cash market onthe expiration day

DERIVATIVES PRODUCTS OFFERED BY NSE

INDEX FUTURES

Index Futures are Future contracts where the underlying asset is theIndex. This is of great help when one wants to take a position on marketmovements. Suppose you feel that the markets are bullish and the Sensexwould cross 5,000 points. Instead of buying shares that constitute theIndex you can buy the market by taking a position on the Index future

Index futures can be used for hedging, speculating, arbitrage, cash flowmanagement and asset allocation. The S&P 500 futures products are thelargest traded index futures product in the world.

Both the Bombay Stock exchange (BSE) and the National Stock Exchange(NSE) have launched index futures in June 2000

ADVANTAGES OF INDEX FUYTURES

The contracts are highly liquidIndex Futures provide higher leverage than any other stocksIt requires low initial capital requirementIt has lower risk than buying and holding stocksSettled in cash and therefore all problems related to bad delivery,forged, fake certificates, etc can be avoided.

INDEX OPTIONS

An index option provides the buyer of the option, the right but not the obligation to buy orsell the underlying index, at a pre-determined strike price on or before the date ofexpiration, depending on the type of option.

Index option offer investors an opportunity to either capitalize on an expected marketmove or hedge price risk of the physical stock holdings against adverse market moves.

NSE introduce index option in June 2001.

FUTURES ON INDIVIDUAL SECURITIES

A futures contract is a forward contract, which is traded on an Exchange.NSE commenced trading in futures on individual securities on November9, 2001.

NSE defines the characteristics of the futures contract such as theunderlying security, market lot, and the maturity date of the contract. Thefutures contracts are available for trading from introduction to the expirydate.

CONTRACT SPECIFICATIONS

PARTICULARS INDEX FUTURES ANDOPTIONS

FUTURES AND OPTIONS ONINDIVIDUAL SECURITIES

Underlying S&P CNX Nifty and CNX ITIndividual Securities, atpresent 53 stocks

Contract Size S&P CNX Nifty Futures /Permitted lot size 200 andmultiplesS&P CNX Nifty Options there of(minimum value Rs.2 lakh)

Futures / Options on Minimumvalue of Rs 2 Lakh for eachindividual securities IndividualSecurity

Strike Price Interval S&P CNX Nifty Options Rs.10/-2.

Options on individual BetweenRs.2.50 and Rs. 100.00securities : depending on theprice of underlying

Trading Cycle Maximum of three month tradingcycle- near month(one), the nextmonth (two)and the far month(three). New series of contractwill be introduced on the nexttrading day following expiry ofnear month contract

Maximum of three monthtrading cycle- nearmonth(one), the next month(two)and the far month (three).New series of contract will beintroduced on the next tradingday following expiry of nearmonth contract.

Expiry Date The last Thursday of the expirymonth or the Previous tradingday if the last Thursday of themonth is a trading holiday

The last Thursday of the expirymonth or the Previous tradingday if the last Thursday of themonth is a trading holiday

Settlement Basis Index Futures / Futures Mark toMarket and final settlement onindividual securities be settled incash on T+1 basisIndex Options Premiumsettlement on T+1 Basis andFinal Exercise settlement on T+1basis

Options on individual Premiumsettlement on T+1 basis andsecurities option Exercisesettlement on T+2 basis.

Settlement Price S&P CNX Nifty Futures / Dailysettlement price will be theclosing value of the underlyingindexIndex Options The settlementprice shall be closing value ofunderlying index

Final settlement price shall bethe closing value of theunderlying security on the lasttrading day

The settlement price shall beclosing on individual securityprice of underlying security.

OPEN INTEREST(OPTIONS)

Open Interest is a crucial measure of the derivatives market. The totalnumber of options contracts outstanding in the market at any given pointof time. In short Sum of all positions taken by different traders reflectsthe Open Interest in a contract. Opposite positions taken by a trader in acontract reduces the open interest. However, opposing positions taken (inthe same contract) by two different traders are added to the open interest.

Assuming that the market consists of three traders only following tableindicates how Open Interest changes on different day’s trades in PATNICOMPUTERS with a call American option at a strike price of Rs. 180

DAY TRADER 1 TRADER 2 TRADER 3 OPENINTEREST

1 LONG 1200 SHORT 2400 LONG 1200 48002 NO TRADE LONG 1200 SHORT 1200 24003 LONG 1200 NO TRADE SHORT 1200 24004 SHORT 2400 LONG 1200 LONG 1200 0

OPEN INTEREST(FUTURES)

The total number of net outstanding futures contracts is called as openinterest i.e. long minus short contracts. A decline in open interest of thenear term futures indicates a short-term weakness whereas an increasein the open interest in the long term futures indicate that the marketsmay bounce back after some time provided this trend persists for a longtime

A rising open interest in an uptrend is BullishA declining open interest in an uptrend is Bearish

A rising open interest in a downtrend is Bearish

A declining open interest in a downtrend is Bullish

“RELIANCE ADD 5LAKH SHARES IN THE OPEN INTEREST”

This shows that total number of option contracts comprising of 5lakhshares are outstanding in the market. There has been no square offpositions(opposite positions) in the market. Thus from the openinterest we come to know long and short positions made by theinvestor.

RELATIONSHIP OF OPEN INTEREST WITH MARKET VOLUMES

If open interest and market volumes increases but the market isbullish this shows that there has been buying positions in themarket, which results into the positive open interest.

If open interest and volumes increases but the market is in thebearish phase this shows that there has been selling positionsmade by the investor which results into the negative open interest

If open interest remains constant and volumes are increasing andmarket is also bullish this shows that there has been intra daytrading in the market.

RELATIONSHIP OF OPEN INTEREST WITH PRICES

If both open interest and prices are increasing, this shows that thebuyers have entered in the market unfolding. Expect the uptrend tocontinue.

If on the other hand, open interest is increasing while pricesdecline, sellers are expecting for the price rise in a technically weak

market. As open interest is growing while prices decline, buyers areobviously the more aggressive party.

In the event of open interest declining while prices are also slipping,liquidation by long positions is the implication, thereforesuggesting a technically strong market overall. In other words, themarket is strong as open interest declining suggests no newaggressive shorts, as this would entail an increase in open interest.

When open interest is declining and prices are increasing, shortcovering is the most likely cause suggesting that overall the marketis weak - i.e. attracting new buyers would be required for atechnically strong market and consequently open interest wouldrise.

ILLUSTRATIONSuppose there are only two brokers Mr. A and Mr. B in the market. A buysand B sells contracts on Index futures on a specific day. At the end of theday , we may say that open interest in the market is 10 contracts andvolume for the day is 10 contracts.

Now, if next day a new trader Mr. C comes from Mr. A, open interest atthe endo f the 2 day of trading remains same 10 contracts and volumefor the day is again 10 contracts. Understand that on the second day, Mr.C assumes Mr. A’s position on first day of trading. But for the market as awhole, at the end of the 2nd day all only 10 contracts remain open.

COST OF CARRY

The relationship between futures and spot prices can be summarized interms of what is know as the cost of carry. This measures the storagecost plus the interest that is paid to finance the asset less the incomeearned on the asset.

Cost of carry gives us an idea about the demand-supply forces in thefutures market. It basically indicates the annualized interest cost whichplayers are willing to pay (receive) for buying (selling) a futures contract.

In the Indian markets the cost of carry marketing varies between anegative 35% per annum to a positive 35 % per annum. It can even behigher or lower than the 35% figure but that would be an extraordinary

event. We all know that at expiry the futures price closes at the cash priceof the security or an index.

The cost-of-carry model in financial futures, thus, is

Futures price = Spot price + Carrying cost — Returns (dividends, etc.)

RELATIONSHIP OF FUTURES PRICE WITH SPOT PRICE

FUTURES PRICE HIGHER THAN THE CASH PRICE

Here futures price exceeds the cash price which indicates thatthe cost of carry is negative and the market under such circumstances istermed as a backwardation market or inverted market.

EXAMPLE

Suppose the RELIANCE share is trading at Rs.400 in the spot market.While RELIANCE FUTURES is trading at Rs.406.Thus in this circumstancesthe normal strategy followed by investors is buy the RELIANCE in the spotmarket and sell in the futures. On expiry, assuming RELIANCE closes at Rs450, you make Rs.50 by selling the RELIANCE stock and lose Rs.44 bybuying back the futures, which is Rs 6 in a month. Thus Futures pricesare generally higher than the cash prices, in an overbought market.

CASH PRICE HIGHER THAN THE FUTURES PRICE

Here cash price exceeds the futures price which indicates that the cost ofcarry is positive and this market is termed as oversold market. This maybe due to the fact that the market is cash settled and not delivery settled,so the futures price is more a reflection of sentiment, rather than that ofthe financing cost.

EXAMPLE

Now let us assume that the RELIANCE share is trading at Rs.406 in thespot market. While RELIANCE FUTURES is trading at Rs.400.Thus in this

circumstances the normal strategy followed by investors is buy theRELIANCE FUTURES and sell the RELIANCE in the spot market. So atexpiry if Reliance closes at Rs 450, the investor will buy back the stock ata loss of Rs 44 and make Rs 50 on the settlement of the futures position.This is applied when the cost of carry is high.

Thus t he ar bi t r ageur can appl y t hi s st r at egy and make t he pr of i t s

VOLATILITY

Volatility is one of the most important factors in an option’s price. Itmeasures the amount by which an underlying asset is expected tofluctuate in an given period time. It significantly impacts the price of anoption’s premium and heavily contributes to an option’s time value.

In basic terms, volatility is merely a term used to describe how fast astock, future or index changes with respect to change in the price. It canbe viewed as the speed of change in the market, although the investormay prefer to think of it is as market confusion. The more confused amarket is the better the chance an option of ending up “in the money”. Astable market moves slowly. Volatility measures the speed of change inthe price of the underlying instrument or the option. Higher the volatilitythe more the chance an option of becoming profitable by expiration

RELATIONSHIP OF PRICE VOLATILITY WITH PREMIUM

Higher the price volatility of the underlying stock of the put option,higher would be the premium.

Lower the price volatility of the underlying stock of the call option, lowerwould be the premium.

TYPES OF VOLATILITY

HISTORICAL VOLATILITY:

This (also called statistical volatility) measures price movement interms of past. Historical volatility is calculated by using thestandard deviation of underlying asset price changes from close to closeof trading for a given period - month, half yearly, annualized

IMPLIED VOLATILITY:

It is the option market predication of volatility of the underlyinginstrument over the life of the option. It helps in determining whatstrategies are to be used.When implied volatility is high, the marketprice of the option will be greater than their theoretical price.

Example

Stock Price: Rs 280

Strike Price: Rs 260

Annual volatility: 50%

Days to expiry 20 days

Interest rate 12% annual

The price of the Option applying Black-Scholes Model comes to Rs 26.28.But the actual price of that Option in the market might be (say) Rs 29.50.This means that the market is imputing another volatility to that optiongoing forward. Now instead of providing the volatility figure yourself, youcan provide the Option price instead. Now if the investor work backwardsand find out what is the volatility that would support the price of Rs29.50, that volatility comes to 65 per cent.

While the value of a call option is an increasing function of the value of itsunderlying, it is also an increasing function of the volatility of itsunderlying. That is, the more uncertain the underlying, the more theoption is worth.

From the above scenario it is possible that the players are expecting thescrip to increase another possibility is that the market is mis-pricing theoption and could fall. It could also be possible that the market isanticipating some development, which could push the stock higher. If youbelieve that volatility would rise and the underlying then you may go infor a bull strategy or if you are an aggressive player you could sell theoption with a belief to buy them at a later date.

Most traders, however, use a general rule of thumb: Buy options in lowvolatility and sell options during periods of high volatility.

If you see low implied volatilities, you should buy the At the Money (ATM)option and sell an Out of the Money (OTM) option. You can also create asimilar position using puts. In this case, you should buy ATM and sell Inthe Money (ITM) put options. If you see high implied volatilities, youshould buy an In the Money (ITM) Call and sell an ATM call. You will findthat both the calls are expensive, but the ATM will be in mostcircumstances more expensive than the others. Thus, by selling the ATMcall, you can realize a good price.

Finally implied volatility can increase or decrease even without pricechanges ion the underlying security. This is because implied volatility isthe level of expected volatility i.e. it is also based not on actual prices ofthe security, but expected price trends. Implied voltility also declines, asthe option gets closer to expiration, as changes in volatility become lesssignificant with fewer trading days

BEST STRATEGY TO BE FOLLOWED IN CASE OF IMPLIED VOLATILITY

SHORT STRADDLE:

These involve simultaneously selling put and call options for the samestock, same strike price and with the same expiration date. In contrast, ashort strangle involves simultaneously selling both a put and call on thesame stock and same expiration date, but with the different strike price.

ILLUSTRATION

Let's choose the strike price 165 in Satyam for the June contracts. Satyamis one of the most actively traded contracts in the NSE F&O segment.

The IV for the call is 97.66 per cent and that of put is 99.40 per cent onApril 25, 2005 Since the IV is high, it is a premium-selling time. (a goodtime to sell calls and puts)

# On May 25, the investor `short straddle' the Satyam by selling the 165call and put for Rs 27.

# The inflow in this strategy is Rs 54 (2X27).

# The underlying spot has been trading within a range of 157-177.

# However, the call IV has ranged from 99.40 - 63.36 and that of put hasranged from 97.66-46.01

# On May 29, 2003 the IV of call and put are low, hence the investor cansquare off positions.

# The respective IV was 63.36 for call and 46.01 for put. The underlyingSatyam was Rs 169.50.

# The call closed at Rs 11.45 and the put closed at Rs 9.50.

# Square-off position by buying call and put of the same strike. Youroutflow would be 20.95 (11.45+9.50). Hence, your net profits would beRs 33.05 (54-20.95).

Here the strategy has “limited profit and unlimited losses”. Here the Profitis limited to the premiums received. Losses would be unlimited if you arewrong on the stock outlook and the volatility outlook.