BUYER feels price will go UP. SELLER (SHORT) feels price will go DOWN.
A transaction will happen between 2 people when they have different opinions.
A Derivative is a financial instrument that derives its value from an underlying asset. E.g.
Prices of petrol and diesel are derived from the price of crude oil.
Prices of gold bonds are derived from the price of the gold.
In case of a cricket match bet, the winner is derived from the outcome of the match.
You need gold, one year from now. The current price of a gold is $100. You have 3 options, to
fulfill your requirement:
1. Buy it now at $100 and use it after a year = immediate cash outflow.
2. Buy it after a year, but price is unknown, and this is a risk
3. Enter into an agreement to buy the gold a year from now for $100 = lock in the price
today, pay later. This is a forward contract as the transaction will happen on a later date.
FORWARD CONTRACT
• Farmer & Wholesaler
• 1000 kg Onion
• 5*1000 = 5,000
• Settled after 30 days.
• Physical delivery.
• Obligation
• Farmer will deliver it to
wholesaler’s warehouse.
• Farmer has agreed to sell and the wholesaler has agreed to buy.
• There is an obligation from both the sides to play their part.
• Farmer has locked-in the selling price and wholesaler has locked-in the buying price,
irrespective of market conditions/price.
FORWARD CONTRACT TERMINOLOGIES
• Contract
• UNDERLYING
• LONG - when you are the buyer/want to buy something = Long Forward
• SHORT - when you are the seller/want to sell something = Short Forward
• Tenure/Expiry
• Forward Price/Strike Price
• Settlement
• Customized Contract
• Obligation
• Spot market & Forward Market
• Risk = Default risk, Price Risk
VALUE OF THE CONTRACT
• Compare spot price vs forward contract price to derive the value of the contract for the
long and for the short.
• If the price increases (Spot price > Forward Price), the contract is profitable for the long.
• If the price decreases (Spot price < Forward Price), the contract is profitable for the short.
• Zero sum Game Spot Market Contract Price Farmer has agreed Wholesaler has
Price * 1000 * 1000 to sell at 5 agreed to buy at 5
• Physical vs Cash Settlement
1 5
In case of Cash Settlement,
the Loser pays the Gainer. 3 5
7 5
The full amount is
exchanged in physical 10 5
settlement only.
Categories of people:
• Trader = physical settlement
• Speculator = cash settlement
• Hedger*
Note = The underlying is required to only derive the value of the contract. One
may/may not be in actual possession of the underlying. One can enter the
contract just for betting (speculation) also.
If the profit and loss
potential is the same for
Non-Linear Payout both the long and the short,
the payoff is linear or
Linear Payout symmetric. Futures and
Y-axis → Profit/Loss on (D)
Forwards have linear
payoffs.
Non-linear (asymmetric)
payoff is common in
options.
X-axis → Value of Underlying (A)
FUTURES MARKET
Characteristics of Futures:
1) Standardized and not Customised
2) Backed by a Clearinghouse*, so NO Default Risk. But there is Price Risk.
3) Higher Liquidity (Uniformity promotes market liquidity)
4) Can close-out positions by taking the opposite side of the contract.
5) Cash Settlement usually.
6) Contract Multiplier – Market Lot
7) Marking to market – Margin requirements
# National Clearing Limited (NSE Clearing) formerly known as National Securities Clearing Corporation Limited (NSCCL)
Margin Requirement in Future Markets:
• Margin is some form of collateral required to enter into the Futures Contract.
• It is posted by both buyers and sellers with their respective brokers.
• Margin is a percentage of the value of the contract and the percentage is set by the Exchange.
• The margin account fluctuates everyday depending upon the closing prices of the underlying.
Say for a Futures Contract worth $1000 has a 10% margin requirement -
• Initial Margin = amount posted by both long and short to enter into a futures contract. ($100)
• Maintenance Margin = value beyond which the margin account cannot fall. ($75)
• Variation Margin = if the account falls below maintenance margin, we have to bring the account
back to the level of Initial Margin. (If margin account goes to $60, add $40 more to make it
$100).
Adjusting the Margin Account at the end of the Trading Day is known as Marking to Market.
Marking to market refers to the daily settlement of gains and losses, arising due to changes in the
market value of the security. If there is an insufficient margin, trader will get a Margin Call.
https://zerodha.com/margin-calculator/Futures/
Enter into a futures contract to buy silver at $100.
Initial margin is 10, maintenance margin is 7.
Price at end of day 1 = 102
Price at end of day 2 = 98
Price at end of day 3 = 96
Price at end of day 4 = 97
How will the marking to market work in this scenario for the LONG
10 – start or initial margin
+2
12
-4
8
-2
6 is below maintenance margin
+4 is variation margin posted to bring the account back to levels of initial margin
10
+1
11
FORWARDS FUTURES
Not traded on exchanges Traded on exchanges
Are private agreements between Standard contracts
two parties and are not as rigid in
their stated terms and conditions Clearing house and daily mark to
Credit risk is high market reduces credit risk
High customization Settlement can occur over a range
Settlement at the end of contract of dates
and on a specific date Usually closed out before maturity
Mostly used by hedgers that want to and hardly any deliveries happen.
remove the volatility of the
underlying, hence delivery/cash
settlement usually takes place.
Over the Counter (OTC) Exchange Traded
Contracts are customized Contracts are standardized.
Counter-party is another individual Counterparty is the Exchange.
No initial exchange of cash. No collateral. Collateral is posted with the Broker/Exchange in the
form of Margins, that need to be maintained.
Liquidity is low. Liquidity is high.
High Counter-party risk No Default risk.
No Centralized trading location Transactions are routed through the exchange and is
backed by a Clearinghouse.
Unregulated Regulated
Contracts are designed to be held till maturity Can exit the contract through secondary market sale.
E.g. Forwards, Swaps, Exotics E.g. Futures & Options
OPEN INTEREST
Open interest is the total number of unsettled / outstanding (not closed) derivative contracts held by market
participants at a point of time. It measures the level of activity in the futures/options market.
• If the OI is very high, it means that market is closely watched by the participants.
• Increase in OI means new money is flowing into the markets & the current trend is expected to continue.
• Declining OI means current trend is coming to an end and the participants are liquidating their positions.
• If OI remains flat after substantial price rise OI it indicates that market is forming a top.
Open Interest vs Trading Volume
• Volume refers to the no. of transactions / trades executed during a particular day.
• OI refers to the no. of open contracts.
• For every buy and sell the volume is 1. If 10 trades are executed, volume is 10.
Suppose, A and B entered into a futures trade on a particular day. Details of the transactions are as
follows:
9.30 AM – A buys 10 contracts and B Sells 10 Contracts.
Volume is 10 and OI is 10 – New contract is initiated.
2.30 PM – A sells 5 contracts and B Buys 5 Contracts.
Volume is 10+5 = 15
Open Interest is 10-5 = 5
USING OPEN INTEREST AND VOLUME TO DETERMINE TREND
Price Volume Trader’s Perception
Increase Increase Bullish
Decrease Decrease Bearish trend could probably end, expect reversal
Decrease Increase Bearish
Increase Decrease Bullish trend could probably end, expect reversal
Price OI Trader’s Perception
Increase Increase More trades on the long side
Decrease Decrease Longs are covering their position, also called long unwinding
Decrease Increase More trades on the short side
Increase Decrease Shorts are covering their position, also called short covering
• High volumes along with high OI indicates greater hedger and trader participation on a
stock futures or options counter.
• Conversely, high volumes and low OI means more speculative interest in a counter.
Basis is the difference between spot price and futures price.
Basis = Spot Price – Futures Price.
If futures price is greater than spot price, the basis is negative and vv.
Basis = 10000 – 10050 = -50
If Basis is negative, Futures are trading at a Premium.
If Basis is positive, Futures will trade at a Discount.
CONTANGO – when future prices are greater than future expected spot prices because of
storage costs, financing costs (cost to carry), insurance costs, etc. (These are applicable in
case of commodity derivatives).
BACKWARDATION – when future prices are less than future expected spot prices due to
convenience yield or expected dividend.
CONVENIENCE YIELD (contd.) – If you hold the underlying physically, instead of the
contract, you can keep your production process continuous. You need not wait for the
delivery of the underlying after the expiry date to resume the production process.
In case you have the physical commodity, you can sell it at abnormally higher prices during
a crisis. Physical demand will be more than demand for future contracts.
COST OF CARRY = the difference between the cost (storage) and benefit
(convenience/dividend) of holding the underlying asset during a particular period.
If cost of carry is positive i.e. costs are more than benefits – Contango
If cost of carry is negative i.e. benefits are greater than costs – Backwardation
Rollover is carrying forward a particular month’s futures positions to the next month.
Cost current month’s futures position and simultaneously take similar position in next
month’s futures.
If you are long in the September Contract, on the expiry date you will have to exit the
September contract by going short, and then going long again on the October Contract.
Why traders Rollover in future market
• Expect the current trend to continue in the near future.
• Not willing to book losses and expecting the trend to reverse from the current situation.
CALL OPTION CONTRACT
• Lady might buy 1 kg rice @ 60/- from
the shopkeeper.
• Anytime during this week.
• She pays 5/- to enter into the contract.
• Option to BUY the underlying.
• Lady has a Choice.
• Shopkeeper has Obligation.
If during the week, the spot market price of rice is
A. 75 /-
B. 55/-
A. Rice is cheaper under the contract – so use the contract. Net profit = 75 – 60 – 5 = 10
B. Rice is cheaper in the spot market – so lose the premium paid = -5
Always calculate the profit/loss only under the contract & not from what you do in the spot market.
CALL OPTION = ‘OPTION TO BUY’ the underlying at the agreed upon Price.
CALL OPTION
LONG CALL = BUY the ‘Option to Buy’ the underlying = Lady OPTION
SHORT CALL = SELL the option and must Compulsorily DELIVER the underlying if Called = Shopkeeper CONTRACT
STRIKE PRICE = Price at which the underlying will be brought/sold (60)
TO BUY THE
UNDERLYING
EXPIRY = Date on or before which you can use the contract.
SPOT PRICE – that helps you decide whether to use the contract or let it expire
PREMIUM – money paid upfront to enter into the contract (5). This is not an Advance or token.
IN-THE-MONEY OPTION = If we get a profit upon exercising the option (spot price 75 is greater than call option price 60)
OUT-OF-THE-MONEY = We let the option expire (spot price 50 is less than call option price 60)
BREAKEVEN PRICE for Call Option = X+P
PROFIT for Call Option = S – (X+P) or Spot price - BEP
What happens if the price is 65?
You will use the option and buy the rice at 60/-.
Profit = 65-60 = 5
Premium paid = -5
Total Profit = 0
This is the Breakeven price. Profits only begin after the BEP, which may vary for different
transactions.
OPTION TYPE:
1. AMERICAN = Can be exercised anytime during the tenor, or on Expiry Date.
2. EUROPEAN = Can be exercised only on the Expiry Date.
3. BERMUDA = Can be exercised on specific dates, or on Expiry Date.
Calculate the Payout for both the Long Call and the Short Call if the Strike price
is 100, premium is 5 and the Spot prices upon expiry are as follows:
105
98
90
85
125
70
PUT OPTION CONTRACT
• Value = 500/-
• Premium = 20/-
• Farmer has Option to sell i.e. he has
a choice.
• Wholesaler has a compulsion to buy
• Can be exercised on/before 31st Jan.
• Farmer has purchased an option contract (Long) from the Wholesaler (Short) for 20/-
premium (non-refundable).
• This is an Option to sell, therefore is a PUT OPTION.
• If he decides TO SELL, the Wholesaler HAS to buy it from him, i.e. Farmer has a choice,
Wholesaler has an Obligation.
• If the Farmer decides NOT TO SELL, the Wholesaler can keep the premium he has received.
• What if the spot market price on expiry is 400 and what if it is 600?
TERMINOLOGIES PUT OPTION
PUT OPTION = ‘OPTION TO SELL’ the underlying at the agreed upon Price OPTION
CONTRACT TO
LONG PUT = BUY the ‘Option to Sell’ the underlying = FARMER
SELL THE
SHORT PUT= SELL the option and must Compulsorily Buy the underlying UNDERLYING
if Option is Exercised = WHOLESALER
STRIKE PRICE = Price at which the underlying will be brought/sold.
PREMIUM = is paid by the Option buyer to the Option Seller.
EXPIRY
SPOT PRICE is compared with the Strike Price to determine whether to
exercise the option or not.
Calculate the Payout for both the Long Put and the Short Put if the Strike price is
100, premium is 5 and the Spot prices upon expiry are as follows:
105
98
90
85
125
70
Rationale behind Trading Options:
1) Long Call = Price of the underlying will go Up = Bullish
2) Long Put = Price of the underlying will go Down = Bearish
3) Short Call = Price of the underlying will not go UP or will go down = Bearish or not Bullish
4) Short Put = Price of the underlying will not go DOWN or will go up = Bullish or not Bearish
OPTION VALUE
INTRINSIC VALUE
TIME VALUE
E.g. On 13th April, a Call with X of 20 and a Spot price of 25, is trading for 7/-. This call expires on 30th April.
Intrinsic value is 5 and time value is 2. Time value keeps on reducing as the option nears expiry.
On 25th April, say the Spot price remains at 25, this same option will now be trading for 5.5/- with the time value now
reduced to 0.5/-.
Option Premium = Intrinsic Value + Time Value
OTM Options are Cheaper than ATM and ITM.
On 13th April a call with a X of 30 and spot price of 25, is trading for 1.5$. This call expires on 30th April. Here, the IV is 0
because option is OTM and the entire 1.5$ is the TV.
OTM and ATM options have no IV and only TV. ITM options have both.
STRATEGY OPTIONS USED REASON
COVERED CALL 1. Buy the stock • Mildly bullish or neutral
2. Sell the call • Generate ST Income
PROTECTIVE PUT 1. Buy the stock • Need protection from downside
2. Buy the put option
BULL CALL SPREAD 1. Buy call X = 100 • Bullish between 100 and 120 and
2. Sell Cal X = 120 expects resistance at 120 levels
BEAR PUT SPREAD 1. Buy Put X = 100 • Bearish between 100 and 80, but
2. Sell Put X = 80 expects support around 80 levels
PROTECTIVE COLLAR Is already holding a stock from 70 levels, • Strong Bearish
now the stock has risen to 100. • Locking in a selling price using Call for
1. Buy Put X = 100 booking profits.
2. Sell Call X = 105 • Downside protection
(Covered call + Long Put)
LONG STRADDLE 1. Buy Call X = 100 • Expect the stock to move strongly in
2. Buy Put X = 100 either of the direction.
Options used are ATM
LONG STRANGLE 1. Buy Call X = 105 • Same strategy as Straddle, but cheaper,
2. Buy Put X = 95 as options used are OTM.
Options used are OTM
STRATEGY OPTIONS USED REASON
LONG CALL BUTTERFLY 1. Buy 1 Call X = 100 (ITM) • Do not expect heavy movement upside.
2. Buy 1 Call X = 120 (OTM) • Limited upside and limited downside.
3. Sell 2 Calls X = 110 (ATM)
CALENDER SPREAD 1. Buy/Sell current month Call/Put • By selling the next month option, we
2. Sell/Buy next month Call/Put are trying to capture the Time value
• Expect rangebound movement.
