Course on Derivatives

July 24, 2015 1

Section 1:
What are Derivatives?

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What are Derivatives?
Derivative is a product whose value is derived from the value of one or more basic variables,
called bases (underlying asset, index, or reference rate), in a contractual manner.

In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R)A) defines derivative
to include-
1. A security derived from a debt instrument, share, loan whether secured or unsecured, risk
instrument or contract for differences or any other form of security.
2. A contract which derives its value from the prices, or index of prices, of underlying
Securities.

Derivatives are tools for transferring risk - They can be used to reduce risk as well increase risk.

Prices of derivatives reflect useful information about future events that can lead to better
decisions.

Derivatives can provide leverage to the investors, magnify both the return on the upside and
losses on the downside.
Source: NSE

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How Derivatives are different from Cash Market

Leverage - Amplified Gains/Losses, Both can be more than your initial

margin/investment in a short span of time.
Daily Margin Settlement
Short term Investments; Maximum for 3 months.
You can take short positions in Derivatives in Cash only intraday shorting is
allowed.
If one wants to carry forward his position then there are rollover costs
Higher Transaction Costs particularly for retail
Biggest difference in Cash investing and Derivatives is, In investing there
could be value creation but Derivatives is a Zero sum game for every
winner there is a loser and vice versa.
Section 2:
Why Derivatives got Introduced?
History of Derivatives
Derivative products initially emerged as hedging devices against fluctuations in commodity
prices, and commodity-linked derivatives remained the sole form of such products for almost
three hundred years.

Financial derivatives came into spotlight in the post-1970 period due to growing instability in
the financial markets. However, since their emergence, these products have become very
popular and by 1990s, they accounted for about two-thirds of total transactions in derivative
products.

The National Stock Exchange of India Ltd. (NSE), set up in the year 1993, is today the largest
stock exchange in India.

NSE has four broad segments Wholesale Debt Market Segment (commenced in June 1994),
Capital Market Segment (commenced in November 1994) Futures and Options Segment
(commenced June 2000) and the Currency Derivatives segment (commenced in August 2008).

Today NSEs share to the total equity market turnover in India averages around 72% whereas in
the futures and options market this share is around 85%.
Source: NSE

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History of Derivatives
The derivatives trading on the NSE commenced with S&P CNX Nifty Index futures on June 12,
2000.

The trading in index options commenced on June 4, 2001.

Trading in options on individual securities commenced on July 2, 2001.

Single stock futures were launched on November 9, 2001.

Source: NSE

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Current Status

Today, both in terms of volume and turnover, NSE is the largest derivatives exchange in India.

Currently, the derivatives contracts have a maximum of 3-month expiration cycles have some
liquidity.

Three contracts are available for trading, with 1 month, 2 months and 3 months expiry. Expiry is
last Thursday of every month.

Nifty is the only instrument for which contracts are available for 5 years.

There are 9 indices including Nifty and global indices such as S&P 500, Dow Jones & 144 active
individual securities future and option contracts are traded on NSE.

A new contract is introduced on the next trading day following the expiry of the near month
contract.

Source: NSE

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Section 3:
Derivative Products

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Derivative Products
Derivative contracts have several variants. The most common variants are forwards, futures,
options and swaps.

Forwards: A forward contract is a customized contract between two entities, where settlement
takes place on a specific date in the future at today's pre-agreed price.

Futures: A futures contract is an agreement between two parties to buy or sell an asset at a
certain time in the future at a certain price. Futures contracts are special types of forward
contracts in the sense that the former are standardized exchange-traded contracts.

Options: Options are of two types - Calls and Puts. Calls give the buyer the right but not the
obligation to buy a given quantity of the underlying asset, at a given price on or before a given
future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the
underlying asset at a given price on or before a given date.

Swaps: Swaps are private agreements between two parties to exchange cash flows in the future
according to a prearranged formula. They can be regarded as portfolios of forward contracts. The
two commonly used swaps are:

Source: NSE

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Derivative Products

Interest rate swaps: These entail swapping only the interest related cash flows between the parties
in the same currency.

Currency swaps: These entail swapping both principal and interest between the parties, with the
cash flows in one direction being in a different currency than those in the opposite direction.

Warrants: Options generally have lives of up to one year, the majority of options traded on options
exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and
are generally traded over-the-counter.

LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options having
a maturity of up to three years.

Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually
a moving average of a basket of assets. Equity index options are a form of basket options.

Source: NSE

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Section 4:
Players in Derivatives Market and Their Roles
Players in Derivatives Market
The three broad categories of participants - Hedgers, Speculators and Arbitrageurs.

Hedgers face risk associated with the price of an asset. They use futures or options markets to
reduce or eliminate this risk.

Speculators wish to bet on future movements in the price of an asset. Futures and options
contracts can give them an extra leverage; that is, they can increase both the potential gains and
potential losses in a speculative venture.

Arbitrageurs are in business to take advantage of a discrepancy between prices in two different
markets. If, for example, they see the futures price of an asset getting out of line with the cash
price, they will take offsetting positions in the two markets to lock in a profit.

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Section 5:
Understanding and Calculating Market Index

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Market Index

Index- An index is a number which measures the change in a set of values over a period of time.

Stock Index number is the current relative value of a weighted average of the prices of a pre-
defined group of equities.

Key Facts:

It is a relative value because it is expressed relative to the weighted average of prices at some
arbitrarily chosen starting date or base period.

The starting value or base of the index is usually set to a number such as 100 or 1000.

For example, the base value of the Nifty was set to 1000 on the start date of November 3, 1995.

Stock market index is one which should be able to captures the behaviour of the overall equity
Market.

It should be well diversified and yet highly liquid.

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How is Index Constructed?
Market capitalisation weighted index- In a market capitalization weighted index, each stock
in the index affects the index value in proportion to the market value of all shares outstanding.

Free Float market capitalisation is used for the calculation of the index.

Instead of using all of the shares outstanding like the full-market capitalization method, the free-
float method excludes locked-in shares such as those held by promoters and governments.

Index = Current Market Capitalisation * Base Value

Base Market Capitalisation

where:
Current market capitalization = Sum of (current market price * outstanding shares)
of all securities in the index.
Base market capitalization = Sum of (market price * outstanding shares) of all securities as
on base date.

Price weighted index: In a price weighted index each stock is given a weight proportional to its
stock price.
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S&P CNX Nifty or Nifty

Nifty is an market capitalisation index based upon solid economic research

Consists of 50 liquid stocks with low impact cost.

Hedging Effectiveness.

Diversified with some weight to every sector

Impact Cost : Measure of the liquidity, reflects the costs faced when actually trading an index

e.g. The market impact cost on a trade of Rs.3 million of the full Nifty works out to be about 0.05%. This means
that if Nifty is at 2000, a buy order goes through at 2001, i.e.2000+(2000*0.0005) and a sell order gets
1999, i.e. 2000- (2000*0.0005)

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Section 6:
Forward, Futures, Options

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Forward

A forward contract is an agreement to buy or sell an asset on a specified date for a specified price
between two parties.

Advantages Disadvantages

Customised Counterparty Risk

Unique in terms of Contract size, Illiquidity

Expiration date and the asset type and
Quality. Lack of centralization of trading

Not available in public domain Unorganised

Lower Transaction Cost

Futures markets were designed to solve the problems that exist in forward
markets

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Future
A futures contract is an agreement between two parties to buy or sell an asset at a certain time in
the future at a certain price. But unlike forward contracts, the futures contracts are standardized and
exchange traded.

Advantages Disadvantages

No Counter-Party Risk Can not be customised

Traded on an organised Exchange Requires margin payments

Very Liquid Follows daily settlement

Organised and very transparent Higher Transaction Cost

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Futures Terminologies

Spot price: The price at which an asset trades in the spot market.

Futures price: The price at which the futures contract trades in the futures market.

Contract cycle: The period over which a contract trades. The index futures contracts on the NSE
have one- month, two-months and three months expiry cycles which expire on the last Thursday
of the month.(i.e. Near Month, Mid Month and Far Month respectively). On the Friday following
the last Thursday, a new contract having a three- month expiry is introduced for trading.

Expiry date: It is the date specified in the futures contract. This is the last day on which the
contract will be traded, at the end of which it will cease to exist.

Contract size: The amount of asset that has to be delivered under one contract. Also called as lot
size.

Basis (also known as Badala): Futures price minus the spot price (Premium/Discount)

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Futures Terminologies

Cost of carry: This measures the storage cost plus the interest that is paid to finance the asset
less the income earned on the asset.

Initial margin: The amount that must be deposited in the margin account at the time a futures
contract is first entered into is known as initial margin.

Marking-to-market: In the futures market, at the end of each trading day, the margin account
is adjusted to reflect the investor's gain or loss depending upon the futures closing price. This is
called marking-to-market

Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that
the balance in the margin account never becomes negative. If the balance in the margin account
falls below the maintenance margin, the investor receives a margin call and is expected to top up
the margin account to the initial margin level before trading commences on the next day

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Options (Introduction)

An option is a contract written by a seller that conveys to the buyer the right but not the
obligation to buy (in the case of a call option) or to sell (in the case of a put option) a
particular asset, at a particular price (Strike price / Exercise price) in future.

In return for granting the option, the seller collects a payment (the premium) from the buyer.

Options can be used for hedging, taking a view on the future direction of the market,
for arbitrage or for implementing strategies which can help in generating income for
investors under various market conditions

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Options Terminologies

Index options: These options have the index as the underlying. In India, they have a European
style settlement. eg. Nifty options, CNX IT, Bank Nifty etc.

Stock options: Stock options are options on individual stocks. A stock option contract gives the
holder the right to buy or sell the underlying shares at the specified price. They have an American
style settlement.

Buyer of an option: The buyer of an option is the one who by paying the option premium buys
the right but not the obligation to exercise his option on the seller/writer.

Writer / seller of an option: The writer / seller of a call/put option is the one who receives the
option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him.

Call option (C): A call option gives the holder the right but not the obligation to buy an asset by a
certain date for a certain price.

Put option(P): A put option gives the holder the right but not the obligation to sell an asset by a
certain date for a certain price.

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Options Terminologies

Option price/premium: Option price is the price which the option buyer pays to the option
seller. It is also referred to as the option premium

Expiration date: The date specified in the options contract is known as the expiration
date, the exercise date, the strike date or the maturity.

Strike price(K): The price specified in the options contract is known as the strike price or the
exercise price.

Spot Price(St): The price at which underlying security/index is trading at that point of time is
spot price.

American options: American options are options that can be exercised at any time up to the
expiration date.

European options: European options are options that can be exercised only on the
expiration date itself..

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Options Terminologies

In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive
cash flow to the holder if it were exercised immediately. A call option on the index is said to be in-
the-money when the current index stands at a level higher than the strike price (i.e. spot price >
strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the
case of a put, the put is ITM if the index is below the strike price.

At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cash
flow if it were exercised immediately. An option on the index is at-the-money when the current
index equals the strike price (i.e. spot price = strike price).

Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to

a negative cash flow if it were exercised immediately. A call option on the index is out-of-the-
money when the current index stands at a level which is less than the strike price (i.e. spot price <
strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the
case of a put, the put is OTM if the index is above the strike price.
ITM Calls and OTM Puts OTM Calls and ITM Puts
S
S is lesser than K S is greater than K
ATM
Options
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S= K
Options Terminologies

The option premium can be broken down into two components - Intrinsic value and
Time value.

The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is OTM, its
intrinsic value is zero. Putting it another way, the intrinsic value of a call is Max[0, (St K)] which
means the intrinsic value of a call is the greater of 0 or (St K). Similarly, the intrinsic value of a put
is Max[0,K St],i.e. the greater of 0 or (K St). K is the strike price and St is the spot price.

The time value of an option is the difference between its premium and its intrinsic value. Both
calls and puts have time value. An option that is OTM or ATM has only time value. Usually, the
maximum time value exists when the option is ATM. The longer the time to expiration, the greater
is an option's time value, all else equal. At expiration, an option should have no time value.

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Payoff on Long/Short Future

Long Future Short Future

Profit /(Loss) on Long Future Profit /(Loss) on Short Future

600
600

400 400

200 200

0 0
Nifty 5500 5600 5700 5800 5900 6000 6100 6200 6300 6400 Nifty 5500 5600 5700 5800 5900 6000 6100 6200 6300 6400
200 on 200 on
Expiry Expiry
400 400

600 600

Spot Price 6000 Spot Price 6000

Future Price 6020 Future Price 6020

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Payoff on Long/Short Call Option

Long Call Option Short Call Option

Profit /(Loss) on Long Call Option Profit /(Loss) on Short Call Option
150
350
300 100

250 50
200 0
150 50 Nifty 5500 5600 5700 5800 5900 6000 6100 6200 6300 6400
on
100 100 Expiry
50 150
0 200
50 Nifty 5500 5600 5700 5800 5900 6000 6100 6200 6300 6400
250
on
100
Expiry 300
150
350

Spot Price 6000 Spot Price 6000

Future Price 6020 Future Price 6020
Strike Price 6100 Strike Price 6100
Call Price 100 Call Price 100

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Payoff on Long/Short Put Option

Short Put Option Long Put Option

Profit /(Loss) on Short Put Option Profit /(Loss) on Long Put Option
150 350
100 300
50 250
0 200
50 Nifty 5500 5600 5700 5800 5900 6000 6100 6200 6300 6400 150
100 on 100
150 Expiry 50
200 0
50 Nifty 5500 5600 5700 5800 5900 6000 6100 6200 6300 6400
250
100 on
300
150 Expiry
350

Spot Price 6000 Spot Price 6000

Future Price 6020 Future Price 6020
Strike Price 5900 Strike Price 5900
Put Price 100 Put Price 100

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 Summary of 6 Basic Payoffs
S Spot Price or Future Price
X or K Strike Price
C Call Price
P Put Price
So Spot Price or Future Price Today
St Spot Price or Future Price on Expiry

View Initial Payout

Trade Payout BEP Money Made Max Profit Max Loss
if Expiry is,
Long Futures Bullish Nil (only margin) St-So So Above So Unlimited Unlimited
Short Futures Bearish Nil (only margin) So-St So Below So Unlimited Unlimited

Long Call Bullish C is Paid Max (0,St-K)- C X+C Above X+C Unlimited Limited to C
Short Call Bearish C is Received C-Max (0,St-K) X+C Below X+C Limited to C Unlimited

Long Put Bearish P is Paid Max (0,K-St)- P X-P Below X-P Unlimited Limited to P
Short Put Bullish P is Receieved P-Max (0,K-St) X-P Above X-P Limited to P Unlimited
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Some Practical Quotes

Instru Symbol Exp Date BQTY SQTY MKT_RATE BRKG Net Rate

OPTIDX NIFTY 29-Apr-2010 5,300.00 PE 50 0 48.00 2.00 50.00

OPTIDX NIFTY 29-Apr-2010 5,300.00 PE 0 50 55.60 2.00 53.60

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Section 7:
Price Movement & Open Interest

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Open Interest

Open Interest is total number of contracts outstanding.

Open interest indicates total number of long/short position in the instrument.

The instrument could be a future or an option.

It is a good indicator of the liquidity in the contract.

Open interest is maximum in near month expiry contracts.

Open interest data along with price is used as a trend indicator.

Open interest data can be used for finding major resistances & supports as well.

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Nifty Option Prices- Practical Case
Calls
Open Change in Net Bid Bid Offer Offer

Strike Price Interest

Open
Interest LTP Change Volume Qty Price Price Qty Nifty
4700.00 43,850 2,000 568 19.25 44 500 568.25 579.55 500
4800.00 1,56,850 1,600 476 21.45 82 1,100 475 480.65 50
4900.00 86,350 1,600 385 20.15 48 150 383.25 388.6 1,150 Spot Price:5278
5000.00 4,29,500 -10,050 298 17.7 1,220 500 299 303.25 4,550
5100.00 8,01,250 78,150 220 16.9 4,215 1,000 218.35 221 50
5200.00 21,90,650 2,40,350 149.2 11.15 22,511 1,250 149.2 149.8 900 Future Price:5270
5300.00 53,58,350 10,86,600 89.65 7.85 89,111 150 89.6 89.7 250
5400.00 49,60,650 6,58,500 45.65 4.3 54,385 150 45.55 45.85 200
5500.00 34,05,100 4,07,500 18.55 1.1 40,522 700 18.45 18.55 3,450
5600.00 27,77,050 84,600 6.8 -0.2 13,934 3,150 6.75 6.8 350

Nifty

Spot Price:5278

Future Price:5270

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How to interpret Price Movement & Change in Open Interest

Price Change in OI Trend

Bullish

Close to end of
Rally

Bearish

Close to end of
Correction

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How to Identify Key Support & Resistance based on OI

Key Support- Strike Price with Highest Open

Interest in Puts

Key Resistance- Strike Price with Highest Open

Interest in Calls

Remember these are Thumb Rules

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Rollover & Rollover Cost

Rollover is the process of carrying ones futures position (long/short) from current
month to next month.

Rollover Cost is the difference between the prices of next month contract and current
month contract in case of long rollovers. It is the difference between current month
contract & next month contract in case of short rollover.

Rollover Cost is expressed as a percentage of current month future contract.

Rollovers are expressed as a percentage of total outstanding open interest.

Rollovers typically tend to happen just a week before expiry with a maximum rollovers
happening close to expiry.

Rollover are compared with previous 3-4 month expires to get a sense of where the
markets are headed.

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Put Call Ratio (PCR)

Put Call Ratio (PCR) is the ratio of total number of outstanding puts against total
number of outstanding calls.(i.e. Put Option Volume/Call Option Volume) for a particular
security.

PCR is used as an indicator to the market sentiment.

PCR is used by many traders as a contrarian indicator to gauge whether markets

are overbought or oversold.

PCR of close to 1 is considered to be at parity level.

PCR significantly higher than 1 (i.e. typically close to 2 or less) is considered to be

oversold and one can expect a technical bounce in the underlying.

PCR significantly lower than 1 (i.e. typically close to 0.5 or less) is considered to be
overbought and one can expect a technical correction in the underlying.

PCR for index typically tends to be less volatile given its diversified nature.
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Practical Insights in the Put Call Ratio (PCR)

Put Call Ratio (PCR) needs to be looked at along with strike price.

PCR is between 0.21 to 0.55 for stock options from Dec-2010 to June 2011.

This is mainly on account of OTM calls being written and ATM puts being bought as a
hedge against cash position.

PCR is between 0.75 to 1.39 for index options from Dec-2010 to June 2011.

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THANK YOU