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Derivatives Beginner Guide

The document provides a comprehensive guide to understanding futures and options markets. It defines futures and options contracts, explores their key features and participants. The guide discusses pricing factors for options, risk management strategies using derivatives, and growth in the global derivatives market between 2018-2022 due to increased volatility and demand. It also defines concepts like moneyness, option Greeks, and option chains which provide valuable information for traders.

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GAURAV UPADHYAY
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18 views

Derivatives Beginner Guide

The document provides a comprehensive guide to understanding futures and options markets. It defines futures and options contracts, explores their key features and participants. The guide discusses pricing factors for options, risk management strategies using derivatives, and growth in the global derivatives market between 2018-2022 due to increased volatility and demand. It also defines concepts like moneyness, option Greeks, and option chains which provide valuable information for traders.

Uploaded by

GAURAV UPADHYAY
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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How derivatives

work: A
comprehensive
guide

A guide to understanding futures


and Options

Prepared by: Amogh Patil


Equity Research Analyst
02

Introduction
The world of financial markets offers various investment opportunities,
including futures and options trading. These markets play a crucial role in
facilitating price discovery, risk management, and speculation. However,
understanding how futures and options markets work can be quite
daunting for beginners. In this comprehensive guide, we will delve into the
intricacies of futures and options, exploring their mechanics, participants,
and the underlying principles that govern these markets. Whether you're
new to trading or looking to deepen your knowledge, this guide will
provide valuable insights into the functioning of futures and options
markets.

Understanding F&O
Futures contracts are standardized agreements to buy or sell an underlying
asset at a predetermined price on a future date. These contracts serve various
purposes, including hedging against price volatility and speculating on price
movements. Key features of futures contracts include standardization of
contract specifications, margin requirements, and daily settlement. Futures
markets involve three main participants: hedgers, speculators, and market
makers.
Options contracts provide the buyer with the right, but not the obligation, to
buy (call option) or sell (put option) an underlying asset at a specified price
(strike price) within a given time frame. There are two main types of options:
American and European options. American options can be exercised at any
time before the expiration date, while European options can only be exercised
at expiration. Options pricing involves several factors, including the underlying
asset's price, time to expiration, volatility, interest rates, and dividend yield.
The Greeks, such as delta, gamma, theta, vega, and rho, are used to measure
an option's sensitivity to these factors.
03

Growth in Derivatives from 2018


to 2022

% Growth
30

20

10

0
2018 2019 2020 2021 2022

Here are some reasons for growth in derivatives market


The global derivatives market grew by 47% from 2018 to 2022, from $12.4 trillion to
$18.3 trillion. This growth was driven by a number of factors, including:

Increased volatility in financial markets, which led to increased demand for hedging
products.
The growth of the Chinese economy, which led to increased demand for derivatives
in Asia.
The development of new derivative products, such as those based on
cryptocurrencies.
04

Risk Management and hedging strategies


Futures and options markets are essential tools for managing risks associated with
price volatility. Hedging involves using futures contracts to offset potential losses in
the underlying asset. For example, producers can enter into long hedges to mitigate
the risk of falling prices, while consumers can enter into short hedges to protect
against rising prices. Options contracts also provide risk management solutions.
Protective puts allow investors to hedge against downside risk by purchasing put
options, which give them the right to sell the underlying asset at a predetermined
price. Covered calls involve selling call options on assets already owned, generating
income and providing some downside protection. Collars combine protective puts and
covered calls to limit potential losses and profits within a specific price range.

utures and options markets serve as crucial tools for managing risks, speculating, and
enhancing investment strategies. By understanding the mechanics of these markets,
participants can make informed decisions and navigate the complexities of trading. This
comprehensive guide has explored the functioning of futures and options markets,
providing valuable insights into their definition, features, participants, pricing, strategies,
and risk management applications. Remember, learning and practicing in a simulated
environment are essential before venturing into the live markets. Continual education and
staying updated with market trends will help you become a more knowledgeable and
successful trader in the world of futures and options.
05

Moneyness of an option
Moneyness is categorized into three main classifications: in-the-money
(ITM), at-the-money (ATM), and out-of-the-money (OTM) options.

In-the-Money (ITM) Options: An option is considered in-the-money when its


strike price is favorable compared to the current price of the underlying asset. For
call options, if the current market price of the asset is higher than the strike price,
the call option is ITM. Conversely, for put options, if the current market price of
the asset is lower than the strike price, the put option is ITM. Intrinsic value is
positive for ITM options because exercising the option would result in a profit if
done immediately.

At-the-Money (ATM) Options: An option is considered at-the-money when its


strike price is approximately equal to the current price of the underlying asset.
This means there is no intrinsic value in an ATM option. Both call and put options
are considered ATM when the strike price and the current market price are very
close or identical. ATM options have only extrinsic value (also known as time
value), which is influenced by factors such as time to expiration, implied volatility,
and interest rates.

Out-of-the-Money (OTM) Options: An option is considered out-of-the-money


when its strike price is unfavorable compared to the current price of the
underlying asset. For call options, if the current market price of the asset is lower
than the strike price, the call option is OTM. Conversely, for put options, if the
current market price of the asset is higher than the strike price, the put option is
OTM. OTM options have no intrinsic value and are composed entirely of extrinsic
value. Exercising an OTM option would result in a loss if done immediately.
06

Option Greeks

Option Greeks are measures that help traders and investors understand and quantify the
various factors that influence the pricing and behavior of options. The Greeks provide
insights into an option's sensitivity to changes in underlying asset price, time, volatility,
interest rates, and other market factors. Let's explore the main Option Greeks and their
significance

Delta (Δ): Delta measures the rate of change in an option's price in relation to changes in
the price of the underlying asset. It indicates the expected change in the option's price for
a $1 movement in the underlying asset's price.

Gamma (Γ): Gamma measures the rate of change in an option's Delta in response to
changes in the price of the underlying asset. It represents the curvature or convexity of
the option's price.

Theta (Θ): Theta measures the rate of time decay of an option's value as it approaches its
expiration date. It indicates how much value an option loses with the passage of time,
assuming all other factors remain constant.

Vega (V): Vega measures an option's sensitivity to changes in implied volatility, which is
the market's expectation of future price volatility of the underlying asset

Rho (ρ): Rho measures an option's sensitivity to changes in interest rates. It represents the
expected change in an option's price for a 1% change in interest rates
07

Understanding option chain


Basics of option chain
1An option chain, also known as an option matrix or option table, is a comprehensive listing of
all available options contracts for a particular underlying asset. It provides traders and
investors with a snapshot of the various strike prices, expiration dates, and corresponding
prices (bid and ask) for both call and put options.
Let's dive deeper into the components and key information found in an option chain:
1. Underlying Asset: At the top of the option chain, you'll find the name or symbol of the
underlying asset for which the options are available. It could be a stock, index, ETF, or
any other tradable asset.
2. Expiration Dates: Option chains typically display a range of expiration dates for the
available options contracts. These dates represent when the options expire and can no
longer be traded. Common expiration periods include monthly, quarterly, or even longer-
term contracts.
3. Strike Prices: Strike prices, also known as exercise prices, are the pre-determined prices
at which the underlying asset can be bought or sold when exercising the options. Option
chains list a range of strike prices, usually above and below the current market price of
the underlying asset. They are typically displayed in ascending order.
4. Call Options: In the call options section of the option chain, you'll find information about
available call contracts. This includes the bid and ask prices, which represent the highest
price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask)
for the option contract. Other relevant data may include the option's volume (number of
contracts traded), open interest (number of outstanding contracts), and the option's
implied volatility.
5. Put Options: The put options section of the option chain provides similar information to
the call options section but for put contracts. You'll find bid and ask prices, volume, open
interest, and implied volatility for put options at various strike prices and expiration
dates.
6. Option Codes: Option chains often use symbols or codes to represent different
expiration dates and strike prices. These codes help identify specific options contracts
quickly.
7. Greeks: Some option chains may also include the Greeks, which are measures of an
option's sensitivity to various factors. The most common Greeks are delta, gamma, theta,
vega, and rho. Delta measures the change in the option's price in relation to changes in
the underlying asset's price.

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