DERIVATIVES:

FUTURES &
OPTIONS
(PRACTICAL ASPECTS)
INDIAN INSTITUTE OF FINANCE
 DERIVA TIVE
                                      
  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. The underlying 
asset can be 
equity , forex  commodity or any other asset.
In the Indian context the securities contracts
(Regulation)Act, 1956(SC(R)A) defines “Derivative” to
include :

•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.
•A contract which derives its value from the prices, or index of
prices, of underlying securities.
 TYPES OF DERIVATIVES
                                          
 Forwards

A forward contract is customized contract between two entities, where settlement

takes place on a specific date in the future at today’s pre-agreed price.

Futures

An agreement between two parties to buy or sell an asset at a certain time in the

future at a certain price . Futures contacts are special types of forward

contracts in the 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 obligation to sell a
given quantity of the underlying asset at a given price on or before a given date.
 DIFFERENCE BETWEEN FUTURES & OPTIONS

FUTURES OPTIONS

Futures contract is an agreement to In options the buyer enjoys the right

buy or sell specified quantity of the and not the obligation, to buy or sell
underlying assets at a price agreed the underlying asset.
upon by the buyer and seller, on or
before a specified time. Both the
buyer and seller are obliged to
buy/sell the underlying asset.

Unlimited upside & downside for both Limited downside (to the extent of
buyer and seller. premium paid) for buyer and unlimited
upside. For seller (writer) of the option,
profits are limited whereas losses can
be unlimited.

Futures contracts prices are affected Prices of options are however, affected
mainly by the prices of the underlying by a)prices of the underlying asset,
asset b)time remaining for expiry of the
contract and c)volatility of the
underlying asset.
 Call Option Put Option

Option Buyer Buys the right to buy the Buys the right to sell the
underlying asset at the underlying asset at the
Strike Price Strike Price
Option Seller Has the obligation to sell Has the obligation to buy
the underlying asset to the the underlying asset from
option holder at the Strike the option holder at the
Price Strike Price
 Illustration on Call Option

An investor buys one European Call option on one share of Reliance

Petroleum at a premium of Rs.2 per share on 31 July. The strike price is
Rs.60 and the contract matures on 30 September. It may be clear form
the graph that even in the worst case scenario, the investor would only
lose a maximum of Rs.2 per share which he/she had paid for the
premium. The upside to it has an unlimited profits opportunity.

On the other hand the seller of the call option has a payoff chart
completely reverse of the call options buyer. The maximum loss that he
can have is unlimited though a profit of Rs.2 per share would be made
on the premium payment by the buyer.
 Illustration on Put Options

An investor buys one European Put Option on one

share of Reliance Petroleum at a premium of Rs. 2
per share on 31 July. The strike price is Rs.60 and
the contract matures on 30 September. The
adjoining graph shows the fluctuations of net profit
with a change in the spot price.
 OPTION TERMINOLOGY (For The Equity Markets)

Options
Options are instruments whereby the right is given by the option seller to the option buyer to
buy or sell a specific asset at a specific price on or before a specific date.
•Option Seller - One who gives/writes the option. He has an obligation to perform, in case
option buyer desires to exercise his option.
•Option Buyer - One who buys the option. He has the right to exercise the option but no
obligation.
•Call Option - Option to buy.
•Put Option - Option to sell.

•American Option - An option which can be exercised anytime on or before the expiry date.

•Strike Price/ Exercise Price - Price at which the option is to be exercised.

•Expiration Date - Date on which the option expires.
•European Option - An option which can be exercised only on expiry date.
•Exercise Date - Date on which the option gets exercised by the option holder/buyer.

•Option Premium - The price paid by the option buyer to the option seller for granting the
option.
 What are Index Futures?

•Index futures are the future contracts for which underlying is the cash market
index.
For example: BSE may launch a future contract on "BSE Sensitive Index" and NSE
may launch a future contract on "S&P CNX NIFTY".

Concept of basis in futures market

•Basis is defined as the difference between cash and futures prices:
Basis = Cash prices - Future prices.
Basis can be either positive or negative (in Index futures, basis generally is
negative).
•Basis may change its sign several times during the life of the contract.
•Basis turns to zero at maturity of the futures contract i.e. both cash and
future prices
converge at maturity
 Future & Option Market Instruments

The F&O segment of NSE provides trading

facilities for the following derivative
instruments:
2. Index based futures
3. Index based options
4. Individual stock options
5. Individual stock futures
 Operators in the derivatives market

•Hedgers - Operators, who want to transfer a

risk component of their portfolio.
•Speculators - Operators, who intentionally
take the risk from hedgers in pursuit of profit.
•Arbitrageurs - Operators who operate in the
different markets simultaneously, in pursuit of
profit and eliminate mis-pricing.
STRATEGIES OF TRADING IN
FUTURE AND OPTIONS
 USING INDEX FUTURES
There are eight basic modes of trading on the index future market:

Hedging
1. Long security, short Nifty Futures
2. Short security, long Nifty futures
3. Have portfolio, short Nifty futures
4. Have funds, long Nifty futures

Speculation
1. Bullish Index, long Nifty futures
2. Bearish Index, short Nifty futures

Arbitrage
1. Have funds, lend them to the market
2. Have securities, lend them to the market
 USING STOCK FUTURES
1. Hedging: long security, sell future

2. Speculation: bullish security, buy Futures

3. Speculation : bearish Security, Sell Futures

4. Arbitrage: overpriced Futures: buy spot, sell futures

5. Arbitrage: underpriced Futures: buy spot, sell futures

 USING STOCK OPTIONS

Hedging:Have stock, buy puts

Speculation: bullish stock, buy calls or sell puts

Speculation : bearish Stock, buy put or sell calls

IIF/DERIVATIVE/2004/06 17
BULLISH
STRATEGIES
    LONG CALL
    Market Opinion ­ Bullish
    Most popular strategy with investors.
    Used by investors because of better leveraging compared to buying the underlying stock – 
insurance
    against decline in the value of the underlying

Profit +

BEP
S
0
Underlying Asset Price
DR

Stock Price

Loss - Lower Higher

 Risk Reward Scenario
Maximum Loss = Limited (Premium Paid)
Maximum Profit  = Unlimited
Profit at expiration = Stock Price at expiration – 
Strike Price –
       Premium paid
Break even point at Expiration = Strike Price + 
Premium paid
SHORT PUT
Market Opinion - Bullish

Profit +

CR BEP

S
0
Underlying Asset Price

Stock Price
Loss - Lower Higher

Risk Reward Scenario

Maximum Loss – Unlimited
Maximum Profit – Limited (to the extent of option premium)
Makes profit if the Stock price at expiration > Strike price - premium
      BULL CALL SPREAD
 
For Investors who are bullish but at the same time conservative
 
BUY A CALL CLOSER TO SPOT PRICE & WRITE A CALL WITH A HIGHER PRICE
 
In a market that has bottomed out, when stocks rise, they rise in small steps for a 
short duration. Bull Call Spread can be Used where gains & losses are limited.
 
Reliance Spot Price = Rs.250
 
Premium of  260 CA=  Rs.10
 
Premium of 270 CA =   Rs. 6
 
Strategy – Buy 260 CA @ Rs.10 & Sell 270 CA @ Rs.6
 
Net Outflow = Rs.4
 
 
Stock P rice at Expiration Net P ro fit/ Los s

250 -4

260 -4

264 0

266 2

270 6

280 6

Risk is Low & confined to Spread. Return is also limited. 
 
While Trading try to minimize the Spread.
 BULL PUT SPREAD
 
For Investors who are bullish but at the same time conservative
 
Write a PUT Option with a higher Strike Price and Buy a Put Option with a lower Strike Price
 
Reliance Spot Price  = Rs.270
Premium on Rs. 270 PA = Rs.12
Premium on Rs. 250 PA = Rs. 3
 
Sell Rs.270 PA and Buy Rs.250 PA
Net Inflow = Rs. 9
 

Stock Price at Expiration Net Profit/ Loss

230 - 11   (­ 40 + 20+9) 

250 ­  11  ( ­20+9)

270 +  9   (Net Inflow)

300 +  9   (Net Inflow – Both  options expire worthless)

350 +  9   (Net Inflow – Both  options expire worthless)
 COVERED CALL
 Neutral to Bullish
 Buy The Stock & Write A Call 
 Perception – Bullish on the Stock in the long term but expecting 
little
                       variation during the lifetime of Call Contract
 Income received from the premium on Call 
 Reliance Spot Price  = Rs.270
Premium on Rs. 270 CA = Rs. 12

Buy Reliance @ Rs.270 and sell Rs. 270 CA @ Rs.12.  
Stock Price at Expiration                Net Profit/Loss
230 ­ 28   (­ 40 + 12)
250 ­   8   ( ­20+12)
270 + 12   ( + 12)
300 + 12   (­30+30+12)
350 + 12   (­80 +80+12)
Profits are limited . Losses can be unlimited
 COVERED CALL

Profit +

BEP

0
Strike Price

Stock Price
Loss - Lower Higher
MARRIED PUT
A person is bullish on the stock but is concerned about near term downside due to market risks.
 
Buy a PUT Option and at the same time buy equivalent number of shares. 
 
Benefits of Stock ownership & Insurance against too much downside.
 
Maximum Profit – Unlimited
 
Maximum Loss – Limited =  Stock Purchase Price – Strike Price + Premium Paid
 
Profit at Expiration = Profit in Underlying Share Value – Premium Paid
 
Reliance Industries  :  
 
Spot Price = Rs.270
Premium on Rs.250 PA = Rs. 3
 
Buy shares of Reliance @ Rs.270/­ and Buy Rs.250 PA @ Rs.3
 
Stock Price at Expiration Net Profit/ Loss
 
230     ­ 23   (­ 40 + 20­3)
250     ­ 23   ( ­20­3)
270      ­ 3    (Loss of Premium Paid)
300     +27    (30­3)
350     +77     (80­3)
 
Maximum Loss restricted to Rs.23 , Profit Unlimited
 MARRIED PUT

Profit +

BEP

Strike Price

Stock Price
Loss - Lower Higher
 THE OPTIMAL BULL STRATEGY
LONG CALL : BULLISH BUT RISK AVERSE; INSIDER
WITH LIMITED CAPITAL
SHORT PUT : LONG TERM BULLISH BUT LOOKING FOR
LOWER COST.
COVERED CALL : LONG TERM BULLISH BUT NOT
EXPECTING UPSIDE IN NEAR TERM
MARRIED PUT : BULLISH BUT AFRAID OF NEAR
TERM DOWNSIDE RISK
BULL CALL SPREAD : MILDLY BULLISH AS WELL
AS RISK AVERSE.
BULL PUT SPREAD : BULLISH BUT LOOKING
FOR LOWER COSTS AND SCARED OF A MAJOR
FALL.
 BEARISH
STRATEGIES
            
LONG PUT
Market Opinion – Bearish
For investors who want to make money from a downward price move 
in the underlying stock
Offers a leveraged alternative to a bearish or short sale of the 
underlying stock.

Profit +

Underlying Asset Price

S
0
BEP
DR
Stock Price
Loss - Lower Higher
Risk Reward Scenario
 
Maximum Loss – Limited (Premium Paid)
Maximum Profit - Limited to the extent of
price of stock
 
Profit at expiration ­ Strike Price – Stock Price at 
expiration ­ Premium paid
Break even point at Expiration – Strike Price ­ Premium 
paid
SHORT CALL
Market Opinion – Bearish

Profit + Underlying Asset Price

CR
BEP

S
0

Stock Price
Loss -
Lower Higher

Risk Reward Scenario
 
Maximum Loss – Unlimited
Maximum Profit  ­ Limited (to the extent of option premium) 
 
Makes profit if the Stock price at expiration < Strike price + premium
 BEAR CALL SPREAD
 
Low Risk Low Reward Strategy
 
Sell a Call Option with a Lower Strike Price and Buying a Call Option with a Higher Strike 
Price
 
 
Reliance Spot Price  = Rs.270
Premium on Rs. 290 CA = Rs.  5
Premium on Rs. 270 CA = Rs. 12
 
Sell Rs.270 CA and Buy Rs.290 CA
Net Inflow = Rs. 7
 
Stock Price at Expiration Net Profit/ Loss
 
230     +  7   (Both Options expire worthless )
250     +  7   (Both Options expire worthless )
270     +  7   ((Both Options expire worthless)
300     ­  13  (­30+10+7)
350     ­  13  ( ­80+60+7) 
 
Maximum Possible Profit = Rs.7 & Loss = Rs.13

Limited Upside & Downside

BEAR PUT SPREAD
 
Again a LOW RISK, LOW RETURN Strategy
 
Gains as Well as Losses are Limited
 
BUY PUT OPTION AT A HIGHER STRIKE PRICE AND SELL ANOTHER WITH A
 LOWER    STRIKE PRICE
 
Profit Accrues when the price of underlying stock goes down.
 
Reliance Spot Price  = Rs.260
Premium on Rs. 250 PA = Rs. 6
Premium on Rs. 230 PA = Rs. 2
 
BUY Rs.250 PA and SELL Rs.230 PA
Net Outflow = Rs. 4
 
Stock Price at Expiration Net Profit/ Loss
 
200  + 16   (+50­30­4)
230  + 16   (+20­4)
250   ­  4   Both options expire w’thles
270   ­  4   Both options expire w’thles 
300   ­  4   Both options expire w’thles 
 
Maximum Possible Profit = Rs.16 & Loss = Rs.4
 
Limited Upside & Downside
 BEAR PUT SPREAD

Profit +

0 Higher Strike
Price

Lower Strike
Price

Loss - BEP

Stock Price

Lower Higher
     NEUTRAL
                        STRATEGIES
     SHORT STRADDLE
 

WRITE CALL & PUT OPTIONS
 
If you expect the Stock to show very little volatility, it is worthwhile to write a call & put 
option.
 
Reliance Petroleum – has been range bound for the last 3 months. You don’t expect it to 
move up or down too much.
 
RPL Spot Price Rs. 25
 
Premium of Rs.25 CA Rs. 1.5
Premium on Rs.25 PA Rs. 1.5
 
Sell Rs.25 CA and Rs.25 PA. 
 
Total Premium Received = Rs.3 . 
 
Investor incurs a loss incase price drops below Rs. 22 or goes up above Rs. 28
 
Risky Strategy since profits limited but losses unlimited.
SHORT STRANGLE
 
SELL OUT OF MONEY CALL & PUT OPTIONS
 
Reliance Spot Price  = Rs.270
Premium on Rs. 250 PA= Rs.5
Premium on Rs. 290 CA = Rs.4

Sell Reliance Rs. 250 PA @ Rs.5 and sell Rs.290 CA @ Rs.4. 
 
Total Premium Received = Rs. 9

You start incurring a loss if price goes above Rs. 299 or drops below Rs. 241

 
VOLATILITY
STRATEGIES
    STRADDLE

Long Straddle
 
Buying a Straddle is simultaneous purchase of a CALL & PUT option for a Stock, with 
same expiration date & Strike Price. 
 
Why Straddle – If you expect the stock to fluctuate wildly but unsure of the direction. 
Enables investors to make profits on both upward and downward fluctuation of stock. 
Potential gain can be unlimited 
 
Satyam Computers
 
Spot Price  = Rs. 250
Premium on Rs. 250 CA = Rs. 12
Premium on Rs. 250 PA = Rs. 12
 
BUY Rs. 250 CA and Rs. 250 PA
 
You Start making profits if Price goes above Rs. 274 or goes below Rs. 226
                STRANGLE
 

Long Strangle
 
Buying a Strangle is simultaneous purchase of Out of Money CALL & PUT 
option for a Stock, with same expiration date.
 
Satyam Computers
 
Spot Price  = Rs. 
250
Premium on Rs. 270 CA = Rs. 5
Premium on Rs. 230 PA = Rs. 5
 
 
BUY Rs. 270 CA and Rs. 230 PA
 
Total Premium Paid = Rs. 10
 
You Start making profits if Price goes above Rs. 280 or goes below Rs. 220
 
 REFER NSE WEBSITE:
nseindia.com
1. S&P CNX Nifty Futures

2. S&P CNX Nifty Options

3. Futures on Individual Securities

4. Options on Individual Securities

S&P CNX Nifty Futures
A futures contract is a forward contract, which is
traded on an Exchange. NSE commenced trading in
index futures on June 12, 2000. The index futures
contracts are based on the popular market
benchmark S&P CNX Nifty index.

NSE defines the characteristics of the futures

contract such as the underlying index, market lot,
and the maturity date of the contract. The futures
contracts are available for trading from introduction
to the expiry date.
•Contract Specifications
•Trading Parameters
 S&P CNX Nifty Options
An option gives a person the right but not the
obligation to buy or sell something. An option is a
contract between two parties wherein the buyer
receives a privilege for which he pays a fee (premium)
and the seller accepts an obligation for which he
receives a fee. The premium is the price negotiated
and set when the option is bought or sold. A person
who buys an option is said to be long in the option. A
person who sells (or writes) an option is said to be
short in the option.

NSE introduced trading in index options on June 4,

2001. The options contracts are European style and
cash settled and are based on the popular market
benchmark S&P CNX Nifty index.
•Contract Specifications
•Trading Parameters
 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 November 9,
2001. The futures contracts are available on
41 securities stipulated by the Securities &
Exchange Board of India (SEBI). (
Selection criteria for securities)

NSE defines the characteristics of the futures

contract such as the underlying security, market
lot, and the maturity date of the contract. The
futures contracts are available for trading from
introduction to the expiry date.
•Contract Specifications
Trading Parameters
 Options on Individual Securities
An option gives a person the right but not the obligation to
buy or sell something. An option is a contract between two
parties wherein the buyer receives a privilege for which he
pays a fee (premium) and the seller accepts an obligation for
which he receives a fee. The premium is the price negotiated
and set when the option is bought or sold. A person who buys
an option is said to be long in the option. A person who sells
(or writes) an option is said to be short in the option.

NSE became the first exchange to launch trading in options on

individual securities. Trading in options on individual securities
commenced from July 2, 2001. Option contracts are American
style and cash settled and are available on 41 securities
stipulated by the Securities & Exchange Board of India (SEBI).
(Selection criteria for securities)

•Contract Specifications

Trading Parameters
Thank you

INDIAN INSTITUTE OF FINANCE