Derivatives Basic Module: What Is Derivative? Derivatives Were Emerged As

Derivatives Basic Module: What is Derivative? Derivatives were emerged as hedging tools. In the current financial environment the derivatives have become an integral part of the trading at the domestic as well as global level. They are nothing but the instruments that derive the value from underlying assets and that asset can be anything i.e. Stock, Commodity, Currency, Index etc., Why is Derivative? The most important thing in the stock market is that there must not be any reduction in the market value of the investment that one holds. One wants the value of his investments not to jump up suddenly but gradually over a period of time but not to come down beyond a certain limit. There is another group of people who wants to speculate at any cost, so there are derivatives for them also. One can deal in derivative with a calculated risk. When to enter into stock markets? Stock market is highly volatile and completely unpredictable. There are investors, speculators, operators and regulators in the stock market and it is very risky too. So one has to be careful to enter into stock market. Please answer the following questions? Have Have Have Have Have

you you you you you

and your family a Life insurance policy of an appropriate amount? and your family a Mediclaim Policy? and your family an Accident insurance policy? any idea that how much amount you are going to invest in stock market? calculated the amount of loss that you incur on a certain position?

What are the derivatives Products? There are various types of derivative products like Stock Futures, Stock Options, Index Futures and Index Options. What are Futures Contracts? It is a bit risky to deal in Futures contracts. One has to hedge his position otherwise there may be a possibility of an Unlimited loss and unlimited profit. Stock futures as the name suggests belonging to an individual stock while Index Futures pertaining to Index based products like Bank Nifty index, CNX IT index etc., What are Options Contracts? Options are of two types, Call Options and Put Options. Stock options are with reference to respective stock and Index options are with reference to respective Index. Derivatives are traded in both the stock exchanges i.e. NSE and BSE but NSE has higher volume, liquidity, fair prices and more transparency as compared to BSE. All the stock options are American type options i.e. they can be exercised at any time during the expiry period while Index Options are European Style options i.e. they will be settled and exercised on the day of expiry only.

What are Index Futures? BankNifty Futures, CNX IT Futures, Nifty Futures What are Stock Futures? What is the Risk Return Profile? In case of Futures there is unlimited profit and unlimited loss on an open future position. Call - Right to buy Put - Right to sell In case of an option buyer (whether call or put), he has to pay premium and that is his maximum loss and profit is unlimited. In case of an option seller (whether call or put), he will get premium and so his maximum profit is the amount of premium and his loss is unlimited. 186 Stock Futures (including the newly introduced 31 stocks to be traded on 14-May) How to Deal in Derivatives? Contact to a broker and open a trading account to deal in futures & options. Fill up a form and necessary stamp duty etc., You will be assigned a code unique for each trader. Have to pay upfront margin or shares of higher value have to be pledged as margin money. The Calculation of the fair value of Future Cost of Carry, Transaction cost, Brokerage cost etc., The Calculation of option Time value, In the money option, Out of the money option, at the money option The risk attached in dealing in Derivatives? Margin Payment, Clearing & Settlement Upfront margin, Marked to market margin, Clearing & Settlement generally on Expiry that is last Thursday of the month. What is Cost of Carry? The cost of holding a particular future position is called a cost of carry. Difference between the future and cash price (spot) and should be calculated on annualized term to be more specific. COC is affected by dividend as there is no dividend in future but it is given to equity holders.

What is open interest? Open interest is a single contract takes place between a buyer and a seller who have not squared of their respective positions. Open interest should be viewed in two terms namely open interest in terms of Number of shares and open interest in terms of value. How to get the data of open interest? www.nseindia.com, F&O Market Today, Bhav copy How to analyse the data One has to track the open interest positions in the market, price movements with respective change in open interest positions, addition and reduction in the open interest positions in options, movement of cost of carry etc., What is Put Call Ratio? Open interest of puts / Open interest of calls Total volume of puts / Total volume of puts FIIs movement in Index Futures & Options and Stock Futures & Options What does FII do in F&O Segment, long build up, short build up, profit booking, short covering etc., FIIs dealing in Cash Segment FIIs buying and selling in cash market should be taken care of. Are the Open Interest, Cost of Carry and Price Movement are sufficient? The answer is yes but some sort of Technical Analysis is required Global Indices need to be taken care of. Basic Strategies:Bull Spread, Bear Spread, Butterfly Spread, Naked Call, Naked Put, Covered Call, Covered Put etd.,

Advanced Module Option Pricing Factors Affecting Options Pricing Volatility, Time Till Expiration, Strike Price, Dividend, Interest Rates One Must Track Greeks of Derivatives What is Delta?

1. Delta is the change in the value of an option premium due to change in the value 2. 3. 4. 5.

of stock price. The delta of a call option has to be positive and the delta of a put option is negative. Generally it is expressed in % Terms. Example Suppose Reliance is trading at Rs 1695 in spot market and Its June 1700 Call is trading at Rs 25. Now suppose Reliance goes up at Rs 1696 and 1700 Call premium goes up at Rs 25.50. Then its delta is considered to be 50%. 25.50 – 25.00/ (1696-1695) = 0.50 or 50%.

Some General Facts about Delta • • • • • • • • • • • • • • •

The Delta of an option is not constant. Every option has its own unique delta. It is expressed in % terms. Options delta moves in relation to the movement of the stock price either up or down. As an expiry of a month comes closer, the option’s delta will change. Delta of call option is positive and Delta of put option is negative. Call Option’s Delta ranges from 0 to 1 in ratio terms and from 0 to 100 in % terms. Deep in the money call option has a delta of 1 (100%) and deep out of the money option has a delta of 0. At the money option has a delta of 0.50 (50%). An out of the money option has delta of 40% when there are 30 days to expiry, the same out of the money option has delta of 30% when there are only 15 days to expiry and the delta would be 10% when only a week is left to expiry. Absolute value of The Call Delta + Put Delta = 1. Call Delta has a range of 0 to 1. Put Delta has a range of –1 to 0. Delta = Share Equivalence (Hedge Ratio) Share Equivalence = No. of contracts * Option’s Delta * 100 Share Equivalence = 10 * 0.50 * 100 = 5 contracts long positions in underlying Short 20 Puts * -0.35 * 100 = 700 shares long

Finally the delta of an equity option contract can also be considered to represent the theoretical probability (in %) of that option expiring in the money. In the Money Delta = 0.75 or 75%, its probability is 75% to expire in the money. Out of the money Delta = 0.0 or 0%, its probability is 0% to expire in the money. At the money Delta = 0.50 or 50%, its probability is 50% to expire as in the money.

What is Gamma?

Gamma is change due to change in option delta due to change in stock price.wwe have to manage gamma at the time of expiry. Delta= %change in Delta % change in price Suppose Price of XYZ in 60 Call delta is 0.51 Gamma is 0.25 June 60 Call=Atm If Price fall to 58 Then call delta is 0.11 Gamma is 0.12 June 60 call = otm Price

Delta 60 58 3.45

0.51 0.11 0.4 40%

Gamma 0.25 0.12 11.6

Gamma is the change in option’s delta due to change in the value of the underlying. An option’s Gamma is the rate of change of an option’s Delta. Any change in the any of the six factors will change the delta and ultimately change the value of gamma. It is important to note that, Gamma like Delta, changes as each time an input factor changes. An option’s Gamma is largest when the option is at-the-money. As the underlying stock’s price moves away from the option’s strike price, whether become more in the money or more out of the money, the delta of that option will change at a decreasing rate. For a Call and Put with the same strike price and expiration, the gamma for both options is the same.

What is Theta? The Theta of an option is the rate at which an option’s time value erodes per unit of time. It is the change in the value of an option purely due to passage of time. As the expiration approaches, an option’s time value decreases. Theta measures that time decay. Any change in one of the six input factors will have an impact on the option’s theta just like other theoretical outputs. It is important to understand that Theta is not a constant but will change with reference to change in input factors. Option Price = Intrinsic Value + Time Value Option premium= Intrinsic Value + Time Value Intrinsic Value is the difference between Strike price – spot price Time value is difference between premiums - Intrinsic Value IV is possible only in in the money (ITM) Intrinsic Value Call= spot price – strike price Intrinsic Value Put= strike price – spot price Suppose take a example if a satyam Feb 260 call is quoting for Rs 25 while the market price is satyam is Rs 262. Premium=IV+Time value IV of a call=spot – strike price Time value=IV-premium IV=(262-260) Time value=(25-2) Premium=(23+2)

Rs 2 Rs 23 Rs 25

When u buy put or call option u give time value as a premium.so its gng to be negative theta for the person who buy put & call option.but when u write call & put option u earn time value so its gng to positive theta for the person who write put & call option. Gamma & theta will be inversely related For Example when u write a put your delta will be negative so as gamma.but ur theta will be positive as u r earning time value. Time value represents what an investor is willing to pay for the luxury of time during which the underlying stock can move favorably to an in-the-money position. An important concept for the investors to appreciate is that the rate of an option’s time decay increases rapidly as that option’s expiration reaches. By definition, an option’s Theta represents the theoretical time decay for a single day. What is Vega? A stock’s tendency to fluctuate in price is called volatility. Volatility does not imply a bias for movement in one direction or the other. The price trend of a stock may be up, down or

sideways, volatility is simply a measurement of the amount by which stock price is expected to fluctuate in a given period of time. All other things remain constant, as the volatility of the underlying stock increases, call prices increases and put prices increases and if the volatility of the underlying stock decreases, call prices decreases and put prices decreases.

What is Historical Volatility? What is implied volatility? What is the forecasted volatility? What is Rho? Rho denotes the interest rate movements. Rho is the least affecting factor to the option price. All other things remain constant, as the short term interest rates move up, Call price goes up and Put price goes down and vice-versa. How to conclude the movement of implied volatility? This explanation requires an option calculator and a sort of presentation. What is conversion and reversion? Buy Call, Sell Put, Sell Future - Conversion Buy Put, Buy Future and Sell Call - Reversion Badla Trading? Try to buy in cash and sell corresponding quantity in future and earn 1% or may be less than that. What is Delta Neutral Strategy? You need to earn time value by hedging and shorting at the money options. Are the softwares helpful in dealing in derivatives? Yes, They are an integral part of the trading. What to do during Dividends declared by the companies? Generally, Market discounts the dividend factor lying in the stock. How to analyse whether FIIs have built up long positions or merely a short covering?

We have to track the number of contracts and whether they have sold further. We will see by way of an example. If one has Rs 4,00,000 he can easily earn 2% to 3% return excluding brokerage and expenses by dealing in derivatives. One should take risk but not blind risk but a calculated and rational risk. The last but not least “ You are at big risk if you are not taking the risk “.

One more example When my delta is positive let say 300+ then its indicate me to buy either call, future or put write at this levels to hedge my position.so that I will maintain delta.and vice versa if my delta is negative let say-300 it indicate me that to buy put short nifty future or call write to maintain my delta.its also indicate that my downward risk levels. Supoose take a example Nifty current is at 4270 Nifty 4300 call dealing is at 93 Nifty 4000 put dealing is at 48.5 I have (1200 Share or 24 nifty lots) write 4300 call at Rs 93 & I have(1200 Share or 24 nifty lots) write 4000 put at Rs 48.5.so in that case my delta is 286 so its indicate me that my upside risk.so it tell me to buy 3 nifty Future to maintain delta.so if I buy 3 future at 4270 my delta will be –16.its is manageable.or I can either buy 4350 call to maintan my delta.or I can write some more put let say either 4000 or 3900. Lets calculate brokerage Strike price

Nifty share 4300 4000

premium 1200 1200

93 48.5

Total Brokerage according to lot For 96 lots max 60 Rs 5760(96*60) 0.01 20 Rs Per lot 0.02 40 Rs per lot 0.02 60 Rs per lot Brokerage at 20paise Before Strike price

Nifty share 4300 4000

Premium 1200 1200

Total Brokerage at 20paise Suppose lets us take the above example I will write 24(lot) Nifty call & 24(lot) nifty put My one time brokerage will be 48*60=2880

93 48.5

Value 111600 58200 169800

(169800*0.2/100) 339.6

Nifty premium + strike price Value 4393.0 5271600 4048.5 4858200 10129800 20259.6

What is Implied Volatility The estimated volatility of a security's price. In general, implied volatility increases when the market is bearish and decreases when the market is bullish. This is due to the common belief that bearish markets are more risky than bullish markets.

Implied volatility IV of the call A call option is trading at $1.50 with the underlier trading at $42.05. The implied volatility of the option is determined to be 18.0%. A short time later, the option is trading at $2.10 with the underlier at $43.34, yielding an implied volatility of 17.2%. Even though the option's price is higher at the second measurement, it is still considered cheaper on a volatility basis. This is because the underlier needed to hedge the call option can be sold for a higher price. When a IV of the put goes down with significant addition in the contract we can assume that there is a put writing in those scrips. May Call Stike price

5200 5300 5400 5500

Contract +/+4816 +4709 +3149 +2810

IV(%) 30-Apr 23.80 22.70 22.30 22.00

29-Apr 23.8 22.4 21.7 21.7

When IV of call increases we can make it out there is call writing & vice versa When IV of put increases we can make it out there is put buying & vice versa

Just take a example IV of Nifty 4,250 Call & 4250 Put was 15.8% & 27.7% respectively. Previous day IVS were 15.4% & 21.8% respectively for near strike options. So it indicate that the has been put buying & call writing.In call wrting there has been been flat rise so one wheather don’t indicate wheather it has call buying or call writing. From IV we can indicate that Suppose if there is significant OI addition in 4300 call we can assumed that it has been call writing.

Roll over Just take a example Nifty cash 4285 Nifty June future trade at a premium of 4290 Nifty July future trade at a discount of 4270 Suppose I have short June Nifty future at 4260.nifty expiry settled at 4285.so if I want to roll over my position to July.trading at 4270 discount due to dividend results season. So if I rollover my position to next month I have book loss of Rs 25.and I will again short at 4270.so I will not make till nifty future goes to 4245.

Future price = spot price +interest –dividend Option affects option value Call options: Higher Market Price – higher option value Higher strike price-lower option value Higher volatility-higher option value Longer time to expiry-higher option value Higher interest rates-higher option value Higher dividend –lower option value Put option Higher Market Price – lower option value Higher strike price-higher option value Higher volatility-higher option value Longer time to expiry-higher option value Higher interest rates-lower option value Higher dividend –higher option value Short straddle Strategies In short straddle strategies u will Sell put & call With the same strike price to gain volatility. You will do short straddle strategies when u can assume that there will be low volality. Long straddle strategies In Long straddle Strategies u will buy put & call with the same stike price to gain volatility. You will do long straddle strategies when u assume that there is high volatility