Dalal & Broacha Stock Broking Private Limited Derivatives

A NEW ‘OPTION’ IN THE STOCK MARKET

You buy or trade stocks, bonds and mutual funds. Did you know you might be using a form of options as part of
your everyday life? Do you pay a premium every quarter for house, auto and medical insurance? You have
purchased insurance as a option (safeguard) against a fire in your home, a damage to your car, or large medical
bills. Investors can also use options on stocks or indexes to protect and insure the value of their portfolios. A
major advantage of options is their versatility. They can be as conservative or as speculative as your investing
strategy dictates. Options enable you to tailor your position to your own set of circumstances. Consider the
Following benefits of Options:
• You can protect stock holdings from a decline in market price.
• You can increase income against current stock holding.
• You can prepare to buy a stock at a lower price.
• You can position yourself for a big market move even when you don’t know which way prices will move.
• You can benefit from a stock price rise without incurring the cost of buying the stock outright.
What are options?
An option is a deferred delivery contract, which gives the buyer (holder) the right, but not the obligation, to buy
or sell specified quantity of the underlying assets, at a specific (strike) price on or before a specified time (expira-
tion date). The underlying may be physical commodities like wheat/ rice/ cotton/ gold/ oil or financial instru-
ments like equity stocks/ stock index/ bonds etc.
Let us understand the various terms involved with the help of an example:
Supposing the current market price of Reliance Industries is Rs. 400 and right now it is the month of June. Now
there are the following Call and Put Options available in the market:
Sr. No. Particulars Type of Option Exercise Price Exercise Date Premium
1 RILCJUL380 Call 380 July 40
2 RILCJUL400 Call 400 July 20
3 RILCJUL420 Call 420 July 5
4 RILCAUG400 Call 400 August 25
5 RILCSEP400 Call 400 September 30
6 RILPJUL420 Put 420 July 40
7 RILPJUL400 Put 400 July 20
8 RILPJUL380 Put 380 July 5
9 RILPAUG400 Put 400 August 25
10 RILPSEP400 Put 400 September 30

Now let us understand each of the terms with the help of this example.

Important Terminology involved

• Underlying - The specific security / asset on which an options contract is based. In the above example, the
underlying is the stock of Reliance Industires.

• Option Buyer / Holder - The person who buys an option, which can be a call option or a put option. He
enjoys the right to buy or sell the underlying asset at a specified price on or before specified time, but he does
not have the obligation to do so. The option buyer has to pay a premium to the option writer in order to
purchase this right. His upside potential is unlimited while losses are limited to the Premium paid by him
to the option writer. Any one can be an option buyer, provided he pays the premium.

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• Option Seller / Writer – The person who writes the option, which can be a call option or a put option. He has
the obligation to buy (in case of Put option) or to sell (in case of call option) the underlying asset, in case the
buyer of the option decides to exercise his option. The option writer collects the premium from the option
buyer. His profits are limited to the premium received from the buyer while his downside is unlimited.
There are some requirements for a person to become an option writer, one of them being that the minimum
networth requirement is Rs. 3 crores. Moreover, Mutual Funds are not allowed to act as Option Writers.

• Call Option - A call option gives the buyer/holder the right to buy specified quantity of the underlying asset
at the strike price on or before expiration date. The seller of the call option on the other hand has the
obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy. For
example, in the above case, the first option, which is a call option, gives the buyer the right to buy shares of
Reliance at the exercise price of Rs. 380 on or before the expiration date of July by paying a premium of Rs.
40.

• Put Option - A Put option gives the buyer/holder the right to sell specified quantity of the underlying asset
at the strike price on or before expiration date. The seller of the put option on the other hand has the obligation
to buy the underlying asset at the strike price if the buyer decides to exercise his option to sell. For example,
in the above case, the sixth option, which is a put option, gives the buyer the right to sell shares of Reliance
at the exercise price of Rs. 420 on or before the expiration date of July by paying a premium of Rs. 40.

• Option Premium – Option Premium is the price paid by the buyer to the option seller to acquire the right to
buy or sell the underlying. In the above case, supposing a person buys the first option i.e. the July – 380 Call
Option, he has to pay a premium of Rs. 40, while the writer receives the same for writing the option. The
premium has to be paid up front and the writer receives the premium irrespective of whether the option is
exercised or not. Calculation of the option premium depends on a lot of factors, which will be covered later.

• Strike Price or Exercise Price - The strike or exercise price of an option is the specified/ pre-determined price
of the underlying asset at which the same can be bought or sold if the option buyer exercises his right to buy/
sell on or before the expiration day. For example, Option no. 1 will have an exercise price of Rs. 380, i.e. the
call buyer can buy the stock of Reliance at Rs. 380, while Option no. 6 will have an exercise price of Rs. 420
i.e. the put buyer can sell the stock of Reliance at Rs. 420.

• Expiration date -The date on which the option expires is known as Expiration Date. On Expiration date,
either the option is exercised or it expires worthless. For example, if it is an August option (Option no. 4/9),
then the expiration date would be the last Thursday of the month, beyond which the option cannot be
exercised.

• Exercise Date – The date on which the option is actually exercised by the buyer. In case of European Options,
the exercise date is same as the expiration date while in case of American Options, the exercise date may be
the same or it may be earlier than the expiration date. Exercise date cannot be beyond the expiration date.

• European & American Style of options - An American style option is the one which can be exercised by the
buyer any time on or before the expiration date, i.e. anytime between the day of purchase of the option and the
day of its expiry. For example, if a person has purchased option no. 5 i.e. the September Call Option, he can
exercise the option any time till the end of September.
The European style of option is the one which can be exercised by the buyer on the expiration day only & not
anytime before that. For example, if a person has purchased option no. 5 i.e. the September Call Option, he
can exercise the option only on the end September date.

• Option Class – It refers to all listed options of a particular type (i.e., call or put) on a particular underlying
instrument. For example, in the above example, all Call Options of Reliance or all Put Options of Reliance are
referred to as an Option Class.

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• Option Series - An option series consists of all the options of a given class with the same expiration date and
strike price. For example, RILCJUL400 is an options series, which includes all Reliance Call options that are
traded with Strike Price of 400 & Expiry in July.

• Open Interest - The total number of options contracts outstanding in the market at any given point of time.

POSITONS THAT CAN BE TAKEN

Long Call
A long call, the purchase of a call, is an option to buy an asset at the Strike price. It is a strategy to take advantage
of any increase in the price of the underlying asset.
E.g. Strike Price = Rs.100 Current Market Price = Rs.100
Option Premium/Price = Rs.5
Now let us consider the Pay-off table
Mkt.Prices Exercise (Y/N) Profit/(Loss)
98 No (5)
101 Ye s (4)
103 Ye s (2)
105 Ye s 0
108 Ye s 3

Short Call
A short call, the writing of a call, is the obligation to sell an asset at the strike price if the long call chooses to
exercise the option. Here the strategy is designed to profit from falls in the price of the underlying asset.
Erg. Considering the above values, the Pay-off table would be as follows;
Mkt.Prices Profit/Loss
98 5
101 4
103 2
105 0
108 (3)

Long Put
A long put, the purchaser of the put, is an option to sell an asset at the Strike price. It is a strategy designed to take
advantage of a fall in the spot price of the underlying.
E.g. Considering the same values, the Pay-off table would be as follows:
Mkt.Prices Exercise (Y/N) Profit/(Loss)
94 Yes 1
95 Yes 0
99 Yes (4)
102 No (5)

Short Put
A short put, the writer of the put, has the obligation to buy an asset at the strike price if the long put chooses to
exercise.
E.g. Considering the same values, the Pay-off table would be as follows;
Mkt.Prices Profit/Loss
94 5
95 4
97 2
99 0
102 (1)

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PERCEPTIONS & STRATEGIES
! BULLISH
Strategy View : The market will move upwards.
Strategy Implementation : Buy a Call Option (preferably Out-of-the-money)
Upside Potential : Unlimited
Downside risk : Limited to the amount of the premium paid.
BEP : Strike Price + Premium
Margin : Not Required
! BEARISH
Strategy View : The market will move downwards.
Strategy Implementation : Buy a Put Option
Upside Potential : Unlimited
Downside risk : Limited to the extent of the Premium paid.
BEP : Strike Price + Premium
Margin : Not Required
! CERTAIN THAT MARKET WILL NOT RISE
Strategy View : The market will not rise/could be in a trading zone.
Strategy Implementation : Sell a Call Option (preferably at-the-money option)
Upside Potential : Limited to the extent of the Premium Received.
Downside risk : Unlimited upon exercise of the option by the holder.
BEP : Strike Price - Premium
Margin : Required
! CERTAIN THAT THE MARKET WILL NOT FALL
Strategy View : The market will not fall/could be in a trading zone.
Strategy Implementation : Sell a Put Option (preferably at-the-money option)
Upside Potential : Limited to the extent of the Premium Received.
Downside risk : Unlimited upon exercise of the option by the holder.
BEP : Strike Price - Premium
Margin : Required
! MODERATELY BULLISH
Strategy View : The participant is moderately bullish as he feels that the
Market will not fall considerably.
Strategy Implementation : (i) Buy a lower Strike Call option and Sell a higher Strike Call option
(ii) Buy a lower Strike Put option and Sell a higher Strike Put option
Upside Potential : Limited in both the cases as follows:
(i) Calls: Diff. Between Strikes minus Initial Debit
(ii) Puts: Net Initial Credit
Downside risk : Limited in both the cases as follows:
(i) Calls: Net Initial debit
(ii) Puts: Diff.between Strikes minus Initial Credit
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Dalal & Broacha Stock Broking Private Limited Derivatives
BEP : (i) Calls: Lower Strike + Net Premium paid
(ii) Puts: Higher Strikes – Net Premium Received
Margin : Set-off of margins possible
Analysis : This is a very conservative strategy as the Profit potentials and the risk factors
are limited. If the closing is above the higher strike it gives you the maximum
profit and if the closing happens to be below the lower strike, it gives you
maximum loss.
! MODERATELY BEARISH
Strategy View : The participant is moderately bearish as he feels that the Market will not rise
considerably.
Strategy Implementation : (i) Buy a higher Strike Call option and Sell a lower Strike Call option
(ii) Buy a higher Strike Put option and Sell a lower Strike Put Option
Upside Potential : Limited in both the cases as follows:
(i) Calls: Net Initial Credit
(ii) Puts: Diff.between Strikes minus premium paid.
Downside risk : Limited in both the cases as follows:
(i) Calls: Diff in Strikes minus net premium received.
(ii) Puts: Net Initial debit
BEP : (i) Calls: Lower Strike + Net Premium Received
(ii) Puts: Higher Strike – Net Premium paid
Margin : Set-off of margins possible
Analysis : This is also very conservative strategy. The maximum occurs when the closing
is below the lower strike and the maximum loss if the closing is above the
higher strike.

A NOTE ON INDEX FUTURES

The world financial markets have undergone qualitative changes in the last two-three decades due to phenomenal
growth of derivatives. Amongst the financial futures, the first to emerge were the currency futures in 1972 in US
followed by Interest Rate futures. Index Futures and Options first emerged in 1982.Since then, the financial
futures have quickly spread to an increasing number of developed and developing countries. Countries having
securities market much smaller than that of India have successfully implemented derivatives segment. With the
world embracing the derivatives market on a large scale, the India market obviously cannot remain aloof and nor
do our investors.
Futures
Futures are exchange traded contracts to sell or buy financial instruments at an agreed price. There is an agreement
to buy or sell a specified quantity of the financial instruments at a price agreed upon. Futures are recognized as
the best and most efficient way of meeting the need for risk hedging.
Stock Index Futures
Stock Index represents the change in the value of the set of the underlying stocks, which constitute the index. Any
index is an average of its constituents. The BSE Sensex is the weighted average of the prices of the 30 selected
stocks & S&P CNX Nifty of 50 selected stocks, where the weight is the market capitalization of the constituent
stocks. Thus Index Futures are future contracts where the underlying asset is the Stock Index ie.the BSE Sensex
in BSE & CNX Nifty in the NSE.
The Bombay Stock Exchange and the National Stock Exchange launched Index based Futures inJune2000.

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Dalal & Broacha Stock Broking Private Limited Derivatives
A BIRD’S EYE-VIEW OF THE INDEX FUTURES MECHANISM
The Multiplier Effect
The multiplier for the Index futures is 50 & 200 in BSE and NSE respectively. To explain, if you buy or sell an
index in BSE at 4000 then your Contract Value would be Rs.200000 (i.e. 1*50*4000).
Margins
The exchange at present charges two margins viz. Initial Margin & Mark -to-Market margin
Based on the volatility of the market indices, the initial margin is expected to be between 8-18%.
Mark-to-Market margin is the daily settlement of profits or losses at the day’s closing rate of the particular Index
Series.
Opening Dly.Setl.Rt Calculation Daily MTM
Pstn op.@ 4280 - - -
Day 1 4300 4300-4280 +1000
Day 2 4300 4250 4250-4300 -2500
Day 3 4250 4305 4305-4205 +2750
Day 4 4305 4295 4295-4305 -500
Day 5 4295 4310 4310-4295 +750
Pstn cls @ 4345 4310 4345-4310 +1750
+3250

Thus, you have a final profit of Rs.3250 [(4345-4280)*50*1]

Tenure of the Contract
At any point of time, next three months contracts are available.
(In March one can take positions in March, April and May Series)
All the open positions will be settled out on the last Thursday of the Contract month.
(March expires on- 29/03/2001, April on 26/04/2001& May on 31/05/2001)
New contracts will be open for trading on the next day of the expiry day.
Settlement Price for the Series
The Final Settlement Price for a particular series would converge with the closing index of the Equity segment of
that particular day.
STRATAGIES
Speculation
Speculators are those traders who take an open view on the market. A speculator may take a long position on the
futures when he expects the market to go up. He intends to make money by reversing his position at a higher
price. Similarly, he would take a short position when he is bearish on the market to make profits by reversing his
position at a lower price. Thus, a speculator accepts open risk in pursuit of profit. This is a highly specialized
strategy as the speculators success is dependent on their ability to forecast the Future prices.
Hedging
Hedging is a strategy to reduce the price inherent in the open positions. Hedging using derivatives has become
a central part of the risk management in the modern economies. Hedging does not mean maximisation of returns;
it only means reduction in variation of returns. The basic logic behind hedging is “IF LONG IN CASH - GO
SHORT IN FUTURES & IF SHORT IN CASH - GO LONG IN FUTURES.”
It may thus be observed that any gains in the futures market offset losses in the cash market and any losses in the
futures market are offset by gains in the cash market.

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Dalal & Broacha Stock Broking Private Limited Derivatives
Arbitrage
Arbitrage is a simultaneous purchase and sale of the same underlying in two markets in an attempt to make
profits without risk. The complexity of the arbitrage activity is such that it is reserved particularly to well
informed and professional traders, equipped with powerful calculative and analytical ability.
Arbitrage opportunities can be explained as follows:
• Cash & Carry arbitrage: It refers to a long position in the Cash segment and a short position in the Futures
market.
• Reverse Cash & Carry Arbitrage: It refers to a short position in the Cash segment and a long position in the
Futures market.
• Inter-Market arbitrage: It refers to taking opposite position on Sensex and Nifty.
How are options different from futures?
The significant differences in Futures and Options are as follows:
• Futures are contracts to buy or sell specified quantity of the underlying assets at a price agreed upon by the
buyer & seller, on or before a specified time. Both the parties are obligated to buy/sell the underlying asset.
In case of options the buyer enjoys the right but not the obligation, to buy or sell the underlying asset.
• Futures Contracts have symmetric risk profile for both the buyer and the seller, whereas options have
asymmetric risk profile. In case of an option buyer, the downside is limited to the premium paid while the
profits may be unlimited, while for the writer of an option, the downside is unlimited while profits are
limited to the premium received from the buyer.
• Futures contract prices are affected mainly by the prices of the underlying asset. The prices of options are
however affected by prices of the underlying asset, time remaining for expiry of the contract & volatility of the
underlying asset.
• Futures contract does not involve any cost for entering into the contract, whereas there is a cost (in the form
of Premium) of entering into an options contract. However, in case of Futures, one is required to pay margins
(up-front as well as mark to market), while Options does not involve any such margins.