Sunday, 28 October 2012

FUTURE & OPTIONS GUIDE

                                                  "HARE KRISHNA"


                           FUTURE & OPTIONS

Today the share market is mainly divided into 2 segments,
1.     Cash Market (CAPITAL MARKET)
2.     Derivative Market

Now most of the people are familiar with cash market today. The cash market is a rolling settlement, therefore to earn in cash market you need money as much as share you want to buy.
          There are three types of persons who are trying to earn in cash market.
1.     Long term investors: LTI’s are actually smart investors who buy the shares as if they buy the gold. They are not worried about the intraday/ short-term movements of the shares. They sell the shares only when it gets very highly appreciated. If the long-term investment is well-planned and there is systematic diversified portfolio then it is almost sure that the investment will give high return.
2.     Short Term Investors:STI’s are not so good investors as LTI’s but they are far better than intra day traders. STI’s are of two types one who follow investment advisor (Fundamental as well as technical analysis of the shares) and then buy the share, other type is the one who blindly follow anybody such as tipsters or rumors.
3.     Intra-Day Traders: IDT’s are mostly innocent traders who try to make money in single day without any investment / stock but by taking risk either limited (using stop loss option) or unlimited risk. Intraday traders annual balance sheet is mostly a loss because in limited profit they close their option while in loss they keep waiting till they lose big amount.

Now suppose there is a news of bullish trend in Reliance then LTI’s will buy the share as per their capacity so that they can wait for long period till the share price is highly appreciated, they can wait for long time because they can afford to forget the investment they made, they will not peep into newspaper quotation daily.

STI’s will buy little more beyond its capacity, they will make a temporary arrangement of money and they will book the profit or loss in short term, but here the STI’s take some risk to gain some profit because they can’t remain invested in stock for long period.

IDT’s will buy much more shares than STI’s because they buys for one day, not also for a day but for a few hours till the market closes, they has to close their outstanding position as they won't have fund to invest, they can’t afford to lose more money. Hence they uses stop loss thereby trying to earn on same day by taking limited risk.

Looking at the above three cases in cash market we find that LTI’s though safe has a limitation they can’t take full advantage of the news as they can buy few share as their capacity says 100 shares. STI’s are also unable to take full advantage as they can buy few more shares say 200 shares, since they buys more shares than their capacity, they take some risk. IDT’s buy much more shares than their capacity say 500 – 1000 shares taking much more risk than STI’s for eg. If they buy at 250/- wishing to sell above 255/- putting stop loss at 245/- suppose they buy 1000 shares then risk is 5000/-. But with 5000/- risk they can hold their outstanding position only for few hours till  the market closes down and also the profit if they will make will be mostly limited since on the same day the chance of the major bull trend is rare, also many a times it happens the stop loss gets triggered and then the share price start rising up so you can assume how costly is Cash Market.

But in Derivative Market with 5000/- or with some limited amount you can hold your amount in outstanding position in lakhs for some period (In 1/2/3 months) to gain unlimited profits with limited risk. In derivative market risk is limited and profit is unlimited with limited premium, you can buy or sell shares in lakhs of value in contractual manner.

DERIVATIVE 



In simple words derivative means the thing that is derived from another. For example plastic toys are made from plastic granules hence plastic toys is a derivative product derived from plastic granules. Similarly stock / index / future/ options are derivative product whose value is derived from the value of corresponding stock/ index in cash market.

The derivative trading on the exchange commenced with S&P CNX Nifty Index futures on June 12, 2000.

The derivative trading is of two types currently traded at the stock exchange. They are as follows:

1.     Futures &
2.     Options
      Futures:  Before studying the definition of futures lets understand the following  
      Forward trading examples.

There are two major trader Mr. A & Mr. B, now Mr. A sold 1000 boxes of mangoes (each 5 dozen) to Mr. B on 20-11-2002 @ 250/- per box (50 per dozen) and promised to give delivery on or before 20-03-2003. Mr. B agreed and he to promised to pay payment when he will receive the delivery but made a contract with Mr. A stating that if Mr. A fails to give delivery on time mentioned i.e.20-03-2003 then Mr. B will buy 1000 boxes of mangoes from the market and then Mr. A has to pay difference between the market price and agreed price (250/-) per box.

 

Now suppose Mr. A fails to give delivery and on expiry date of the contract the market price of the mango per box were Rs. 350/- then Mr. A will have to pay 100000/-  (100 X 1000) to Mr. B.

 

Such type of contract is called forward trading. Forward trading is an agreement between two persons, which are settled on specific date at certain price, but forward trading are customized, not regulated by some authorities. But when such type of contract is regulated with margin daily settlement by an authorized exchange and they are traded on that exchange then such type of contract is called future .

 

Definition of future:


          “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.”
         

      In Future contract risk and profit both are unlimited.

      Option:

Options give the holder the right to do something.

Options are of two types
1.     Call &
2.     Put

Call Options:
    
      Let us study the following example before studying the definition of Call Option.

      Example:-On 20th November 2002 XYZ builder company has advertised their scheme stating that book the flat @ 1000/- per square feet just by paying Rs. 10/- per square feet as a premium but made a condition to pay 1000/- per square feet on or before 19th feb. 2003. Otherwise the premium amount that is paid (Rs. 10/- per sq. ft.) will not be refundable.
          Now suppose you have booked 1000 sq. ft. of flat just by paying Rs. 10000/-     (10 x 1000) to XYZ builders on 22-11-2002. On expiry date i.e. on 19-02-2003 you came to know the property market has fallen down and the flat which you were going to buy at Rs. 1000/- per sq. ft. from XYZ, is now available at Rs. 700/- per sq. ft. from XYZ themselves, then what will you do now? Nothing, just forget your Rs. 10000/-. Since you had paid a premium and not advance, hence you have got the right whether to buy the flat or not. Builder cannot force you to buy the flat since he has taken a premium; he is compelled to give you the flat if the flat price rises on or before the expiry date. Such type of contract is called a Call Option.

Definition of Call Option:
   
          “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:
        
Let us study the following example before studying the definition of Put Option.

Example1: Suppose Mr. A bought a house from XYZ at 700 sq. ft. and got it insured from insurance company by paying a premium of approximately 3000/- Rs. Per annum. In return the insurance company gives Mr. A the right to claim for any damage upto Rs. 2 lacs to Mr. A’s flat due to earthquake, flood, fire etc.

          Suppose before expiry date Mr. A’s house faces damage due to earthquake then he got the right to claim the damage’s amount not exceeding the agreed amount i.e. Rs. 2 lacs from the insurance company, such type of contracts is called Put Option.

Example 2:  Mr. A bought a car worth Rs. 2 lacs and got it insured by paying a premium of Rs. 3000/- to the insurance Company. In return insurance company issued him a contract valid for a year. Now insurance company is liable to pay him if any damage occurs to the car before the expiry date. Before expiry date Mr. A’s car faced an accident and his car was damaged and he had to pay Rs. 60000/- to the car mechanic to get it repaired.

          Here Mr. A got the right to claim Rs. 60000/- from the insurance company, since he had made contract with them just by paying the premium. Insurance company paid Mr. A Rs. 60000/-. Such type of contracts is called a Put Option.

          Mediclaim, vehicle insurance, life insurance etc, such type of contracts can be compared to put option.

Definition of Put Option: 
          ‘A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price.’

Buying Put Option is buying insurance.

Strike Price: The price specified in the option contracts is known as the strike price.

Let us under stand from the following diagram:
SP= Strike price

           SP             SP              SP            SP           SP            SP           SP           SP  
_____220______230______240_____250_____260_____270_____280_____290______         

Premium of STRIKE PRICE (of Call Option)
                                         250>260>270>280>290…

Premium of STRIKE PRICE (of Put Option)
                                  260>250>240>230……….
Price of Put Option 250>240>230>220
American Options:

          American option are option that can be exercised at any time upto the expiration date.

 example:  Mr. A brought Reliance 260 call at Rs. 5/- on 1st Jan. 2003, the expiry date is 30th Jan. 2003. On 20th Jan. the closing price of Reliance is 290/- and Mr. A thinks that tomorrow i.e. on 21st Jan. the stock price may not be above 290/- and he desires to close the call position. Hence he exercised at 290 and hence he closes his position without executing opposite transaction. In American option the contract can get exercised at closing price of the stock on that day.

European Option:

          European options are option that can be exercised only on the expiration date itself eg. Index Option.
          If you want to close your position you can close by doing opposite transaction during market hour, but you can’t exercise after market hours on basis of closing price.

ITM, OTM, ATM, Intrinsic value of an option.
Time value of an option:

In the Money (ITM): An in the money option is an option that would lead to a positive outflow to the holder if it were exercised immediately.
If spot (Market) price is greater than strike price then call option will be in the money (ITM).
Eg.
                                                                    Market price
                            ______________________255_______
                                  230        240         250
           
                   Market Price 255> Strike Price 24
                      Therefore 240 CA is ITM
                       Similarly 230, 220, 210, and so on.
                   If Market Price < Strike Price then the Put Option will be ITM.
Eg.                   MP=Market price
                   SP=Strike price
                    

                           __________260____270____280_________                                                               
                                  255
                                  MP
                   Market Price < Strike Price              
255<270<, 280,290,………..   
                   Therefore 260, 270, 280 & so on are ITM Put Option.

At the money (ATM): An at the money option is an option that would lead to zero cash flow if it were exercised immediately.
Spot price = Strike price

                         MP
____________250______________
                        SP (ATM)

Out the money (OTM): Out the money option is an option that would lead to a negative cash flow if it were exercised immediately.

If spot price <strike price then CA is OTM
If spot price >strike then price PA is OTM




Intrinsic value of an option:-

         
          The option premium consists of 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, and then it will only have time value. All OTM option has time value and no intrinsic value. Intrinsic value of a call is max (0, current price-strike price)

          Similarly, the intrinsic value of put is max [0, (strike price – current price)].
For eg.
          For call,
                                      SP               MP
                   ___________230__________255_____________
Intrinsic Value (IV) = Market Price – Strike Price
                       =255-230
                       =25 intrinsic value of CA

For Put Option,
                  
                                      MP                       SP
                   ____________255_______________270__________

Intrinsic Value = Strike Price – Market Price
       (PUT) 
                   =270-255
                   =15 intrinsic value for 270 PA when market price was 255.

Time value of an option:

          Difference between the premium and the intrinsic value is known as time value of an option.
          OTM or ATM has only time value. Usually, the max time value exists, when option is ATM. Time value depends upon strike price and date of expiry.

          Time value = Premium – Intrinsic value
          (Max time value exist when the stock is ATM)

For CA eg.
         
          255 CA premiums is 20
          Market price is 270             (IV = 270-255)
            (TV = premium – intrinsic value)
          Then, TV=20-15
          For PA eg.
          270 PA premiums 30
          Market price is 260
          Then TV=P-IV
                     =30-IV
                     =30-10
                     =20

          (IV= Strike Price- Current Market Price)
                    =270-260
                    =10
Futures
Options
1.  In futures contract buyer/seller have unlimited risk.
1. In options contract buyer has limited risk while option seller who is also known as option writer has unlimited risk. 
2. Unlimited Profit/loss
2. Unlimited profit to option buyer while limited profit to seller of option contract.
3. Linear payoff
3. Unlinear payoff
4. Require to pay margin at the time of entry and also daily margin upto the day he closes his position.
4. Buyer pay full premium at a time of purchase and hence he need not pay further, after this he has only upside.
5. not safe buyer/seller
5. Safe buyer

Example:

1.     Mr. A is bullish in Reliance. He will buy
a)     Call Option
b)    A Put Option
The correct answer is a) Call Option.
2.     The current price of Reliance is Rs. 250/-. Mr. A is not interested in taking much risk and he wishes to pay little premium, hence he will purchase a call since he is bullish.
a)     230 INTM option
b)    250 ATM option
c)     270 OTM option
The correct answer is c) 270 OTM option
      3. Mr. A brought 270 CA of Reliance at Rs. 3/- premium when the spot price was Rs. 250/-, before expiry date Reliance reached 295, and Mr. A exercised his option on that day when closing price was 295/-. What will be his net profit after deducting the premium he paid?
a)     30
b)    22
c)     –30
The correct answer is b) 22


4. Mr. B bought 270 CA Reliance at Rs. 4/- premium when the spot price was Rs. 260/-, on expiry date the closing price was Rs. 240/-, how much money did Mr. B lose.
a.     30
b.     Zero
c.      4
d.     34
The correct answer is Rs. 4/- because he had bought the option at Rs. 4/- premium. Hence, his loss was limited to Rs. 4/- only and there was nothing for him to worry if the share prices would go down.
5.     Mr. X is bearish in Telco hence he will buy
a.     Call Option
b.     Put Option
The correct answer is b) Put Option; since he is bearish he will buy put option by which he will get the right to sell the shares of Telco by a certain price.
6.     Mr. X bought 150 put of Telco when its spot price was Rs. 155/- at Rs. 4/- premium. On expiry date the closing price was Rs. 120/-. How much did he earn after deducting the premium
a.     30
b.     26
c.      Zero
The current answer is Rs. 26/-

(Strike price – closing rate – premium paid = net profit in case of put option bought)
(150 – 120 – 4 = 26)

      NOTE:    
      Use this formula only when the closing price is ITM, since OTM options on expiry                     date has no value and the buyer will only lose the premium he paid.        

7.     Mr. X bought 150 put options of Telco when its current price was Rs. 155/- at rs. 4/- premium. On expiry date, closing price was Rs. 146/-. How much did he earn after deducting the premium he paid
a.     Zero
b.     4
c.      8
Applying the same formula as above, the correct answer will be a) Zero.
8.     Mr. X bought 150 put of Telco when its current price was Rs. 4/- premium. On         expiry date the closing price was Rs. 180. How much did he lose?
a.     34
b.     30
c.      4
The correct answer is c) 4 because he will lose only the premium amount he paid since he had bought the put option thus his risk is limited to the premium he paid.

OPTION PRICING:
                 The premium of an option is affected by the following factors.
1.     The current market price of an underlying asset.
2.     The strike price of the option in comparison to the current market price.
3.     The amount of time remaining until expiration.
4.     Risk free interest rate.
5.     Volatility of the underlying instrument.
6.     Sentiment of the market.
              The first five factors are familiar and are easily understandable at how they affect the option premium but according to me, the sixth factor i.e. the sentiment of the market is a very important factor that cannot be ignored while pricing the option.
           The sentiment of our market especially Indian Market depends upon even a word of a Prime Minister or like such reputed persons. The sentiment of a market can change the logic of pricing the option. For eg. When WTC was attacked, all the put options became costly, irrespective of time left or time remaining. People were rushing to buy put options.
          Another example is, when our Prime Minister announced disinvestments in BPCL and HPCL their call options that was available at fair rate a day before was now available at very high cost.

Golden Points to Remember:
         
           I would like to suggest you some Golden Points, which you should remember before placing the orders to your broker.
         
          Following are the Golden points to be remembered:
1.     Trade within your limit. It is better to buy an option in-group or partnership so that the risk is minimum as opportunity will come again and again but the money lost once will never come back again.
2.     Do not invest all your money in one strategy or in single opportunity.
3.     To earn in derivative market you need patience, knowledge and experience. So don’t be in a hurry, as hurry will make you worry.
4.     Be confident in your strategy to avoid stress.
5.     Never take risk beyond your capacity.
6.     Do not sell naked call or put option because selling call or put option will lead to unlimited risk.


MY FINANCIAL PLANNING

PRADEEP S CHOKHANI
(DERIVATIVE  EXPERT)
CPFA, AFP

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