"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/ shortterm movements of the shares. They
sell the shares only when it gets very highly appreciated. If the longterm
investment is wellplanned 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. IntraDay 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 20112002 @ 250/ per box (50 per dozen) and promised to give delivery on or before 20032003. 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.20032003 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 20^{th} 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 19^{th} 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 22112002. On expiry date i.e. on
19022003 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 1^{st} Jan. 2003, the
expiry date is 30^{th} Jan. 2003. On 20^{th} Jan. the closing
price of Reliance is 290/ and Mr. A thinks that tomorrow i.e. on 21^{st}
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 pricestrike 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
=255230
=25 intrinsic value of CA
For
Put Option,
MP SP
____________255_______________270__________
Intrinsic
Value = Strike Price – Market Price
(PUT)
=270255
=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 = 270255)
(TV = premium – intrinsic value)
Then, TV=2015
For PA eg.
270 PA premiums 30
Market price is 260
Then TV=PIV
=30IV
=3010
=20
(IV= Strike Price Current Market
Price)
=270260
=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 ingroup 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
GET
YOUR FINANCIAL PLAN PREPARED BY US
LEARN
FUTURE & OPTION TRADING STRATEGY
APPLICATION
OF FUTURE & OPTIONS IN FINANCIAL PLANNING
GROW YOUR MONEY
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