Chapter Two:

Risk Management through

Derivatives

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Investors operate with limited funds and limited intelligence; they don’t need to know
everything. As long as they understand something better than others, they have an
edge. - George Soros, famed financier and financial philosopher

In this age of globalization, the world is a riskier place and exposure to risk is
growing. Risk cannot be avoided or ignored. Man is risk averse. This characteristic of
human beings has brought about growth in derivatives. Derivatives markets provide
two very important benefits to the economy. One is that they make possible risk
shifting, which is also known as risk management or hedging or redistributing risk
away from risk averse investors towards those more willing and able to accept risk.

Derivatives are powerful risk management tools. Derivatives help the investors by
offering an instrument for hedging risks. Futures, Options, Forwards and Swaps are
the most popular instruments in Derivative Segment. Derivative instruments are very
helpful in market risk management because it transfers risk in opposite market
conditions. While derivatives are very useful for hedging and risk transfer, and hence
improve market effectiveness, it is necessary to keep in view the risks of too much
leverage, lack of transparency particularly in complex products, difficulties in
valuation, tail risk exposures, counterparty exposure and hidden systemic risk.

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Table 2.1 Milestones in the history of risk management

This table shows the important milestones in the history of Risk management. This
table covered chronological events in the field of Risk Management since 1730. This
table also discusses the introduction of pricing models, important compliances, and
government regulations in the field of risk management.

Year Milestone
1730 First futures contracts on the price of rice in Japan
1864 First futures contracts on agricultural products at the Chicago
Board of Trade
1900 Louis Bachelier’s thesis “Théorie de la Spéculation”; Brownian
motion
1932 First issue of the Journal of Risk and Insurance
1946 First issue of the Journal of Finance
1952 Publication of Markowitz’s article “Portfolio Selection”
1961-1966 Treynor, Sharpe, Lintner and Mossin develop the CAPM
1963 Arrow introduces optimal insurance, moral hazard, and adverse
selection
1972 Futures contracts on currencies at the Chicago Mercantile
Exchange
1973 Option valuation formulas by Black and Scholes and Merton
1974 Merton’s default risk model
1977 Interest rate models by Vasicek and Cox, Ingersoll and Ross
(1985)
1980-1990 Exotic options, swaptions and stock derivatives
1979-1982 First OTC contracts in the form of swaps: currency and interest
rate swaps.
1985 Creation of the Swap Dealers Association, which established the
OTC exchange standards
1987 First risk management department in a bank (Merrill Lynch)
1988 Basel I
Late 1980s Value at risk (VaR) and calculation of optimal capital

38 
 
 

1992 Article by Heath, Jarrow and Morton on the forward rate curve
1992 Integrated Risk Management
1992 RiskMetrics
1994-1995 First bankruptcies associated with misuse (or speculation) of
derivatives: Procter and Gamble (manufacturer, rates derivatives,
1994), Orange County (management funds, derivatives on
financial securities, 1994) and Barings (futures, 1995)
1997 CreditMetrics
1997-1998 Asian and Russian crisis and LTCM collapse
2001 Enron bankruptcy
2002 New governance rules by Sarbanes-Oxley and NYSE
2004 Basel II
2007 Beginning of the financial crisis
2009 Solvency II (not yet implemented in April 2013)
2010 Basel III
Source: Georges Dionne, (2013)36. Risk Management: History, Definition, and
Critique. Risk Management and Insurance Review.16(2), 147-166.

2.1 Functions of Financial Derivatives

Some of the functions of financial derivatives can be enumerated as below

2.1.1 Risk Management

This is most important function of derivatives. Risk management is not about the
elimination of risk rather it is about the management of risk. Financial derivatives
provide a powerful tool for limiting risks that individuals and organizations face in the
ordinary conduct of their businesses. It requires a thorough understanding of the basic
principles that regulate the pricing of financial derivatives. Effective use of
derivatives can save cost, and it can increase returns for the organizations.

2.1.2 Price Discovery

The futures and options market provides an important function of price discovery.
The individuals with better information and judgment are liable to participative in

39 
 
 

these markets to take advantage of such information. When some new information
arrives, possibly some good news about the economy, for instance, the actions of
speculators quickly feed their information into the derivatives markets causing
changes in prices of the derivatives. As these markets are usually the first ones to
react because the transaction cost is much lower in these markets than in the spot
market. Therefore, these markets indicate what is likely to happen and thus assist in
better price discovery.

2.1.3 Efficiency in Trading

Derivative instruments allow for free trading of risk components and that leads to
improving market efficiency. Usually derivative traders enter in derivative contract as
an option for a position in underlying asset. In many occasion, traders find financial
derivatives instrument to be a very attractive instrument than the underlying asset.
This is mainly because of the greater amount of liquidity in the market offered by
derivatives as well as the lower transaction costs associated with trading a financial
derivative as compared to the costs of trading the underlying assets in equity cash
market.

2.1.4 Speculation and Arbitrage

Derivatives can be used to obtain risk, rather than to hedge against risk. Various
traders enter into a derivative market to speculate on the price of the underlying asset.
Speculators appear to purchase an asset in the future at a low price according to a
derivative contract when the future market price is high, or to sell an asset in the
future at a high price according to derivative contract when the future market price is
low. Investors or traders may also look for arbitrage opportunities, as when the
current buying price of an asset falls under the price specified in a futures contract to
sell the asset.

2.1.5 Other Functions

The other uses of derivatives are that the derivatives have smoothen out price
fluctuations, compress the price spread, incorporate price structure at different points
of time and take out gluts and deficiency in the markets. The derivatives also assist
the investors, traders and managers of huge pools of funds to device such strategies so

40 
 
 

that they may make appropriate asset share raise their yields and achieve other
investment targets.

“Some people think of speculative traders as gamblers; they earn too much money
and provide no economic value. But to avoid crises, markets must have liquidity
suppliers who react quickly, who take contrarian positions when doing so seems
imprudent, who search out unoccupied habitats and populate those habitats to
provide the diversity that is necessary, and who focus on risk taking and risk
management.” -Richard M. Bookstaber, Risk Management Principles and Practices,
AIMR, 1999, p. 17

2.2 The Potential Risks in Derivatives Usage

"A derivative is like a razor, you can use it to shave yourself, or you can use you it to
commit suicide."- James Morgan - Financial Times

Derivatives are neutral until utilized. It is with utilization that positive and negative
attributes can recognize. The main utilization issue related to the use of derivatives is
the use to which management is applying derivative strategies - hedging or
speculating. When hedging is used as a primary investment, they become extremely
risky. The problem is that much of the investing public do not appreciate that when
properly used, hedging can actually reduce risk, rather than worsen it. Hedging is
generally perceived to be good and speculating is generally perceived to be bad.
Option trading has been deemed risky mainly because of the possibility of leveraged
loss of trading capital due to the leveraged nature of stock options. Many forms of
option trading risks can lead to catastrophic losses. The below three factors Leverage,
Volatility and Liquidity are the possible dangers in the derivatives trading which
needs to use properly for successful trading in derivative segment.

2.2.1 Leverage:

Derivative instrument provides facility of Leverage positions to the traders. It means

derivative trading allows huge trading by paying very small margin amount usually
five to ten percent of the contract value. Thus this makes possibility of huge gains and
losses as well in case of unfavorable market conditions so it may be very dangerous
for the new traders.

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2.2.2 Volatility:

Volatility is the trend in the price of the asset to vary either up or down. It increases
the effect of leverage. In case of huge price movement in the asset price the price of
derivatives also changes in multiple times. Thus it creates potential risk for the traders
in derivatives segment.

2.2.3 Liquidity:

Liquidity plays an important role in the derivatives trading it helps to buy and sell
asset easily. Due to poor liquidity sometimes it is very difficult to exit from the
trade83. The reality is, if the investors use derivatives properly then it tend to be no
riskier than the underlying asset from which they are derived. When the investors use
a hedge vehicle as an investment by itself, the risks raise exponentially. The major
warning is suitability for the investor; one size does not fit all.

2.3 Pricing of Derivatives

Paris-based Natexis Banques Populaires has announced that it has made “significant
losses” in its equity derivatives trading business due to poor risk control and failures
in its valuation models. - Risk, January 2003, p. 8

Key to measuring risk in derivatives trade is the ability to value it. Without a firm grip
on trade’s valuation, it is impossible to calculate its risk.

2.3.1 Pricing of Futures:

The relationship between futures price and spot price can be written in terms of cost
of carry. This measures the storage cost plus the interest paid to finance the asset less
the income earned on the asset.

Cost of Carry
A futures trade necessitates storing and carrying the underlying asset until the delivery
date. This entails costs, benefits, or both to the potential deliverer. "Cost of Carry”
includes storage costs, transportation costs, insurance costs, interest costs, other
opportunity costs as well as interest/dividend receipts and other opportunity benefits.

Futures Price = Spot (Cash) Price + Cost of Carry

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2.3.2 Pricing of Options:

"A trader who slavishly uses a model to make every trading decision is heading for
disaster. Only a trader who fully understands what a model can and cannot do will be
able to make the model his servant rather than his master.” Sheldon Natenberg -
Derivatives Trader

The price of the option is known as the premium. Option Premium is the price the
buyer has to pay the seller to purchase the right to buy/sell the asset at the strike price.
Option premiums can be divided into two components: time value and intrinsic value.

Option Premium = Intrinsic Value + Time Value

Intrinsic Value

It is the in the money part of the option. The amount an option holder can realize by
exercising the option immediately. Intrinsic value refers to what the option is actually
worth. Intrinsic value is always positive or zero.

Intrinsic value of a Call Option = underlying product price - strike price

Intrinsic value of Put Option = Strike price - underlying product price

Time Value (Extrinsic Value)

Time value is the amount option buyers are willing to pay for the possibility that the
option may become profitable prior to expiration due to favorable change in the price
of the underlying. Time has value, since the longer the option has to go until expiry,
the more opportunity there is the underlying price to move a level such that the option
becomes in-the-money. The time value is the premium value that exceeds the intrinsic
value. Generally longer the time to expiry, the higher the options time value. Options
are “wasting assets” which means that the value of an option declines over time. The
time value declines at an accelerating rate as the expiration date approaches. If the
investor buys an option that is not in-the-money, i.e. no intrinsic value, the entire
premium is being paid for time value.

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Factors that affect the value of the option premium:

Non Quantifiable Factors

1. Demand and Supply

2. Unexpected News
3. Market participants' varying estimates of the underlying asset's future volatility.
4. Individuals' varying estimates of future performance of the underlying asset, based
on fundamental or technical analysis.

Quantifiable Factors

1. Underlying stock price

2. Strike price of the option
3. Volatility of the underlying stock
4. Time to expiration of option contract
5. Risk free interest rate
6. Dividend

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Table 2.2: Summary of the effect on the price of a stock option of increasing one
variable while keeping all others fixed.

This table shows the effect of different variable like current stock price, Strike price,
dividend, volatility, time to expiration, and risk free interest rate on the option
premium.

European European American American

Variable
Call Put Call Put

Current Stock Price + - + -

Strike Price - + - +
Time to Expiration ? ? + +
Volatility + + + +
Risk Free Rate + - + -
Amount of Future - + - +
Dividends

Where + indicates that an increase in the variable causes the option price to increase;
- indicates that an increase in the variable causes the option price to decrease;
? Indicates that the relationship is uncertain

Source: Hull, John, (2009)44. Options, Futures and other Derivatives. New Delhi:
Pearson Education Inc

2.3.3 Option Pricing Models:

Option Pricing Model is a mathematical formula used to calculate the theoretical

value of an option. The theoretical option pricing models are used by option traders
for calculating the fair value of an option on the basis of the different influencing
factors.

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Black Scholes Model

Black and Scholes (1973) are pioneers in pricing option theory. They started from the
principle that if options are properly evaluated, there can be undoubtedly no gain from
the sale and purchase of options and underlying assets. Using this principle, they
introduced a formula for determining the theoretical value of an option. Black-Scholes
model for determining the price of a European option is extensively used in practice
because it requires knowledge of observable parameters like the underlying asset
price, the strike price, the time to maturity of the option, the continuously
compounded risk free interest rate and a parameter to be estimated independently, the
underlying assets volatility. This model is based on a set of assumptions of which the
most restrictive are: the underlying asset yield are normally distributed, volatility
remains constant throughout the life of the option, there are no transaction costs and it
can borrow money at the risk free rate.

Factors determine the price of option according to B-S

Stock Price - S
Strike Price - K
Time until expiration - t
Volatility Parameter (std deviation) - σ
Risk-free Interest Rate - r
Black-Scholes Formula

C = So N (d1)-Ke-rt N (d2)

C= Current value of the option

So = Price of the underlying stock
K= Strike price.
r = the continuously compounded risk free interest rate
t = the time in years until the expiration of the option
N (d) = the standard normal cumulative distribution function.

Advantage of Black-Scholes Model

The main advantage of the Black-Scholes model is speed. It enables to calculate a
very large number of option prices in a very short time.

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Drawbacks of Black-Scholes Formula

1. Does not account for dividends

2. Only account for European options
3. Assumes Geometric Brownian motion

“When I first saw the formula I knew enough about it to know that this is the answer.
This solved the ancient problem of risk and return in the stock market. It was
recognized by the profession for what it was as a real tour de force.”-Merton Miller,
Trillion Dollar Bet, PBS, February, 2000

Binomial Model

Binomial Option Pricing Model first proposed by Cox, Ross and Rubinstein in a paper
published in 1979, this solution to pricing an option is probably the most common
model used for equity calls and puts today. Binomial Model which assumes that
percentage change in price of the underlying follows a binomial distribution. The
Binomial Model is widely used by practitioners. It is particularly useful in calculating
the value of options when early exercise may be optimal (e.g. American Puts and
executive options).

The Cox-Ross-Rubenstein model126 makes certain assumptions, including:

1. No possibility of arbitrage; a perfectly efficient market

2. At each time node, the underlying price can only take an up or a down move and
never both simultaneously.

The model divides the time to an options expiry into a large number of intervals, or
steps. At each interval it calculates that the stock price move either up or down with a
given possibility and also by an amount calculated with reference to the stock’s
volatility, the time to expiry and the risk free interest rate. A binomial distribution of
prices for the underlying stock or index is thus produced. At expiry the option values
for each possible stock price are known as they are equal to their intrinsic values. The
model then works backwards through each time interval, calculating the value of the
option at each step. At the point where a dividend is paid (or other capital adjustment
made) the model takes this into account. The final step is at the current time and stock

47 
 
 

price, where the current theoretical fair value of the option is calculated. The number
of steps in the model determines its speed, however most home PCs today can easily
handle a model with 100 or so steps, which gives a sufficient level of accuracy for
calculating a theoretical fair value.

Other pricing Models:

Adesi Whaley model: Barone Adesi & Whaley (1987) presented in the paper
“Efficient Analytic Approximation of American Option Values” a model for pricing
American options on stocks, stocks index, futures and currencies. This model is based
on an analytical approximation but it has a high accuracy, errors are generally small
even for options on underlying asset with a high volatility. Some errors occur for
options with longer maturities, the method being recommended for options with
maturity up to one year.

Monte Carlo Option pricing model: Monte Carlo method for option pricing relies
on risk neutral valuation. Here the price of the option is its discounted expected value;
see risk neutrality and rational pricing. The technique applied then, is to generate a
large number of possible price paths for the underlying via simulation, and to then
calculate the associated exercise value of the option for each path. These payoffs are
then averaged and discounted to today. This result is the value of the option137.

Merton Model: This is a generic equation for European options, in which risk-free
rate and dividend can assume any values. The Black-Scholes model and the Black
model are special cases of the Merton model for particular assumptions of interest
rate.

“You can think of a derivative as a mixture of its constituent underliers much as a

cake is a mixture of eggs, flour, and milk in carefully specified proportions. The
derivative’s model provides a recipe for the mixture, one whose ingredients’
quantities vary with time.” - Emanuel Derman, Risk, July, 2001, p. 48

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2.4 Risk Management: An overview

Risk is an uncertainty of outcome. It may positive opportunity or negative threats.

Simply it is the difference between the expected and actual. Risk is as a usual and
fundamental component of doing business. However, when the level of risk is too
high, it can unfavorably affect the financial position of the firm. It is this need to
manage risk that led to the genesis of the derivative market. Risk Management is an
integral part of managing a business. The entire process of identifying, evaluating,
controlling and reviewing risks, to make sure that the organization is exposed to only
those risks that it needs to take to attain its primary objectives, is known as risk
management. There are various tools available to manage risks. Some of them are
derivative products like Forwards, Futures, Options and Swaps. The others involve
having better internal controls in place, due diligence exercises, compliance with rules
and regulations, etc.

There are two types of risk

2.4.1 Operational Risk

The Risk of Loss Resulting from insufficient or unsuccessful Internal Processes,

People and Systems or from external event. The key to minimizing operational risk is
to minimize manual handling and interference in derivatives trading and clearing
processes, and to design reliable electronic processes.

E.g. Fraud, Failure of Management, Process Errors, Natural Disaster.

2.4.2 Investment Risk

Typically, investment returns are not known with certainty. Investment risk pertains
to the possibility of earning a return less than that expected. The risk is greater if the
chance of a return far below the expected return. There are three major types of
investment risks

1. Market Risk
2. Credit Risk
3. Liquidity Risk

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Market Risk

Market Risk is the risk to the financial portfolio from the adverse movement in market
price. Risk can be classified mainly into two groups, systematic and unsystematic
risk. Unsystematic risk is sector specific or company specific risk which can be
reduced by diversification. Systematic risk or market risk is beyond the control of any
particular sector or company but it can be reduced by adopting proper hedging
strategy. Derivatives are suitable for managing market risk associated with financial
markets.

Credit Risk

Risk arises due to unwillingness or inability of counterparty to fulfill its obligations

on the agreed date. Credit risk is not much of a problem for derivatives traded on
organized exchanges, since these exchanges are designed in such a way that their
contracts are almost always honored. Organized exchanges use arrangements such as
daily marking to market and clearing houses to guarantee performance of the contract.

Liquidity Risk

Another risk in the use of derivative instruments is liquidity risk, which refers to the
ease with which the contract can be traded. Liquidity risk is not specific to derivative
contracts; it can play an important role in any financial market during periods of high
volatility or significant changes in economic fundamentals. There is little evidence
that liquidity risk has increased with the size of derivatives markets. Most exchange
traded derivatives such as future and options are very liquid.

50 
 
 

2.5 Market Risk Measurement

Value at Risk (VAR) is the most popular method to measure Market risk.

2.5.1 Value at Risk (VAR)

Value at Risk (VAR) is the maximum expected loss of a portfolio over a specific time
interval at a given confidence level under normal market conditions.

VAR is a very general concept that has broad applications; it is most commonly used
by security firms or investment banks to measure the market risk of their asset
portfolios (market value at risk)

Parameters of Value at Risk:

Confidence Level
The confidence level is the interval estimate in which the VAR would not be expected
to exceed the maximum loss. Generally used confidence levels are 95% and 99%.

Time Period
The time horizon (period) to be analyzed may relate to the time period over which a
financial institution is committed to holding its portfolio, or to the time required to
liquidate assets.

Typical periods using Value at Risk are 1 day, 10 days, or 1 year. A 10 day period is
used to compute capital requirements under the European Capital Adequacy Directive
(CAD) and the Basel II Accords for market risk, whereas a 1 year period is used for
credit risk

Unit of Currency
Value at risk (VAR) is given in a unit of the currency.

Value at Risk Approaches:

Value at Risk can be calculated using following methods

51 
 
 

A. Parametric (Variance Covariance) Method

Variance-Covariance approach is based on the hypothesis that the underlying market

factors have follows normal distribution. Using this hypothesis it is likely to
determine distribution of mark to market portfolio profit and losses, which is also
normal.

¾ Constructs Variance Covariance Matrix

¾ Delta Normal Analytical Approach
¾ Used for Traditional Assets and Linear Derivatives

Advantages

¾ Few parameters estimated, so does the most with the least data.

Disadvantages

¾ Difficult to handle assets with non-linear payoffs like options.

¾ Most asset returns are not Normal Distributions.

B. Non Parametric (Historical Simulation) method

The historical simulation, assuming that asset returns in the future will have the
similar distribution as they had in the history.

¾ Uses Historical Rates and Revalues Positions

¾ Simulation Approach
¾ Used for Linear and Non-Linear Instruments

Advantages

¾ Easy to understand

Disadvantages

¾ Past portfolio may be different from portfolio going forward.

¾ Difficult to get extreme values.

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C. Monte Carlo Simulation Method

Monte Carlo simulation allows overcoming the problems of limited actual

observations. Non linear exposures and complex pricing patterns can also be handled.
In Monte Carlo simulation, every single instrument in portfolio is revalued according
to numerous randomly generated sources of risk, lets you create a distribution of
portfolio values which represent how your portfolio is likely to fare under a wide
variety of future circumstances.

¾ Simulates random scenarios and revalues positions.

¾ Simulation Approach
¾ Used for Linear and Non-Linear Instruments

Advantages

¾ Easy to do sensitivity analysis.

¾ Easily handles non linear Instruments.

Disadvantages

¾ Requires a lot of processing power and modeling expertise.

2.5.2 Stress Testing

Stress testing is a useful method for determining how a portfolio will fare during a
period of financial crisis. A stress test is also used to calculate the strength of
institutions. Stress Testing is computer simulation technique that measures market
risk over a certain period under abnormal market conditions. The Monte Carlo
simulation is one of the most commonly used methods of stress testing.

53 
 
 

2.6 Risk Management through Derivatives

Global derivatives trading volumes are rising speedily as investors use derivatives as a
technique to manage risk. Investment strategies are becoming more complex with
investors trading in all over the world, frequently into rising markets, and integrating
various instrument types to maximize returns. Hedging is risk avoiding strategy to
protect position values. Hedging strategies usually involve the use of financial
derivatives, which are securities whose values depend on the values of other
underlying securities. The two most common derivative markets are the futures
market and the options market. Portfolio managers, institutions and individual
investors use financial derivatives to construct trading strategies where a loss in one
investment is offset by a gain in a derivative and vice versa. According to Chui
(2012)60 “some fundamental changes in global financial markets have contributed to
rapid growth in derivative markets. First, the collapse of the Bretton Woods system of
fixed exchange rates in 1971 increased the demand for hedging against exchange rate
risk. Consequently, trading in currency futures is allowed at the Chicago mercantile
Exchange in the following year. Second, emerging market financial crises
substantially influence the demand for hedging against credit risk. Third, innovation
in financial theory and advancements in options pricing research also contribute to
rapid development of the derivative markets. Lastly, rapid improvements in computer
technology enabled asset managers to design and develop increasingly sophisticated
derivatives as part of their risk management tools.” Derivative Strategies are specific
game plans created by investors based on their idea of how the market will move.
Derivative Strategies are generally combinations of various products like futures, calls
and puts and enable investors to realize unlimited profits, limited profits, unlimited
losses or limited losses depending on investors profit appetite and risk appetite. The
simplest starting point of a Strategy could be having a clear view about the market.
There could be strategies of an advanced nature that are independent of views, but it
would be correct to say that most investors create strategies based on views.

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2.7 Hedging Strategies Using Futures

It is often said in the derivatives business that “you cannot hedge history.” -Dan
Goldman

Risk Management for the Investment Community, 1999, p. 16

“Many of the participants in futures markets are hedgers. Their aim is to use futures
markets to decrease a particular risk that they face. This risk may relate to fluctuations
in the price of oil, a foreign exchange rate, the level of the stock market, or some other
variable. A perfect hedge is one that completely eliminates the risk. Perfect hedges are
rare. For the most part, therefore, a study of hedging using futures contracts is a study
of the ways in which hedges can be constructed so that they perform as close to
perfect as possible44.”

Hedge Ratio:

The market is exposed to basis risk, as the above mentioned situation does not always
work; the hedge ratio is to be found out because the exposure in futures has to be
different than the exposure in the underlying asset.

A hedger has to determine the number of futures contracts that provide best hedge for
his exposure. It helps the hedger to decide the number of contracts that must be
entered into for minimizing the risk of the combined cash futures position. The hedge
ratio is defined as the number of futures contracts to hold for a given position in the
underlying asset.

Hedge Ratio = Future Position/ Underlying Asset Position

Short Hedges:

A short hedge is a hedge, which involves a short position in futures contracts. A short
hedge is suitable when the hedger already hold an asset and expects to sell it at some
time in the future.

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Long Hedges:

Hedges that involve taking a long position in a futures contract are known as long
hedges. A long hedge is suitable when a company knows it will have to buy a certain
asset in the future and wants to lock in a price now.

“An important concept in hedging is basis risk. The basis is the difference between
the spot price of an asset and its futures price. Basis risk arises from uncertainty as to
what the basis will be at maturity of the hedge. Stock index futures can be used to
hedge the systematic risk in an equity portfolio. The number of futures contracts
required is the beta of the portfolio multiplied by the ratio of the value of the portfolio
to the value of one futures contract. Stock index futures can also be used to change the
beta of a portfolio without changing the stocks that make up the portfolio44.”

2.8 Option Strategies

Options are used for hedging, speculation, or arbitrage. Options are extremely flexible
tools that can be employed in many combinations to create strategies with widely
differing risk and return characteristics. In order to develop a strategy on the options
market, investors have to define their expectations regarding the trend of the
underlying asset and its volatility degree. Options trading strategies may be classified
in simple strategies (long call, short call, long put, short put, spread) and mixed
strategies (straddle, strip, strap, strangle). One of the major attractions of using
options is that they can be used to make a very extensive range of payoff patterns. A
wide range of option strategies can largely be classified into three broad categories.
Options strategies can favor movements in the underlying that are bullish, bearish or
neutral. In the case of neutral strategies, they can be further classified into those that
are bullish on volatility and those that are bearish on volatility. The option positions
used can be long and/or short positions in Calls and Puts.

Bullish Strategies

Bullish options strategies are employed when the options trader expects the
underlying stock price to move upwards. It is necessary to assess how high the stock
price can go and the time frame in which the rally will happen in order to select the
best possible trading strategy.

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Bearish Strategies

Bearish options strategies are employed when the options trader expects the
underlying stock price to move downwards. It is required to assess how low the stock
price can go and the time frame in which the decline will happen in order to select the
optimum trading strategy.

Neutral Strategies

Neutral strategies in options trading are employed when the options trader does not
know whether the underlying stock price will go up or collapse. Also known as non
directional strategies, they are so named because the potential to profit does not
depend on whether the underlying stock price will go upwards or downwards. Rather,
the proper neutral strategy to employ depends on the expected volatility of the
underlying stock price.

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2.8.1 Bullish Strategies:

Table 2.3: Bullish Strategies

This table discusses different Bullish strategies with the potential upside and
downside risk. This table also mentioned the ideal market situations for the selection
of the correct strategy and the breakeven point in the strategy.

Bullish Strategy Market Upside Downside Break

Strategies Implementation Expectation Potential Risk Even
Point

Long Call Purchase of call bullish on Unlimited Limited to Strike

option market as the the price plus
direction and market premium premium
also bullish rallies paid
on market
volatility
Short Put sale of a put bullish on Limited to Unlimited Strike
option market the in a falling price less
direction and premium market premium
bearish on received
market
volatility
Covered Long the Own the Limited to Unlimited Current
Call underlying asset underlying the on the stock
and short call stock (or premium downside price
options futures received minus the
contract) and premium
wish to lock received
in profits by selling
the call

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Protective Long the long stock Unlimited Limited to Current

Put underlying asset and want to as the the Stock
and long put protect market premium Price plus
options yourself rallies paid for the
against a the put premium
market option paid for
correction the put
Option
Bull Call Long one call mildly Limited to Limited to Strike
Spread option with a bullish on the premium price of
low strike price market price difference paid for long call
and short one and/or between the long plus net
call option with a volatility the two option debit paid
higher strike strike minus the
price prices premium
minus the received
net for the
premium short
paid for option
the spread
Bull Put Long one put bullish on Limited to Limited to Strike
Spread option and short market the net the price of
another put direction credit difference long put
option with a received between minus net
higher strike for the the two debit paid
price spread strike
prices
minus net
premium
received
for the
position

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Short Buy a call and Bullish on Unlimited Unlimited For net

Combo sell put at lower Market and in Rising in Falling credits:
strike Neutral on Market Market higher
Volatility strike
plus net
credit and
debits:
lower
strike
minus net
debit
Source: www.optiontradingtips.com and LIFFE Options – A Guide to Trading
Strategies

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2.8.2 Bearish Strategies:

Table 2.4: Bearish Strategies

This table discusses different Bearish Strategies with the potential upside and
downside risk. This table also mentioned the ideal market situations for the selection
of the correct strategy and the breakeven point in the strategy.

Bearish Strategy Market Upside Downside Break

Strategies Implementation Expectation Potential Risk Even
Point

Long Put purchase of put bearish on Unlimited Limited to Strike

option market as the the net price
direction and market premium minus
bullish on sells off paid Premium
market
volatility
Short sale of call bearish on Limited to Unlimited Strike
Call option market the as the price plus
direction and premium market premium
market received rises
volatility
Protective Buy a ATM Call Bearish on Very High Premium Initial
Call and short same Market (Until the Paid + Stock
quantity of Direction stock goes Call Strike Price
stocks to zero - Shorted minus
minus Price of cost of
premium Under call
paid) lying option
bought

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Bear Call Short one call mildly Limited to Limited to Lower

Spread option with a bearish on the net the Strike
low strike price market premium difference plus net
and long one call direction received between Credit
option with a for the the two
higher strike position strikes
price minus the
net
premium
Bear put Short one put bearish on Difference Limited to strike
Spread option at a lower market between the net price of
strike price and direction strike amount the
long one put prices paid for purchase
option at a minus net the spread d put
higher strike cash minus the
price outflow/de net debit
bit paid, or
net cash
outflow
Long Sell a call and Bearish on Unlimited Unlimited For net
Combo buy a put at Market and in Falling in Rising credits:
lower strike Neutral on Market Market higher
Volatility strike
minus net
credit and
debits:
higher
strike
plus net
debit
Source: www.optiontradingtips.com and LIFFE Options – A Guide to Trading
Strategies

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2.8.3 Neutral Strategies:

Table 2.5: Neutral Strategies

This table discusses different Neutral Strategies with the potential upside and
downside risk. This table also mentioned the ideal market situations for the selection
of the correct strategy and the breakeven point in the strategy.

Neutral Strategy Market Upside Downside Break

Strategies Implementation Expectation Potential Risk Even
Point
Long Buy one call bullish on Unlimited Limited to Strike
Straddle option and buy volatility but as the the total Price
one put option at are unsure of market premium Plus/
the same strike market moves in paid for Minus
price direction either the call Net Debit
direction and put Paid
options
Short Short one call bearish on Limited to Unlimited Strike
Straddle option and short volatility and the net as the Price
one put option at think market premium market minus /
the same strike prices will received moves in Plus Net
price remain stable for selling either Credit
the direction Received.
options
Long Long one OTM bullish on Unlimited Limited to Put Strike
Strangle Call volatility but as the the total minus
Long one OTM are unsure of market premium Net Debit
Put market moves in paid or Call
direction either Strike
direction plus net
debit
paid.

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Short Short one OTM bearish on Limited to Unlimited Put Strike

Strangle Call volatility and the net as the - Net
Short one OTM think market premium market credit/
Put prices will received moves in call
remain stable either Strike +
direction net credit
received
Long Long ITM Neutral on The The net Up:
Condor Option Market and difference debit paid higher
Short ITM bearish on between strike -
Option Volatility adjacent net debit
Short OTM strikes Down:
Option minus net lower
Long OTM debit strike +
Option net debit.
Short Short ITM Neutral on Net credit Difference Up:
Condor Option Market and received between highest
Long ITM bullish on adjacent strike -
Option Volatility strikes net credit
Long OTM minus net Down:
Option credit lowest
Short OTM strike
Option plus net
credit
Long Buy put (or call), Neutral on The Net debit Up:
Butterfly sell two puts (or Market and difference paid higher
calls) at higher bearish on between strike
strike , buy put Volatility strikes price -
(or call) at an minus net net debit.
even higher debit Down:
strike lower
strike +
net debit

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Short Sell put (or call), Neutral on Net credit Difference Up:
Butterfly buy two puts (or Market and received between higher
calls) , sell put bullish on adjacent strike
(or call) Volatility strikes minus net
minus net credit and
credit Down:
lower
strike
plus net
credit

Source: www.optiontradingtips.com and LIFFE Options – A Guide to Trading

Strategies

2.9 Option Sensitivities: The Greeks

The price of an Option depends on certain factors like price and volatility of the
underlying, time to expiry etc. The options Greeks are the tools that measure the
sensitivity of the option price to the above mentioned factors. Option Greeks are
mathematical outputs from an Option Valuation Model which help investors to
understand the possible future movement in Option Values based on various
underlying parameters. Greeks help investors in possible predictions of Option Values
and help them to fine tune their buy sell hedge decisions much better. They are
frequently used by professional traders for trading and managing the risk of huge
positions in options and stocks.

The easiest and known hedging strategy that uses derivatives is static hedging which
involves opening a certain position and waiting the result at the end of the period. The
investor does not modify the composition of the portfolio between the beginning and
the end of the period even if the price change, what matters is the portfolio value at
maturity. This technique provides only partial protection because delta remains
constant during the hedging. The alternative is therefore to adjust periodically the
portfolio, this strategy being known as dynamic hedging. The most popular dynamic
strategies are: delta hedging, gamma hedging, Vega hedging.

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2.9.1 Delta
The most important of the ‘Greeks’ is the option delta. This measures the sensitivity
of the option value to a given small change in the price of the underlying. Delta (∆or
δ) is defined as the change in the value of an option for a small change in the price of
the underlying, with all the other inputs to the model remaining constant. Because it is
calculated as the slope on the option value curve, delta assumes a linear relationship
between the spot price and the option value. The advantage is that it is easy to
estimate from the delta the predicted change in the option value for a larger change in
the spot price.

2.9.2 Gamma
Gamma (Γ or γ) measures the change in the delta for a small change in the spot price
of the underlying. It is actually a second-order Greek; since it measures the ‘change in
a change’. Thus, the Gamma predicts movements in Delta given changes in the
underlying share price. Gamma indicates how quickly your exposure to the price
movement of the underlying security changes as the price of the underlying security
varies. The gamma will be large when the option is at the money and nearly zero
when the option is deep in the money or out of the money.

2.9.3 Theta:
Theta (ɸ) measures the change in the value of an option (all other inputs to the model
remaining constant) for a given change in time to expiry. It shows the decay in an
option’s time value over a day or some other time period. The Time Value component
of the Option will gradually move down to zero on expiry day. Theta determines
precisely how much the value of the Option will decrease by passage of time. For
European calls, the theta is negative meaning that the option price will fall as
expiration approaches.

2.9.4 Vega:
Vega (occasionally stated as kappa, κ) measures the change in the value of an option
(all other factors remaining constant) for a given change in volatility, typically 1%.
Vega indicates impact of Volatility. Volatility has a positive impact Option Values.
Both Calls and Puts will increase in Value if Volatility rises and fall in Value if
Volatility falls. Vega determines the increase or decrease in Value with precision. The

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relationship is nearly linear when the option is at the money. The option price is very
sensitive to the volatility.

2.9.5 Rho:
Rho (ρ) measures the change in the value of an option for a given change in the
interest rate (all other factors remaining constant). The relationship is nearly linear
and is fairly weak. In other words, the call price is not very sensitive to the risk free
rate.

Table 2.6: Greeks for four basic option strategies with European Options

This table shows the Greeks (Delta, Gamma, Vega and Rho) positions for the most
basic options strategies (Long Call, Long Put, Short Call and Short Put) with
European Options.

Strategy Delta Gamma Vega Rho

Long Call + + + +
Long Put - + + -
Short Call - - - -
Short Put + - - +
5
Source: Andrew Chisholm, (2004) . Derivatives Demystified. West Sussex: John
Wiley &Sons Ltd.

2.10 Difficulties in using Derivatives risk management

strategies

Due to the increased effects of globalization, last decade has seen the derivatives
investors being increasingly exposed to global market factors and are faced by rising
levels of complexity of risks. To mitigate the effect of those underlying risks, Indian
investors are increasingly using highly complex derivative strategies with the help of
exchange traded derivative instruments. Putting the right derivative risk management
strategy in place is only half the battle won; derivative investors need to continuously
monitor and evaluate the effectiveness of the derivative risk management strategies
and make sure that they are in sync with the underlying risk profile.

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Some of the key challenges that derivative investors face when tackle with such
complex derivative strategies are as follows:

1. Lack of Knowledge about derivative Strategies to evaluate the complication of the

transactions and skill to identify, recognize and quantify the risks associated with
the strategy.
2. Difficulty in understanding the Exposure by performing periodic Mark to Market
calculations
3. Difficulty in Pricing Derivatives so lack of ability to build worse case scenarios in
the valuation models to integrate sudden and unfavorable price movements.
4. Credit Risk is not so effective in case of exchange traded derivatives.
5. Transaction Cost is sometime become a challenge in case of maintain breakeven
point in derivative strategy.
6. Liquidity Risk in Derivatives instruments such as stock options. It is important
factor in case of unwinding the derivatives positions prematurely in times of
adverse market conditions.
7. Limited or no access to risk measurement tools as well as market data systems to
independently validate the Mark to Market numbers reported by counterparties. 

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