Options and Futures

Learning Objectives

To understand the concept of derivatives

To know call and put option To learn about the option buyers and sellers position To understand the nature of futures

Derivatives

The term Derivative stands for a contract whose price is derived from or is dependent upon an underlying asset. The underlying asset could be financial asset such as currency, stock and market index or a physical commodity. Some examples are:

Options Futures Swap

Option

An option is the right, but not the obligation to buy or sell something on a specified date at a specified price. Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. One can buy and sell each of the contracts. When one buys an option he is said to be having a long position and when one sells he is said to be having a short position.

Terminology of Derivatives

Spot price (ST) Spot price of an underlying asset is the price that is quoted for immediate delivery of the asset. Forward price or futures price (F) Forward price or futures price is the price that is agreed upon at the date of the contract for the delivery of an asset at a specific future date. These prices are dependent on the spot price, the prevailing interest rate and the expiry date of the contract.

Terminology of Derivatives

Expiration date (T) In the case of Futures, Forwards, Index and Stock Options, Expiration Date is the date on which settlement takes place. It is also called the final settlement date. Strike price (K) The price at which the buyer of an option can buy the stock (in the case of a call option) or sell the stock (in the case of a put option) on or before the expiry date of option contracts is called strike price. It is the price at which the stock will be bought or sold when the option is exercised. Strike price is used in the case of options only; it is not used for futures or forwards.

Terminology of Derivatives

Margins- In the spot market, the buyer of a stock has to pay the entire transaction amount (for purchasing the stock) to the seller. In a derivatives contract, a person enters into a trade today (buy or sell) but the settlement happens on a future date. Because of this, there is a high possibility of default by any of the parties. In order to prevent any of the parties from defaulting on his trade commitment, the clearing corporation levies a margin (approximately 20%) of the total contract value.

Option Payout

There are two sides to every option contract. On the one side is the option buyer who has taken a long position (i.e., has bought the option). On the other side is the option seller who has taken a short position (i.e., has sold the option). The seller of the option receives a premium from the buyer of the option.

A long position in a call option

In this strategy, the investor has the right to buy the asset in the future at a predetermined strike price (K) and the option seller has the obligation to sell the asset at the strike price (K). If the settlement price (underlying stock closing price) of the asset is above the strike price, then the call option buyer will exercise his option and buy the stock at the strike price (K). If the settlement price (underlying stock closing price) is lower than the strike price, the option buyer will not exercise the option as he can buy the same stock from the market at a price lower than the strike price.

A long position in a put option

In this strategy, the investor has bought the right to sell the underlying asset in the future at a predetermined strike price (K). If the settlement price (underlying stock closing price) at maturity is lower than the strike price, then the put option holder will exercise his option and sell the stock at the strike price (K). If the settlement price (underlying stock closing price) is higher than the strike price, the option buyer will not exercise the option as he can sell the same stock in the market at a price higher than the strike price.

A short position in a put option

In this strategy, the option seller has an obligation to buy the asset at a predetermined strike price (K) if the buyer of the option chooses to exercise his/her option. The buyer of the option will exercise his option to sell at (K) if the spot price at maturity is lower than (K). If the spot price is higher than (K), then the option buyer will not exercise his/her option.

A short position in a call option

In this strategy, the option seller has an obligation to sell the asset at a predetermined strike price (K) if the buyer of the option chooses to exercise the option. The buyer of the option will exercise the option if the spot price at maturity is any value higher than (K). If the spot price is lower than (K), the buyer of the option will not exercise his/her option.

Pay -off for a buyer of a call option

As the spot Nifty rises, the call option is in-the-money. If upon expiration, Nifty closes above the strike of 2250, the buyer would exercise his option and profit to the extent of the difference between the Nifty-close and the strike price. The profits possible on this option are potentially unlimited. However, if Nifty falls below the strike of 2250, the buyer lets the option expire. His losses are limited to the extent of the premium that he paid for buying the option.

Pay-off for a buyer of a put option

As the spot Nifty falls, the put option is in-the-money. If upon expiration, Nifty closes below the strike of 2250, the buyer would exercise his option and profit to the extent of the difference between the strike price and Nifty-close. The profits possible on this option can be as high as the strike price. However, if Nifty rises above the strike of 2250, he lets the option expire. His losses are limited to the extent of the premium he paid for buying the option.

Long option strategy

A person with a bullish opinion on the underlying asset will buy a call option on that asset/security, while a person with a bearish opinion on the underlying will buy a put option on that asset/security. An important characteristic of long option strategies is limited risk and unlimited profit potential. An option buyer can only lose the amount paid for the option premium. At the same time, theoretically, the profit potential is unlimited.

Long option strategy (Call)

Mr. A buys a Call on an index (such as Nifty 50) with a strike price of Rs. 2000 for premium of Rs. 81. Consider the values of the index at expiration as 1800, 1900, 2100, and 2200.
For ST = 1800, Profit/Loss = 0 81 = 81 (maximum loss = premium paid) For ST = 1900, Profit/Loss = 0 81 = 81 (maximum loss = premium paid) For ST = 2100, Profit/Loss = 2100 2000 81 = 19 For ST = 2200, Profit/Loss = 2200 2000 81 = 119

Long option strategy (Put)

Mr. X buys a put at a strike price of Rs. 2000 for a premium of Rs. 79. Consider the values of the index at expiration at 1800, 1900, 2100, and 2200. For ST = 1800, Profit/Loss = 2000 1800 79 = 121 For ST = 1900, Profit/Loss = 2000 1900 79 = 21 For ST = 2100, Profit/Loss = 79 (maximum loss is the premium paid) For ST = 2200, Profit/Loss = 79 (maximum loss is the premium paid)

Short options strategy

A short options strategy is a strategy where options are sold to make money upfront with a view that the options will expire out of money at the expiry date (i.e., the buyer of the option will not exercise the same and the seller can keep the premium). A person with a bullish opinion on the underlying will sell a put option in the hope that prices will rise and the buyer will not exercise the option leading to profit for the seller. A person with a bearish view on the underlying will sell a call option in the hope that prices will fall and the buyer will not exercise the option leading to profit for the seller.

Short options strategy

The maximum loss suffered by the seller of the Put option is unlimited (this is the reverse of the buyers gains). His maximum profits are limited to the premium received.

Moneyness of an Option

Moneyness of an option indicates whether an option is worth exercising or not i.e. if the option is exercised by the buyer of the option whether he will receive money or not. Moneyness of an option at any given time depends on where the spot price of the underlying is at that point of time relative to the strike price.

In-the-money option

An option is said to be in-the-money if on exercising the option, it would produce a cash inflow for the buyer. Thus, Call Options are inthe-money when the value of spot price of the underlying exceeds the strike price. On the other hand, Put Options are in-the- money when the spot price of the underlying is lower than the strike price. Thus a holder of an in-the-money option need not always make profit as the profitability also depends on the premium paid.

Out-of-the-money option

An out-of-the-money option is an opposite of an in-the-money option. An option-holder will not exercise the option when it is out-of-themoney.

At-the-money option

An at-the-money-option is one in which the spot price of the underlying is equal to the strike price. It is at the stage where with any movement in the spot price of the underlying, the option will either become in-the-money or out-of-the-money.

Determination of option prices

Like in case of any traded good, the price of any option is determined by the demand for and supply of that option. This price has two components: intrinsic value and time value.

Intrinsic value of an option

Intrinsic value of an option at a given time is the amount the holder of the option will get if he exercises the option at that time. In other words, the intrinsic value of an option is the amount the option is in-the-money (ITM). If the option is out-of the-money (OTM), its intrinsic value is zero.

Time value of an option

In addition to the intrinsic value, the seller charges a time value from the buyers of the option. This is because the more time there is for the contract to expire, the greater the chance that the exercise of the contract will become more profitable for the buyer. This is a risk for the seller and he seeks compensation for it by demanding a time value. The time value of an option can be obtained by taking the difference between its premium and its intrinsic value.

Intrinsic and Time Value for Call Options

Underlying Price (Rs.)
100 101

Strike Price

Premium

Intrinsic Value
10 11

Time Value
2 2

90 90

12 13

Process

The option seller or writer is a person who grants someone else the option to buy or sell. He receives a premium on its price. The option buyer pays a price to the option writer to induce him to write the option. The securities broker acts as an agent to find the option buyer and the seller, and receives a commission or fee for it.

Call Options

The call option that gives the right to buy. The contract gives the particulars of:

The name of the company whose shares are to be bought or the underlying asset.

The number of shares to be purchased.

The purchase price or the exercise price or the strike price of the shares to be bought.

The expiration date, the date on which the contract or the option expires.

Put Options

Put option gives its owner the right to sell (or put) an asset or security to someone else. Like the call option the contract contains:
Strongly efficient market All information is reflected on prices. Semi strong efficient market All public information is reflected on security prices Weakly efficient market All historical information is reflected on security

The name of the company whose shares are to be sold. The number of shares to be sold. The selling price or the striking price. The expiration date of the option.

Factors Affecting the Value of Call Option

1. 2. 3. 4. 5. 6.

The market price of the underlying asset The striking price Option period Stock volatility Interest rates Dividends

Intrinsic Value and Time Value

The price of an option has two components intrinsic value or expiration value and time value.

Call option intrinsic value

or

expiration value = Stock price Striking price

Put option intrinsic value or expiration value = Striking price Stock price
Time value = Premium Intrinsic value

Gain or Loss of Call Buyer

When the market price exceeds the strike price by just enough to cover the premium, the profit is zero for the buyer if he exercises the option. This is the point of no profit and no loss and hence known as break-even point. If there is a rise in the price of the stock beyond the break-even point, the call buyer gains profit.

Call Buyers Position

Option Profit
30 25 20 15 10 5 0 5 10 15 20 25 10 20 30 Exercise Price (Rs 50) 40 60 70 Profit line to Call option buyer

Market price of optioned stock

Intrinsic value 80 90 100

Loss of Premium Break-even Rs 55

Call Writers Gain or Loss

When the market price is lower than the strike price, the call buyer may not exercise his option, hence the premium is the only profit the call writer can gain. If the price increases further it would be a loss to the call writer.

Writing a Call
Option profit 25 20 15 10 5 Premium gain 0 5 10 15 20 25 10 20 30 40 60 70 80 90 100 Break-even Rs 55 Intrinsic value Market price of optioned stock

Exercise Price (Rs 50)

Loss line to call writer

Put Buyers Position

Put buyer gains in the bearish market when the price falls. When the price increases, the put buyer has to pay the premium alone and his liability is limited to the premium amount he has paid.

Put Buyers Gain or Loss

40 Profit line to p ut buyer 30

20

Intrin sic value

10 Break-even Rs 45 30 Exercise Price Rs 50 Price of the optioned stock

70

90 Premium loss

10

20

Put Writers Position

The gains of the put buyer are the losses of the put writer. If the market price increases the put writer will gain the premium because the put buyer may not be willing to sell the shares at the lower rate i.e., the strike price is lower than the market price.

Writing a Put
30 20 Break-even Rs 45 Strike Price Rs 50 10 Intrinsic value Premium gain 0 20 5 40 60 80 Price of the optioned stock

15 Loss line of put writer 25

35

Profits in Stocks, Bonds and Options

Stock, Bond and Option Details
Stock Bond Current price Rs 70 Rs 100 Exercise price ----Terms to expiration --6 months Prices at termination Variable Rs 100 Call Put Rs 5 Rs 5 Rs 70 Rs 70 6 months 6 months Variable Variable

Bond Return
Profit Rs 30 20 10 40 50 60 10 20 80 90 100 Return Stock Price at Termination

30
LOSS Rs

Exercise Price = 70

Stock Return
PROFIT Rs 30 20 10 Stock Price at Termination

40

50

60 10 20 30 LOSS Rs

80

90

100

Exercise Price = 70

Selling the Stock Short

PROFIT Rs 30 20 10 Stock Price at Termination Exercise Price = 70

40

50

60 10 20 30 LOSS Rs

80

90

100

Investment in Calls

Protective buy the stock and buy a put

Covered call writing own the stock and sell a call

Artificial convertible bonds buy bonds and buy calls

The Black-Scholes Option Pricing Model

The Black-Sholes model (1973) is given below:

V = P{N(d1 )} e RTS{N(d 2 )}

ln(P/S) + (R + 0.5 2 )T d1 = T d 2 = d1 s T
where V = Current value of the option P = Current price of the underlying share N(d1), N(d2) = Areas under a standard normal function S = Striking price of the option R = Risk free rate of interest T = Option period s = Standard deviation e = Exponential function

Futures

Futures is a financial contract which derives its value from the underlying asset. There are commodity futures and financial futures. In the financial futures, there are foreign currencies, interest rate, stock futures and market index futures. Market index futures are directly related with the stock market.

Forward and Futures

In a forward contract, two parties agree to buy or sell some underlying asset on some future date at a stated price and quantity. The forward contract involves no money transaction at the time of signing the deal. Forward contract safeguards and eliminates the price risk at a future date. But the forward market has the problem of: (a) lack of centralisation of trading (b) liquidity (c) counterparty risk

Future Market
The three distinct features of the future markets are:

Standardised contracts
Centralised trading Settlement through clearing houses to avoid counterparty risk

Benefits of the Index Based Futures

Liquidity: The index based futures attract a much more substantial order flow and have greater liquidity in the market. Information: Information flow is more in the index than in the case of securities. The insiders are privileged to have more information in securities. Settlement: In the settlement, stocks have to be delivered either in the physical mode or in the depository mode. No such delivery is needed in the index based futures. They are settled through cash. Less volatile: The changes that occur in index values are less compared to the price changes that occur in the individual securities. This leads to lower prices for the index futures and can work with lower margins. Manipulation: The securities in the index are carefully selected, keeping the liquidity considerations and as such are hard to manipulate. But security prices could be manipulated more easily than the index. Beneficial to the mutual funds.

Chapter Summary
By now, you should have:

Understood the concept of derivates

Learnt about call and put option Learnt the option buyer's and seller's position Understood the nature of futures