basic of derivatives (1)

7/30/2019 Basic of Derivatives (1)

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Summary Slide

Dr.Anup Raj

M.Com,M.A.(Eco),MBA (Fin &Markt),PGDPM,Ph.D in Derivative


2/82

Derivatives

A security whose price is dependent uponor derived from one or more underlyingassets. Contract between two or more parties.

Value derived from the underlying assets.

Underlying assets include stocks,

bonds, commodities, currencies, interest ratesand market indexes etc.

High leverage Product.


3/82

Example

Person who comes with this paper canpurchase a Peter England shirt at Rs.400on or before 31st March, 12

Comes with the paper, Predetermined asset, Predetermined maturity,

Predetermined rate,now find out the value of that paper,if.


4/82

Question - Answer

Price of that shirt is Rs. 500

If price changes from 500 to 700 ?

If price changes from 500 to 400 ? If price comes to 300 ?

If price comes to 100 ?

If price comes to 1000 ? If asset does not exist ?


5/82

Pay off of Peter England Shirt

-600

-400

-200

0

200

400

600

800

1000

1200

0 100 200 300 400 500 600 700 800 900 1000 1100

Price of Shirt

ValueofPaper


6/82

Call Option

An agreement that gives an investor theright (but not the obligation) to buy a stock,bond, commodity, or other instrument at aspecified price within a specific timeperiod.

Buyer of Call ----- Bullish View

Seller of Call ----- Bearish View


7/82

Example

Mr. X Purchases the 3000 Nifty Feb 09Call Option at Rs.100. If Price goes up. The value of call option will

go up If Price goes down. The value of call option

will go down

If Price remains constant the value ofcall option will come down


8/82

Break Even Point

Mr. X has already paid Rs.100 to Purchase the Calloption.

If price goes up than he can buy Nifty at Rs.3000,,,,that means he has to pay Rs.3000. So net costing to Mr.

X will be Rs.3100. Above Rs.3100, Mr. X will be in Profit Below Rs.3100, He will loose money. Max Loss to him is Rs.100 at price on or below Rs.3000

Max Profit to him is unlimited. He has to use his option on or before the maturity.


9/82

Calculate the Value of Call option if NiftySpot Price is

3100

3200 3500 3000 2950

2900 2500 3050 3025

Question - Answer


10/82

Pay off of Call Option Buyer

Events Price Of Nifty Value of Option

Profit / (Loss)

1 2700 0 -100

2 2750 0 -100

3 2800 0 -100

4 2850 0 -100

5 2900 0 -100

6 2950 0 -100

7 3000 0 -100

8 3050 50 -50

9 3100 100 0

10 3150 150 50

11 3200 200 100

12 3250 250 150

13 3300 300 200

14 3350 350 250

15 3400 400 300

16 3450 450 350

17 3500 500 400

P ay o f f o f C a l l O

-200

-100

0

10 0

20 0

30 0

40 0

50 0

60 0

270

0

275

0

280

0

285

0

290

0

295

0

300

0

305

0

310

0

315

0

320

0

325

0

330

0

335

0

340

0

345

0

350

0

P r i c e o f N

Profit/(Loss)


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Example

Mr. Y has sold the 3000 Nifty Feb 09 CallOption at Rs.100. If Price goes up. The value of call option will

go up If Price goes down. The value of call option

will go down

If Price remains constant the value ofcall option will come down


12/82

Break Even Point

Mr. Y has already received Rs.100 to sell the Call option. If price goes up than he has to sell Nifty at Rs.3000,,,,

that means he will get Rs.3000. So net receipt to Mr. Ywill be Rs.3100.

Above Rs.3100, Mr. Y will be in Loss. Below Rs.3100, He will earn money. Max Profit to him is Rs.100 at price on or below Rs.3000 Max Loss to him is unlimited.

After the date of maturity, the option will be lapsed. Mr. Ywill not be forced to sell the Nifty at Rs.3000 after thematurity.


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Pay off of Call Option SellerEvents Price Of Nifty Value of OptionProfit / (Loss)

1 2700 0 100

2 2750 0 100

3 2800 0 100

4 2850 0 100

5 2900 0 100

6 2950 0 100

7 3000 0 100

8 3050 50 50

9 3100 100 0

10 3150 150 -50

11 3200 200 -100

12 3250 250 -150

13 3300 300 -200

14 3350 350 -250

15 3400 400 -300

16 3450 450 -350

17 3500 500 -400

P a y O f f o f C a l

-6 0 0

-4 0 0

-2 0 0

0

2 0 0

4 0 0

6 0 0

2700

2750

2800

2850

2900

2950

3000

3050

3100

3150

3200

3250

3300

3350

3400

3450

3500

P r i c e o f

Profit/(Loss)


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Impact of Time

Date Maturity Price Change

1-Feb 26-Feb 100.20

2-Feb 26-Feb 98.18 -2.02

3-Feb 26-Feb 96.11 -2.07

4-Feb 26-Feb 94.00 -2.11

5-Feb 26-Feb 91.84 -2.16

6-Feb 26-Feb 89.63 -2.21

7-Feb 26-Feb 87.36 -2.27

8-Feb 26-Feb 85.03 -2.33

9-Feb 26-Feb 82.64 -2.39

10-Feb 26-Feb 80.17 -2.47

11-Feb 26-Feb 77.63 -2.54

12-Feb 26-Feb 74.99 -2.6313-Feb 26-Feb 72.27 -2.73

14-Feb 26-Feb 69.43 -2.83

15-Feb 26-Feb 66.48 -2.96

16-Feb 26-Feb 63.38 -3.09

17-Feb 26-Feb 60.13 -3.25

18-Feb 26-Feb 56.69 -3.44

19-Feb 26-Feb 53.03 -3.66

20-Feb 26-Feb 49.10 -3.93

21-Feb 26-Feb 44.82 -4.28

22-Feb 26-Feb 40.09 -4.73

23-Feb 26-Feb 34.72 -5.37

24-Feb 26-Feb 28.35 -6.37

25-Feb 26-Feb 20.05 -8.3026-Feb 26-Feb 0.00 -20.05

Price of Option comes down as thetime passes.

Speed of Price reduction increases

as the maturity comes nearer.Here price of call was Rs.100on 1st of the month

Which comes to Rs.87 after oneweek,

Then it comes to Rs.66 after 15days

And finally it came to 0 onmaturity


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Impact of Time

0.00

20.00

40.00

60.00

80.00

100.00

120.00

2/1/20

09

2/3/20

09

2/5/20

09

2/7/20

09

2/9/20

09

2/11/2009

2/13/2009

2/15/2009

2/17/2009

2/19/2009

2/21

/2009

2/23

/2009

2/25

/2009

Date

Price

and

Change

-25.00

-20.00

-15.00

-10.00

-5.00

0.00


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Put Option

An agreement that gives an investor theright (but not the obligation) to Sell astock, bond, commodity, or other

instrument at a specified price within aspecific time period.

Buyer of Put ----- Bearish View

Seller of Put ----- Bullish View


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Example

Mr. X Purchases the 3000 Nifty Feb 09Put Option at Rs.100. If Price goes down. The value of Put option

will go up If Price goes up. The value of Put option will

go down

If Price remains constant the value ofPut option will come down


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Break Even Point

Mr. X has already paid Rs.100 to Purchase the Putoption.

If price goes down than he can Sell Nifty at Rs.3000,,,,that means he will receive Rs.3000. So net receipt to Mr.

X will be Rs.2900. Above Rs.2900, Mr. X will be in Loss Below Rs.2900, He will earn money. Max Loss to him is Rs.100 at price on or above Rs.2900

Max Profit to him is unlimited. He has to use his option on or before the maturity.


19/82

Calculate the Value of Put option if NiftySpot Price is

2900 2500 2800 2000 3100 3200

3500 3000 2950

Question - Answer


20/82

Pay off of Put Option BuyerEvents Price Of Nifty Value of Option Profit / (Loss)

1 2700 300 200

2 2750 250 150

3 2800 200 100

4 2850 150 50

5 2900 100 0

6 2950 50 -50

7 3000 0 -100

8 3050 0 -100

9 3100 0 -100

10 3150 0 -100

11 3200 0 -10012 3250 0 -100

13 3300 0 -100

14 3350 0 -100

15 3400 0 -100

16 3450 0 -100

17 3500 0 -100

P a y o f f o f P u t O

-150

-100

-5 0

0

50

100

150

200

250

300350

2700

2750

2800

2850

2900

2950

3000

3050

3100

3150

3200

3250

3300

3350

3400

3450

3500

P r ic e o f N

Prof

it/(Loss)


21/82

Example

Mr. Y has sold the 3000 Nifty Feb 09 PutOption at Rs.100. If Price goes up. The value of Put option will

come down If Price goes down. The value of Put option

will go up

If Price remains constant the value ofPut option will come down


22/82

Break Even Point

Mr. Y has already received Rs.100 to sell the Put option. If price goes down than he has to buy Nifty at

Rs.3000,,,, that means he has to pay Rs.3000. So netcost to Mr. Y will be Rs.2900.

Below Rs.2900, Mr. Y will be in Loss. Above Rs.2900, He will earn money. Max Profit to him is Rs.100 at price on or above Rs.3000 Max Loss to him is unlimited.

After the date of maturity, the option will be lapsed. Mr. Ywill not be forced to buy the Nifty at Rs.3000 after thematurity.


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Pay off of Put Option SellerEvents Price Of Nifty Value of

OptionProfit / (Loss)

1 2700 300 -200

2 2750 250 -150

3 2800 200 -100

4 2850 150 -50

5 2900 100 0

6 2950 50 50

7 3000 0 100

8 3050 0 100

9 3100 0 100

10 3150 0 100

11 3200 0 10012 3250 0 100

13 3300 0 100

14 3350 0 100

15 3400 0 100

16 3450 0 100

17 3500 0 100

P a y O f f o f P u t O

- 300

-200

-100

0

100

200

300

400

2700

2750

2800

2850

2900

2950

3000

3050

3100

3150

3200

3250

3300

3350

3400

3450

3500

P r ic e o f N

Profit/(Loss)


24/82

Synthetic Option and Futures

Synthetic Call option = Buy one future andbuy one put option

Synthetic Put option = Sell one future andbuy one call option

Synthetic Future = Buy one call and sellone put option


25/82

Types of Option

As per Maturity Current Month Option

Next Month Option

Far Month Option As per Right to Exercise

European Option

American Option Short key to understand


26/82

Intrinsic Value

The intrinsic value of an option is the amount anoption holder can realise by excercising theoption immediately. Intrinsic value is alwayspositive or zero.

An out of the money & at the money option haszero intrinsic value.

Intrinsic value of In the money call option =

underlying product price strike price. Intrinsic value of In the money put option = strikeprice underlying product price.


27/82

Options as per Intrinsic Value

At the Money Option ATM When the intrinsic value of the option is 0, it is called ATM Meaning of Intrinsic Value

Eg. Spot price of Nifty is 3000, the call n put of 3000 strikeprice is ATM Option

In the Money Option ITM When the intrinsic value of the option is positive, it is called

ITM Eg. Spot price of Nifty is 3000, the call of 2800 strike price

and put of 3200 strike price is ITM Option Out of the Money Option OTM When the intrinsic value of the option is negative, it is called

OTM Eg. Spot price of Nifty is 3000, the call of 3200 and put of

2800 strike price is OTM Option


28/82

Bullish Strategies

Buy Lower Strike Call Option & Sell HigherStrike Call Option

Buy Lower Strike Put Option & Sell HigherStrike Put Option

Buy one Future and One ATM Put andSell one OTM Call


29/82

Purchase 2500 March Call option at Rs.100and Sell 2700 March Call option at Rs.50

Events Price Of Nifty Value of IOption

Value of IIOption

Profit / (Loss)

1 2200 -100 50 -50

2 2250 -100 50 -50

3 2300 -100 50 -50

4 2350 -100 50 -50

5 2400 -100 50 -50

6 2450 -100 50 -50

7 2500 -100 50 -50

8 2550 -50 50 0

9 2600 0 50 50

10 2650 50 50 10011 2700 100 50 150

12 2750 150 0 150

13 2800 200 -50 150

14 2850 250 -100 150

15 2900 300 -150 150

16 2950 350 -200 150

17 3000 400 -250 150

P a y o f f o f B u l l

- 3 0 0

- 2 0 0

- 1 0 0

0

1 0 0

2 0 0

3 0 0

4 0 0

5 0 0

200

250

230035

0400

450

250055

026

00650

700

750

280085

029

00950

000

P r i c e o

ro

oss


30/82


31/82

Purchase 2700 March Put option at Rs.100and Sell 2500 March Put option at Rs.50

Events Price Of Nifty

Value of IOption

Value of IIOption

Profit /(Loss)

1 2200 400 -250 150

2 2250 350 -200 150

3 2300 300 -150 150

4 2350 250 -100 150

5 2400 200 -50 1506 2450 150 0 150

7 2500 100 50 150

8 2550 50 50 100

9 2600 0 50 50

10 2650 -50 50 0

11 2700 -100 50 -50

12 2750 -100 50 -50

13 2800 -100 50 -50

14 2850 -100 50 -50

15 2900 -100 50 -50

16 2950 -100 50 -50

17 3000 -100 50 -50

P a y o f f o f B e a r P

-3 0 0

-2 0 0

-1 0 0

0

1 0 0

2 0 0

3 0 0

4 0 0

5 0 0

2200

2250

2300

2350

2400

2450

2500

2550

2600

2650

2700

2750

2800

2850

2900

2950

3000

P r i c e o f

Profit/(Loss)


32/82

Long Straddle

Buy same strike price call and put option.

It is beneficial when market looks veryvolatile.

Trader has to pay time value.


33/82

Purchase 2600 March Call option at Rs.75and 2600 March Put option at Rs.75

Events Price Of

Nifty

Value of I

Option

Value of II

Option

Profit /

(Loss)

1 2200 -75 325 250

2 2250 -75 275 200

3 2300 -75 225 150

4 2350 -75 175 100

5 2400 -75 125 50

6 2450 -75 75 0

7 2500 -75 25 -50

8 2550 -75 -25 -100

9 2600 -75 -75 -150

10 2650 -25 -75 -100

11 2700 25 -75 -50

12 2750 75 -75 0

13 2800 125 -75 50

14 2850 175 -75 100

15 2900 225 -75 150

16 2950 275 -75 200

17 3000 325 -75 250

P a y o f f o f L o n g S

- 2 0 0

- 1 0 0

0

1 0 0

2 0 0

3 0 0

4 0 0

2200

2250

2300

2350

2400

2450

2500

2550

2600

2650

2700

2750

2800

2850

2900

2950

3000

P r i c e o f

Profit/(Loss)


34/82

Short Straddle

Sell same strike price call and put option.

It is beneficial when market looks rangebound.

Trader will receive time value.


35/82

Sell 2600 March Call option at Rs.75 and2600 March Put option at Rs.75


Value of IOption

Value of IIOption

Profit /(Loss)

1 2200 75 -325 -250

2 2250 75 -275 -200

3 2300 75 -225 -150

4 2350 75 -175 -100

5 2400 75 -125 -50

6 2450 75 -75 0

7 2500 75 -25 50

8 2550 75 25 100

9 2600 75 75 150

10 2650 25 75 100

11 2700 -25 75 5012 2750 -75 75 0

13 2800 -125 75 -50

14 2850 -175 75 -100

15 2900 -225 75 -150

16 2950 -275 75 -200

17 3000 -325 75 -250

Pay off of Short Straddle

-400

-300

-200

-100

0

100

200

2200 2350 2500 2650 2800 2950

Price of Nifty

P

rofit/(Los


36/82


37/82

Purchase 2700 March Call option at Rs.50and 2500 March Put option at Rs.50

Events Price Of Nifty Value of IOption Value of IIOption Profit /(Loss)

1 2200 -50 250 200

2 2250 -50 200 150

3 2300 -50 150 100

4 2350 -50 100 50

5 2400 -50 50 0

6 2450 -50 0 -50

7 2500 -50 -50 -100

8 2550 -50 -50 -100

9 2600 -50 -50 -100

10 2650 -50 -50 -100

11 2700 -50 -50 -100

12 2750 0 -50 -50

13 2800 50 -50 0

14 2850 100 -50 50

15 2900 150 -50 100

16 2950 200 -50 150

17 3000 250 -50 200


- 1 5 0

- 1 0 0

- 5 00

5 0

1 0 0

1 5 0

2 0 0

2 5 0

3 0 0

2200

2250

2300

2350

2400

2450

2500

2550

2600

2650

2700

2750

2800

2850

2900

2950

3000

P r i c e o f

Pro

fit/(Loss)


38/82

Short Strangle

Sell different strike price call and putoption.




39/82

Sell 2700 March Call option at Rs.50 and2500 March Put option at Rs.50

Events Price Of Nifty Value of IOption Value of IIOption Profit /(Loss)

1 2200 50 -250 -200

2 2250 50 -200 -150

3 2300 50 -150 -100

4 2350 50 -100 -50

5 2400 50 -50 0

6 2450 50 0 50

7 2500 50 50 100

8 2550 50 50 100

9 2600 50 50 100

10 2650 50 50 100

11 2700 50 50 100

12 2750 0 50 50

13 2800 -50 50 0

14 2850 -100 50 -50

15 2900 -150 50 -100

16 2950 -200 50 -150

17 3000 -250 50 -200


- 3 00

- 250

- 200

- 150

- 100

-5 0

0

5 0

1 0 0

1 5 0

2200

2250

2300

2350

2400

2450

2500

2550

2600

2650

2700

2750

2800

2850

2900

2950

3000

P r ic e o f N

Pro

fit/(Loss)


40/82

Long Butterfly

Sell same strike price call and put option &buy lower strike price put & higher strikeprice call (of equal distance).



SELL BUY


41/82

Events Price Of Nifty Value ofCall Sold Value ofPut Sold Value ofCallBought

Value ofPutBought

Profit /(Loss)

1 2200 100 -300 -25 175 -50

2 2250 100 -250 -25 125 -50

3 2300 100 -200 -25 75 -50

4 2350 100 -150 -25 25 -50

5 2400 100 -100 -25 -25 -50

6 2450 100 -50 -25 -25 0

7 2500 100 0 -25 -25 50

8 2550 100 50 -25 -25 100

9 2600 100 100 -25 -25 150

10 2650 50 100 -25 -25 100

11 2700 0 100 -25 -25 50

12 2750 -50 100 -25 -25 0

13 2800 -100 100 -25 -25 -50

14 2850 -150 100 25 -25 -50

15 2900 -200 100 75 -25 -50

16 2950 -250 100 125 -25 -50

17 3000 -300 100 175 -25 -50

P a y o f f o f L o

- 4 0 0

- 3 0 0

- 2 0 0

- 1 0 0

0

1 0 0

2 0 0

2 2 0 02 2 5 02 3 0 02 3 5 02 4 0 02 4 5 02 5 0 02 5 5 02 6 0 02 6 5 02 7 0 02 7 5 02 8 0 02 8 5 02 9 0 02 9 5 03 0 0

P r i c e

ro

oss

SELL BUY

2600 CE 100

2600 PE 100

2800 CE 25

2400 PE 25


42/82

Short Butterfly

Buy same strike price call and put option &sell lower strike price put & higher strikeprice call (of equal distance).

It is beneficial when market looks volatile. Trader will pay time value.

SELL BUY


43/82

2600 CE 100

2600 PE 100

2800 CE 25

2400 PE 25


Value ofCallBought

Value ofPutBought

Value ofCall Sold

Value ofPut Sold

Profit /(Loss)

1 2200 -100 300 25 -175 50

2 2250 -100 250 25 -125 50

3 2300 -100 200 25 -75 50

4 2350 -100 150 25 -25 50

5 2400 -100 100 25 25 50

6 2450 -100 50 25 25 0

7 2500 -100 0 25 25 -50

8 2550 -100 -50 25 25 -100

9 2600 -100 -100 25 25 -150

10 2650 -50 -100 25 25 -100

11 2700 0 -100 25 25 -5012 2750 50 -100 25 25 0

13 2800 100 -100 25 25 50

14 2850 150 -100 -25 25 50

15 2900 200 -100 -75 25 50

16 2950 250 -100 -125 25 50

17 3000 300 -100 -175 25 50

P a y o f f o f S h

- 2 0 0

- 1 0 0

0

1 0 0

2 0 0

3 0 0

4 0 0

2 2 0 02 2 5 02 3 0 02 3 5 02 4 0 02 4 5 02 5 0 02 5 5 02 6 0 02 6 5 02 7 0 02 7 5 02 8 0 02 8 5 02 9 0 02 9 5 03 0 0 0

P r i c e o

ro

oss


44/82

Calendar Spread

Sell a call or put option & buy same strikeprice call or put of far month.

It is beneficial when disparity in volatility indifferent months found.



45/82

Sell 2600 March Call option at Rs.110 andBuy 2600 April Call option at Rs.130


Value ofCall Sold

Value ofCall

Bought

Profit /(Loss)

1 2200 110 -125 -15

2 2250 110 -122 -12

3 2300 110 -117 -7

4 2350 110 -110 0

5 2400 110 -101 9

6 2450 110 -88 22

7 2500 110 -72 38

8 2550 110 -51 59

9 2600 110 -27 83

10 2650 60 1 61

11 2700 10 33 43

12 2750 -40 67 27

13 2800 -90 106 16

14 2850 -140 146 6

15 2900 -190 190 0

16 2950 -240 233 -7

17 3000 -290 280 -10

P a y o ff o f C a l e n d e r

- 400

-300

-200

-100

0

1 00

2 00

3 00

4 00

2200

2250

2300

2350

2400

2450

2500

2550

2600

2650

2700

2750

2800

2850

2900

2950

3000

P r ic e o f N

Profit/(Loss)


46/82

Last day strategies

Either call or put will become zero.


47/82

Option Greeks

Option Greeks represents Dimensions ofrisk involved in taking a position inan option. Option Greeks are :-

Delta Gamma

Vega

Theta

Rho


48/82

Delta

The ratio comparing the change in the price ofthe underlying asset to the correspondingchange in the price of a derivative.

Means delta shows the net change in the priceof option due to 1 Rs. Change in the price ofunderlying. For Eg. If price of GNFC changes from Rs.100 to

Rs.101 and the price of its 100 strike call optionchanges from Rs.5 to Rs.5.50. It shows that the deltaof 100 strike call option is 0.50


49/82

Directional effect of Delta

The relationship between underlying price and call option delta ispositive as the price of underlying increases, the price of call optionalso increases and vice versa.

That means delta of call option is positive & when you sell calloption it becomes negative.

On Second side relationship between underlying price and putoption delta is negative as the price of underlying increases, theprice of put option decreases and vice versa.

That means delta of put option is negative & when you sell putoption it becomes positive.

The positive and negative sign of delta shows the favorable andunfavorable direction of the position of option. Means whether the

position is bullish or bearish can be checked by checking the netdelta of the position.

Call Option Delta Behavior


50/82

UnderlyingPrice Increases

Value ofCall OptionIncreases

Positive Delta

UnderlyingPrice Decreases

Value ofCall OptionDecreases

Positive Delta

Call Option Delta Behavior

Put Option Delta Behavior


51/82

UnderlyingPrice Increases

Value ofPut OptionDecreases

Negative Delta

UnderlyingPrice Decreases

Value ofPut OptionIncreases

Negative Delta

Put Option Delta Behavior


52/82

Normally Delta of Out of the money optionlies between 0 to 0.49

Delta of At the money option lies at 0.50

Delta of In the money option lies between0.51 to 1

Can delta go above 1 ?????????????????


53/82

Gamma

Gamma measures the change in delta fora given change in the underlying. Eg. If acall option has a delta of 0.5 and a gamma

of 0.05, this indicates that the new deltawill be 0.55 if the underlying price movesup by one full point and 0.45 if underlying

price moves down by one full point.


54/82

Need of Gamma

Gamma anticipates the speed of deltawhich is very helpful at the time of runningthe delta neutral strategies. Because there

we need to know the effect of delta due tochange in spot price from one level toanother.


55/82

Theta

Theta measures the effect of time decayon an option. As time passes, option willlose time value and the theta indicates the

extent of this decay. Both call and putoptions are wasting assets and thereforehave a negative theta. Note that the decay

of options is nonlinear in that the rate ofdecay will accelerate as the optionapproaches expiry.


56/82

Eg. of theta

For Eg. If price of GNFC remains Rs.100 onDay 1 & Day 2 but the price of its 100 strikecall option changes from Rs.5 to Rs.4.85. It

shows that the theta of 100 strike call option is0.15 for one day. (Annualised 54.75)


57/82

Vega

Vega measures the effect that a change inimplied volatility has on an options price.Both calls and puts tend to increase in

value as the volatility increases, as thisraises the probability that the option willmove in the money. Both calls and puts

will thus possess a positive vega.


58/82

Volatility

The volatility of an option is a measure of thespread of the price movements of the underlyinginstrument.

The more volatile the underlying instrument, thegreater the time value of the option will be.

This will mean greater uncertainty for the optionseller who, will charge a high premium tocompensate.

Option prices increase as volatility rises anddecrease as volatility falls.


59/82

Rho

Rho measures the impact on price of anoption due to change in the rate ofinterest.

It provides very less impact in short termmaturity option while it is very importanttool for long run maturity option.


60/82

Delta Neutral Strategies

Delta neutral strategy makes the portfolioin such a way so that the delta of completeportfolio should be Zero.

That signifies that trader do not want toearn money through bull or bear marketwhile he just want to earn either time value

or volatility value.


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Few eg of delta neutral strategies

Sell one call and one put option Sell one put option, buy one call option and sell one

future Buy one put option, sell one call option and buy one

future Buy one call and buy one put option Buy one ATM call and Sell two OTM call Buy one ATM Put and Sell two OTM Put Buy one ITM Call and sell one ATM and one OTM call

Buy one ITM Put and sell one ATM and one OTM call Buy one future and sell two calls Sell one future and sell two puts

Relationship between Vega and


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Relationship between Vega andTheta

Generally Vega and Theta are rivals ofeach other.

If trader wants to earn theta, he must be

having the risk of Vega and vice versa. For eg if you sell the option, you will get

time value as the time passes, But if the

volatility rises in the market, you will losemoney.

Put Call Parity An Arbitrage


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Put Call Parity An ArbitrageOpportunity

Formula Finding Opportunity

Risk of Exercise

Transaction Charge


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Volatility Smile

Sell high vol option and buy low vol option. Delta Neutral


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Long Gamma Strategy

Buy options and try to reduce the costingby trading either in future or in stock.

Buy at low and sell at high so that the

profit accumulated should make optionfree.


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Bhavcopy

INSTRUMENT SYMBOL EXPIRY_DT STRIKE_PR OPTION_TYP OPEN HIGH LOW

FUTIDX MINIFTY 26-Mar-09 0XX 2634 2639 2538.4

FUTIDX MINIFTY 30-Apr-09 0XX 2630 2631 2527

FUTIDX MINIFTY 28-May-09 0XX 2645 2645 2525

FUTIDX NFTYMCAP50 26-Mar-09 0XX 1101.3 1101.3 1101.2

FUTIDX NFTYMCAP50 30-Apr-09 0XX 0 0 0

FUTIDX NFTYMCAP50 28-May-09 0XX 0 0 0

FUTIDX NIFTY 26-Mar-09 0XX 2634.8 2639.45 2538.4

FUTIDX NIFTY 30-Apr-09 0XX 2618 2625 2527.3

FUTIDX NIFTY 28-May-09 0XX 2619 2625 2525.05

OPTSTK TATASTEEL 26-Mar-09 150CA 13.05 14.95 8.5


OPTSTK TATASTEEL 26-Mar-09 160CA 8.2 9.15 4.4OPTSTK TATASTEEL 26-Mar-09 165CA 5.75 6.45 3.1

OPTSTK TATASTEEL 26-Mar-09 170CA 5 5.4 2.4




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Bhavcopy II

CLOSE SETTLE_PR CONTRACTS VAL_INLAKH OPEN_INT CHG_IN_OI TIMESTAMP

2556.8 2556.8 96215 49657.24 941780 246300 05-Mar-09

2545.15 2545.15 7030 3612.7 130100 28000 05-Mar-09

2543.75 2543.75 707 363.1 14360 4180 05-Mar-09

1101.2 1018.9 2 6.6 600 600 05-Mar-09

1180.2 1026.75 0 0 0 0 05-Mar-09

1110.85 1032.4 0 0 0 0 05-Mar-09

2556.8 2556.8 842741 1086216 32326450 1302250 05-Mar-09

2545.5 2545.5 20815 26701.08 1418400 233400 05-Mar-09

2542.1 2542.1 1347 1728.48 131000 31700 05-Mar-09

8.9 8.9 197 481.01 152800 74872 05-Mar-09

6.4 6.4 30 75.12 169608 10696 05-Mar-09

4.8 4.8 520 1324.15 1326304 155856 05-Mar-09

3.15 3.15 12 31.05 67232 1528 05-Mar-09

2.65 2.65 303 804.35 774696 59592 05-Mar-09

2.5 2.5 1 2.71 12224 -1528 05-Mar-09

1.55 1.55 140 389.28 764000 77928 05-Mar-09


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Open Interest

Meaning Use

Exchange Regulation

Calculation


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Blunders in Derivatives Market

The 1990s saw a number of episodes in which companiesusing derivatives lost large amounts of money

The 1993 Metallgesellschaft oil hedgingdebacle The 1994 bankruptcy of Orange county

The 1995 collapse of Barings bank The 1998 LTCM collapse The recent collapse of Enron


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Metallgesellschaft

The Event

MGRM decided in 1991 to enter the US heating oil and gasoline

markets. To do this, it offered retailers five and ten year fixed price contracts. These gave MGRM a short position of 160 million barrels of oil.

MGRM hedged this position through purchase of NYMEX crude oil

futures. MGRM used a stacked hedge, rolling over 1 and 2 month contracts.

This exposed MGRM to cashflow risk (margin calls, since futuresposition large relative to cashflow) & basis risk (change inbackwardation - contango at roll).


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The problems

End 1993 oil price fell and NYMEX futuremoved into contango.

Falling crude price forced large margin payments.

Move to contango made the roll expensive. MG reacted in December 1993 by taking direct

control of MGRM , and liquidating the hedgeposition.

Liquidation cost Mg $1.83bn ,around one half ofthe total value of the firm.


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Lessons

Highly speculative to hedge long-date position with short-dated instruments.

MGRM was substantially over-hedged initial shortexposure become a long exposure.

Size of MGRM position induced contango. MGRM viewed synthetic storage as cheaper than physical

storage. The contango was the price they needed to pay themarket to do this storage.

MGRM was a gamble that oil prices would rise from 1991-92 levels. The hedge was part of a speculative strategy tobecome a major player in the US oil refining industry.


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Orange County

The Event Citron dominates the orange county treasury in the 1980s and 90s.

He was one of the nations best known municipal treasurers,primarily because his investment strategies produced a very highaverage return of 9.3 %.

Citrons strategies consisted primarily of large, leveraged bets thatshort term interest rates would not increase.

Citron borrowed about $13 billion from various securities firmthrough arrangements known as reverse repurchase agreements,

using Orange countys $7.4 billion investment pool as collateral.This gave him about $20 billion to invest.

Citron used structured notes to buy large amounts of inversefloaters, bonds whose value increases rapidly when interest ratesdecline and vice versa.


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The problems

The federal reserve increased short-term rates on February4,1994,and five times thereafter in the same year.

Orange countys investment pool began hemorrhaging.

Citron was able to hide these losses during 1994, because of

the way in which his derivative investments were structuredand as they technically fit within Orange countysinvestments guidelines.

On December 1, 1994 Orange countys officials held a press

conference announcing losses of $1.7 billion. Orange county was unable to repay the money it had

borrowed and filed the largest municipal bankruptcy petitionin history on December 6, 1994.


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lessons

Naked directional bets will never succeed indefinitely citrons strategy gained only till interest rates remainedlow and once the rates started rising ,they resulted inlarge losses.

Limited disclosure As citrons investments were short-term and issued by highly rates entities. It technically fitwithin the orange county investment guidelines.

However, The fact that they were structured notes withleveraged directional bets was never highlighted.


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Barings bank

The Event Leeson accumulated a very large long position in Nikkei

stock index futures ($7b exposure) and to Japanesegovernment bonds (JGBs) , both in Osaka andSingapore.

Leeson was able to hide these losses from seniormanagement in London.

Leeson hid trading losses in an error account, thefamous 88888 account.


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The problems

The Nikkei fell following the kobe 1995earthquake.

Margin calls exhausted Baringsreserves.

Barings was sold for 1 to ING.


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Lessons

Leesons background was not in tradingbut in futures settlement and he used hissettlement experience to hide his trading

losses.


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Relevant experience is essential

Bad traders are present on every major trading floor. therole of managers is to identify rogue traders before theydo significant damage. baring lacked the mostelementary system for risk control and facilitated

leesons rogue trades by not appointing an independentmanger for the Singapore back office.

Barings management understood very little about

derivatives. Control presupposes understanding.

C


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LTCM

The Event LTCM was a hedge fund involved in convergence (arbitrage) trades.

They betted on convergence of German and other European bondslong and short term corporate & emerging market bonds versus US

treasuries Russian and Japanese government bonds long and shortterm US equity swaption straddles.

LTCM had very high leverage, which was further increased by the theDecember 1997 decision to return capital to investors. The leverage

finally reached mare than 20 in 1988 , resulting in the fact that LTCMwould make (or Lose) large amounts of money on small movements inrelative rates.

Th bl


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The problems

Leveraged convergence trade made good profits for LTCMsinvestors over its initial three years of operations(1994-96).

September 1998 Russian default resulted in rush into quality andhuge increase in volatility resulting in all the convergence tradesgoing badly Wrong.

In the rush to quality following the Russian default, there werefew buyers of corporate bonds.

In September 1998 , the relative spreads widened instead ofnarrowing as LTCM had thought would happen.

LTCM lost &4.6bn and there was a significant fear on the part of theregulators that LTCM bankruptcy might trigger other bankruptcies ,inducing the fed to organize a $3.6bn rescue for LTCM.

L


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Lessons

Liquidity risk : size is not always a benefit. Leverage: LTCMs equity base was

insufficient to support the degree of

leverage required to generate the returnsthey were promising to their investors. Basis risk : Even if basis risks on the

different LTCM trades were small anduncorrelated, multiplied by twenty theybecame quite large.

basic of derivatives (1)

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