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222option and future
- 2. Derivatives Derivatives are financial contracts which derive their values from the underlying assets or securities. Some examples are: Options Futures Swaps
- 3. Option An option is the right, but not the obligation to buy or sell something on a specified date at a specified price. In the securities market, an option is a contract between two parties to buy or sell specified number of shares at a later date for an agreed price. Three parties are involved in the option trading, the option seller, buyer and the broker.
- 4. 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.
- 5. 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.
- 6. 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: StrongAlif lyeficnormat tmarkeis reflct edonpric es. Sem istronge ficentm arket Al publicnf ormatin is refl ectdons ecurityp ices Weakly eficnt market Alhistref oricalnfteds ormatincuy 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.
- 7. Factors Affecting the Value of Call Option 1. The market price of the underlying asset 2. The striking price 3. Option period 4. Stock volatility 5. Interest rates 6. Dividends
- 8. 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
- 9. 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.
- 10. Call Buyers Position Option Profit 30 25 Profit line to 20 Call option buyer Market price of 15 optioned stock 10 Exercise Price Intrinsic (Rs 50) 5 value 0 10 20 30 40 60 70 80 90 100 5 Loss of Premium 10 Break-even Rs 55 15 20 25
- 11. 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.
- 12. Writing a Call O p tio n p r o fit 25 20 15 10 I n t r in s ic v a lu e M a r k e t p r ic e o f 5 o p t io n e d s t o c k P r e m iu m g a in 0 10 20 30 40 60 70 80 90 100 5 B re a k -e v e n R s 5 5 E x e rc is e P ric e (R s 5 0 ) 10 15 L o s s lin e to c a ll w r ite r 20 25
- 13. 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.
- 14. Put Buyers Gain or Loss 40 Profit line to p ut buyer 30 20 Intrin sic value 10 Break-even Exercise Price Rs 50 Rs 45 Price of the optioned stock 30 70 90 Premium loss 10 20
- 15. 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.
- 16. Writing a Put 30 20 Break-even Rs 45 Strike Price Rs 50 10 Intrinsic value Premium gain 0 20 40 60 80 5 Price of the optioned stock 15 Loss line of put writer 25 35
- 17. Profits in Stocks, Bonds and Options Stock, Bond and Option Details Stock Bond Call Put Current price Rs 70 Rs 100 Rs 5 Rs 5 Exercise price --- --- Rs 70 Rs 70 Terms to expiration --- 6 months 6 months 6 months Prices at termination Variable Rs 100 Variable
- 18. Bond Return Profit Rs 30 20 10 Return Stock Price at Termination 40 50 60 80 90 100 10 20 Exercise Price 30 = 70 LOSS Rs
- 19. Stock Return PROFIT Rs 30 20 10 Stock Price at 40 50 60 80 90 100 Termination 10 20 Exercise Price 30 = 70 LOSS Rs
- 20. Selling the Stock Short P R O F IT R s 30 E x e r c is e P r ic e 20 = 70 10 S to c k P r ic e a t 40 50 60 80 90 100 T e r m in a tio n 10 20 30 LO SS R s
- 21. 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
- 22. The Black-Scholes Option Pricing Model The Black-Sholes model (1973) is given below: V = P{N(d1 )} eRTS{N(d 2 )} ln(P/S) + (R + 0.5 2 )T d1 = T d 2 = d1 T
- 23. 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 = Standard deviation e = Exponential function
- 24. 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.
- 25. 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
- 26. Future Market The three distinct features of the future markets are: Standardised contracts Centralised trading Settlement through clearing houses to avoid counterparty risk
- 27. 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.
- 28. 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.