Derivatives Basic Module: -

What is Derivative?

Derivatives were emerged as hedging tools. In the current financial environment the
derivatives have become an integral part of the trading at the domestic as well as global
level. They are nothing but the instruments that derive the value from underlying assets
and that asset can be anything i.e. Stock, Commodity, Currency, Index etc.,

Why is Derivative?

The most important thing in the stock market is that there must not be any reduction in the
market value of the investment that one holds. One wants the value of his investments not
to jump up suddenly but gradually over a period of time but not to come down beyond a
certain limit. There is another group of people who wants to speculate at any cost, so there
are derivatives for them also. One can deal in derivative with a calculated risk.

When to enter into stock markets?

Stock market is highly volatile and completely unpredictable. There are investors,
speculators, operators and regulators in the stock market and it is very risky too. So one
has to be careful to enter into stock market. Please answer the following questions?

Have you and your family a Life insurance policy of an appropriate amount?
Have you and your family a Mediclaim Policy?
Have you and your family an Accident insurance policy?
Have you any idea that how much amount you are going to invest in stock market?
Have you calculated the amount of loss that you incur on a certain position?

What are the derivatives Products?

There are various types of derivative products like Stock Futures, Stock Options, Index
Futures and Index Options.

What are Futures Contracts?

It is a bit risky to deal in Futures contracts. One has to hedge his position otherwise there
may be a possibility of an Unlimited loss and unlimited profit. Stock futures as the name
suggests belonging to an individual stock while Index Futures pertaining to Index based
products like Bank Nifty index, CNX IT index etc.,

What are Options Contracts?

Options are of two types, Call Options and Put Options. Stock options are with reference to
respective stock and Index options are with reference to respective Index. Derivatives are
traded in both the stock exchanges i.e. NSE and BSE but NSE has higher volume, liquidity,
fair prices and more transparency as compared to BSE. All the stock options are American
type options i.e. they can be exercised at any time during the expiry period while Index
Options are European Style options i.e. they will be settled and exercised on the day of
expiry only.
What are Index Futures?

BankNifty Futures, CNX IT Futures, Nifty Futures

What are Stock Futures?

What is the Risk Return Profile?

In case of Futures there is unlimited profit and unlimited loss on an open future position.
Call - Right to buy
Put - Right to sell

In case of an option buyer (whether call or put), he has to pay premium and that is his
maximum loss and profit is unlimited.

In case of an option seller (whether call or put), he will get premium and so his maximum
profit is the amount of premium and his loss is unlimited.

186 Stock Futures (including the newly introduced 31 stocks to be traded on 14-May)

How to Deal in Derivatives?

Contact to a broker and open a trading account to deal in futures & options.

Fill up a form and necessary stamp duty etc.,

You will be assigned a code unique for each trader.

Have to pay upfront margin or shares of higher value have to be pledged as margin money.

The Calculation of the fair value of Future

Cost of Carry, Transaction cost, Brokerage cost etc.,

The Calculation of option

Time value, In the money option, Out of the money option, at the money option

The risk attached in dealing in Derivatives?

Margin Payment, Clearing & Settlement

Upfront margin, Marked to market margin,
Clearing & Settlement generally on Expiry that is last Thursday of the month.

What is Cost of Carry?

The cost of holding a particular future position is called a cost of carry.

Difference between the future and cash price (spot) and should be calculated on annualized
term to be more specific. COC is affected by dividend as there is no dividend in future but it
is given to equity holders.
What is open interest?

Open interest is a single contract takes place between a buyer and a seller who have not
squared of their respective positions. Open interest should be viewed in two terms namely
open interest in terms of Number of shares and open interest in terms of value.

How to get the data of open interest?

www.nseindia.com, F&O Market Today, Bhav copy

How to analyse the data

One has to track the open interest positions in the market, price movements with respective
change in open interest positions, addition and reduction in the open interest positions in
options, movement of cost of carry etc.,

What is Put Call Ratio?

Open interest of puts / Open interest of calls

Total volume of puts / Total volume of puts

FIIs movement in Index Futures & Options and Stock Futures & Options

What does FII do in F&O Segment, long build up, short build up, profit booking, short
covering etc.,

FIIs dealing in Cash Segment

FIIs buying and selling in cash market should be taken care of.

Are the Open Interest, Cost of Carry and Price Movement are sufficient?

The answer is yes but some sort of Technical Analysis is required

Global Indices need to be taken care of.

Basic Strategies:-

Bull Spread, Bear Spread, Butterfly Spread, Naked Call, Naked Put, Covered Call, Covered
Put etd.,
Advanced Module

Option Pricing

Factors Affecting Options Pricing

Volatility, Time Till Expiration, Strike Price, Dividend, Interest Rates

One Must Track Greeks of Derivatives

What is Delta?

1. Delta is the change in the value of an option premium due to change in the value
of stock price.
2. The delta of a call option has to be positive and the delta of a put option is negative.
3. Generally it is expressed in % Terms.
4. Example
5. Suppose Reliance is trading at Rs 1695 in spot market and Its June 1700 Call is
trading at Rs 25. Now suppose Reliance goes up at Rs 1696 and 1700 Call premium
goes up at Rs 25.50. Then its delta is considered to be 50%.

25.50 – 25.00/ (1696-1695) = 0.50 or 50%.

Some General Facts about Delta

• The Delta of an option is not constant.

• Every option has its own unique delta. It is expressed in % terms.
• Options delta moves in relation to the movement of the stock price either up or
down.
• As an expiry of a month comes closer, the option’s delta will change.
• Delta of call option is positive and Delta of put option is negative.
• Call Option’s Delta ranges from 0 to 1 in ratio terms and from 0 to 100 in % terms.
• Deep in the money call option has a delta of 1 (100%) and deep out of the money
option has a delta of 0. At the money option has a delta of 0.50 (50%).
• An out of the money option has delta of 40% when there are 30 days to expiry, the
same out of the money option has delta of 30% when there are only 15 days to
expiry and the delta would be 10% when only a week is left to expiry.
• Absolute value of The Call Delta + Put Delta = 1.
• Call Delta has a range of 0 to 1.
• Put Delta has a range of –1 to 0.
• Delta = Share Equivalence (Hedge Ratio)
• Share Equivalence = No. of contracts * Option’s Delta * 100
• Share Equivalence = 10 * 0.50 * 100 = 5 contracts long positions in underlying
• Short 20 Puts * -0.35 * 100 = 700 shares long

Finally the delta of an equity option contract can also be considered to represent the
theoretical probability (in %) of that option expiring in the money.

In the Money Delta = 0.75 or 75%, its probability is 75% to expire in the money.
Out of the money Delta = 0.0 or 0%, its probability is 0% to expire in the money.
At the money Delta = 0.50 or 50%, its probability is 50% to expire as in the money.
What is Gamma?

Gamma is change due to change in option delta due to change in stock price.wwe have to
manage gamma at the time of expiry.

Delta= %change in Delta

% change in price

Suppose Price of XYZ in 60

Call delta is 0.51
Gamma is 0.25
June 60 Call=Atm

If

Price fall to 58
Then call delta is 0.11
Gamma is 0.12
June 60 call = otm

Price Delta Gamma

60 0.51 0.25
58 0.11 0.12
3.45 0.4 11.6
40%

Gamma is the change in option’s delta due to change in the value of the underlying.

An option’s Gamma is the rate of change of an option’s Delta. Any change in the any of the
six factors will change the delta and ultimately change the value of gamma.

It is important to note that, Gamma like Delta, changes as each time an input factor
changes.

An option’s Gamma is largest when the option is at-the-money. As the underlying stock’s
price moves away from the option’s strike price, whether become more in the money or
more out of the money, the delta of that option will change at a decreasing rate.

For a Call and Put with the same strike price and expiration, the gamma for both options is
the same.
What is Theta?

The Theta of an option is the rate at which an option’s time value erodes per unit of time. It
is the change in the value of an option purely due to passage of time. As the
expiration approaches, an option’s time value decreases. Theta measures that time decay.

Any change in one of the six input factors will have an impact on the option’s theta just like
other theoretical outputs. It is important to understand that Theta is not a constant but will
change with reference to change in input factors.

Option Price = Intrinsic Value + Time Value

Option premium= Intrinsic Value + Time Value

Intrinsic Value is the difference between Strike price – spot price

Time value is difference between premiums - Intrinsic Value

IV is possible only in in the money (ITM)

Intrinsic Value Call= spot price – strike price

Intrinsic Value Put= strike price – spot price

Suppose take a example if a satyam Feb 260 call is quoting for Rs 25 while the market price
is satyam is Rs 262.

Premium=IV+Time value
IV of a call=spot – strike price
Time value=IV-premium

IV=(262-260) Rs 2
Time value=(25-2) Rs 23
Premium=(23+2) Rs 25

When u buy put or call option u give time value as a premium.so its gng to be negative
theta for the person who buy put & call option.but when u write call & put option u earn
time value so its gng to positive theta for the person who write put & call option.

Gamma & theta will be inversely related

For Example when u write a put your delta will be negative so as gamma.but ur theta will be
positive as u r earning time value.

Time value represents what an investor is willing to pay for the luxury of time during which
the underlying stock can move favorably to an in-the-money position.

An important concept for the investors to appreciate is that the rate of an option’s time
decay increases rapidly as that option’s expiration reaches.

By definition, an option’s Theta represents the theoretical time decay for a single day.

What is Vega?

A stock’s tendency to fluctuate in price is called volatility. Volatility does not imply a bias for
movement in one direction or the other. The price trend of a stock may be up, down or
sideways, volatility is simply a measurement of the amount by which stock price is expected
to fluctuate in a given period of time.

All other things remain constant, as the volatility of the underlying stock increases, call
prices increases and put prices increases and if the volatility of the underlying stock
decreases, call prices decreases and put prices decreases.

What is Historical Volatility?

What is implied volatility?
What is the forecasted volatility?

What is Rho?

Rho denotes the interest rate movements.

Rho is the least affecting factor to the option price.

All other things remain constant, as the short term interest rates move up, Call price goes
up and Put price goes down and vice-versa.

How to conclude the movement of implied volatility?

This explanation requires an option calculator and a sort of presentation.

What is conversion and reversion?

Buy Call, Sell Put, Sell Future - Conversion

Buy Put, Buy Future and Sell Call - Reversion

Badla Trading?

Try to buy in cash and sell corresponding quantity in future and earn 1% or may be less
than that.

What is Delta Neutral Strategy?

You need to earn time value by hedging and shorting at the money options.

Are the softwares helpful in dealing in derivatives?

Yes, They are an integral part of the trading.

What to do during Dividends declared by the companies?

Generally, Market discounts the dividend factor lying in the stock.

How to analyse whether FIIs have built up long positions or merely a short covering?
We have to track the number of contracts and whether they have sold further. We will see
by way of an example.

If one has Rs 4,00,000 he can easily earn 2% to 3% return excluding brokerage and
expenses by dealing in derivatives.

One should take risk but not blind risk but a calculated and rational risk.

The last but not least “ You are at big risk if you are not taking the risk “.
One more example

When my delta is positive let say 300+ then its indicate me to buy either call,
future or put write at this levels to hedge my position.so that I will maintain
delta.and vice versa if my delta is negative let say-300 it indicate me that to buy
put short nifty future or call write to maintain my delta.its also indicate that my
downward risk levels.

Supoose take a example

Nifty current is at 4270

Nifty 4300 call dealing is at 93
Nifty 4000 put dealing is at 48.5

I have (1200 Share or 24 nifty lots) write 4300 call at Rs 93 & I have(1200 Share
or 24 nifty lots) write 4000 put at Rs 48.5.so in that case my delta is 286 so its
indicate me that my upside risk.so it tell me to buy 3 nifty Future to maintain
delta.so if I buy 3 future at 4270 my delta will be –16.its is manageable.or I can
either buy 4350 call to maintan my delta.or I can write some more put let say
either 4000 or 3900.

Lets calculate brokerage

Strike price Nifty share premium Value

4300 1200 93 111600

4000 1200 48.5 58200
Total 169800
Brokerage according to lot For 96 lots max 60 Rs 5760(96*60)
0.01 20 Rs Per lot
0.02 40 Rs per lot
0.02 60 Rs per lot
Brokerage at 20paise (169800*0.2/100) 339.6
Before

Strike price Nifty share Premium Nifty premium + strike price Value

4300 1200 93 4393.0 5271600

4000 1200 48.5 4048.5 4858200
Total 10129800
Brokerage at 20paise 20259.6

Suppose lets us take the above example

I will write 24(lot) Nifty call & 24(lot) nifty put

My one time brokerage will be 48*60=2880

What is Implied Volatility

The estimated volatility of a security's price.

In general, implied volatility increases when the market is bearish and decreases when the
market is bullish. This is due to the common belief that bearish markets are more risky than
bullish markets.

Implied volatility

IV of the call

A call option is trading at $1.50 with the underlier trading at $42.05. The implied volatility of the
option is determined to be 18.0%. A short time later, the option is trading at $2.10 with the
underlier at $43.34, yielding an implied volatility of 17.2%. Even though the option's price is
higher at the second measurement, it is still considered cheaper on a volatility basis. This is
because the underlier needed to hedge the call option can be sold for a higher price.

When a IV of the put goes down with significant addition in the contract we can assume that
there is a put writing in those scrips.

May Call

Stike price Contract IV(%)

+/-
30-Apr 29-Apr
5200 +4816 23.80 23.8
5300 +4709 22.70 22.4
5400 +3149 22.30 21.7
5500 +2810 22.00 21.7

When IV of call increases we can make it out there is call writing & vice versa

When IV of put increases we can make it out there is put buying & vice versa
Just take a example

IV of Nifty 4,250 Call & 4250 Put was 15.8% & 27.7% respectively. Previous day IVS were
15.4% & 21.8% respectively for near strike options.

So it indicate that the has been put buying & call writing.In call wrting there has been been
flat rise so one wheather don’t indicate wheather it has call buying or call writing.

From IV we can indicate that Suppose if there is significant OI addition in 4300 call we can
assumed that it has been call writing.

Roll over

Just take a example

Nifty cash 4285

Nifty June future trade at a premium of 4290
Nifty July future trade at a discount of 4270

Suppose I have short June Nifty future at 4260.nifty expiry settled at 4285.so if I
want to roll over my position to July.trading at 4270 discount due to dividend
results season.

So if I rollover my position to next month I have book loss of Rs 25.and I will

again short at 4270.so I will not make till nifty future goes to 4245.
Future price = spot price +interest –dividend

Option affects option value

Call options:

Higher Market Price – higher option value

Higher strike price-lower option value
Higher volatility-higher option value
Longer time to expiry-higher option value
Higher interest rates-higher option value
Higher dividend –lower option value

Put option

Higher Market Price – lower option value

Higher strike price-higher option value
Higher volatility-higher option value
Longer time to expiry-higher option value
Higher interest rates-lower option value
Higher dividend –higher option value

Short straddle Strategies

In short straddle strategies u will Sell put & call With the same strike price to gain volatility.
You will do short straddle strategies when u can assume that there will be low volality.

Long straddle strategies

In Long straddle Strategies u will buy put & call with the same stike price to gain volatility.

You will do long straddle strategies when u assume that there is high volatility