Derivatives

DERIVATIVE

A product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index or reference rate ), in a contractual manner. The underlying asset can be equity , forex commodity or any other asset.

In the Indian context the securities contracts (Regulation)Act, 1956(SC(R)A) defines “Derivative” to include :
• A security derived from a debt instrument ,share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security.
• A contract which derives its value from the prices, or index of prices, of underlying securities.

TYPE OF DERIVATIVES
 Forwards
A forward contract is customized contract between two entities, where settlement takes place on a specific date in the future at today’s pre-agreed price.

 Futures
An agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contacts are special types of forward contracts in the contracts in the sense that the former are standardized exchange-traded contracts.

 Options
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 obligation to sell a given quantity of the underlying asset at a given price on or before a given date.

DIFFERENCE BETWEEN FUTURES & OPTIONS
FUTURES OPTIONS
Futures contract is an agreement to buy or sell specified quantity of the underlying assets at a price agreed upon by the buyer and seller, on or before a specified time. Both the buyer and seller are obliged to buy/sell the underlying asset. In options the buyer enjoys the right and not the obligation, to buy or sell the underlying asset.



Unlimited upside & downside for both buyer and seller
Limited downside (to the extent of premium paid) for buyer and unlimited upside. For seller (writer) of the option, profits are limited whereas losses can be unlimited.
Futures contracts prices are affected mainly by the prices of the underlying asset
Prices of options are however, affected by a)prices of the underlying asset, b)time remaining for expiry of the contract and c)volatility of the underlying asset


Call Option
Put Option

Option Buyer
Buys the right to buy the underlying asset at the Strike Price
Buys the right to sell the underlying asset at the Strike Price

Option Seller
Has the obligation to sell the underlying asset to the option holder at the Strike Price
Has the obligation to buy the underlying asset from the option holder at the Strike Price


Illustration on Call Option

An investor buys one European Call option on one share of Neyveli Lignite at a premium of Rs.2 per share on 31 July. The strike price is Rs.60 and the contract matures on 30 September. It may be clear form the graph that even in the worst case scenario, the investor would only lose a maximum of Rs.2 per share which he/she had paid for the premium. The upside to it has an unlimited profits opportunity.

On the other hand the seller of the call option has a payoff chart completely reverse of the call options buyer. The maximum loss that he can have is unlimited though a profit of Rs.2 per share would be made on the premium payment by the buyer.























Illustration on Put Options
An investor buys one European Put Option on one share of Neyveli Lignite at a premium of Rs. 2 per share on 31 July. The strike price is Rs.60 and the contract matures on 30 September. The adjoining graph shows the fluctuations of net profit with a change in the spot price.
















OPTION TERMINOLOGY (For The Equity Markets)
Options
Options are instruments whereby the right is given by the option seller to the option buyer to buy or sell a specific asset at a specific price on or before a specific date.
• Option Seller - One who gives/writes the option. He has an obligation to perform, in case option buyer desires to exercise his option.
• Option Buyer - One who buys the option. He has the right to exercise the option but no obligation.
• Call Option - Option to buy.
• Put Option - Option to sell.
• American Option - An option which can be exercised anytime on or before the expiry date.
• Strike Price/ Exercise Price - Price at which the option is to be exercised.
• Expiration Date - Date on which the option expires.
• European Option - An option which can be exercised only on expiry date.
• Exercise Date - Date on which the option gets exercised by the option holder/buyer.
• Option Premium - The price paid by the option buyer to the option seller for granting the option.

What are Index Futures?

Index futures are the future contracts for which underlying is the cash market index.
For example: BSE may launch a future contract on "BSE Sensitive Index" and NSE may launch a future contract on "S&P CNX NIFTY".

Concept of basis in futures market
• Basis is defined as the difference between cash and futures prices:
Basis = Cash prices - Future prices.
Basis can be either positive or negative (in Index futures, basis generally is negative).
• Basis may change its sign several times during the life of the contract.
• Basis turns to zero at maturity of the futures contract i.e. both cash and future prices Converge at maturity

Future & Option Market Instruments
The F&O segment of NSE provides trading facilities for the following derivative instruments:
1. Index based futures
2. Index based options
3. Individual stock options
4. Individual stock futures

Operators in the derivatives market
• Hedgers - Operators, who want to transfer a risk component of their portfolio.
• Speculators - Operators, who intentionally take the risk from hedgers in pursuit of profit.
• Arbitrageurs - Operators who operate in the different markets simultaneously, in pursuit of profit and eliminate mis-pricing

STRATEGIES OF TRADING IN FUTURE AND OPTIONS

USING INDEX FUTURES

There are eight basic modes of trading on the index future market:
Hedging
1. Long security, short Nifty Futures
2. Short security, long Nifty futures
3. Have portfolio, short Nifty futures
4. Have funds, long Nifty futures
Speculation
1. Bullish Index, long Nifty futures
2. Bearish Index, short Nifty futures
Arbitrage
1. Have funds, lend them to the market
2. Have securities, lend them to the market




USING STOCK FUTURES

1.Hedging: long security, sell future
2. Speculation: bullish security, buy Futures
3. Speculation : bearish Security, Sell Futures
4. Arbitrage: overpriced Futures: buy spot, sell futures
5. Arbitrage: underpriced Futures: sell spot, buy futures

USING STOCK OPTIONS
Hedging: Have stock, buy puts
Speculation: bullish stock, buy calls or sell puts
Speculation: bearish Stock, buy put or sell calls

BULLISH STRATEGIES

LONG CALL

Market Opinion - Bullish
Most popular strategy with investors.
Used by investors because of better leveraging compared to buying the underlying stock – insurance against decline in the value of the underlying

Risk Reward Scenario
Maximum Loss = Limited (Premium Paid)
Maximum Profit = Unlimited
Profit at expiration = Stock Price at expiration – Strike Price –Premium paid
Break even point at Expiration = Strike Price + Premium paid

SHORT PUT
Market Opinion - Bullish

Risk Reward Scenario
Maximum Loss – Unlimited
Maximum Profit – Limited (to the extent of option premium)
Makes profit if the Stock price at expiration > Strike price - premium

BULL CALL SPREAD

For Investors who are bullish but at the same time conservative

BUY A CALL CLOSER TO SPOT PRICE & WRITE A CALL WITH A HIGHER PRICE

In a market that has bottomed out, when stocks rise, they rise in small steps for a short duration. Bull Call Spread can be Used where gains & losses are limited.

CESE Spot Price = Rs.250
Premium of 260 CA = Rs.10
Premium of 270 CA = Rs. 6
Strategy – Buy 260 CA @ Rs.10 & Sell 270 CA @ Rs.6
Net Outflow = Rs.4

Stock Price at Expiration Net Profit/ Loss
250 -4
260 -4
264 0
266 2
270 6
280 6
Risk is Low & confined to Spread. Return is also limited.
While Trading try to minimize the Spread.

BULL PUT SPREAD

For Investors who are bullish but at the same time conservative
Write a PUT Option with a higher Strike Price and Buy a Put Option with a lower Strike Price
CESE Spot Price = Rs.270
Premium on Rs. 270 PA = Rs.12
Premium on Rs. 250 PA = Rs. 3
Sell Rs.270 PA and Buy Rs.250 PA
Net Inflow = Rs. 9

Stock Price at Expiration Net Profit/ Loss
230 - 11 (- 40 + 20+9)
250 - 11 ( -20+9)
270 + 9 (Net Inflow)
300 + 9 (Net Inflow – Both options expire worthless)
350 + 9 (Net Inflow – Both options expire worthless)
COVERED CALL

Neutral to Bullish
Buy The Stock & Write A Call
Perception – Bullish on the Stock in the long term but expecting little
variation during the lifetime of Call Contract
Income received from the premium on Call
CESE Spot Price = Rs.270
Premium on Rs. 270 CA = Rs. 12

Buy CESE @ Rs.270 and sell Rs. 270 CA @ Rs.12.
Stock Price at Expiration Net Profit/Loss
230 - 28 (- 40 + 12)
250 - 8 ( -20+12)
270 + 12 ( + 12)
300 + 12 (-30+30+12)
350 + 12 (-80 +80+12)
Profits are limited . Losses can be unlimited

MARRIED PUT

A person is bullish on the stock but is concerned about near term downside due to market risks.
Buy a PUT Option and at the same time buy equivalent number of shares.
Benefits of Stock ownership & Insurance against too much downside.
Maximum Profit – Unlimited
Maximum Loss – Limited = Stock Purchase Price – Strike Price + Premium Paid
Profit at Expiration = Profit in Underlying Share Value – Premium Paid

CESE :

Spot Price = Rs.270
Premium on Rs.250 PA = Rs. 3
Buy shares of CESE @ Rs.270/- and Buy Rs.250 PA @ Rs.3

Stock Price at Expiration Net Profit/ Loss

230 - 23 (- 40 + 20-3)
250 - 23 ( -20-3)
270 - 3 (Loss of Premium Paid)
300 +27 (30-3)
350 +77 (80-3)

Maximum Loss restricted to Rs.23 , Profit Unlimited



THE OPTIMAL BULL STRATEGY

LONG CALL : BULLISH BUT RISK AVERSE; INSIDER WITH LIMITED CAPITAL

SHORT PUT : LONG TERM BULLISH BUT LOOKING FOR LOWER COST.

COVERED CALL : LONG TERM BULLISH BUT NOT EXPECTING UPSIDE IN NEAR TERM

MARRIED PUT : BULLISH BUT AFRAID OF NEAR TERM DOWNSIDE RISK

BULL CALL SPREAD : MILDLY BULLISH AS WELL AS RISK AVERSE

BULL PUT SPREAD : BULLISH BUT LOOKING FOR LOWER COSTS AND SCARED OF A MAJOR FALL.

BEARISH STRATEGIES

LONG PUT
Market Opinion – Bearish
For investors who want to make money from a downward price move in the underlying stock
Offers a leveraged alternative to a bearish or short sale of the underlying stock.

Risk Reward Scenario

Maximum Loss – Limited (Premium Paid)
Maximum Profit - Limited to the extent of price of stock

Profit at expiration - Strike Price – Stock Price at expiration - Premium paid
Break even point at Expiration – Strike Price - Premium paid

SHORT CALL
Market Opinion – Bearish

Risk Reward Scenario

Maximum Loss – Unlimited
Maximum Profit - Limited (to the extent of option premium)

Makes profit if the Stock price at expiration < Strike price + premium




BEAR CALL SPREAD

Low Risk Low Reward Strategy

Sell a Call Option with a Lower Strike Price and Buying a Call Option with a Higher Strike Price


CESE Spot Price = Rs.270
Premium on Rs. 290 CA = Rs. 5
Premium on Rs. 270 CA = Rs. 12

Sell Rs.270 CA and Buy Rs.290 CA
Net Inflow = Rs. 7

Stock Price at Expiration Net Profit/ Loss

230 + 7 (Both Options expire worthless )
250 + 7 (Both Options expire worthless )
270 + 7 ((Both Options expire worthless)
300 - 13 (-30+10+7)
350 - 13 ( -80+60+7)

Maximum Possible Profit = Rs.7 & Loss = Rs.13

Limited Upside & Downside

BEAR PUT SPREAD

Again a LOW RISK, LOW RETURN Strategy

Gains as Well as Losses are Limited

BUY PUT OPTION AT A HIGHER STRIKE PRICE AND SELL ANOTHER WITH A
LOWER STRIKE PRICE

Profit Accrues when the price of underlying stock goes down.

IPCL Spot Price = Rs.260
Premium on Rs. 250 PA = Rs. 6
Premium on Rs. 230 PA = Rs. 2

BUY Rs.250 PA and SELL Rs.230 PA
Net Outflow = Rs. 4

Stock Price at Expiration Net Profit/ Loss

200 + 16 (+50-30-4)
230 + 16 (+20-4)
250 - 4 Both options expire w’thles
270 - 4 Both options expire w’thles
300 - 4 Both options expire w’thles

Maximum Possible Profit = Rs.16 & Loss = Rs.4

Limited Upside & Downside

NEUTRAL STRATEGIES

SHORT STRADDLE

WRITE CALL & PUT OPTIONS

If you expect the Stock to show very little volatility, it is worthwhile to write a call & put option.

Ashok Leyland – has been range bound for the last 3 months. You don’t expect it to move up or down too much.

Ashok Leyland Spot Price Rs. 25

Premium of Rs.25 CA Rs. 1.5
Premium on Rs.25 PA Rs. 1.5

Sell Rs.25 CA and Rs.25 PA.

Total Premium Received = Rs.3 .

Investor incurs a loss incase price drops below Rs. 22 or goes up above Rs. 28

Risky Strategy since profits limited but losses unlimited.

SHORT STRANGLE

SELL OUT OF MONEY CALL & PUT OPTIONS

CESE Spot Price = Rs.270
Premium on Rs. 250 PA= Rs.5
Premium on Rs. 290 CA = Rs.4

Sell CESE Rs. 250 PA @ Rs.5 and sell Rs.290 CA @ Rs.4.

Total Premium Received = Rs. 9

You start incurring a loss if price goes above Rs. 299 or drops below Rs. 241

VOLATILITY STRATEGIES

STRADDLE

Long Straddle

Buying a Straddle is simultaneous purchase of a CALL & PUT option for a Stock, with same expiration date & Strike Price.

Why Straddle – If you expect the stock to fluctuate wildly but unsure of the direction. Enables investors to make profits on both upward and downward fluctuation of stock. Potential gain can be unlimited

IPCL

Spot Price = Rs. 250
Premium on Rs. 250 CA = Rs. 12
Premium on Rs. 250 PA = Rs. 12

BUY Rs. 250 CA and Rs. 250 PA

You Start making profits if Price goes above Rs. 274 or goes below Rs. 226

STRANGLE
Long Strangle

Buying a Strangle is simultaneous purchase of Out of Money CALL & PUT option for a Stock, with same expiration date.

IPCL

Spot Price = Rs. 250
Premium on Rs. 270 CA = Rs. 5
Premium on Rs. 230 PA = Rs. 5


BUY Rs. 270 CA and Rs. 230 PA

Total Premium Paid = Rs. 10

You Start making profits if Price goes above Rs. 280 or goes below Rs. 220


REFER NSE WEBSITE: nseindia.com

1. S&P CNX Nifty Futures

2. S&P CNX Nifty Options

3. Futures on Individual Securities

4. Options on Individual Securities

S&P CNX Nifty Futures
A futures contract is a forward contract, which is traded on an Exchange. NSE commenced trading in index futures on June 12, 2000. The index futures contracts are based on the popular market benchmark S&P CNX Nifty index.

NSE defines the characteristics of the futures contract such as the underlying index, market lot, and the maturity date of the contract. The futures contracts are available for trading from introduction to the expiry date.
• Contract Specifications
• Trading Parameters

S&P CNX Nifty Options
An option gives a person the right but not the obligation to buy or sell something. An option is a contract between two parties wherein the buyer receives a privilege for which he pays a fee (premium) and the seller accepts an obligation for which he receives a fee. The premium is the price negotiated and set when the option is bought or sold. A person who buys an option is said to be long in the option. A person who sells (or writes) an option is said to be short in the option.

NSE introduced trading in index options on June 4, 2001. The options contracts are European style and cash settled and are based on the popular market benchmark S&P CNX Nifty index.
• Contract Specifications
• Trading Parameters


Futures on Individual Securities
A futures contract is a forward contract, which is traded on an Exchange. NSE commenced trading in futures on individual securities on November 9, 2001. The futures contracts are available on 41 securities stipulated by the Securities & Exchange Board of India (SEBI). (Selection criteria for securities)

NSE defines the characteristics of the futures contract such as the underlying security, market lot, and the maturity date of the contract. The futures contracts are available for trading from introduction to the expiry date.
• Contract Specifications
Trading Parameters


Options on Individual Securities
An option gives a person the right but not the obligation to buy or sell something. An option is a contract between two parties wherein the buyer receives a privilege for which he pays a fee (premium) and the seller accepts an obligation for which he receives a fee. The premium is the price negotiated and set when the option is bought or sold. A person who buys an option is said to be long in the option. A person who sells (or writes) an option is said to be short in the option.

NSE became the first exchange to launch trading in options on individual securities. Trading in options on individual securities commenced from July 2, 2001. Option contracts are American style and cash settled and are available on 117 securities stipulated by the Securities & Exchange Board of India (SEBI). (Selection criteria for securities)
• Contract Specifications
Trading Parameters

Derivatives - Accounting

In the books of Client
Accounting for Initial Margin
Accounting for payments/receipts in respect of initial margin is common for all types of Equity Derivative Instruments contracts.


Accounting for Equity Index Futures and Equity Stock Futures
• Accounting for payment/receipt of Mark-to Market Margin
• Accounting for Open Interests in Futures contracts as on the Balance Sheet Date

Accounting for Equity Index Futures and Equity Stock Futures (contd.)
• Accounting at the time of final settlement or squaring-up
- Index Futures and cash-settled stock futures contracts
- Delivery-settled stock futures contracts
• Accounting in case of default

Accounting for Equity Index Options and Equity Stock Options
• Accounting for payment/receipt of the premium
• Accounting for Open Interests in Options contracts as on the Balance Sheet Date

Accounting for Equity Index Options and Equity Stock Options (contd.)
• Accounting at the time of final settlement
- Index options and cash-settled stock options contracts
- Delivery-settled stock options contracts
• Accounting at the time of squaring-up of an option contract
• Method for determination of profit/loss in multiple options situation


Derivatives - Taxation
“Speculative transaction” – A transaction in which a contract for the purchase or sale or any commodity, including stocks and shares, is periodically or ultimately settled otherwise than by actual delivery or transfer of the commodity or scripts.

Eligible transaction in respect of trading in derivatives referred to in the Securities Contract (Regulation) Act carried out in a recognised stock exchange is not a speculative transaction

Eligible transaction means
(a) Transaction carried out electronically on screen based systems through a stock broker or sub-broker or such other inter-mediary in accordance with the provision of Securities Contracts (Regulation) Act, 1956, SEBI Act, 1992 or the Depositories Act, 1996.

 Such transaction can also be carried out by banks or by mutual funds.
 They should be on a recognised stock exchange.
 They should be supported by a time stamped contract note issued by such stock broker or sub-brokers or such other intermediaries to every client indicating in the contract note the unique client identity number allotted under the above mentioned Acts and PAN allotted under Income-tax Act

Turnover for section 44AB
• Derivatives, futures and option: Such transactions are completed without the delivery of shares or securities. These are also squared up by payment of differences. The contract notes are issued for the full value of the asset

• purchased or sold but entries in the books of account are made only for the differences. The transactions may be squared up any time on or before the striking date. The buyer of the option pays the premia.

• The turnover in such types of transactions is to be determined as follows:
(i) The total of favourable and unfavourable differences shall be taken as turnover.
(ii) Premium received on sale of options is also to be included in turnover.
(iii) In respect of any reverse trades entered, the differences thereon, should also form part of the turnover.