Derivatives

DERIVATIVESPresented By:

Dhaval Dedhia (08)

INTRODUCTION• Accounting Standard 30 defines derivatives as:

A derivative is a financial instrument or other contract within the scope of this Standard with all three of the following characteristics: 

• its value changes in response to the change in 'underlying'• it requires no initial investment or an initial net investment and• it is settled at a future date.

Derivatives MarketsExchange traded :

Traditionally exchanges have used the open-outcry system, but increasingly they are switching to electronic trading

Contracts are standard there is virtually no credit risk.

Over-the-counter (OTC) :A computer- and telephone-linked network of dealers at

financial institutions, corporations, and fund managersContracts can be non-standard and there is some small

amount of credit risk

Types of Derivatives Forward

Option

Futures

Swaps

Forward Rate Agreements(FRA)

Forward Contracts Contractual Commitment to buy or sell

a specified quantity and quality of underlying asset at a future date and for a specified price.

Forward contracts are similar to futures except that they trade in the over-the-counter market.

Forward contracts are particularly popular on currencies and interest rates

Futures Contracts contract is an agreement to buy or sell

a specified quantity and quality of an underlying product at a specified date in the future, for a price agreed

Similar to forward contract

Whereas a forward contract is traded OTC, a futures contract is traded on an exchange

Types of TradersHedgers

Use derivatives to reduce risk that they face from potential future movements in the market variables

Speculators – day traders, Position traders and scalpersUse derivatives to bet on the future direction of the market

variables

ArbitrageursTake offsetting positions in two or more instruments to lock

in a profit

OptionsAn option is a contract that grants a right to the holder or

purchaser of the contract

to buy or sell an underlying asset at a specific price on a specific date or upto a specified datewithout a corresponding obligation to perform on the

contract.

The holder or the purchaser pays a premium for the right.

Types of options

Call option- The right to buy a specified amount of currency at

a specified rate.

Put option- The right to sell a specified amount of currency at

a specified rate.

ITM,ATM,OTMCall Option Put Option

1.In-the-money Strike Price less than Spot Price of underlying asset

Strike Price greater than Spot Price of underlying asset

2. At-the-money Strike Price equal to Spot Price of underlying asset

Strike Price equal to Spot Price of underlying asset

3. Out-of-the-money Strike Price greater than Spot Price of underlying asset

Strike Price less than Spot Price of underlying asset

Margin required• Initial Margin :

An Initial margin is the deposit required to maintain either a short or long position in a futures contract.

• Maintenance Margin :

Maintenance margin is the amount of initial margin that must be maintained for that position before a margin call is generated.

Basis & ConverganceBasis = Spot price – Future price

process of basis moving towards zero is Convergance.

Intrinsic value & Time valueIntrinsic value is difference between strike price and the spot

price.

Time value is the difference between premium and intrinsic value

VolatilityVolatility is a measure of the rate and magnitude of the change

of prices (up or down) of the underlying.

If volatility is high, the premium on the option will be relatively high, and vice versa.

Greeks

• Delta

• Gamma

• Vega

• Theta

DeltaThe movement of the option position relative to the movement

of the underlying position.

It is the probability of option being itm at the expiration.

At ATM delta of Call & Put is 0.5

At OTM delta is between 0 to 0.5

At ITM delta is between 0.5 to 1

GammaOptions Gamma is the rate of change of options delta with a

small rise in the price of the underlying stock.

Just as options delta measures how much the value of an option changes with a change in the price of the underlying stock, Options Gamma describes how much the options delta changes as the price of the underlying stock changes.

VegaOptions Vega measures the sensitivity of a stock option's price

to a change in implied volatility.

When implied volatility rises, the price of stock options rises along with it.

Options Vega measures how much rise in option value with every 1 percentage rise in implied volatility.

Vega is highest for ATM options, and is progressively lower as options are ITM and OTM.

Theta• Theta is that options Greek which tells you how much an

option's price will diminish over time, which is the rate of time decay of stock options.

• Time decay is a well known phenomena in options trading where the value of options reduces over time even though the underlying stock remains stagnant

• Positive Theta means that the option's value will increase as the time passes & vice-versa.

• Negative Theta means that the option's value will fall as the time passes & vice-versa.

• Theta is highest for ATM options, and is progressively lower as options are ITM and OTM.

Greeks TableLong call Long put Short call Short put

Delta Positive Negative Negative Positive

Gamma Positive Positive Negative Negative

Vega Positive Positive Negative Negative

Theta Negative Negative Positive positive

OPTION STRATEGY

INCOME STRATEGIES

COVERED CALL

BULL PUT SPREAD

BEAR CALL SPREAD

COVERED CALLDIRECTION Assset legs Max risk Max reward Strategy type

Bullish Long stock Uncapped Capped Income

Short call (OTM)

•Description: It is like collecting rent while you own a stock• Outlook : neutral to bullish (steady rise).• Greeks :

1. Delta : positive and expected to fall to zero2. Gamma: negative (net seller)3. Vega: negative (harmful for this position)4. Theta: positive (time decay is helpful for the position)

BULL PUT SPREADDirection Asset Legs Max Risk Max

RewardsStrategy Types

Bullish Long Put (FOTM)

Capped Capped Income

Shot Put (OTM)

Oulook: bullish or neutral to bullishRationale: income for a net credit while reducing your maximum risk.Greeks : Delta:Positive

Bear call spreadDirection Asset Legs Max Risk Max

RewardsStrategy Type

Bearish Short Call (ITM)

Capped Capped Income

Long Call (OTM)

Outlook: bearish or neutral to bearish. Greeks:

Delta: negativeGamma: negativeVega: positveTheta: negative

OPTION STRATEGY

VOLATILITY STRATEGIES

Straddle

Strangle

STRADDLEDirection Asset

LegsMax Risk Max

RewardsStrategy Type

Neutral Long Put (ATM)

Capped Uncapped Capital Gains

Long Call (ATM)

Outlook: movement in either directionGreeks:

Delta: highest in either directionGamma: highestVega: positive (helpful)Theta: negative (harmful)

STRANGLEDirection Asset Legs Max Risk Max

RewardsStrategy Type

Neutral Long Put (OTM)

Capped Uncapped Capital Gains

Long Call (OTM)

Outlook: huge movement expected in either direction.Greeks:

Delta: is highestGamma: positiveVega: positiveTheta: negative or harmful

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