Risk Management Through Derivatives in Equity Segment ACKNOWLEDGEMENT I express my sincere gratitude to the following dignitaries for helping me and providing necessary information during various stages of project thereby making it successful. I would like to thank my external guide Mr. Sandeep Das Mohapatra (Manager Equity, Religare securities ltd. Bhubaneswar) for giving me the opportunity to work in their esteemed organization under his guidance, and helping me to complete the project in a successful manner. I am also thankful to all the staff members of Religare securities ltd. Bhubaneswar who extended their hands and cooperation directly or indirectly for successful completion of the training programme. I am obliged to my Faculty guide Prof. Ashok Ku. Rath for providing time, effort and most of all his patience in helping me for preparing this project report. I am also thankful to all the faulty members of our college for their kind cooperation with me to write this report. Last but not least I am thankful to my family members and friends for providing me moral support to do this project successfully. Date: Place: Soumya Ranjan Tripathy 1
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Risk Management Through Derivatives in Equity Segment
ACKNOWLEDGEMENT
I express my sincere gratitude to the following dignitaries for helping me and providing necessary
information during various stages of project thereby making it successful.
I would like to thank my external guide Mr. Sandeep Das Mohapatra (Manager Equity, Religare
securities ltd. Bhubaneswar) for giving me the opportunity to work in their esteemed organization
under his guidance, and helping me to complete the project in a successful manner. I am also thankful to
all the staff members of Religare securities ltd. Bhubaneswar who extended their hands and
cooperation directly or indirectly for successful completion of the training programme.
I am obliged to my Faculty guide Prof. Ashok Ku. Rath for providing time, effort and most of all his
patience in helping me for preparing this project report. I am also thankful to all the faulty members of
our college for their kind cooperation with me to write this report.
Last but not least I am thankful to my family members and friends for providing me moral support to do
this project successfully.
Date:
Place: Soumya Ranjan Tripathy
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Risk Management Through Derivatives in Equity Segment
DECLARATION
I, SOUMYA RANJAN TRIPATHY, pursing MBA (2009-11) from Regional College Of
Management Autonomus, Bhubaneswar, bearing Registration No.-0906247039, declare that the project
titled “RISK MANAGEMENT THROUGH DERIVATIVES IN EQUITY SEGMENT” is an
original work of my own and submitted to Regional College Management Autonomous for partial
fulfillment of MBA programme.
This project report has not been submitted to any other institute/university for the award of any
degree or diploma.
Date:
Place: Soumya Ranjan Tripathy
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Risk Management Through Derivatives in Equity Segment
CORPORATE GUIDE CERTIFICATE
This is to certify that the project entitled “RISK MANAGEMENT THROUGH DERIVATIVES
IN EQUITY SEGMENT” is done by SOUMYA RANJAN TRIPATHY student of RCMA
(second year) under my guidence and supervision for partial fulfillment of MBA curriculum of
Regional College Of Management Autonomous, Bhubaneswar.
To the best of my knowledge and belief the report:
1. Is an original work done by the candidate himself
2. Has been duly completed.
3. Is up to the standard both in respect to the content and language for being referred to the
examiner.
Mr. Sandeep Das Mohapatra
Manager, Equity
Religare Securities Ltd.
Bhubaneswar
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Risk Management Through Derivatives in Equity Segment
FACULTY GUIDE CERTIFICATE
This is to certify that the project entitled “RISK MANAGEMENT THROUGH DERIVATIVES IN
EQUITY SEGMENT” is done by SOUMYA RANJAN TRIPATHY, student of RCMA (second
year) under the guidance and supervision for partial fulfillment of MBA curriculum of Regional
College Of Management Autonomous, Bhubaneswar.
To the best of my knowledge and belief the report:
1. Is an original work done by the candidate himself
2. Has been duly completed.
3. Is up to the standard both in respect to the content and language for being referred to the
examiner.
Prof. Ashok Ku. Rath
H.O.D. Finance
Regional College of Management (Autonomous)
Bhubaneswar
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Risk Management Through Derivatives in Equity Segment
ABSTRACT
The emergence of the market for derivative products, most notably forwards, futures and options, can be
traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties
arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very
high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer
price risks by locking-in asset prices. As instruments of risk management, these generally do not
influence the fluctuations in the underlying asset prices. However, by locking in asset prices, derivative
products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of
risk-averse investors. The past decade has witnessed a massive growth in the use of financial derivatives
by a wide range of corporate and financial institutions. This growth has run in parallel with the increasing
direct reliance of companies on the capital market as the major source of long term funding. In this
respect, derivatives have a vital role to play in enhancing shareholder value by ensuring minimum risk of
investment.
During this project I got to know different ways or different strategies by using which investor can
minimize the loss. An individual always faces the problem as to which strategy he should use in different
market condition. During this course of Internship I had gathered a good knowledge of cash and
derivative market. This knowledge was helpful in my project to achieve the objective.
I had worked out on 14 strategies by applying which in appropriate market condition an investor can
minimize his risk/loss and even earn profit by only taking positions.
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Risk Management Through Derivatives in Equity Segment
EXECUTIVE SUMMARY
This is the report submitted by Soumya Ranjan Tripathy studying at Regional College of
Management(Autonomous), Bhubaneswar, in the partial fulfillment of the requirement of MBA
Program, carried at Religare securities Ltd, Bhubaneswar.
Religare Securities Limited is engaged in providing financial services all across the country and is one of
the most renowned broking houses in India.
The project is on RISK MANAGEMENT THROUGH DERIVATIVES IN EQUITY SEGMENT
and the objective of the project is to identify, understand and analyze the strategy which helps to
minimize the Risk in the Indian Equity Derivative Market. Using the findings depicted at the end of the
project will helpful for the investor by indicating whether to invest in the option and future or not.
Equity market reforms are a major constituent of the overall economic reforms in India and considering
the growing surge in the broking firm, the objective of the project is such set so that it will enable the
investors as well as the RMs to formulate strategies as per market trend and investor’s risk appetite.
To achieve the objectives of the project, training was undergone to gain practical knowledge and learn
about derivatives and its applications and also to know the behaviors of investor during trading hours.
The training enabled to learn the concepts of secondary market, the derivatives and the importance of
various tools that were used to undergo the activities to invest in equity market.
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Risk Management Through Derivatives in Equity Segment
CONTENTS
1. Introduction
a. Objectives of the study
b. Methodology used
2. Company profile
3. Investment
4. Equity investment
5. Secondary Market
6. Derivatives
(I) Forward contract
(II) Future contract
Futures terminology
Futures payoffs
Applications of future contract
(III)Option contract
Option contracts
Option terminologies
Option strategies
7. Findings
8. Conclusion
9. Bibliography
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INTRODUCTION
Derivative products initially emerged as hedging devices against fluctuations in commodity prices, and
commodity-linked derivatives remained the sole form of such products for almost three hundred years.
Financial derivatives came into spotlight in the post-1970 period due to growing instability in the
financial markets. However, since their emergence, these products have become very popular and by
1990s, they accounted for about two-thirds of total transactions in derivative products. In recent years,
the market for financial derivatives has grown tremendously in terms of variety of instruments available,
their complexity and also turnover. In the class of equity derivatives the world over, futures and options
on stock indices have gained more popularity than on individual stocks, especially among institutional
investors, who are major users of index-linked derivatives. Even small investors find these useful due to
high correlation of the popular indexes with various portfolios and ease of use.
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Risk Management Through Derivatives in Equity Segment
OBJECTIVE OF THE PROJECT:
To learn the basics of secondary market, it includes learning various terminologies used for day-to-day
trading.
To give an insight into derivatives and their application in Indian context.
To gain an insight into derivative trading at a broking firm
To identify, understand and analyze the strategies which help to minimize the Risk in the Indian Equity
Derivative Market in different market conditions.
To implement strategies on investor’s portfolio and measures the profit or loss as a result of
implementing the strategies.
METHODOLOGY USED
The information used for this study was collected through secondary sources whch are available for public
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Risk Management Through Derivatives in Equity Segment
COMPANY PROFILE OF RELIGARE SECURITIES LTD.
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Risk Management Through Derivatives in Equity Segment
About Religare Enterprises Ltd:
A diversified financial services group with a pan-India presence and presence in multiple international
locations, Religare Enterprises Limited ("REL") offers a comprehensive suite of customer-focused
financial products and services targeted at retail investors, high net worth individuals and corporate and
institutional clients.
REL, along with its joint venture partners, offers a range of products and services in India, including
asset management, life insurance, wealth management, equity and commodity broking, investment
banking, lending services, private equity and venture capital. Religare has also ventured into the
alternative investments sphere through its holistic arts initiative and film fund.
With a view to expand and diversify, REL operates in the life insurance space under 'Aegon Religare
Life Insurance Company Limited' and has launched India's first wealth management joint venture under
the brand name 'Religare Macquarie Private Wealth'.
REL, through its subsidiaries, has launched India's first holistic arts initiative - with a gallery - as well as
the first SEBI approved film fund, which is an initiative towards innovation and spotting new
opportunities for creation and maximization of wealth for investors.
REL operates from seven domestic regional offices, 43 sub-regional offices, and has a presence in 498
cities and towns controlling 1,837 business locations all over India & having an employee strength of
over 10000 employees.
To make a mark in the global arena, REL acquired UK-based Hichens, Harrison & Co. in 2008 which
was subsequently re-named as Religare Hichens Harrison PLC ("RHH"). Hichens, Harrison & Co. was
incorporated in London in the year 1803 and is believed to be one of the oldest firms of stockbrokers in
the City of London.
Pursuant to expansion of REL's business, the company has grown from largely an equity trading
company into a diversified financial services company. With the addition of RHH the REL group now
operates out of multiple global locations, other than India, (the UK, the USA, Brazil, South Africa, South
East Asia, Dubai and Singapore).
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Risk Management Through Derivatives in Equity Segment
Vision & Mission:
Vision: To build Religare as a globally trusted brand in the financial services domain and
present it as the ‘Investment Gateway of India'.
Mission: Providing complete financial care driven by the core values of diligence and transparency.
Brand Essence: Core brand essence is Diligence and Religare is driven by ethical and dynamic
processes for wealth creation.
Name: Religare is a Latin word that translates as 'to bind together'. This name has been chosen to
reflect the integrated nature of the financial services the company offers.
Symbol: The Religare name is paired with the symbol of a four-leaf clover. Traditionally, it is
considered good fortune to find a four-leaf clover as there is only one four-leaf clover for every
10,000 three-leaf clovers found. For us, each leaf of the clover has a special meaning. It is a symbol
of Hope, Trust, Care, & Good Fortune. For the world, it is the symbol of Religare.
The first leaf of the clover represents Hope. The aspirations to succeed. The
dream of becoming. Of new possibilities. It is the beginning of every step and the
foundation on which a person reaches for the stars.
The second leaf of the clover represents Trust. The ability to place one’s own faith
in another. To have a relationship as partners in a team. To accomplish a given
goal with the balance that brings satisfaction to all, not in the binding, but in the
bond that is built.
The third leaf of the clover represents Care. The secret ingredient that is the
cement in every relationship. The truth of feeling that underlines sincerity and the
triumph of diligence in every aspect. From it springs true warmth of service and
the ability to adapt to evolving environments with consideration to all.
The fourth and final leaf of the clover represents Good Fortune. Signifying that
rare ability to meld opportunity and planning with circumstance to generate those
often looked for remunerative moments of success.
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Risk Management Through Derivatives in Equity Segment
Hope. Trust. Care. Good Fortune. All elements perfectly combine in the
emblematic and rare, four-leaf clover to visually symbolize the values that bind
together and form the core of the Religare vision.
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Risk Management Through Derivatives in Equity Segment
Religare Enterprises Limited: Other group companies
Religare Securities Limited
Equity Broking
Online Investment Portal
Portfolio Management Services
Depository Services
Religare Commodities Limited
Commodity Broking
Religare Capital Markets Limited
Investment Banking
Proposed Institutional Broking
Religare Realty Limited
In house Real Estate Management
Company
Religare Hichens Harrison**
Corporate Broking
Institutional Broking
Derivatives Sales
Corporate Finance
Religare Finvest Limited
Lending and Distribution business
Proposed Custodial business
Religare Insurance Broking Limited
Life Insurance
General Insurance
Reinsurance
Religare Arts Initiative Limited
Business of Art
Gallery launched - arts-i
Religare Venture Capital Limited
Private Equity and Investment
Manager
Religare Asset Management*
*Religare Asset Management Company (P) Limited is a wholly owned subsidiary of Religare
Securities Limited (RSL), which in turn is a 100% subsidiary of Religare Enterprises Limited.
** Religare Hichens, Harrison plc. (RHH) is a part of Religare Enterprises Limited (REL).
Hichens, Harrison & Co. plc. (HH), established in 1803, is London’s oldest brokerage and
investment firm with a global footprint. Post its acquisition through REL’s indirect subsidiary -
Religare Capital Markets International (UK) Limited, HH has been rechristened as Religare
Hichens Harrison plc
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Risk Management Through Derivatives in Equity Segment
INVESTMENT
Investment in a general way is defined as any use of resources intended to increase future production
output or income.
In finance investment refers to the purchase or acquisition of an asset or item with a hope to get return
from it in the future. The return may be in terms of regular income or value appreciation.
In an economy, people indulge in economic activity to support their consumption requirements. Savings
arise from deferred consumption, to be invested, in anticipation of future returns. Investments could be
Index options: These options have the index as the underlying. Some options are
European while others are American. Like index futures contracts, index options contracts
are also cash settled.
Stock options: Stock options are options on individual stoc ks. Options currently trade on
over 500 stocks in the United States. A contract gives the holder the right to buy or sell
shares at the specified price.
Buyer of an option: The buyer of an option is the one who by paying the option premium
buys the right but not the obligation to exercise his option on the seller/writer.
Writer of an option: The writer of a call/put option is the one who receives the option
premium and is thereby obliged to sell/buy the asset if the buyer exercises on him. There
are two basic types of options, call options and put options.
Call option: A call option gives the holder the right but not the obligation to buy an asset
by a certain date for a certain price.
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Risk Management Through Derivatives in Equity Segment
Put option: A put option gives the holder the right but not the obligation to sell an asset by
a certain date for a certain price.
Option price/premium: Option price is the price which the option buyer pays to the option
seller. It is also referred to as the option premium.
Expiration date: The date specified in the options contract is known as the expiration
date, the exercise date, the strike date or the maturity.
Strike price: The price specified in the options contract is known as the strike price or the
exercise price.
American options: American options are options that can be exercised at any time upto
the expiration date. In India stock options are American options
European options: European options are options that can be exercised only on the
expiration date itself. European options are easier to analyze than American options, and
properties of an American option are frequently deduced from those of its European
counterpart. In Indian context Index options are European options
In-the-money option: An in-the-money (ITM) option is an option that would lead to a
positive cashflow to the holder if it were exercised immediately. A call option on the
index is said to be in-the-money when the current index stands at a level higher than the
strike price (i.e. spot price > strike price). If the index is much higher than the strike price,
the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below
the strike price.
At-the-money option: An at-the-money (ATM) option is an option that would lead to zero
cashflow if it were exercised immediately. An option on the index is at-the-money when
the current index equals the strike price (i.e. spot price = strike price).
Out-of-the-money option: An out-of-the-money (OTM) option is an option that would
lead to a negative cashflow if it were exercised immediately. A call option on the index is
out-of-the-money when the current index stands at a level which is less than the strike
price (i.e. spot price < strike price). If the index is much lower than the strike price, the
call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the
strike price.
Intrinsic value of an option: The option premium can be broken down into two
components - intrinsic value and time value. The intrinsic value of a call is the amount the
option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it another
way, the intrinsic value of a call is Max[0, (St — K)] which means the intrinsic value of a
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Risk Management Through Derivatives in Equity Segment
call is the greater of 0 or (St — K). Similarly, the intrinsic value of a put is Max[0, K —
St],i.e. the greater of 0 or (K — St). K is the strike price and St is the spot price.
Time value of an option: The time value of an option is the difference between its
premium and its intrinsic value. Both calls and puts have time value. An option that is
OTM or ATM has only time value. Usually, the maximum time value exists when the
option is ATM. The longer the time to expiration, the greater is an option's time value, all
else equal. At expiration, an option should have no time value.
FACTS RELATING TO OPTION
1. Option gives its holder the right to buy an underlying asset.
2. The buyer of the option simply has the right to and not obligation to sell the underlying asset.
3. The seller of the option is obligated to deliver the underlying asset (call) or take delivery of the
underlying asset (put) at the strike price of the option regardless of the current price of the underlying
asset if the option is exercised.
4. Options are good for a specified period of time, after which they expire and the holder loses the right
to buy or sell the underlying instrument at the specified price.
5. Options when bought are done so at a debit to the buyer.
6. Options when sold are done so by giving a credit to the seller
7. Options are available in several strike prices representing the price of the underlying instrument.
8. The cost of an option is referred to as the option premium. The price reflects a variety of factors
including the current price of the underlying asset, the strike price of the option, the time remaining until
expiration, and volatility.
9. Options are not available on every stock. There are approximately 2,200 stocks with tradable options.
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Risk Management Through Derivatives in Equity Segment
OPTION STRATEGIES
BUY CALL
Strategy View Investor thinks that the market will rise significantly in the short-term.
Strategy Implementation Call options are bought with a strike price of a. The more bullish the investor
is, the higher the strike price should be. By this strategy, the downside risk is avoided
PAY OFF FROM BUY CALL (RELIANCE CAPITAL)
Price of Rel Cap on 1st June 2010 Rs 652.56.
The stock is expected to increase up to Rs 765 in
Short term.
So buy a call option of Rel cap with a strike price
Of Rs 720 of the maturity 24 June.
Premium paid for the option – Rs 37.50
Exercise the option on 21 June 2010 as on 21 june, the price of the scrip touched Rs 766.05
Payoff = 766.05-(720+37.50)
Rs 8.55(profit)
This strategy has an unlimited profit potential as the diagram depicts but the loss is limited upto the premium amount paid. The strategy works in a bullish market.
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a
Profit
Loss
Stock Price
Buy call
Profit/Loss
Risk Management Through Derivatives in Equity Segment
BUY PUT Strategy View - Investor thinks that the market will fall significantly in the short-term. .
Strategy Implementation - Put option is bought with a strike price of E. The more bearish the investor
is, the lower the strike price should be.
EXAMPLE
Option premium to be paid – Rs7.50*100 = Rs750
Amount to be received for selling shares = Rs110*100 = Rs11000
If market value of the underlying share will be Rs100 then
Profit/Loss = 11000-(10000+750) = 250(profit)
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E Stock price
Profit
Loss
Buy Put
Profit/loss
Risk Management Through Derivatives in Equity Segment
This strategy gives increaing profit with decrease in price. As the diagram depicts the loss is limited upto the premium amount paid. The strategy works in a bearish market.
SELL CALL
Strategy View Investor is certain that the market will not rise and is unsure/ unconcerned whether it will
fall.
Strategy Implementation Call option is sold with a strike price of E. If the investor is very certain of his
view then at-the-money options should be sold, if less certain, then out-of-the-money ones should be
sold.
EXAMPLE
Option premium to be received – Rs10.00*100 = Rs1000
Amount to be received for selling shares = Rs150*100 = Rs15000
If market value of the underlyned share will be Rs140, then the buyer will not exercise the contract.
Exercise Price 150
Size of the contract 100 shares
Price of the share on the date of contract 144
Price of option on the date of contract 10
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Risk Management Through Derivatives in Equity Segment
Hence Profit/Loss will be the premium received = 100*10 = 1000(profit)
This strategy has a limited profit potential upto the amount of premium received as the diagram depicts but the loss is unlimited with the increase in stock price. The strategy works when the investor is not bullish.
SELL PUT
Strategy View Investor is certain that the market will not go down, but unsure/unconcerned about
whether it will rise.
Strategy Implementation Put options are sold with a strike price E. If an investor is very bullish, then
in-the-money puts would be sold.
EXAMPLE
Exercise price Rs110
Size of the contract 100 shares
Price of the put option on the date of the contract Rs7.5
Option premium to be received – Rs7.50*100 = Rs750.
Amount to be paid for buying shares = Rs110*100 = Rs11000
If market value of the underlyned share will be Rs100, then the buyer will exercise the contract.
Hence Profit/Loss will be the premium received = (100*100)+750-11000 = 250(loss)
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E Stock price
Profit
Loss
Sell Call
Risk Management Through Derivatives in Equity Segment
Possible prices of the share Investor Position
80 -2250
90 -1250
100 -250
110 750
120 750
130 750
140 750
Stock pricce Payoff from short put Total pay off Net profit=
Payoff + premium
S1>110 0(Not exercised) 0 Rs7.50
S1=102.50 102.50 – 110 - 7.50 -7.50+7.50=0
S1<102.50 X<102.50-110
This strategy has a limited profit potential as the diagram depicts but the loss is unlimited upto the amount increase in stock cash market price. The strategy works when the investor is not bearish.
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E
Stock price
Profit
Loss
Sell Put
Risk Management Through Derivatives in Equity Segment
BULL SPREAD (CALL)
Strategy View Investor thinks that the market will not fall. It is a Conservative strategy for one who
thinks that the market is more likely to rise than fall.
Strategy Implementation It involves having two calls on the same stock with same expiry date but with
different exercise prices. Call option is bought with a strike price below the stock price and another call
option sold with a strike price above the stock price.
PAY OFF FROM BULL SPREAD (SIEMENS) WITH CALL
Price of Siemens on 1st June 2010 Rs 684.
The stock is expected to increase up to Rs 735 in Short term.
So buy a call option of 24 June with a strike price of Rs 680 – premium paid Rs 104.90
& sell a call option with same maturity date with a strike price of 700 – premium received Rs 29.00.
Initial outlay = 29 – 104.90 = -76.10
Exercise the option on 23 June 2010 as on 23 June, the price of the scrip touched Rs 738.
Payoff from bought call = 738 -680 = 58
Payoff from sold call = 700-738 = -38
Total payoff = 58 - (76.10+38) = Rs 56.10(loss)
This strategy minimizes the loss up to the amount of initial outlay due to difference in premium
paid amount and received amount. The profit is also limited.
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a
Stock price
Profit
Loss
Bull Spread (Call)
b
Profit/loss
Risk Management Through Derivatives in Equity Segment
BULL SPREAD (PUT)
Strategy View Investor thinks that the market will not fall, but wants to minimize the risk. It is a
conservative strategy for one who thinks that the market is more likely to rise than fall.
Strategy Implementation It involves writing put b at a higher strike price and buying a put a with a
lower strike price.
PAY OFF FROM BULL SPREAD (AXIS BANK) WITH PUT
Price of Axis Bank stock on 1st June 2010 Rs 1180.
The stock is expected to increase up to Rs 1250 in Short term.
So buy a put option with maturity 29 July with a strike price of Rs 1100 – premium paid Rs 18.05
& sell a put option with same maturity date with a strike price of 1250 – premium received Rs 41.00.
Initial payoff = 41.00 – 18.05 = 22.95
Exercise the option on 29 July 2010 as on 23 June, the price of the scrip touched Rs 738.
Payoff from bought call = 0
Payoff from sold call = 0
Total payoff = 22.95(loss)
This strategy gives protection from downside risk as loss of sold put gets adjusted with profits from
bought put and the strategy gives usually an initial inflow of premium which is a clear profit in an
increasing market.
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a
Stock price
Profit
Loss
Bull Spread (Put)
b
Profit/loss
Risk Management Through Derivatives in Equity Segment
BEAR SPREAD (CALL)
Strategy View Investor thinks that the market will not rise, but wants to minimize the risk. It is a
conservative strategy for one who thinks that the market is more likely to fall than rise.
Strategy Implementation Call option is sold with a lower strike price of ‘a’ and another call option is
bought with a higher strike of ‘b’
PAY OFF FROM BEAR SPREAD (PATNI) WITH CALL
Price of Patni stock on 2nd June 2010 = Rs 577.
The stock is expected to be bearish in Short term.
1. Buy a call option with maturity 29 July with a strike price of Rs 600 – premium paid Rs 03.50
2. Sell a call option with same maturity date with a strike price of Rs 540 – premium received Rs
09.75.
Initial payoff = 09.75 – 03.50 = 06.25
Exercise the option on 24th June 2010. Stock price on 24th june = Rs 505
Payoff from bought call = 0 (as the option will not be exercised)
Payoff from sold call = 0 (as the option will not be exercised)
Total payoff = 06.25 (profit)
This strategy involves very less risk in a bearish outlook. In this strategy both profit and loss gets
limited thus provides a hedge against risk.
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a
Stock price
Profit
Loss
Bear Spread (Call)
b
Profit/loss
Risk Management Through Derivatives in Equity Segment
BEAR SPREAD (PUT)
Strategy View Investor thinks that the market will not rise, but wants to minimize the risk. Conservative
strategy for one who thinks that the market is more likely to fall than rise.
Strategy Implementation Put option is sold with a lower strike price of a and another put option is
bought with a strike of b
PAY OFF FROM BEAR SPREAD (BPCL) WITH PUT
Price of BPCL stock on 1st June 2010 = Rs 583.
The stock is expected to be bearish in Short term.
1. Option 1 - Sell a put option with maturity of 24th June with an exercise price of Rs 580 –
premium received Rs 79.50.
2. Option 2 - Buy a put option with same maturity date with an exercise price price of Rs 600 –
premium paid Rs 95.60.
Initial payoff = 79.50 – 95.60 = (-16.10)
Exercise the option on 24th June 2010. Stock price on 24th june = Rs 550.05
Payoff from put-1 = 550.05-580 = (-29.95)
Payoff from Put-2 = 600-550.05 = 49.95
Net payoff = 49.95- (16.10+29.95) Rs 03.90(profit)
.
BUY STRADDLE (LONG STRADDLE)
50
a
Stock price
Profit
Loss
Buy StraddleProfit/loss
Risk Management Through Derivatives in Equity Segment
Strategy view Where the Investor expects a sharp movement in the share price, but unsure of direction, it
is an appropriate strategy.
Strategy implementation long straddle involves buying a Call & a Put at the same exercise price and for
the same tenure. A buyer of the Straddle buys both call & the put.
IF END STOCK IS CALL PAYOFF PUT PAYOFF NET PAYOFF95 0 5 -496 0 4 -597 0 3 -698 0 2 -799 0 1 -8100 0 0 -9101 1 0 -8102 2 0 -7103 3 0 -6104 4 0 -5105 5 0 -4
In this strategy maximum loss can be the amount of total premium paid for the call and put where
as the amount of profit can be unlimited as the diagram indicates.
SHORT STRADDLE
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Risk Management Through Derivatives in Equity Segment
Strategy view: Investor thinks that the market will be not be very volatile in the short-term. It is a
strategy for relatively stable stock. A short straddle works whenever the price remains within the band.
Strategy implementation: A short straddle involves selling both the call and the put.
PAY OFF FROM SHORT STRADDLE (JP ASSOCIATE)
Price of BPCL stock on 1st June 2010 = Rs 117.6.
The stock is a relatively less volatile one.
1. Option 1 - Sell a call option with maturity of 29th July with an exercise price of Rs 130 –
premium received Rs 06.00.
2. Option 2 - Sell a put option with same maturity date and exercise price – premium paid Rs 05.55.
Initial payoff = 06.00 + 05.55 = Rs 11.55
Exercise the option on 22nd July 2010. Stock price on 22nd July Rs 131.50
Payoff from option-1 = 130.00-131.50 = (-01.50)
Payoff from option-2 = 0 option will not be exercised.
Net payoff = 11.55-01.50Rs 10.05(profit)
This strategy gives a limited profit of total premium received for both the option sold but the loss can be unlimited. So this strategy is risky and maximum precaution should be taken while adopting this strategy.
BUY STRANGLE
52
a
Stock price
Profit
Loss
Sell StraddleProfit/loss
Risk Management Through Derivatives in Equity Segment
Strategy view: Investor thinks that the market will be very volatile in the short-term.
Strategy implementation: This is identical to the straddle except that the call has an exercise price
above the stock price and the put has an exercise price below the stock price and the premium paid is
less.
PAY OFF FROM BUY STRANGLE (TATA STEEL)
Price of Tata Steel stock on 1st June 2010 = Rs 493.17.
The stock shows a high volatility in the short term.
1. Option 1 - Buy a call option with maturity of 24th June with an exercise price of Rs 480.00 –
premium paid Rs 14.25.
2. Option 2 – Buy a put option with same maturity date and exercise price of Rs 500.00 – premium
paid Rs 01.05.
Initial outlay = -(14.25 + 01.05) = -15.30
Exercise the option on 24th June 2010. Stock price on 24th June Rs 501.12
Payoff from option-1 = 501.12-480.00 = 21.12
Payoff from option-2 = 0 option will not be exercised.
Net payoff = 21.12-15.30Rs 05.82(profit)
In this strategy maximum loss can be the amount of total premium paid for the call and put where
as the amount of profit can be unlimited as the diagram indicates.
SELL STRANGLE53
a
Stock price
Profit
Loss
Buy Strangle
Profit/lossFrom put option
b
Profit/lossFrom call option
Risk Management Through Derivatives in Equity Segment
Strategy view: The investor thinks that the market will not be volatile within a broadish band.
Strategy implementation: This is identical to the straddle except that the call has an exercise price
above the stock price and the put has an exercise price below the stock price and the premium paid is
less.
PAY OFF FROM SELL STRANGLE (SUZLON)
Price of Suzlon stock in June 2010 = Rs 55.6.
The stock shows a relative stability in the short term.
1. Option 1 - Sell a call option with maturity of 24 th June with an exercise price of Rs 60.00 –
premium received Rs 00.60.
2. Option 2- Sell a put option with same maturity date and exercise price of Rs 50.00 – premium
received Rs 00.05.
Initial payoff = 00.60+00.05 = 00.65
Exercise the option on 24th June 2010. Stock price on 24th June Rs 57.65
Payoff from option-1 = 0 (option will not be exercised).
Payoff from option-2 = 0 (option will not be exercised).
Net payoff = 00.65(Profit)
This strategy gives a limited profit of total premium received for both the option sold but the loss can be unlimited. So this strategy is risky and maximum precaution should be taken while adopting this strategy.
54
a
Profit
Loss
Sell Strangle
Profit/lossFrom put option
b
Profit/lossFrom call option
Risk Management Through Derivatives in Equity Segment
BUTTERFLY SPREAD
Strategy view: This strategy hopes that the price will remain within a steady range , but does not want
exposure to an unexpected rise or fall.
Strategy implementation: This involves the following;-
1. Buying a call at low exercise price
2. Buying a call at higher exercise price
3. Selling two calls at an intermediate price.
PAYOFF OF BUTTERFLY SPREAD (UNITECH)
Price of Suzlon stock in June 2010 = Rs 69.00.
1. Option 1 - Buy a call option with maturity of 24th June with an exercise price of Rs 65.00 –
premium paid Rs 10.00.
2. Option 2- Buy another call option with same maturity date and exercise price of Rs 75.00 –
premium paid Rs 00.05.
3. Option 3&4- Sell two calls with the same maturity of intermediate strike price of
Rs 70.00 – premium received 2*4.35 = Rs 08.70
Initial payoff = 08.70-(10.00+00.05) = -01.35
Exercise the option on 23rd June 2010. Stock price = Rs 76.45
Payoff from option-1 = 76.45- 65.00 = Rs 11.45
Payoff from option-2 = 76.45- 75.00 = Rs 01.45
Payoff from option-3&4 = 2*(70.00- 76.45) = -12.90
Net payoff = 01.35(Loss)
In this strategy there is very minimum risk and limited profit. This strategy should be used when
proper strike prices are available to make this strategy.
FINDINGS
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Risk Management Through Derivatives in Equity Segment
BULLISH STRATEGIES
A. Buy Call: This strategy is very easy to implement and give good amount of return if price
increase. Here maximum loss is only the premium paid.
B. Buy Futures: Futures has given large amount of profits as compared to options
strategies but at the same time risk associated with it also very high.
C. Bull Spread (Call): It provides limited profits and limited loss. If Index/ Scrip goes up
then one can have profits and vice-versa. This strategy should be use when expected
volatility in the market is less.
D. Bull Spread (Put): It provides limited profit and limited loss. The maximum gain can be
net premium received in this strategy.
E. Sell Put: In this strategy maximum profit is premium received and loss is unlimited. If
a person expects bullish view then he may go with this strategy but this strategy is quite
risky.
NEUTRAL STRATEGIES
F. Buy Straddle: This strategy should only be used when expected volatility is very high and
market outlook is not known. If scrip remains at the same price then loss will be maximum.
G. Buy Strangle: This strategy should be used in very volatile market.
H. Sell Strangle: This strategy should be used when volatility is very less.
I. Long Butterfly: In this strategy there is very minimum risk and limited profit. This strategy
should be used when proper strike prices are available to make this strategy.
J. Short Butterfly: This strategy led to profit when volatility is very high in the option
market.
K. Sell Straddle: When investor want more returns at higher risk then he may go with this
strategy. IF suddenly the volatility increases at a very high rate then huge losses may occur.
BEARISH STRATEGIES
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Risk Management Through Derivatives in Equity Segment
L. Buy Put: This strategy should be used when investors perceive that the option price will
go down.
M. Sell Future: This strategy can be use to hedge or it can be use as a speculative
strategy when option market is expected to fall.
N. Bear Spread (Put) & Bear Spread (Call): This strategy involves very less risk & bearish
outlook. So for those investors who expect the option prices will go down but they are not
sure about it then they may use this strategy.
O. Sell Call: In this strategy maximum profit earned and maximum loss is unlimited. So
less risk takers should select very lower strike price while selecting this strategy.
CONCLUSION AND RECOMMENDATIONS
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Risk Management Through Derivatives in Equity Segment
Although derivative market is growing in a faster rate still it is not so popular in Indian financial market.
Due to lack of awareness or risk averseness, Indian investors don’t show interest to use derivatives to
hedge in equity market. Notwithstanding the endorsement of derivatives by financial economists and
business persons, there is a widespread belief among regulators, bureaucrats and politicians that
derivatives are employed mainly for speculation purposes, and they accentuate the volatility of the
underlying cash markets.
Many in the profession, however, disagree vehemently with the view that derivatives accentuate
volatility in the cash markets. On the contrary volatility in the underlying cash market declines with the
introduction of derivatives. Since hedging opportunities prove valuable only if the underlying cash
markets are volatile, derivatives are introduced only when the underlying asset prices become more
volatile.
After studying about financial derivatives and different derivative strategies following
recommendations are suggested:
Many strategies like straddle, strangle and butterfly depend upon volatility of scrip or
index and give returns accordingly. So volatility should be forecasted before forming any
strategy.
Fundamental and Technical analysis of the scrip or index should be done before
formulating any strategy.
Specific strategy should be used according to the purpose of investor instead of investing
haphazardly in futures and options.
Derivative market is highly ill- famed among the investor. Thus it is required to provide
in depth knowledge of the market to investors.
Strategies should be evaluated daily for better returns and less risk.
Theoretical price of an option should be found out using option pricing models and
those options whose price is less than theoretical price should be used for formulation
of strategy.
By using a hedging strategy an investor can recover some of his losses and can also make
profit.
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Risk Management Through Derivatives in Equity Segment
When the movement and volatility of market or scrip is not known at that time
investor should use hedging strategies.
Investor should make strategy according to position in the cash market and accordingly
make strategy.
BIBLIOGRAPHY
Books
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Risk Management Through Derivatives in Equity Segment
(a) Options, futures and Other Derivatives by JOHN C. HULL
(b) NCFM Derivative Market (dealers) Module
(c) Future and Option‖ second edition Tata McGraw- Hill by N D VOHRA, B R Bagri