Derivative Applications

Submitted to:-
Dr. Harsh Purohit
Reader, FMS
WISDOM
THE TERM DERIVATIVE….

 A derivative is a contract whose value is derived from the value of

another asset, known as the underlying, which could be a share ,a
stock price ,a stock market index ,a commodity, or a currency.

 “A derivative can be defined as a financial instrument whose value

depends on (or derives from) the values of other, more basic
underlying variables. By- John C. Hull
Derivatives: Risk Management Tool
Derivatives are financial instruments that are used as risk
management tools. They help in transferring risk from the risk averse
to the risk taker.

Participants in the Derivatives Markets

Foreign institutional investors (FIIs)
Individuals
Banks
Firms
DERIVATIVE PRODUCTS
 Forwards
 Futures
 Options
 Swaps

FUTURE CONTRACT
A future contract is exchange traded forward contract to buy or
sell a predetermined quantity of an asset on a pre determined
future date at a predetermined price.
FUTURES TERMINOLOGY

 Long
 Short
 Spot price
 Futures price
 Expiry date
 Basis
 Margin
 Marked to market
HEDGING WITH STOCK AND INDEX
FUTURE
Long stock ,short index future:
Investor thinks that the stock is intrinsically undervalue so he takes a
long position in a stock plus short position in index.

Case:
An investor buys 100 shares of Reliance@ Rs 200 each and
hedges by shorting 300 Nifties @ Rs 992 each.
Reliance has dropped by 5% and Nifty future have dropped by4% at
the closing price of next day.
His reliance position loses Rs 10,000(Rs 2,00,000-Rs 1,90,000) and
his short position of the Nifty earns him Rs 11,904(Rs 2,97,600-Rs
2,85,696)

OVERALL PROFIT= Rs 1,904.(Rs 11,904-Rs 10,000)

Short stock,long index future:
Investor thinks that the stock is intrinsically overvalue so he takes a
short position in the cash market and long position in index.

Case:
An investor who sells 1,000 shares of reliance @ Rs 200 each and
hedges by buying 3oo Nifties @ Rs 992 each.
Reliance has risen by 5% and Nifty future have risen by 4% at the
closing price of next day.
His reliance position loses Rs 10,000 and his long position of the
Nifty earns him Rs 11,904

OVERALL PROFIT= Rs 1,904

OPTION BASED HEDGING STRATEGIES

Types of options
 Call option
 Put option

Bullish Strategies
For trader who believes that stock’s prices will increase

Bearish strategies
For trader who believes that stock’s prices will decrease
Bullish strategies
Assumption: 1 contract is of 1000 shares
Long call
Purchase of call option
Expectation: To make profit from expected increase in the price of an
underlying share during the option’s life
Situation: 1st Nov L&T at Rs254,Jan 260(strike price) call cost Rs14
Action: Buy one L&T call at 14

Share price 300 Gain: (300-260)1000 = 40000

Premium paid = 14000
Net profit = 26000

Share price < 260 Option Expires worthless

The loss is Rs 14000 (premium)
Short put
Sale of put option
Expectation: To generate earnings on portfolio of shares
Situation: An investor owns 10000 shares of NIIT and in early march
he feels that share prices will either remain constant or rise.
Action : Investor writes 10 NIIT 550 puts at Rs 40,premium received
is 4,00,000

Share price =/> 550 Put will expire without being

exercised. Initial income remains as profit.

Share price < 550 Put option will be exercised, stock

will be purchased for 51,00,000
(55,00,000-4,00,000)
Bearish strategies
Assumption: 1 contract is of 1000 shares

Short call
Sale of call option
Expectation: To earn additional income from a static share holding in terms
of premium received on writing an option.
Situation: 1st Nov L&T share is trading at Rs 254,investor holds 10,000
shares and does not expects their prices to move much over
next few months.
Action: Jan 260 calls are trading at 14 and investor sells 10 contracts
and receives an option premium of 1,40,000

Share price >260 Holder will exercise his call option

writer will sell shares at 274 (260+14)
Share price < 260 Option expires worthless
Long Put
Purchase of put option
Expectation: To gain profit from fall in values of share price
Situation: L&T currently trading at 270 is overvalued and may fall
substantially.
Action: Buy 1 L&T Oct 260 Put at Rs 8 for total consideration of Rs 8000

Share price 240 Gain: (260-240)1000 = 20000

Premium paid = 8000
Net profit = 12000
Share price > 260 Option expires worthless
ADVANCED TRADING STRATEGIES
Long straddle
Simultaneous purchase of a call and put
with same exercise price and expiry date

Expectation- Anticipating significant volatility in in the underlying

asset but uncertain abut the direction

Situation- Buy 1 L&T June 260 call @ Rs 21

Buy 1 L&T June 260 put @ Rs. 19
Upside breakeven= 290 (exercise price 260 + net debit 30)
Downside breakeven = 230 (260-30 net debit)

Share price > 260 Call option is exercised

Profit = I.V 260 call- premium paid
Share price < 260 Put option is exercised
Profit= I.V 260 put- premium paid
Short straddle

Simultaneous sale of a call and put option with

the same exercise price and expiry date

Expectation- Spot price will be very close to the strike price and the
underlying asset will trade between the two breakeven points
Situation- Sell 1 L&T June 260 call @ Rs 21,
Sell 1 L&T June 260 put @ Rs. 9
Upside breakeven- 290 (exercise price 260+ net credit 30)
Downside breakeven- 230 (260- 30 net credit)

Share price between 230 - 290 Profit: 30 (maximum)

Both call and put option goes
worthless
Share price > 290 or < 230 Unlimited loss in both the
directions
Long strangle
Simultaneously buy one call at strike price above stock
price and put option at strike price below stock price

Expectation- Volatility in the prices, but uncertain about the direction.

Situation- Current stock price of L&T -247
Buy 1 L&T June 260 call @ Rs. 12
Buy 1 June 240 put @ Rs. 10
Upside breakeven= 282 (exercise price 260 + net debit 22)
Downside breakeven= 218 (240 – net debit 22)

Share price > 260 Call option exercised

Share price 240-260
Stock price< 240
Profit= I.V 260 call- premium paid
Both call and put goes worthless
Loss= Rs. 22 (maximum)
Put option exercised
Profit= I.V 240 put – premium paid
 Short strangle
Simultaneously sell one call at strike price above stock
price and put option at strike price below stock price

Expectation- Spot prices will move marginally or be less volatile.

Situation- Current stock price of L&T – Rs. 247

Sell 1 L&T June 260 call @ Rs. 12
Sell 1 L&T June 240 put @ Rs. 10
Upside breakeven- 282 (exercise price 260 + net debit 22)
Downside breakeven- 218 (240 – 22 net debit)
Share price > 260 Call is exercised by option holder
Seller delivers the stock at 282 (260+22)

Share price 240- 260 Both call and put will expire worthless.
Profit: Rs. 22 retained (maximum)
Share price < 240 Put is exercised by option holder.
Seller takes the delivery of stock at 218
BENEFITS OF USING DERIVATIVES
 Risk management
 Trading efficiency
 Speculation
 Price discover
BIBLIOGRAPHY
 Options, futures, and other derivatives
By- John C. Hull
 The Indian financial system
By- Bharati V. Pathak
 Demystifying Financial Derivatives
By- Anagram stockbroking Ltd.
 Derivatives Market (Dealers) Module- NCFM
 Currency Derivatives: A Beginner’s Module- NCFM
Queries Please !!!

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