Introduction to Equity Derivatives

WHAT IS A DERIVATIVE? There are derivative instruments available which derive their value from: INDICES COMMODITIES INTEREST RATES CREDIT CURRENCY EQUITIES/STOCK A derivative is a financial instrument which DERIVES its value from another financial product (underlying asset)

INDEX AND STOCK OPTIONS Types of Derivative instruments : 1. OTC derivatives : Customised privately negotiated instruments Interest rate, currency, commodities and credit derivatives Major players : Banks, institutions, corporates 2. Exchange traded derivatives Standardised, traded on exchange platform In India, Exchange traded Derivatives on NSE FUTURES on stocks and indices OPTIONS on stocks and indices

INDEX AND STOCK OPTIONS Worldwide, derivative products are used as RISK MANAGEMENT TOOLS. Derivatives are used for: HEDGING, ARBITRAGE and SPECULATION There has been unprecedented growth in derivatives markets. The derivative products are extensively used by MUTUAL FUNDS, HEDGE FUNDS, INSTITUTIONS AND TRADERS HEDGING SPECULATION ARBITRAGE MUTUAL FUNDS YES MINIMAL HEDGE FUNDS HEAVILY INSTITUTIONS TRADERS

INTRODUCTION TO FUTURES A FUTURE is defined as follows: BUYING FUTURES: Buying (going long) a future contract commits you to buying the underlying at a future date.      SELLING FUTURES: Selling (shorting) a future contract commits you to selling the underlying at a future date Presently, futures are cash settled in the Indian market FUTURES CONSIST OF CONTRACTS TO BUY OR SELL A SPECIFIC UNDERLYING INSTRUMENT (STOCK/INDEX) AT A SPECIFIC TIME IN THE FUTURE FOR A SPECIFIC PRICE.

FUTURES continued… Futures usually trade at a premium or a discount on the underlying stock. This premium theoretically includes the carrying costs associated with the contract for the life of the derivative. This premium or discount decreases with time and as the futures date approaches, the premium/discount becomes zero. The changes in derivative prices are governed by the change in the underlying’s prices (spot). As expiry approaches the futures and the spot prices tend to converge and futures are settled as per the closing of the spot on expiry.

INTRODUCTION TO OPTIONS An OPTION is defined as follows: THE RIGHT: To buy or sell 100, 500, 2400 (depends on the market lot) shares of a specific stock or index if turns profitable. THE EXPIRATION DATE: The date on which your right ends or expires THE EXERCISE PRICE: The price at which you can buy or sell THE OPTION PRICE: The price you paid to Buy the right. AN OPTION CONTRACT GIVES THE BUYER THE RIGHT, BUT NOT THE OBLIGATION, TO BUY OR SELL A CERTAIN NUMBER OF SHARES AT A FIXED PRICE, ON OR BEFORE A FIXED DATE.

TYPES OF OPTIONS Based on Time to Exercise American Options: Can be exercised at any time up to Expiry Date E.G. Reliance Jul 2000 PA bought on 1st Jul can be exercised on 10th Jul when RIL closes at 1800. Stock options are American Style helps to get an exit to profitable options. European options: Can be exercised only on Expiry date E.G. Nifty Jul 4300 PE bought on 1st can not be exercised on 10th Jul when Nifty is 4000. Index (Nifty) options are European style. Note : Always prefer to sell bought options than exercising.

TYPES OF OPTIONS Call options and put options Based on Right to Exercise Call options and put options BUYER SELLER CALL OPTION Right to buy Obligation to sell PUT OPTION Right to sell Obligation to buy

TYPES OF OPTIONS Based on strike price and Underlying price IN-THE-MONEY This option would result in a positive cash flow to the holder if it were exercised immediately. OUT-OF-THE-MONEY Out-of-the-money options will be worthless at expiry. AT-THE-MONEY At-the-money means the current share price is the same as the exercise price.

WHY OPTIONS With options, it is possible to trade profitably in rising, falling, or even stagnant markets. You can: Speculate on price moves. Provide insurance against a fall in price of an asset. Make short term adjustments to the composition of your portfolios exposure. Enhance portfolio returns. OPTIONS PAYOFF Unlimited Profits and limited loss when buying. Unlimited loss and limited profit when selling.

VALUING EQUITY OPTIONS Option Value/Premium Option Premium can be divided into two components: the ‘intrinsic value’, and the ‘time value’. The intrinsic value is the value by which an option is in the money. It is the difference of stock price & strike price. Intrinsic value of a call = max (0, S –X) Intrinsic value of a put = max (0, X –S) Time value Theoretically the time value inculcates the carrying costs, etc of the option. Time value is the difference between the premium & intrinsic value. As time to expiry decreases, the time value of the option will also decrease, extinguishing altogether on the final day. At expiry, options have no time value left in them.

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