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Demystifying Derivatives
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DerivativesDerivatives -- IntroductionIntroduction
Derivatives are wasting assets, which derive their values from an
underlying asset. These underlying assets are of various categories
like
Stocks (Equity)
Agri Commodities including grains, coffee beans, etc. Precious metals like gold and silver.
Foreign exchange rate
Bonds
Short-term debt securities such as T-bills
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No counter party risk
Standardization of contracts
Liquidity
Mark to Market (MTM) margining system
Trade is judged on basis of OPEN Interest
Squared off in cash on expiration.
Three series trade at any point in time.
Contract expires on last Thursday of the month.
DerivativesDerivatives -- FeaturesFeatures
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Types of Derivatives
Forwards Futures
OptionsSwaps
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A Forward Contract is a transaction in which the buyer and the seller
agree upon a delivery of a specific quality and quantity of asset usually
a commodity at a specified future date. The price may be agreed on in
advance or in future.
Forward Contract
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It involves an obligation on both the parties i.e the buyer and
the seller to fulfill the terms of the contract (i.e. these are pre-
determined contracts entered today for a date in the future)
Future Contract
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Features Forward Futures
Operational
Mechanism
Not traded on exchange Traded on exchange.
Contract Specifications Differs from trade to
trade.
Contracts are standardized
contracts.
Counterparty Risk Exists. Exists, but assumed by
Clearing Corporation/
house
Liquidation Poor Liquidity as
contracts are tailor made
contracts
Very high Liquidity as
contracts are standardized
contracts.
Profile Price Discovery Poor; as markets are
fragmented.
Better; as fragmented
markets are brought to the
common platform.
Distinguishing Features b/w Forward and Future
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SWAPS
A Swap transaction is simultaneously buying or selling of same
underlying asset or obligation of equivalent capital amount where the
exchange of financial arrangement provides both parties to the
transaction with more favorable condition than they would otherwise
expect.
Interest rate Swaps
Currency Swaps
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OPTIONS
An Options contract confers the right but not the obligation to buy
(call option) or sell (put option) a specified underlying instrument or
asset at a specified price the Strike or Exercised price up until or
an specified future date the Expiry date.
The Price is called Premium and is paid by buyerof the option to the seller orwriter
of the option.
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Types ofOption
Buy Sell
Call Right to buy an
asset
Obligation to sell
an asset
Put Right to Sell an
asset
Obligation to
buy an asset
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Nature ofOption
ITM ATM OTM
CALL S > K3100 >3000
S = K
3100 = 3100
S < K
3100 < 3200
PUT S < K
3100 < 3200
S = K
3100 = 3100
S > K
3100 > 3000
Index= Nifty Index
Spot (S) = 3100
Strike (K) = 3000,3100,3200
Expiry= 29Jan2008
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Long Call
Short Call
Long Put
Short Put
Loss Limited
Loss Limited
Profit Limited Profit Limited
OptionPay-off
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Derivatives Jargon
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Open Interest
A number of contracts outstanding at a given point of time
Open Interest New contract is traded
Open Interest Existing party squares of the position
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Open Interest cont Ex.
Trade in Infosys futures on 6th January 2009
Time Trader Trade Change Net OI
04th Jan 2009 Mr. A
Mr. B
Buy 2 Futures
Sells 2 Future
2
05th Jan 2009 Mr. B
Mr. C
Buy 2 Futures
Sells 2 Futures
= 2
05th Jan 2009 Mr. D
Mr. E
Sells 4 Futures
Buys 4 Futures
6
06th Jan 2009 Mr. E
Mr. A
Sells 2 Futures
Buys 2 Futures
4
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Open Interest Cont
OI as an Indicator
OPEN INTEREST PRICE OUTLOOK
POSITIVE
NEGATIVE
POSITIVE
NEGATIVE
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BASIS
The difference between the prevailing spot price of an asset and thefutures price
Spot price - Future price
A function of Cost of carry
Contango Market Spot price < Futures price
Backwardation market or Inverted Spot price > Future price
F = Se ( r*t)
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Historical Volatility
Historical Volatility is a statistical measure of the volatility of a futures
contract, security, or other instrument over a specified number of past
trading days
Implied Volatility
Implied Volatility can be defined as the volatility of an instrument as implied by the
prices of an option on that instrument, calculated using an options pricing model
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Option Strategies
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SPREADSSTRATEGY
Bull Spread
(A) Buying a lowerStrike call and Selling a higher strike call
(B) Buying a lowerStrike Put and Selling a higher strike put
(A) Buying a lowerStrike call and Selling a higher strike call
Investor : Ms Kiran
Stock : BPCL
Spot price : 348.00
Buy ATM Call 350 11
Sell OTM Call 380 3
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Long call Short call
Hedged position
Stock price
350 380 383361
Profit
Loss
0
22
-8
DIAGRAMFOR BULL SPREAD (CALL)
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Protective Put
Long position, Buy putInvestor : Mr. Sharma
Current holding : 1000 DLF @ 290
Sentiment: Bullish for the stock
Sceptism: Market may move down
Trading strategy
Buy 1000 OTM PUT OF 280
Premium Rs. 14Profit :
Unlimited
above
breakeven
Loss:
Limited
(X-S) + (P) =
(280-290)+(-14)= -24
Break even:
S+(S-X) + (P)
=
290+(290-280)+14
= 304
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Payoff of put option
Payoff of longposition
Payoff of hedgedposition
290280 304
LONGPOSITION , BUYPUT
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Covered Call
Buying a Stock, Writing a call
Investor: Mr. Mehta
Position: Long 300HDFC BANK980
Strategy: Write 30029JAN2008 call at 1020
Premium inflow:20
Profit: Limited to (X-S) + P i.e. (1020-
980) +20 = 60
Loss: Unlimited if market moves
downwards
Breakeven
: S-P = 980-20 =960
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COVERED CALL STRATEGY
980 1020
Short Call
Long Stock
Hedge position
10601040
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Products
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Smart Trader :
(1) Technical Outlook
(2) Derivatives Outlook
(3) Derivative strategy
Smart trader for 19-01-2009
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Key Support and Resistance ofNifty and
Sensex
13,50 and 200 days Exponential moving averages
acting as crucial support/ Resistance area for the
market
Daily market outlook covering the trend witnessed
in previous trading session along with technical
study using Elliot- wave theory.
Daily 2 intraday call along with description
SmartTrader- Technical
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SmartTrader- Derivatives Outlook
Intraday F&O Call Daily Comments
Premium/Discount
(i) Premium turning into discount - Short built up(ii) Discount turning into premium-Short covering(iii) No change - trend continues
Implied Volatility- Increase from previous day
(i) Call IV > Put IV = Bulls have upper hand(ii) Put IV > Call IV = Bears have upper hand
Putcall Ratio(i) Nifty Open Interest wise(ii) Market volume wise
FII Activity
OI Movement
(i) Call and put distribution across strikes
Highest Call activity - Resistance for the marketHighest Put activity - Support for the market
(ii) Most active contracts(iii) Good indicator during expiry
OI Movers
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SmartTrader- Derivatives Strategy
Outlook(i) Strategy Outlook
(ii) Strategy range
Strategy - Describes the strategy in detail
Leverage Cost(i) Span margin
(ii) Initial outflow/ inflow in rupee term
Conclusion
(i) Profit range for the strategy
(ii) Breakeven(iii) Hedge
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DeriPair
Opportunity based strategy meant for the trader
Position into stock from same sector
Spread price chart of two stocks
Rupee neutral position
Spread ratio chart depicting the reversion oraversion pattern along with Mean +/- 1,2, and 3 std
deviation line
Product Note
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THANKYOU
QUESTION & ANSWER
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