Derivative(Final Derivative)

8/8/2019 Derivative(Final Derivative)

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M.D.College. Trading Strategy (Future & Option). T.Y.F.M.

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Futures Trading.

Futures trading are the trading of futures contracts, which gives the holder the abilityto buy underlying products for a predetermined price after a definite period of time.

These contracts are created mostly for hedging the price uncertainty at the time ofproduct delivery. Futures trading differ from spot trading, in which the trades arecompleted on the spot. The delivery time of the product is mostly 3 months or 6

months. Futures contracts can be grouped into two broad categories as commodityfutures and financial futures.

All futures contracts are guaranteed by clearing houses and have unalterable contract

specifications including delivery time and price of the underlying product. Although

both names, futures contracts and forward contracts, are used alternatively, they differin the trading style. Forward contracts are traded OTC (over the counter) though

broker-dealer interactions, which involve price bargaining. But futures contracts are

traded by open outcry of screen in public domain or simply through centralizedfutures markets. Remember unlike options, in futures trading it is mandatory toown/deliver the underlying product at the end of the contract period.

As discussed earlier, there are a variety of products available for futures trading,

which are named after the underlying product they have. The most common type of

futures is the commodity futures for agricultural, metal, energy, meat and live stockcommodities. The financial futures or money futures are the futures contracts whichhave bonds, treasury notes, and other interest-based assets as underlying product.

Stock futures have individual stocks are underlying product, where as stock index

futures are meant for hedging stock market fluctuations as a whole. Like wise,currency futures are for individual currencies and index futures are for one

group/whole market currencies. Although not a future contract, futures options are

also a familiar product which gives the holder the option to buy a contract for aspecified price at a specific time.

Future contract get expires at every last Thursday of every month. Future or derivative

trading is the process of buying or selling stock future or index future for a certainperiod of time and squaring off before the expiry date.

Expiry period can be of one month, two month and three month and not more then of

three month.Its not compulsion that you have to square off your positions on the expiry date orwait till the expiry period but in fact you can square off at any time even, at the same

day, or you can hold as long as you want but remember t o square off before expirydate.Most of the times on 3rd month expiry future you may see very less trading volumes.

Generally most of the traders/investors trade or invest on current month future or

second month future contract and you may see very low volumes on last month meansthird month expiry.


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Future strategy.

Strategies are game plan created by investor these game plans are based on

expectation how the market are move. There are four type of trading strategy.

Bullish. Bearish. Neutral. Volatile.

1) Bullish Future Strategy:

Bullish options strategies are employed when the options trader expects the

underlying stock price to move upwards. It is necessary to assess how high the stockprice can go and the time frame in which the rally will occur in order to select the

optimum trading strategy.

The most bullish of options trading strategies is the simple call buying strategy used

by most novice options traders.

Stocks seldom go up by leaps and bounds. Moderately bullish options traders usually

set a target price for the Bull Run and utilize bull spreads to reduce cost. (It does not

reduce risk because the options can still expire worthless.) While maximum profit is

capped for these strategies, they usually cost less to employ for a given nominal

amount of exposure. The bull call spread and the bull put spread are common

examples of moderately bullish strategies.

Mildly bullish trading strategies are options strategies that make money as long as theunderlying stock price does not go down by the option's e xpiration date. Thesestrategies may provide a small downside protection as well. Writing out-of-the-money

covered calls is a good example of such a strategy.


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2) Bearish Future Strategy:

Bearish options strategies are the mirror image of bullish strategies. They are

employed when the options trader expects the underlying stock price to move

downwards. It is necessary to assess how low the stock price can go and the timeframe in which the decline will happen in order to select the optimum trading strategy.

The most bearish of options trading strategies is the simple put buying strategy

utilized by most novice options traders.

Stock prices only occasionally make steep downward moves. Moderately bearish

options traders usually set a target price for the expected decline and utilize bear

spreads to reduce cost. While maximum profit is capped for these strategies, they

usually cost less to employ. The bear call spread and the bear put spread are common

examples of moderately bearish strategies.

Mildly bearish trading strategies are options strategies that make money as long as the

underlying stock price does not go up by the options expiration date. These strategies

may provide a small upside protection as well. In general, bearish strategies yield less

profit with less risk of loss.


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4) Volatile Future Strategy:

It is important to understand the difference between volatility and risk. Volatility in

the financial markets is seen as extreme and rapid price swings. Risk is the possibility

of losing some or all of an investment. So as volatility increases, so does profitpotential and the risk of loss, as the market swings from peaks to troughs. Frequenttraders notice a marked increased in the frequency of trades and the decreased time the

position is held. During times of increased volatility, a hyper-sensitivity to news isoften reflected in market prices.The investor anticipated a rapid movement in market or stock price but he is not clearof the direction of the movement.


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Option Trading.

Option trading is a risky but often very profitable business. Naturally, before getting

into it, one should try to understand its essence, and here's the right place where youcan get an option trading definition.

Option Trading is simply the trade in option contracts over an exchange.

Alongside with such investments as stocks, bonds and mutual funds, options arecomplex securities giving its holder the right to buy or sell the asset (usually, stocks or

indices) underlying them at an agreed price in a specified period of time. In other

words, options are contracts with set terms and properties. It is important to bear inmind that the contract provides the option to buy 100 shares; so its price should b e

multiplied by 100.

As has been mentioned above, two types of options can be singled out in optiontrading depending on what right they give their holder to sell the asset or buy it

called accordingly puts and calls. Thus, there are four main participants at the market

ofoption trading. They are: buyers of calls, sellers of calls, buyers of puts and sellersof puts.

Option buyers obtain the right to buy the stock at a certain price even if by the end of

the prescribed term it actually significantly adds in price. However, if it doesn't, it'snot an obligation to let the expiry date pass by, losing at that money paid for the

possibility to exercise the option. Buyers are considered to have long positions inoption trading. The other party involved in option trading, that is, calls and puts'

sellers, also known as writers, are obliged to buy or sell, having short positions. Thereare 2 styles of options: American Options that can be exercised at any time before theexpiration date and European Options exercisable only at the date of expiry.

The price of the underlying asset at the time of contract conclusion is the strike price.

If the former is higher than the latter before the expiry date, the option is 'in-the-money'. Correspondingly, a put option is said to be in-the-money when the stock price

goes below the strike price. Spread between these two positions in option trading is

called intrinsic value.

Option's total price made up of such factors as the share price, strike price, time value

and volatility, is referred to as the premium.

Options are used for two main purposes: for speculation (making profit) and hedging(insuring your investments). Sometimes they are also used in employer-employee

relationship.

When writing covered calls, most investors tend to sell near month options for two

reasons. First, the earlier the expiration, and the less opportunity the stock has to trade


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through thestrike price. Second, and equally important, is the role time decay plays inthe value of the options. Like all out-of-the-money options, the call in the example

above has no intrinsic value. As such, the only value is the time premium or timevalue which, in the final month before expiration, decays more and more rapidly. For

these reasons, investors often sell options that have one month remaining untilexpiration.

In finance an option strategy is the purchase and/or sale of one or

various option positions and possibly an underlying position.

Options strategies can favor movements in the underlying that are bullish, bearish or

neutral. In the case of neutral strategies, they can be further classified into those that

are bullish on volatility and those that are bearish on volatility. The option positions

used can be long and/or short positions in calls and/or puts at various strikes.

Equity calls option:In-the-money = strike price less than stock price

At-the-money = strike price same as stock priceOut-of-the-money = strike price greater than stock price

Equity put option:In-the-money = strike price greater than stock priceAt-the-money = strike price same as stock priceOut-of-the-money = strike price less than stock price

Following are the Option Strategy:-

Covered Call Option Strategy. Long Call Option Strategy. Long Put Option Strategy. Bull Call Spread Option Strategy. Bear Put Spread Option Strategy. Long Straddle Option Strategy. Long Strangle Option Strategy. Collar Option Strategy.


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1) Covered Call Option Strategy:

The covered call is a strategy in which an investor writes a call option contract while

at the same time owning an equivalent number of shares of the underlying stock. If

this stock is purchased simultaneously with writing the call contract, the strategy is

commonly referred to as a "buy-write." If the shares are already held from a previouspurchase, it is commonly referred to an "overwrite." In either case, the stock is

generally held in the same brokerage account from which the investor writes the call,

and fully collateralizes, or "covers," the obligation conveyed by writing a call option

contract. This strategy is the most basic and most widely used strategy combining the

flexibility of listed options with stock ownership.

Maximum profit will occur if the price of the underlying stock you own is at or above

the call option's strike price, either at its expiration or when you might be assigned an

exercise notice for the call before it expires. The risk of real financial loss with this

strategy comes from the shares of stock held by the investor. This loss can become

substantial if the stock price continues to decline in price as the written call expires. At

the call's expiration, loss can be calculated as the original purchase price of the stock

less its current market price, less the premium received from initial sale of the call.

Any loss accrued from a decline in stock price is offset by the premium you received

from the initial sale of the call option. As long as the underlying shares of sto ck are

not sold, this would be an unrealized loss. Assignment on a written call is alwayspossible. An investor holding shares with a low cost basis should consult his tax

advisor about the tax ramifications of writing calls on such shares.

Maximum Profit: Limited

Maximum Loss: Substantial


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3) ong Put Option Strategy.

A long put can be an ideal tool for an investor who wishes to participate profitably from a

downward price move in the underlying stock. Before moving into more complex bearish

strategies, an investor should thoroughly understand the fundamentals about buying and

holding put options.

Purchasing puts without owning shares of the underlying stock is a purely directional

strategy used for bearish speculation. The primary motivation of this investor is to

realize financial reward from a decrease in price of the underlying security. This

investor is generally more interested in the dollar amount of his initial investment andthe leveraged financial reward that long puts can offer than in the number of contracts

purchased.

Experience and precision are key in selecting the right option (expiration and/or strike

price) for the most profitable result. In general, the more out-of-the-money the put

purchased is the more bearish the strategies, as bigger decreases in the underlying

stock price are required for the option to reach the break-even point.

The maximum profit amount can be limited by the stock's potential decrease to no less

than zero. At expiration an in-the-money put will generally be worth its intrinsic

value. Though the potential loss is predetermined and limited in dollar amount, it can

be as much as 100 of the premium initially paid for the put. Whatever your

motivation for purchasing the put, weigh the potential reward against the potential loss

of the entire premium paid.


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4) Bull Call SpreadOption Strategy.

Establishing a bull call spread involves the purchase of a call option on a particular

underlying stock, while simultaneously writing a call option on the same underlying

stock with the same expiration month, at a higher strike price. Both the buy and the

sell sides of this spread are opening transactions, and are always the same number of

contracts. This spread is sometimes more broadly categorized as a "vertical spread": a

family of spreads involving options of the same stock, same expiration mo nth, but

different strike prices. They can be created with either all calls or all puts, and be

bullish or bearish. The bull call spread, as any spread, can be executed as a unit" in

one single transaction, not as separate buy and sell transactions. For this bullish

vertical spread, a bid and offer for the whole package can be requested through your

brokerage firm from an exchange where the options are listed and traded.

A bull call spread tends to be profitable when the underlying stock increases in price.

It can be established in one transaction, but always at a debit (net cash outflow). The

call with the lower strike price will always be purchased at a price greater than the

offsetting premium received from writing the call with the higher strike price.

Maximum loss for this spread will generally occur as the underlying stock price

declines below the lower strike price. If both options expire out-of-the-money with no

value, the entire net debit paid for the spread will be lost.


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5) Bear Put SpreadOption Strategy:

Establishing a bear put spread involves the purchase of a put option on a particular

underlying stock, while simultaneously writing a put option on the same underlying

stock with the same expiration month, but with a lower strike price. Both the buy and

the sell sides of this spread are opening transactions, and are always the same number

of contracts. This spread is sometimes more broadly categorized as a "vertical spread":

a family of spreads involving options of the same stock, same expiration month, but

different strike prices. They can be created with either all calls or all puts, and be

bullish or bearish. The bear put spread, as any spread, can be executed as a "package"

in one single transaction, not as separate buy and sell transactions. For this bearish

vertical spread, a bid and offer for the whole package can be requested through your

brokerage firm from an exchange where the options are listed and traded.

Maximum loss for this spread will generally occur as underlying stock price rises

above the higher strike price. If both options expire out -of-the-money with no value,

the entire net debit paid for the spread will be lost.

The maximum profit for this spread will generally occur as the underlying stock price

declines below the lower strike price, and both options expire in-the-money. This will

be the case no matter how low the underlying stock has declined in price. If the

underlying stock is in between the strike prices when the puts expire, the purchased

put will be in-the-money, and be worth its intrinsic value. The written put will be out-

of-the-money, and have no value.


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6)

ong Straddle Option Strategy:

The long straddle is simply the simultaneous purchase of a long call and a long put on

the same underlying security with both options having the same expiration and same

strike price. Because the position includes both a long call and a long put, the investor

in a straddle should have a complete understanding of the risks and rewards associated

with both long calls and long puts.

Purchasing only long calls or only long puts is primarily a directional strategy. The

long straddle however, consisting ofboth long calls and long puts is not a directional

strategy, rather it is one where the investor feels large price swings are forthcoming

but is unsure of the direction. This strategy may prove beneficial when the investor

feels large price movement, either up or down, is imminent but is uncertain of the

direction.

An instance of when a straddle may be considered is when the investor believes there

is news forthcoming. An example may be when one is anticipating news regarding a

drug in trials from a biotechnology company. The investor feels the news surrounding

the drug will introduce large price swings in the underlying but is unsure of whether

this news will have a positive or negative impact on the price. If the news is positive,

this may positively impact the price of the security. If the news is disappointing, the

stock could decline considerably. The risk is the stock remaining at the strike price of

the straddle until expiration.


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7)

ong Strangle Option Strategy:

The long strangle is simply the simultaneous purchase of a long call and a long put on

the same underlying security with both options having the same expiration but where

the put strike price is lower than the call strike price. Because the position includes

both a long call and a long put, the investor using a long strangle should have a

complete understanding of the risks and rewards associated with both long calls and

long puts.

Since the strangle involves two trades, a commission charge is likely for the purchase

(and any subsequent sale) of each position; one commission for the call and one

commission for the put and commission charges may significantly impact the

breakeven and the potential profit/loss of the strategy.

An instance of when a strangle may be considered is when an earnings announcement

is forthcoming. The investor feels the projected announcement will introduce large

price swings in the underlying. If the earnings announcement and future outlook is

positive, this may positively impact the price of the security. If the earning

announcement and outlook is negative, or fails to impress investors, the stock could

decline considerably. The risk is the stock remains stable or between the strike priceof the call and strike price of the put until expiration. Another risk is that the stock's

move does not produce a corresponding option price increase that is enough to cover

the two premiums paid for the position. Declining implied volatility will also

negatively impact this strategy.


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8) CollarOption Strategy:

A collar can be established by holding shares of an underlying stock, purchasing a

protective put and writing a covered call on that stock. The option portions of this

strategy are referred to as a combination. Generally, the put and the call are both out-

of-the-money when this combination is established, and have the same expiration

month. Both the buy and the sell sides of this spread are opening transactions, and are

always the same number of contracts. In other words, one collar equals one long put

and one written call along with owning 100 shares of the underlying stock. The

primary concern in employing a collar is protection of profits accrued from underlying

shares rather than increasing returns on the upside.

This strategy offers the stock protection of a put. However, in return for accepting a

limited upside profit potential on his underlying shares (to the call's strike price), the

investor writes a call contract. Because the premium received from writing the call can

offset the cost of the put, the investor is obtaining downside put protection at a smaller

net cost than the cost of the put alone. In some cases, depending on the strike prices

and the expiration month chosen, the premium received from writing the call will be

more than the cost of the put. In other words, the combination can sometimes be

established for a net credit - the investor receives cash for establishing the position.

The investor keeps the cash credit, regardless of the price of the underlying stock

when the options expire. Until the investor either exercises his put and sells the

underlying stock, or is assigned an exercise notice on the written call and is obligat ed

to sell his stock, all rights of stock ownership are retained. See both Protective

and Covered Call strategies presented earlier in this section of the site.


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Derivative(Final Derivative)