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Topic
Group 11:- PRINCIPAL OF TRADING & HEDGING WITH OPTIONS
Terminology call, put, writer, buyer, premium, intrinsic value, time value, expiry date,
Settlement date, stock price, ATM, OTM & ITM, The Greeks -(Delta, Gamma, Theta , Vega)
SUBMITTED TO- MOHINA KULKARNI
Presented by-
Name Roll No.
Rohit Gupta 40
Mohsin Khan 41
Ankur Nagwan 42
SHARE MARKET
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A share markets is an open market for fiscal operations such as trading of a firm's
share and derivatives at a fixed cost. These securities are further listed on a stock exchange. A
Share market does not offer any corporeal service and is not a separately owned business entity.
It was in 1875 that the Indian Share Market first started functioning. The first share
trading association in India was known as the Native Share and Stock Broker's Association, only
to become the Bombay Stock Exchange (BSE) later on. This trading association started off its
operations with around 318 members.
Main components of Indian Share Market
Bombay Stock Exchange (BSE)
Bombay Stock Exchange is known to be the oldest stock exchange in the entire Asian
region. If someone wants to know about the history of the India share market, it becomes
synonymous with the history of the Bombay Stock Exchange. It started functioning in 1875 with
the name 'The Native Share and Stock Broker's Association'. Under the Securities Contracts
(Regulation) Act, 1956, the association got its recognition as a stock exchange in 1956. When itstarted, it was just an association of persons but with the recognition it got transferred to a
corporate and demutualised entity.
Trading items in Bombay Stock Exchange
1. Equity or Shares.
2. Derivatives (Futures and Options)
3. Debt Instruments
The main index of BSE is known as the BSE SENSEX or simply SENSEX (Sensitivity
Index). It is an index which comprises of 30 financially sound company scrips, with an option to
be reviewed and modified from time-to-time. The index calculation is based on the 'Free-float
Market Capitalization' methodology. Leading bourses like the Dow-Jones also follow this
methodology. Currently the Sensex is hovering around the 17,000 mark, all expected to touch
20K by 2010. But then volatility has its important role to spoil the entire game.
National Stock Exchange (NSE)
National Stock Exchange (NSE) is considered to be the leader in the stock exchange scenario
in terms of the total volume traded. The market capitalization the National Stock Exchange
touched about $921.31 billion at the end of May 2009. The National Stock Exchange received
the recognition of a stock exchange in July 1993 under Securities Contracts (Regulation) Act,
1956.
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Trading items in National Stock Exchange
1. Equity or Share.
2. Futures (both index and stock).
3. Options (Call and Put).
4. Wholesale Debt Market.
5. Retail Debt Market.
NSE has a fully automated screen based trading system which is known as the NEAT
system. The transactions are carried on with speed, efficiency, and are all transparent. The risk
management system of the National Stock Exchange is world class and can be considered as the
benchmark for other bourses.
The leading index of NSE is known as Nifty 50 or just Nifty. It comprises of 50
diversified benchmark Indian company scrips and is constructed on the basis of weighted
average market capitalization method.
Regulatory Authority of Indian Share Market
SEBI or Securities and Exchange Board of India is the market watchdog and has the
responsibility of protecting the investors' interests, develops regulatory norms and helps in the
development of the securities market in India.
Security market is a board term embracing a number of markets in which securities are
bought and sold. One way in which securities market may be classified is by the type of
securities bought and sold there. The broadest classification is based upon whether the securities
are new issue or are already outstanding and owned by investors. New issue are made available
in the primary markets; securities that are all ready outstanding and owned by the investors are
bought and sold in the secondary market. Another classification is by maturity; Securities with
maturities of one year or less normally trade in the money market; those with maturities of more
than one year are bought and sold in the capital market.
The existence of markets for securities is of advantage to both issuers and investors. As to
their benefit to issuers, securities market assist business and government in raising funds. In a
society with private ownership of the means of production and distribution of goods and services
saving must be directed toward investment in industries where capital is most productive.
Government must also be able to borrow for public improvements. Market mechanisms make
possible the transfer of funds from surplus to deficit sectors, efficiently and at low cost. Investors
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are also benefit from market mechanism. I f investors could not resale the securities readily they
would be hesitant to acquire them and such reluctance would reduce the total quantity of fund
available to finance industry and government. Those who own securities must be assured of a
fast, fair, orderly and peon system of purchase and sale at known prices.
The classification of market we are most interested in is the one that differentiates between
new and old securities the primary and secondary market. In recent years the secondary market
has been further fragmented, creating third and fourth market.
Primary Market
Securities available first time are offered through the primary securities market. The issuer
may be a brand new company or one that has been in business for many years. The securities areoffered may be a new type for the issuer or additional amount of a security used frequently in the
past. The key is that these securities absorb new funds for the coffers of the issuer, whereas in the
secondary market existing securities are simply being transferred between parties and the issuer
not receiving new funds.
After their purchase in the primary market. Securities are traded subsequently in the
secondary Risk is a characteristic feature of all commodity and capital markets. Prices of all
commodities markets. Billions of dollars worth of new securities reach the market each year. The
traditional middlemen in the primary market are called an investment banker. The investment
bankers principle activity is to bring sellers and buyers together thus creating a market Henormally buys the new issue from the issuer to at an agreed upon price and hopes to resale it to
the investing public at a higher price. In this capacity investment, bankers joins to underwrite a
security offering and form what is called an underwriting syndicate. The commission received by
the investment banker in this case is the differential, or spread, between his purchase and resale
price, the risk to the underwriter is that the issue may not attract buyers at a positive differential.
Secondary Markets-The Organized Exchange
Once new issues have been purchased by investors they change hands in the secondary
markets. There are actually two broad segments of the secondary markets. The organize & theover the counter (OTC) market.
The primary middleman in the secondary market is brokers & dealers. The distinction
between the two is important. The technical difference rest upon whether the person acts as an
agent (broker) or as a principal (dealer) in a transaction.
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Organize exchange are physical market places where the agents of buyers & sellers
operate through auction processes. There are number of organize exchange. Two are truly
national market places, & the other is regional or local.
WHAT ARE DERIVATIVES
A derivative instrument, broadly, is a financial contract whose payoff structure is determined
by the value of an underlying commodity, security, interest rate, share price index, exchange rate
oil price and the like. Thus the derivative instrument derives its value from some underlying
variable. A derivative instrument by itself does notconstitue ownership. It is instead a promise to
convey ownership.
All derivatives are based on some cash product. The underlying basis of a derivative
instrument may be any product including
Commodities including grain, coffee, beans, orange, juice etc
Precious metal like gold and silver
Foreign exchange rate
Bonds of different types including medium to long term negotiable debt securities issued
by government companies etc
Short term debt securities such as T-bills; and
Over the counter (OTC) money market products such as loans and deposits...
Derivative are specialized contract which are employed for a variety of purposes including
reduction of funding costs by borrowers enhancing the yield on assets, modifying the payment
structure of assets to correspond to the investors market view. Etc. However the most important
use of derivatives is in transferring market risk called hedging, which protection against losses is
resulting from unforeseen price or volatility changes. Thus derivative is very important tool of
risk management. As awareness about the usefulness of derivatives as a risk management toolhas increased the market for derivatives too has grown. Of late, derivatives have assumed a very
significant place in the field of finance and they seem to be driving global finance markets.
There are many kind of derivatives including futures, options, interest rate swaps, and
mortgage deratives.To understand the nature of future and options let us begin with the idea of
forward and future contract.
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What are Forwards
Farming is a risky venture. A lot of money, time, and effort is needed to produce farm
products, with many risks, such as weather or price fluctuations in the market, which can result
in high or low prices in the spot market (aka cash market), which is the market where the buyer
pays cash to the seller for the immediate delivery of the commodity. Since the farmer can only
sell in the spot market when the product is ready for delivery, there is no way to know
beforehand what the price will be, and the same is true for the buyerboth have price risk.
The spot market is a zero-sum tradeif prices are too high or too low, either the buyer or the
seller profits at the expense of the other. Thus, if grain prices rise, farmers benefit, but millers
suffer because they have to pay higher prices for their grain. If prices fall, then farmers suffer,
but millers benefit. Forward contracts became common in the 1800's to protect both the buyer
and the seller by agreeing to a set price ahead of time.
A forward contract (sometimes called a cash forward sale) is a contract to supply a
commodity at a given date for a specified price. No money is paid until the date of delivery.
Before the organized exchanges, forward contracts were signed where farmers happened to be
selling their goods, such as farmers markets, public squares, and street curbs. But there were 3
main problems with individual forward contracts:
Eventually, organized exchanges developed that solved these basic problems. To lower the
risk of default, the exchanges required that money be deposited with a 3rd party to ensure the
performance of the contract.
The exchanges also standardized the contracts by stipulating the types of contracts that they
would sell, including its terms. Standardized contracts were easier to sell or to offset with
another contract that eliminated the liability of the original contract. Standard specifications
include the amount of the commodity, the grade, and delivery dates. These standard forward
contracts were called futures, and the exchanges developed listings for these contracts that
greatly increased their liquidity.
More recently, futures were created based on assets completely different from agricultural
products, such as stock indexes, interest rates, and even the weather, and provided more
investment opportunities for many more investors. They became great tools to hedge portfolios
or to simply profit from speculation.
The buyers and sellers of futures can be classified as hedgers or speculators. Hedgers use
futures to minimize risk, like the farmers who use futures to guarantee a price for their product,
or a miller who wants a set price for grain when it is harvested. Futures can also be used to hedge
investment portfolios. Thus, futures is a significant means of price risk transfertransferring
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price risk to someone with an opposite risk, or to a speculator who is willing to accept risk to
make a profit
Imagine you are a farmer. You grow 1,000 dozens of mangoes every year. You want to sell
these mangoes to a merchant but are not sure what the price will be when the season comes. You
therefore agree with a merchant to sell all your mangoes for a fixed price for Rs 2 lakhs.
This is a forward contract wherein you are the seller of mangoes forward and the merchant is the
buyer. The price is agreed today in advance and the delivery will take place sometime in the
future
FEATURES OF A FORWARD CONTRACT
The essential features of a forward contract are:
Contract between two par ties (without any exchange between them)
Price decided today
Quantity decided today (can be based on convenience of the parties)
Quality decided today (can be based on convenience of the parties)
Settlement will take place sometime in future (can be based on convenience of the
parties)
No margins are generally payable by any of the par ties to the other
Where are forwards used
Forwards have been used in the commodities market since centuries. Forwards are also
widely used in the foreign exchange market.
What are futures &How are they different from forwards
Futures are similar to forwards in the sense that the price is decided today and the
delivery y will take place in future. But Futures are quoted on a stock exchange. Prices are
available to all those w ho want to buy or sell because the trading takes place on a transparent
computer system.
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What are the features of Futures
The essential features of a Futures contract are:
Contract between two parties through an exchange
Exchange is the legal counterparty to both par ties
Price decided today.
Quantity decided today (quantities have to be in standard denominations specified by the
exchange.
Quality decided today (quality should be as per the specifications decided by the
exchange).
Tick size (i.e. the minimum amount by which the price quoted can change) is decided by
the exchange.
Deliver y will take place sometime in future (expiry date is specified by the exchange)
Margins are payable by both the parties to the exchange.
Who invented Forwards and Futures
It is difficult to say that somebody invented them. Forwards have been used since
centuries especially in commodity trades. Futures are specialized forwards which are supported
by a stock exchange. Futures, as we know them now, were first traded in the USA, in Chicago.
What are the limitations of forwards
Forwards involve counter party risk. In the above example, if the merchant does not buy
the mangoes forRs 2 lakhs when the season comes, what can you do? You can only file a case in
the court, but that is a difficult process. Further, the price of Rs 2 lakhs was negotiated between
you and the merchant. If somebody else wants to buy these mangoes from you, there is no
mechanism of knowing what the right price is.
Thus, the two major limitations of forwards are:
Counter party risk
Price not being transparent
Counter party risk is also referred to as default risk or credit risk.
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How do Futures overcome these difficulties
An exchange (or its clearing corporation) becomes the legal counterparty in case of
futures. Hence, if you buy any futures contract on an exchange, the exchange (or its clearing
corporation) becomes the seller. If the other party (the real seller) does not deliver on the expiry
date, you do not have to worry. The exchange (or its clearing corporation) will guarantee you the
delivery. Further, prices of all Futures quoted on the exchange are known to all players.
Transparency in prices is a big advantage over forwards.
Do Futures suffer from any limitation
Futures suffer from lack of flexibility. Suppose you want to buy 103 shares of Satyam for
a future delivery date of 14February, you cannot buy.
The exchange will have standardized specifications for each contract. Thus, you may findthat you can buy.Satyam futures in lots of 1200 only. You may find that expiry date will be the
last Thursday of every month.
Thus, while forwards can be structured according to the convenience of the trading
parties involved, futures specifications are standardized by the exchange.
What is the meaning of expiry of Futures
Futures contracts will expire on a certain pre-specified date. In India, futures contractsexpire on the last Thursday of every month.
For example, in a February Futures if the last Thursday is a holiday, Futures and Options will
expire on the previous working day. On expiry, all contracts will be compulsorily settled
Settlement can be effected in cash or through delivery.
What does Cash Settlement mean
Cash settlement means that one of the parties will pay the other party the difference incash.
For example; if you bought Sensex Futures for 3350 and the closing price on the last Thursday
was 3360, you will be paid profit of 10 by the exchange. The exchange will collect the 10 from
the party who sold the Futures, because that party would have made a loss of 10. In reality, the
amount would not be 10, because the number of Sensex Units in a contract would be considered.
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One Sensex contract is made up of 50 Units. Therefore, a profit of 10 above would translate into
a profit of Rs 500 (50 Sensex Units x 10).
Thus, Cash Settlement means settlement by payment/receipt in cash of the difference
between the contracted price and the closing price of the underlying on the expiry day. In the
Cash settled system, you can buy and sell Futures on stocks without holding the stocks at any
time.
For example, to buy and sell Futures on Satyam, you do not have to hold Satyam shares.
Therefore assume that contracts will be settled in cash. It is widely expected that we will move to
a physical deliver y system soon. However, Index based Futures and options will continue to be
based on Cash Settlement system.
How is the Value of a Futures Contract worked out & what does Delivery based Settlement
mean
In Deliver y based Settlement, the seller of Futures delivers to the Buyer (through the
exchange) the physical shares, on the expiry day.
For example, if you have bought 1,200 Satyam Futures at Rs 250 each, then you will (on the day
of expiry) get 1,200 Shares of Satyam at the contracted Futures price of Rs 250. It might happen
that on the day of expiry, Satyam was actually quoting at Rs 280. In that case, you would still get
Satyam at Rs 250, effectively generating a profit of Rs 30 for you
What is the Current System in India
Currently in India (as on the date of writing this Work Book), all Futures transactions are
settled in Cash. There is no system of physical delivery.
Contract Value is the price per Futures Unit multiplied by the lot size. The lot size can
also be referred to as the Contract Multiplier. For example, if Sensex Futures are quoting at 3,400
and the Contract Multiplier is 50 Units, the Value of one Futures contract will be Rs 170,000.
What does the Exchange do in Futures
The exchange decides the specifications of each contract. For example, it would decide
that Sensex Futures will have a lot size of 50 units. It would decide that Futures would expire on
the last Thursday of every month, etc. The exchange will also collect Margins from both buyers
and sellers to ensure that trading operates smoothly without defaults. The exchange does not buy
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or sell any shares or index futures or commodities. It does not own any shares. Or index futures
or commodities which might be traded on the exchange. For example, an exchange where gold
fu It is not necessary that trading in commodities also should happen in those exchanges where
commodity futures are traded. For example, an exchange where gold futures are traded might not
allow trading in physical gold at all.
The exchange is supposed to carry out on-line surveillance of the derivatives segment.
Turns are traded might not own any gold at all. Futures are allowed on what underlying.
Currently in India, Futures are allowed on 2 Indices (viz. Sensex and Nifty) and on 31
individual stocks. These individual stocks are carefully selected based on various parameters.
How many month Futures are available at any point of time
Exchanges have currently introduced three series in Futures and Options. For example
during the month of February on any day on or before last Thursday, you will find three Series
available viz. February, March and April. The February Series will expire on the last Thursday of
February. On the next working day, the May Series will open. Thus, on a rolling basis, threeSeries will be made available.
What is the Lot Size for Futures and Options contracts
Lot size differs from stock to stock and index to index. For example, the lot size for
Sensex Futures and Options is 50 units, while the lot size for Satyam Futures and Options is
1,200 units.
When should I buy Futures and when should I sell Futures
Futures can be bought or sold in various circumstances. But the simplest of these circumstancescould be:
Buy Futures when you are Bullish
Sell Futures when you are Bearish
Who decides the price of Futures
Prices of Futures are discovered during trading in the market. For example, who decides the
price of Infosys in the regular cash market? It is discovered based on trading between various
players during market hours. The same logic applies to Futures and Options.
Who are Hedgers
Hedgers are people who are attempting to minimize their risk. If you hold shares and are
nervous that the price of these shares might fall in the short run, you can protect yourself by
selling Futures. If the market actually falls, you will make a loss on the shares, but will make a
profit on the Futures. Thus you will be able to set off your losses with profits.
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When you use some other asset for hedging purposes other than the asset you actually
own, this kind of hedge is called a cross-hedge.
Can Hedging help me to make more profits
No, Hedging is meant for minimizing losses, not maximizing profits. Hedging helps tocreate a more certain outcome, not a better outcome.
How can businessmen use Futures/Forwards
Suppose you are a trader of rice. You expect to buy rice in the next month. But you are
afraid that prices of rice could go up within the next one month. You can use Rice Futures (or
Forwards) by buying Rice Futures (or Forwards) today itself, for delivery in the next month.
Thus you are protecting yourself against price increases in rice. On the other hand, suppose you
are a jeweler and you will be selling some jewelry next month. You are afraid that prices of gold
could fall within the next one month. You can use Gold Futures (or Forwards) by selling Gold
Futures (or Forwards).
Thus, if the price of jewelry and gold falls, you will make a loss on jewelry but make a
profit on Gold Futures (or Forwards) .If you are an importer and you need dollars to pay for your
imports in the next month. You are afraid that dollar will appreciate before that. You should buy
futures/forwards on Dollars. Thus even if the dollar appreciates, you will still be able to get
Dollars at prices decided today. If you are an exporter and you are expecting dollar payments in
the next month. You are afraid that Dollar might depreciate in that period. You can sell
futures/forwards on Dollars. Thus even if the dollar depreciates, you will still be able to get
Dollars converted at the prices decided today
How are Futures prices determined
Prices are determined based on forces of demand and supply and are discovered during trading
hours. Prices of Futures are derived from the price of the underlying. For example, prices of
Satyam Futures will depend upon the price of Satyam in the cash market. You can expect Futures
prices to rise when Satyam price rises and vice-verses of Futures should be equal to Spot Prices
(i.e. Cash market prices) plus Interest (also called Cost of Carry). If this price is not actually
found in the market, arbitrageurs will step in and make profits.
Hedging with Options
Options offer additional flexibility for hedging and investing. Calls can be purchased tocap prices, if the expectation is for rising prices. Conversely, a floor can be established bythe purchase of puts if there is a likelihood of a market decline. Calls and puts can be combined
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in a single strategy to effectively put a collar on prices, limiting the upward and downwardmoves.
Futures contracts have been used to manage cash market price risk for more than acentury. Hedging allows a market participant to lock in prices and margins in advance andreduces the potential for unanticipated loss.
Hedging reduces exposure to price risk by shifting that risk to those with oppositeprofiles or to investors who are willing to accept the risk in exchange for profit opportunity.
Hedging with futures eliminates the risk of fluctuating prices, but also means limiting theopportunity for future profits should prices move favorably.
A hedge involves establishing a position in the futures or options market that is equal andopposite of a position at risk in the physical market. For instance, a metals dealer who holds (islong) 50 ounces of platinum can hedge by selling (going short) platinum futures contract.The principle behind establishing equal and opposite positions in the cash and futures or optionsmarkets is that a loss in one market should offset by a gain in the other market.
Hedges work because cash prices and futures prices tend to move in tandem, convergingas each delivery month contract reaches expiration. Even though the difference between the cashand futures prices may widen or narrow as cash and futures prices fluctuate independently, therisk of an adverse change in this relationship known as basis risk) is generally much less than the
risk of going un hedged and, the larger a group of participants in the market, the greater thelikelihood that the futures. Price will reflect widely held industry consensus on the value of thecommodity.
Because futures are traded on exchanges that are anonymous public auctions with pricesdisplayed for all to see, the markets perform the important function of price discovery. Theprices displayed on the trading floor of the Exchange, and disseminated to information vendorsand news services worldwide, reflect the marketplaces collective valuation of how much buyersare willing to pay and how much sellers are willing to accept.
The purpose of a hedge is to avoid the risk of an adverse market movement resulting inmajor losses. Because the cash and futures markets do not have a perfect relationship, there is nosuch thing as a perfect hedge, so there will almost always be some profit or loss. However, an
imperfect hedge can be a much better alternative than no hedge at all in a potentially volatilemarket.
OPTIONS
Options on futures offer additional flexibility in managing price risk. There are two typesof options, calls and puts. A call gives the holder or buyer of the option the right, but not theobligation, to buy the underlying futures contract at a specific price up to a certain date. A putgives the holder the right, but not the obligation, to sell the underlying futures contract at aspecific price up to a certain date. A call is purchased when the expectation is for rising prices; aput is bought when the expectation is forNeutral or falling prices.
The target price at which a buyer or seller purchases the right to buy or sell the option isthe exercise price or strike price. The buyer pays a premium, or the price of the option, to theseller for the right to hold the option at that strike price.
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An options seller, or writer, incurs an obligation to perform should the option beexercised by the purchaser. The writer of a call incurs an obligation to sell a futures contract andthe writer of a put has an obligation to buy a futures contract.
An option is a wasting asset. The premium declines as time passes. Depending upon themovement of an options price, the buyer will choose one of three alternatives to terminate anoptions position: Exercise the option, liquidate it by selling it back on the Exchange, or let it
expire without market value.
Options give hedgers the ability to protect themselves from adverse price moves whileparticipating in favorable price moves. If the options expire worthless, the only cost is thepremium. Many people think of buying options like buying insurance.
By using options alone, or in combination with futures contracts, strategies can beDevised to cover virtually any risk profile, time horizon, or cost consideration.
Determinants of an Options Premium
In return for the rights they are granted, options buyers pay options sellers a premium.The four major factors affecting the premium are:
Futures price relative to options strike price.
Time remaining before options expiration.
Volatility of underlying futures price.
Interest rates.
As in the futures market, options trading takes place in an open outcry auction market on thefloor of the Exchange. While the value of futures is tied to the underlying cash commoditythrough the delivery process, the value of an option is related to the underlying futures contractthrough the ability to exercise the option.
Options Rights and Obligations
CallBuyer
Has the right to buy a futures contract at a predetermined price on or before a defineddate.
Expectation: Rising prices
Seller Grants right to buyer, so has obligation to sell futures at predetermined price atbuyers sole option.
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Expectation: Neutral or falling prices
PutBuyer
Has right to sell futures contract at a predetermined price on or before a defined date.
Expectation: Falling prices
Seller
Grants right to buyer, so has obligation to buy futures at a predetermined price atbuyers sole option.
Expectation: Neutral or rising prices
Strike Price vs. Futures Price
Strike prices are listed in various increments, depending upon the contract. The mostimportant influence on an options price is the relationship between the underlying futures priceand the options strike price.
Depending upon futures prices relative to a given strike price, an option is said to be at-the-money, in-the-money, or out-of-the-money. An option is at-the-money when the strike priceequals the price of the underlying futures contract.
An option is considered in-the-money when the price of the futures contract is above acalls strike price, or when the futures price is below a puts strike price. An option which is notan in-the-money option has no intrinsic value.
A call is out-of-the-money when the futures price is less than the options strike price.For example, when the March gold futures price is $300 per ounce, the March $310 call grantsthe holder of the options contract the right to buy a March futures contract at $310 even thoughthe market is at $300.
A put is out-of-the-money when the underlying futures price is higher than the putsstrike price, such as when the March futures are $300 and the strike price of the March put is$290.
An options premium will usually equal or exceed whatever intrinsic value the option has,if any. Intrinsic value is the amount by which an option is in-the-money.
Time Value
An options time value is the amount buyers are willing to pay for the option above itsintrinsic value. Out-of-the-money options carry all time premiums since their intrinsic value iszero, as do at-the-money options. As an option becomes deeply in- or out-of-the-money, the timepremium shrinks. As an option approaches expiration, or volatility decreases, time valuedecreases. It is important to note that time value is equal for the same strike and same expirationfor both calls and puts.
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The time value of an option shrinks as the expiration date approaches, all other factors beingequal. The reason is that there is less and less time for a major change in market behavior and adecreasing likelihood that the option will increase in value.
Call/Put Parity
Options prices are linked to futures prices through the exercise feature. If, at the call
options expiration, futures are trading at 100, a 90-call is worth 10, intrinsically thedifference between the futures price and the strike price. This is because the holder of a 90-callcan exercise his option, receive a long futures position at 90, immediately turn around and sellthe futures contract for $1.00, and make 10. This is known as trading at parity. If the call is onlytrading at, say, 5, then a trader can buy 90-calls, exercise them into long futures at 90, sellthem for $1.00 and make a risk-free 5, exclusive of transaction costs; market forces ensure thatan opportunity like this cannot last long.
The option cannot have a negative value, so if the risk does not occur, that is, if futuresprices do not exceed the strike price, the option will be worth zero. An option will not beexercised to buy futures at 90 when the futures can be purchased at 70.
For a put option, the risk is the possibility that the futures price will be below the strikeprice. When this occurs, the option will be worth precisely the difference between the strike priceand the futures price. Since a put gives its holder the right to sell futures, if futures are at 70, theholder of a 90 put could exercise the put into a short futures position at 90 and immediatelybuy it back for 70, making 20, exclusive of transaction costs. At expiration, the put will beworth 20.
If futures prices are not below the strike price, the option will be worth zero. Metalsoptions are automatically exercised if, on expiration day, they are one tick or more in-the-money,unless the holder of the option notifies the Exchange that he wants to abandon them.
Volatility
Volatility is a measure of the amount by which an underlying futures contract is expectedto fluctuate in a given period of time. Markets which move up or down very quickly are highlyvolatile: markets which move up or down only slowly are non-volatile, which is why volatility isan important factor in the pricing of options. As prices fluctuate more widely and frequently, thepremiums for options on futures increase, since the probability of the option attaining intrinsicvalue or moving deeper into the money increases. If market volatility declines, premiums forputs and calls decline correspondingly.
Historical volatility will be calculated from the past movement of commodity futuresprices over a specified time period. Technically, historical volatility is the annual standarddeviation of the changes in the futures price, expressed in percentage terms. Or, to put it anotherway, 50% volatility, for example, means that there is a 68.3% chance (one standard deviation)that, a year from now, prices will be 50% higher or lower.
Historical volatility is useful because it provides a basis for anticipating future volatility,which is what options traders really want to know. Implied volatility is also the most importantaspect of options trading.
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Implied volatility reflects current sentiment of volatility as reflected by todays optionsprice. It is the unknown embedded component in an options premium. Since the past is notnecessarily a good forecaster of the future, at any point in time, implied volatility may be higheror lower than historical volatility.
Implied volatility is the key component to options pricing. It is, in fact, the only unknownin an options pricing model. Given an options market price and knowing the other variables inthe pricing model the futures price, the strike price, the time to expiration, and interest rates
the options pricing model is adjusted to derive the volatility implied by the options price.
Interest Rates
Interest rates have a small bearing on options prices because they represent the profit orcost that could result from an alternate use of the funds used for the premium. The interest rate ofthe 90-day U.S. Treasury bills is often used as a guide. In practice, though, isolating the effect ofinterest rates on futures options premiums is difficult, if not impossible. A change in interestrates influences the net present value calculation of a premium, the cost of buying and storing acommodity, and even the commoditys price. Most of the interest rate effect will already beincorporated in the futures price through the cost of carrying the physical commodity.
Call Option
The purchase of a call option gives the holder the right to buy the stock at a specific strikeprice at or before expiration.
This is a Bullish strategy, meaning you make money as the stock rises. Think of buying
call options the same as buying stock. Let's say you are bullish on ABC company, which iscurrently trading at $60. You think this stock will go up to $80 in 2 months, and it's currentlyAugust. Rather than purchasing the stock, you can purchase call options. Now, let's say forexample, you bought 1 ABC Dec 60 strike call @ $4.00. Your initial cost of investment is $400.
A month later, ABC stock is now at $75 and you decide to lock in your profit. Youexercise your option, meaning you get to buy 100 shares of ABC stock for $60. You then turnaround and sell those 100 shares at market price for $75. This gives you a gross profit of$15/share or $1500. Now, minus your initial cost of investment of $400, your net profit is $1100,not including commission. You just made a 275% return on your $400 investment!!! As long asyou exercise your option above the breakeven point (strike price + initial cost), $64 in ourexample, you would make money.
Compare this to actually buying stock. The purchase of 100 shares of ABC stock at $60will cost you $6000. If you sold at the same price of $75, you made $15/share or $1500. Buthere's the difference, you made a 25% return on your investment. Your initial cost of the stockwas $6000 compared to $400 for the purchase of a call option. That's the beauty of leverage: touse as less money as possible to make as much as possible. Here's another thing, by spending$6000 to purchase the stock, you are exposed to that much risk. If ABC happens to drop to $1,
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you would lose $5999. But, with the call option, the most you would lose is your initial cost, andin this example that would be $400, regardless of how low the stock drops.
Another thing about options is that you do not have to exercise them to make money.You can trade options just like a stock. Call options rise in value when the stock rises. So if youpurchased a call option for $4.00 and now it is worth $5.00 due to a rise in stock price, thismeans you made $100 for every contract you have.
Now, there are definitely more variables associated with buying options. The aboveexample shows how a call option works. Other things to consider when buying options are whichstrike price to pick, which month, time decay, volatility, and the Greeks. All of these topics arediscussed in the members section of the trading community
How Do Call Options Work
Call Options are financial contracts between a buyer and a seller for the purchase of aparticular stock (or whatever other underlying asset it is based on). The seller or "writer" isgiving the Buyer of those Call Options the right to buy his stocks at a fixed price. The buyer or"holder" of these Call Options can now hold on to them, hoping that the stocks will rise in priceover time, before the Call Options contract expires, and then either sell the Call Options on toanother buyer at a higher price orexercise the right vested in the Call Options to buy the stockfrom the seller at the lower agreed price, turning around for a profit by selling those stocks in theopen market.
Call Options Sellers
Clearly, the seller or "writer" of Call Options is expecting his stocks to stay stagnant or togo down. Since the seller expects his stocks to go down, selling Call Options on those stocks
actually results in additional income, offsetting the expected drop in the stocks if he is right. Thishedges the risk of owning those stocks without having to sell the stocks. This is known asa Covered Call.
For instance, you sold a call option on GOOG at the fixed price of $300 when GOOG istrading at $300 and receive a $20 premium. By expiration of those call options, GOOG drops to$280 but your account value remains the same as the loss of $20 is hedged by the $20 premiumthat you received from selling (or known as writing) the call options.Call Options Buyers
The buyer of those Call Options is clearly expecting those same stocks to go up and is
willing to pay a small price to speculate on such a move. This expectation is also captured in thepopular investor sentiment indicator known as Put Call Ratio. Put Call Ratio is the ratio of theamount of put options traded versus call options traded.
For instance, you bought a call option to buy AAPL at the fixed price (known asthe strike price) of $180 when AAPL is trading at $180 per share for $10. By expiration of thosecall options, AAPL rises to $200. Because the call option allows you to buy AAPL at $180, ithas now a value of $20 per share built into it, making a $10 profit ($20 less the $10 premium you
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paid to own the call options). You can now simply sell the call options for that $20 value orexercise your right to buy AAPL at $180 and then sell it in the open market for its present marketprice of $200.
Call Options - Terminology
Strike Price: The price at which you can buy shares of the company no matter how far it has
moved in the future.
Holder: Owners of Call Options. You are the holder of your Call Options.
Writer: Sellers of Call Options. You are a writer when you initiate a position by selling CallOptions. This is called Sell to Open. Learn More About The Types Of Options Orders.
Exercise: To initiate the right to buy the underlying stock at the strike price.
Expiration date: The date by which you must exercise the right to buy shares of the companyor let the Call Options lapse worthless.
In The Money: When the shares of the company is higher than the strike price. Read moreabout In the Money Options.
At The Money: When the shares of the company is the same as the strike price. Read moreabout At the Money Options.
Out Of the Money: When the shares of the company is lower than the strike price, makingthe Call Options worthless upon expiration. Read more about Out Of the Money Options.
Put Options
The purchase of a put option gives the holder the right to sell the stock at a specific strikeprice at or before expiration.
Put options are typically a little more difficult to understand. Unlike buying a call optionwhich is bullish, the purchase of a put option is a Bearish strategy, meaning you make money asthe stock declines. Think of buying puts as shorting stock. Using a similar example, lets say you
are bearish on ABC company, which is currently trading at $80. You think this stock will godown to $50 in 2 months, and it's currently September. Rather than shorting the stock, you canpurchase put options. Now, let's say for example, you bought 1 ABC Jan 80 strike put@ $5.00.You initial cost of investment is $500. Similar to the call option, this is most you can lose if thestock moves against you.
A month later, ABC stock is now at $50 and you decide to lock in your profit. You exerciseyour option, meaning you get to sell 100 shares of ABC stock for $80. Now, you normally wouldnot have these shares in your account. This means you have to buy it back from the market to
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cover the shortage. The good thing is that the stock is now worth $50. This means you get to sell100 shares at $80 and buy it back at $50, giving you a gross profit of $30/share or $3000. Now,minus your initial cost of investment of $500, your net profit is $2500, not includingcommission. You just made a 500% return on your $500 investment!!! As long as you exerciseyour option below the breakeven point (strike price - initial cost), $75 in our example, you wouldmake money.
Similar to calls, buying puts will give you the same buying power and minimal risk that
makes trading options so attractive. And just like calls, puts are under the same variables thataffect options.
ITM, ATM & OTM
These terms stand for in-the-money, at-the-money, and out-of-the-money. All of whichdescribes the relationship between an option strike price to its underlying stock.
Lets start with call options. Describing these terms are pretty dry and straight forward. Using thecurrent stock price of $80, any strike prices that are above the stock price are called OTM calloptions. Its called out-of-the-money because when you exercise, for example, the 85 strikeoption, you would not be making any money. An ATM call option means that the strike andstock price are the same. An ITM call option refers to any strike prices that are below the stockprice. Its called in-the-money because when you exercise, for example, the 75 strike option, youwould make $5: you have the right to buy at $75 and sell at $80
stock price strike price description
75 ITM
$80 80 ATM
85 OTM
Now, lets turn our attention to put options. Using the current stock price of $80, anystrike prices that are below the stock price are called OTM put options. Its called out-of-the-money because when you exercise the 75 strike option, you would not be making any money. AnATM put option means that the strike and stock price are the same. An ITM put option refers toany strike prices that are above the stock price. Its called in-the-money because when youexercise the 85 strike option, you would make $5: you have the right to sell at $85 and buy backat $80.
stock price strike price description
75 OTM
$80 80 ATM
85 ITM
Take some time to understand these terminologies. If you are ever confused, just askyourself "if I exercise my option now, would I be making any money?" If you say yes, then youroption is ITM, if no, then your option is OTM.
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Premium
Premium is how much a particular option is worth. It is made of two main components:intrinsic value and time value.
Premium = intrinsic value + time value
Starting with intrinsic value, it equals to how much an option is in-the-money. Bydefinition, only ITM options will have intrinsic value, and both ATM and OTM will not. If anoption is ITM by $2, then that is the intrinsic value of that option. Intrinsic value is only affectedby price movement; it is immune to time decay. This is an important concept to understand.
The other part is time value. Since options are time dependent, you are paying a portionof the premium to time. Time decays the fastest within the last 30 days. We usually do notrecommend anybody to trade the front (current) month for this reason alone.
Here's an example, if an option costs $5.00 and is ITM by $3.00, then what portion of thepremium is time value. Answer: $2.00.This means of the $5.00 that you paid; only $2.00 of itwill be affected by time decay.
Lets say that your stock does not move at all, the most you can lose from time is $2.00.The other $3.00 is not affected since that is the actual value and is only affected by pricemovement.
If an option costs $5.00 and is OTM, then what portion of the premium is time value.Answer: $5.00. Remember, only ITM options have intrinsic value, by definition. All ATM andOTM options only have time value. This means that the entire $5.00 is exposed to time decay.Lets say that your stock does not move at all, this means you can lose your entire $5.00premium to time decay.
Options Trading Basics - What Stock Options Are
The most important thing to learn before you can even consider Options Trading is
exactly what Stock Options are. In Options Trading, we are not trading the stocks itself. Instead,
we are merely trading the right to own or sell those stocks and these contracts to buy or sell the
underlying stocks are known as stock options. Stock Options are derivative instruments just like
stock futures. Stock Options cost only very little money to buy while allowing you to control the
profits on the underlying stocks as if you owned those stocks! It is very similar to the Option toPurchase you signed when you bought your house. If the price of the stock rallies strongly after
you purchase its stock options, you would make those same profits without buying the stocks at
all! This creates the explosive profits that you read about in Options Trading all the time.
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Options Trading Basics - Call Options
Call Options are stock options that grant you the right, but not the obligation, to buy the
underlying stock at a fixed price in the future. You buy Call Options when you are of the opinion
that the stock is going to rise. If you buy call options with the right to buy the stock at its price
right now, you could turn it around for a good profit should the stock rally because you own the
right to buy it at a lower price! Call options effectively allows you to control those same profitsas if you bought the stock at only a small fraction of the price.
Options Trading Basics - Put Options
Put Options are stock options that grants you the right, but not the obligation, to sell the
underlying stock at a fixed price in the future. You buy Put Options when you are of the opinion
that the stock is going to fall. If you buy put options with the right to sell the stock at its price
right now, you could turn it around for a good profit should the stock fall because you own the
right to sell it at a higher price! Put options effectively allows you to control those same profits
as if you have shorted the stock at only a small fraction of the price without needing any margin.
Options Trading Basics - Risks of Options Trading
Options Trading can be extremely risky in many ways and the biggest reason of all is the
fact that stock options could expireworthless along with all your money put into buying them if
your opinion on the stock is wrong. This is what we call "expiring out of the money". This is
why understanding Options Moneyness is so important to anyone who wish to start Options
Trading.
What Are Option Greeks
The mathematical characteristics of theBlack-Scholes modelare named after the Greek
letters used to represent them in equations. These are known as the Option Greeks. The 5 Option
Greeks measure the sensitivity of the price ofstock optionsin relation to 4 different factors;
Changes in the underlying stock price, interest rate, volatility, time decay.
Option Greeks allow option traders to objectively calculate changes in the value of the
option contracts in their portfolio with changes in the factors that affects the value of stock
options. The ability to mathematically calculate these changes gives option traders the ability
tohedgetheir portfolio or to construct positions with specific risk/reward profiles. This alone
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makes knowing the Option Greeks priceless in options trading.
For the amateur trader, knowing the delta (Greek Symbol ) of your options position is
the most important as it gives you an indication of how your option's value will change with
movements in the underlying stock price - all other variables remaining the same. Knowing your
time decay (theta ) gives you an indication of how much time value your options tradingposition is losing each day - all other variables remaining the s Trading options without an
understanding of the Greeks the essential risk measures and profit/loss guideposts in options
strategies is synonymous to flying a plane without the ability to read instruments on
instruments panel on cockpit.
Unfortunately, many traders not know how to read the Greeks when trading. This puts
them at risk of a fatal error, much like a pilot would experience flying in bad weather without the
benefit of a panel of instruments at his or her disposal.
When taking an option position or setting up an options strategy, there will be risk and
potential reward from the following areas:
Price change
Changes in volatility
Time value decay
If you are an option buyer, then risk resides in a wrong-way price move, a fall in impliedvolatility (IV) and decline in value on the option due to passage of time. A seller of that option,
on the other hand, faces risk with a wrong-way price move in the opposite direction or a rise in
IV, but not from time value decay.
Interest rates, while used in option pricing models, generally dont play a role in typical
strategy designs and outcomes, so they will remain left out of the discussion at this point.
Professionals use the Option Greeks to measure exactly how much they need to hedge their
portfolio and to surgically remove specificrisk factorsfrom their portfolio. The Option Greeks
also enable the measurement of how much risk the portfolio is exposed to, and where that risk
lies (with movements in interest rates or volatility, for example). Having a comprehensive
knowledge of options Greeks is essential to long term success in options trading.
The 5 Option Greeks are:
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Delta (Greek Symbol ) - a measure of an option's sensitivity to changes in the price of the
underlying asset
Gamma (Greek Symbol ) - a measure of delta's sensitivity to changes in the price of the
underlying asset
Vega - a measure of an option's sensitivity to changes in the volatility of the underlying asset
Theta (Greek Symbol ) - a measure of an option's sensitivity to time decay
Rho (Greek Symbol ) - a measure of an option's sensitivity to changes in the risk free
interest rate .
Delta:
Delta for individual options, and position Delta for strategies involving combinations of
positions, are measures of risk from a move of the underlying price. For example, if you buy an
at-the-money call or put, it will have a Delta of approximately 0.5, meaning that if the underlying
stock price moves 1 point, the option price will change by 0.5 points (all other things remaining
the same). If the price moves up, the call will increase by 0.5 points and the put will decrease by
0.5 points. While a 0.5 Delta is for options at-the-money, the range of Delta values will run from
0 to 1.0 (1.0 being a long stock equivalent position) and from -1.0 to 0 for puts.
Vega:
When any position is taken in options, not only is there risk from changes in the underlying but
there is risk from changes in implied volatility. Vega is the measure of that risk. When the
underlying changes, or even if it does not in some cases, implied volatility levels may change.
Whether large or small, any change in the levels of implied volatility will have an impact on
unrealized profit/loss in a strategy. Some strategies are long volatility and others are short
volatility, while some can be constructed to be neutral volatility. For example, a put that is
purchased is long volatility, which means the value increases when volatility increases and falls
when volatility drops (assuming the underlying price remains the same). Conversely, a put that is
sold (naked) is short volatility (the position loses value if the volatility increases). When a
strategy is long volatility, it has a positive position Vega value and when short volatility, its
position Vega is negative. When the volatility risk has been neutralized, position Vega will be
neither positive nor negative.
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Theta
Theta is a measure of the rate of time premium decay and it is always negative (leaving position
Theta aside for now). Anybody who has purchased an option knows what Theta is, since it is one
of the most difficult hurdles to surmount for buyers. As soon as you own an option (a wasting
asset), the clock starts ticking, and with each tick the amount of time value remaining on the
option decreases, other things remaining the same. Owners of these wasting assets take theposition because they believe the underlying stock or futures will make a move quick enough to
put a profit on the option position before the clock has ticked too long. In other words, Delta
beats Theta and the trade can be closed profitably. When Theta beats Delta, the seller of the
option would show gains. This tug of war between Delta and Theta characterizes the experience
of many traders, whether long (purchasers) or short (sellers) of options.
Gamma
Delta measures the change in price of an option resulting from the change in the underlying
price. However, Delta is not a constant. When the underlying moves so does the Delta value on
any option. This rate of change of Delta resulting from movement of the underlying is known as
Gamma. And Gamma is largest for options that are at-the-money, while smallest for those
options that are deepest in- and out-of-the-money. Gammas that get too big are risky for traders,
but they also hold potential for large-size gains. Gammas can get very large as expiration nears,
particularly on the last trading day for near-the-money options.
Rho:
Rho is a risk measure related to changes in interest rates. Since the interest rate risk is generally
of a trivial nature for most strategists (the risk free interest rate does not make large enough
changes in the time frame of most options strategies).
Hedging with Options
Options offer additional flexibility for hedging and investing. Calls can be purchased tocap prices, if the expectation is for rising prices. Conversely, a floor can be established bythe purchase of puts if there is a likelihood of a market decline. Calls and puts can be combinedin a single strategy to effectively put a collar on prices, limiting the upward and downwardmoves.
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Futures contracts have been used to manage cash market price risk for more than acentury. Hedging allows a market participant to lock in prices and margins in advance andreduces the potential for unanticipated loss.
Hedging reduces exposure to price risk by shifting that risk to those with oppositeprofiles or to investors who are willing to accept the risk in exchange for profit opportunity.Hedging with futures eliminates the risk of fluctuating prices, but also means limiting theopportunity for future profits should prices move favorably.
A hedge involves establishing a position in the futures or options market that is equal andopposite of a position at risk in the physical market. For instance, a metals dealer who holds (islong) 50 ounces of platinum can hedge by selling (going short) platinum futures contract.The principle behind establishing equal and opposite positions in the cash and futures or optionsmarkets is that a loss in one market should offset by a gain in the other market.
Hedges work because cash prices and futures prices tend to move in tandem, convergingas each delivery month contract reaches expiration. Even though the difference between the cashand futures prices may widen or narrow as cash and futures prices fluctuate independently, therisk of an adverse change in this relationship known as basis risk) is generally much less than therisk of going un hedged and, the larger a group of participants in the market, the greater thelikelihood that the futures. Price will reflect widely held industry consensus on the value of the
commodity.
Because futures are traded on exchanges that are anonymous public auctions with pricesdisplayed for all to see, the markets perform the important function of price discovery. Theprices displayed on the trading floor of the Exchange, and disseminated to information vendorsand news services worldwide, reflect the marketplaces collective valuation of how much buyersare willing to pay and how much sellers are willing to accept.
The purpose of a hedge is to avoid the risk of an adverse market movement resulting inmajor losses. Because the cash and futures markets do not have a perfect relationship, there is nosuch thing as a perfect hedge, so there will almost always be some profit or loss. However, animperfect hedge can be a much better alternative than no hedge at all in a potentially volatile
market.
PLATT'S FUTURES AND OPTIONS GLOSSARY
Glossary Futures and Options Terminology Category
American optionAn option that may be exercised on any day ahead ofexpiry. These trade on the futures exchanges.
options
ArbitrageThe simultaneous purchase and sale of an instrument intwo separate markets, when the price is out of line.
futures/options/ swaps
Asian option An option that is exercised against an average over aperiod.
Options
At the money option(ATM)
An option with an exercise price at the current marketlevel of the underlying.
Options
BasisThe gap between the active futures price and theimplied forward price of the underlying commodity.
Futures
Basis swap Basis swaps are used to hedge exposure to basis risks, Swaps
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such as locational risk or time exposure risk. Forexample, a natural gas basis swap could be used tohedge a locational price risk: the seller receives fromthe buyer a Nymex settlement value (usually theaverage of the last three days closing prices) plus anegotiated fixed basis, and pays the buyer the publishedindex value of gas sold at a specified location (Source:
Risk Publications)
Black-ScholesOptions pricing theory derived by Fisher Black andMyron Scholes, based on the theory that price volatilityis random around a given trend.
Options
CallThe right, but not the obligation, to buy something, forinstance, a future.
Options
Combination hedgingA risk management strategy that uses a combination ofhedges using different derivative instruments (Source:Risk Publications)
futures/options/swaps
Contracts for difference
This term is used as an alternative to the term swap.
The term is often applied to hedging instruments usedin the UK electricity market, and in the Brent 'CFD'market. (Source: Risk Publications)
Swaps
Covered option An option written against an underlying position Options
Curve-lock swap
Swap which "locks" the counterparty into an existingprice relationship in the forward curve, with the aim ofbenefiting from any shifts in the forward curve e.g.between backwardation and contango (Source: RiskPublications)
Swaps
DeltaThe rate of change of the value of an option withrespect to changes in the price of the underlyingcommodity
options
Diff swaps
Contract to exchange the difference between 1) thedifferential between the price of two products (fixed),and 2) the actual differential over time (floating)(Source: Risk Publications)
Swaps
Double-up swap
This instrument grants the swap provider an option todouble the swap volume before the pricing periodstarts; granting this option, swap users can achieve aswap price which is better than the actual market price.The mechanism by which this is achieved involves
consumers 0,vho are buying fixed) selling a putswaption, or producers (who are selling fixed) selling acall swaption; in either case, the premium earned fromthe sale is used to subsidize the swap price. (Source:Risk Publications)
Swaps
European option Option that can only be exercised on the date of expiry.These typically trade in the OTC markets. For metals,expiry is the third to last day of the month since
Options
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settlement. In crude oil, options expire OTC six daysprior to the 25th of the month or three days before theunderlying future expires.
Exchange-tradedFutures or options that are traded on an exchange suchas NYMEX or IPE, with standard contracts and rules.
futures/options
ExerciseThe conversion of the option into the underlying
commodity
Options
Extendable swap
The extendable swap is constructed on the sameprinciple as the double-up swap , except that instead ofdoubling the swap, the provider has the right to extendthe swap, at the end of the agreed period, for a furtherpredetermined period (Source: Risk Publications)
Swaps
FuturesA forward contract that trades on an organizedexchange allowing traders to take position in themarket at a future date
Futures
GammaThe rate of change in delta per unit change in theunderlying instrument.
Options
Historic volatility
The change in the absolute value of a commodity orinstrument over a certain period, expressed as apercentage of the LOWEST price recorded in thatperiod.
futures/options/swaps
Implied volatility The volatility implied by a certain option price. Options
In the money option(ITM)
An option with an exercise price higher than the currentvalue of the underlying commodity.
options
Index swap
Iin the natural gas market in North America, indexswaps are often used to hedge against location pricerisk (a form of basis risk). The seller receives a fixed,
or otherwise determined, price and pays the buyer thepublished index value for natural gas from a specifiedlocation (Source: Risk Publications)
Swaps
Inter-month spreadSimultaneous purchase and sale of a future in twoseparate trading periods
futures/options/swaps
Long positionA trader buys something, in the hope that its value willgo up
futures/options/swaps
Long-liquidation Selling of a long position futures/options/swaps
Margin swap Refining margin swaps (Source: Risk Publications) Swaps
Margins
A deposit paid on a futures transaction. Initial margin is
paid, followed by top-ups as the position develops.Margins are paid to the exchange. Futures
Naked optionA short option position in which the writer does nothave the underlying commodity
Options
Off-market swap In this type of swap, a premium is built into the swapprice to fund the purchase of options or to allow for therestructuring of a hedge portfolio. Off-market swapsare generally used to restructure or cancel old
Swaps
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swap/hedge deals: essentially, they simulate arefinancing pack-age (Source: Risk Publications)
Options
A system of trading under which the writer of theoption gives someone the right but not the obligation tobuy or sell an underlying commodity, for instance, afutures contract. Options can be over-the-counter orexchange-traded. Because the writer of the option facesmore risk than the buyer, he charges a premium for hisservices.
Options
Out of the money option(OTM)
An option with an exercise prices lower than thecurrent market level of the underlying instrument. Suchan option has no intrinsic value, but has got time value,as price changes in the underlying might bring it backinto the money.
Options
Over the counter (OTC)Bilateral markets in which contracts for futures, optionsand swaps are written on a tailor-made basis.
futures/options/swaps
Participation swap
Similar to a regular swap in that the fixed price payer is
fully protected when prices rise above the agreed(fixed) price, with the difference that the client-participates" in any price decrease. For example, aparticipation swap agreed at a level of $80/mt for highsulfur fuel oil, with a 50% participation, would offerfull protection against prices above $80/mt. But tilebuyer would retain 50% of the savings generated whenprices fell below $80/mt. (Source: Risk Publications)
swaps
PremiumThe price of an option, as determined by an optionspricing model.
Options
Pre-paid swap
By means of a pre-paid swap, the fixed payments that
form one side of the cash-flows generated by a standardswap, and which are normally paid over the life of theswap, arc discounted hack to their net pre-sent valueand paid as an immediate cash sum to one of the swapcounterparties. That counterparty will then makefloating price pay-merits over the life of the swap, justas in a standard swap. Pre-paid swaps are often used asa source of project finance or pre-export financing.(Source: Risk Publications)
Swaps
Profit-takingLong liquidation or short-covering set off by the desireto realize the profits in a position.
futures/options/swaps
PutThe right, but no the obligation, to sell something, forinstance, a future.
Options
Refining margin swaps Swaps that simultaneously hedge the price of theproducts (or output) of a refinery, and the price of thecrude oil feedstock (or input). That is, the products aresold, and the crude is bought, for equivalent for-wardperiods. Refinery margin swaps effectively "lock-in"
Swaps
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the profitability of a refinery. (Source: RiskPublications)
RhoThe rate of change of the value of an option withrespect to the risk-free rate of interest.
Options
Short positionA trader sells something he doesn't have, with a view tobuying it cheaper at a later date.
futures/options/swaps
Short-covering Buying back of short sell positions. futures/options/swaps
SpreadThe difference between two futures contract months (orcontracts for different commodities).
Stop-loss ordersBuy or sell orders put in through a broker, which areautomatically triggered if the price moves above orbelow a certain level.
Futures
Straddle (long)
Simultaneous purchase of a put and a call option withdifferent maturities. This is a bet that volatility willincrease; the rise in the value of one option will offsetthe non-productive premium paid by the other option.
Options
Straddle (short)Simultaneous sale of a put and a call with differentmaturities, with a view that volatility will go down. options
Strangle Buying call and buying put with the same maturity.
Strike price
The price which the buyer of an option decides to lockin. For instance, at $13.00 spot, WTI puts and calls canbe written at strike prices at ...$14.00, $13.50, $13.00,$12.50, 12.00...
Options
SwaptionOption to purchase (call swaption) or sell (putswaption) a swap at some future date. (Source: RiskPublications)
swaps/options
Theta
The rate of change of the value of an option with
respect to time. Options
VegaThe rate of change of the value of an option withrespect to the volatility of the underlying instrument(also sometimes called kappa).
Options