Lesson 1 - Introduction to Derivatives

2. Futures Contracts
• A futures contract is an Agreement to buy or sell an asset for a certain price at a certain
time.
• Similar to a forward contract
• But a forward contract is traded on OTC, a futures contract is traded on an exchange.
(Chicago board exchange, London stock exchange, etc)
• In futures contracts, the exact delivery date is not specified, usually, it is referred to by its
delivery month, and this delivery month is usually decided by the seller, the short
position holder.
• Parties don’t know each other — the exchange acts as a middleman in future contracts.
• Here also, long position (buyer) and short position (seller).

Examples of Futures Contracts

Agreement to:

• Buy 100 oz. of gold @ US$900/oz. in December

• Sell £62,500 @ 2.0500 US$/£ in August
• Sell 1,000 bbl. of oil @ US$150/bbl. in October
Note that the quantity and the quality of the assets above are the standard for a single
futures contract. So, when we say 100 oz of gold, that is always a single futures contract. If
we say 200 oz of gold, there should be 2 future contracts, likewise.
Usually, future contracts are for,
Commodities: gold, oil, copper, cattle, sugar, etc.
Financial assets: stock indices, currencies, Treasury bonds

How the Price is Set

• Based on supply and demand
• If more traders want to buy (go long position) → price goes up
• If more want to sell (go short position) → price goes down
What do you mean by, Contract usually closed out prior to maturity?

• Even though a futures contract has a set delivery/maturity month, most traders don’t
wait until delivery.
• They usually close the contract early by taking the opposite position before the contract
expires.
Let’s say:
• On January 1, you go long position (agree to buy) a March gold futures contract at
$1,380
• But on February 20, you sell (take the short position) the same contract at $1,400 to
close your position.

Explanation:

• On Jan 1, you go long (agree to buy in the future)

• On Feb 20, you take an equal short position (sell) to close out the contract
• Now your positions cancel out, and you never have to actually receive the gold.
 Your Profit:
• Bought at $1,380
• Sold for $1,400
• Profit = $20 per unit
(No physical gold involved—just cash difference)

Further ChatGPT explanation on the above differences:

1. Trading Platform:
Forward contracts are private agreements between two parties, usually traded over-the-counter
(OTC). In contrast, futures contracts are traded on organized exchanges, like the CME, which
adds transparency and structure.
2. Standardization:
Forwards are non-standard, meaning the contract terms (like amount, delivery date, or asset type)
can be customized. Futures, however, are standardized — the exchange sets contract size,
expiration dates, and other features, so only price is negotiated.
3. Delivery Dates:
A forward contract typically has one fixed delivery date chosen by the parties. Futures offer a
range of preset delivery months, allowing traders to select from available options on the
exchange.
4. Settlement Timing:
Forwards are settled at the end of the contract — profit or loss is realized only at maturity.
Futures are settled daily through a process called marking to market, where gains and losses
are calculated and credited each day.
5. Closing the Contract:
In forwards, contracts usually go to delivery or are cash-settled at maturity. In futures, most
traders close out their positions before the contract expires by taking an opposite position in the
market.
6. Credit Risk:
Forward contracts carry some credit risk because there's no intermediary — one party might
default. Futures contracts have virtually no credit risk since the exchange’s clearing house
guarantees both sides of the trade.
3. Options
• Options are traded both on exchanges and in the over-the-counter market.
• Here also, we have 2 parties, as buyer and the seller.

There are two types of options:

1. A call option
2. A put option.

1. A call option

• Gives the holder the right to buy the underlying asset (stock) by a certain date for a
certain price. It means the option holder has the choice to buy something (like a stock)
at a fixed price before a certain date, but only if they want to. They are not forced to
buy it, it's just a right, not an obligation.
Example:
o You have a call option to buy a stock for $100 (strike price) any time before June 30.
o If the stock goes up to $130, you use your option and buy it for $100, making a profit.
o If the stock stays below $100, you do nothing and just let the option expire.

2. A put option

• Gives the holder the right to sell the underlying asset (stock) by a certain date for a
certain price. It means the option holder has the choice to sell something (like a stock) at
a fixed price before a certain date, but only if they want to. They are not forced to sell
— it is just a right, not an obligation.

Example:

o You have a put option to sell a stock for $100 (strike price) any time before June 30.
o If the stock price falls to $70, you use your option and sell it for $100, making a profit.
o If the stock price stays above $100, you do nothing and just let the option expire.

• The fixed price at which the asset can be bought or sold is called the exercise price or
strike price.
• The last date the option can be used is called the expiration date or maturity date
American vs. European Options

• American option: You can exercise it anytime before or on the expiration date.
• European option: You can exercise it only on the expiration date (not before).
• So, American options give more flexibility, while European options are more limited
but easier to analyze.
• Most of the options that are traded on exchanges are American.
• In the exchange-traded equity option market, one contract is usually an agreement to buy
or sell 100 shares.
• Some features of American options are often figured out or estimated by looking at the
simpler European options, because European options are easier to analyze.

A simple ChatGPT explanation of the above slide:

This slide shows the option prices for Intel stock when the stock price is $20.83.
It includes prices for:
• Call options (right to buy)
• Put options (right to sell)
• For two strike prices: $20.00 and $22.50
• And for three different expiration months: June, July, and October
How to read it:
• For example, a June Call with a strike price of $20 costs $1.25
• A July Put with a strike price of $22.50 costs $2.20

What it shows:
• Calls are cheaper when the strike price is higher
• Puts are more expensive when the strike price is higher
• Longer expiry = higher premium (October options cost more than June ones)

Options vs. Futures/Forwards

• A futures or forward contract means you are obligated to buy or sell an asset at a
certain price on a future date. You must complete the contract.
• An option gives you the right, but not the obligation, to buy or sell at a certain price.
You can choose to use the option only if it benefits you — you are not forced to act.

❖ This is the key difference:

Options = right (your choice)
Futures/Forwards = obligation (no choice)

• Also, it's free to enter a forward or futures contract (apart from margin requirements).
But with options, you must pay a premium upfront to buy the right.

Option Positions
In the options market, there are four main types of participants:
1. Buyers of call options – They have the right to buy the asset at a fixed price.
2. Sellers (writers) of call options – They have the obligation to sell the asset if the buyer
chooses to exercise.
3. Buyers of put options – They have the right to sell the asset at a fixed price.
4. Sellers (writers) of put options – They have the obligation to buy the asset if the buyer
chooses to exercise.
Now, if we divide these participants into buyers and sellers of options, every option contract has
two sides:
1. Buyers of Options (Long position)
These participants pay a premium to get the right, but not the obligation, to buy or sell the
asset.
As there are two types of options, buyers can be further divided into:
1. Buyers of Call Options / Long Call – They have the right to buy the asset at a fixed
price.
2. Buyers of Put Options / Long Put – They have the right to sell the asset at a fixed
price.

2. Sellers of Options (Short Position)

These participants are also called writers. They receive the premium and take on the obligation
if the buyer chooses to exercise the option.
Sellers are also divided into:
1. Sellers (Writers) of Call Options / Short Call – They have the obligation to sell the
asset if the call buyer exercises.
2. Sellers (Writers) of Put Options / Short Put– They have the obligation to buy the
asset if the put buyer exercises.

If we divide the above classifications on the two types of options, for further understanding,
we get:
1.Call Option
• Long Call: The buyer of the call option → has the right to buy the asset at the strike
price.
• Short Call: The seller (writer) of the call option → has the obligation to sell the asset if
the buyer exercises.

2.Put Option
• Long Put: The buyer of the put option → has the right to sell the asset at the strike
price.
 • Short Put: The seller (writer) of the put option → has the obligation to buy the asset if
the buyer exercises.

ChatGPT summary of the above:

Option Positions – Summary

There are four main participants in the options market:

Buyers (Long Position) → Have a right, pay a premium

• Long Call: Right to buy the asset

• Long Put: Right to sell the asset

Sellers (Short Position) → Have an obligation, receive a premium

• Short Call: Obligation to sell the asset if exercised

• Short Put: Obligation to buy the asset if exercised

Quick Breakdown by Option Type:

Call Option

• Long Call → Right to buy

• Short Call → Obligation to sell

Put Option

• Long Put → Right to sell

• Short Put → Obligation to buy
Profit or Loss of Options
Here we will look at 4 scenarios, based on the 4 types of participants discussed above.
1. The buyer’s (long position) profit or loss of a call option
2. The seller’s (short position) profit or loss of a call option
3. The buyer’s (long position) profit or loss of a put option
4. The seller’s (short position) profit or loss of a put option

1. The buyer’s (long position) profit or loss of a call option

Example:
Suppose a trader buys a European call option at Rs 5 on HNB, strike price Rs. 100.
Step 1: Understanding the Setup

• Buying a call option means he gets the right to buy stocks of HNB at the strike price Rs.
100 . This position is also known as a long position of a call option, i.e., long call.
• The option cost (premium) is Rs. 5. So, the trader pays Rs. 5 upfront for the right to
buy HNB at Rs. 100.
Step 2: What Happens at Expiry?

• Stock price (of HNB) in the market on the expiration = Terminal stock price
• Terminal stock price can be either higher or lower than the strike price ( Rs. 100)
• Since this option is a call option, the holder, or the buyer, would like to buy the stock at
the lowest possible price to maximize their benefit.
• Hence, he will only use the option if the terminal stock price is above Rs. 100 at
expiration.
• If the stock stays at or below Rs. 100, the option is worthless, and he will not exercise
the option. But he still paid a premium for the right to buy. That becomes a loss here.
To understand further, let’s look at an example:
Example:
• Suppose the stock price at expiration is Rs. 110
• The trader has the right to buy at Rs. 100 (strike price)
• Even though the stock price in the market is Rs. 110, with the option, he can buy the
stocks at a lower price, the strike price of 100. So he exercised the option.
• That’s a gain of Rs. 10, but since he paid Rs. 5 for the option.
Net profit = Rs. 10 – Rs. 5 = Rs. 5
 • But if the stock price is below Rs. 100, like Rs. 90, the trader won’t use the option —
because buying at Rs. 100 ( the strike price) makes no sense when it’s cheaper in the
market.
• So, he simply lets it expire and loses Rs. 5 (the premium paid).
Step 3: Profit Calculation

• In the previous step, we understood that the option is only exercised if the market price
(terminal stock price) > the strike price. Up to that point, the option is not exercised,
hence the premium paid to obtain the right to buy at Rs. 100 becomes a loss
• Here the premium paid was Rs. 5, hence the loss is Rs. 5.
• This section is marked blue.
• If HNB stock goes above 100, the trader starts gaining.
• Profit = Terminal Stock Price – Strike Price – Premium Paid
Example Calculations:

• If stock ends at Rs. 110:

Profit = 110 – 100 – 5 = Rs. 5
• If stock ends at Rs. 120:
Profit = 120 – 100 – 5 = Rs. 15
• If stock ends at Rs. 130:
Profit = 130 – 100 – 5 = Rs. 25
• If stock ends at Rs. 140:
Profit = 140 – 100 – 5 = Rs. 35
• If stock ends at Rs. 150:
Profit = 150 – 100 – 5 = Rs. 45
• If stock ends at Rs. 160:
Profit = 160 – 100 – 5 = Rs. 55
We can see that,

• Profits remain at –5 until the stock price crosses Rs. 100.

• Beyond that, profits rise as the terminal stock price increases.

Step 4: Drawing the Graph

Observations:

• Flat loss line at –5 until Rs. 100

• Upward slope after Rs. 100 — showing increasing profit

Some conclusions:

• The most the buyer can lose is the premium paid (Rs. 5), even if the stock price drops
significantly. Hence the maximum loss of the buyer (Long call) is limited to the premium
paid to obtain the right to buy.
• Profit starts only if stock price > Rs. 100
• Profit increases as stock price rises

• No profit or exercise if stock price is ≤ Rs. 100

• Option gives the right to buy, not an obligation.
2.The seller’s (short position) profit or loss of a call option
In the earlier section, we explored the P or L of a buyer of the call option. For one to buy the call
option, someone must sell it. In this section, we will explore the P or L of the seller of the call
option. This is also known as the short call position.
For understanding, let’s consider the same example, but in the point of the seller or the short
position of the call option.
Example:
Suppose a trader writes (sells) a European call option on HNB for Rs. 5, with a strike price of Rs.
100.
Step 1: Understanding the Setup

• Writing or selling a call option means the trader is giving someone else the right to buy
HNB stock at Rs. 100.
• This is known as a short position in a call option, i.e., short call.
• The trader receives Rs. 5 as the premium from the buyer for the right he sells.

Step 2: What Happens at Expiry?

• On expiry, the terminal stock price is the market price of HNB.

• If the stock price is at or below Rs. 100, the option is not exercised by the buyer of the
call option as we learned earlier, and the trader keeps the Rs. 5 premium as profit.
• But if the stock price goes above Rs. 100, the buyer will exercise the option.
• The trader (writer) must now sell the stock at Rs. 100, even if it's worth more in the
market, causing a loss.
• The higher the stock price goes, the greater the loss.

To understand further, let’s look at an example:

• Suppose the stock price ends at Rs. 110.

• The trader sells at Rs. 100 (strike price), but the stock is worth Rs. 110.
• So, the loss is Rs. 10, but he earned Rs. 5 as premium.
• Net loss = Rs. 10 – Rs. 5 = Rs. 5
• If stock price = Rs. 90, the option is not exercised, and trader keeps Rs. 5
 Step 3: Profit Calculation

• In the previous step, we understood that the call option will only be exercised by the
buyer or the long position holder if the market price (terminal stock price) > the strike
price (Rs. 100).
• Up to that point (i.e., when the terminal stock price is ≤ Rs. 100), the option is not
exercised, and the writer keeps the premium (Rs. 5) as profit. This sections is marked
in blue.
• However, if the stock price goes above Rs. 100, the buyer exercises the option, and the
writer starts making a loss.
• The higher the stock price rises, the greater the writer’s loss.
• Profit if the option is exercised = Premium Received – (Terminal Stock Price –
Strike Price)
• Profit if the option is not exercised = Premium Received

Example Calculations:

• If stock ends at Rs. 70 to Rs. 100 → Profit = Rs. 5

• If stock ends at Rs. 110 → Profit = 5 – (110 – 100) = –5
• If stock ends at Rs. 120 → Profit = 5 – (120 – 100) = –15
• If stock ends at Rs. 130 → Profit = 5 – (130 – 100) = –25
• If stock ends at Rs. 140 → Profit = 5 – (140 – 100) = –35
• If stock ends at Rs. 150 → Profit = 5 – (150 – 100) = –45
• If stock ends at Rs. 160 → Profit = 5 – (160 – 100) = –55
We can see that,

• Profits remain at Rs. 5 until the stock price reaches Rs. 100.
• Beyond Rs. 100, profits turn into losses, and the loss increases as the terminal stock
price rises.

Step 4: Drawing the Graph

Observations:

• Flat profit line at Rs. 5 until the stock price reaches Rs. 100
• Downward slope after Rs. 100 — showing increasing loss as the stock price rises

Some Conclusions:

• The maximum profit is limited to the premium received (Rs. 5)

• Losses begin if the stock price > Rs. 100
• Higher the stock price, greater the loss
• The seller (writer) has an obligation to sell at Rs. 100 if the buyer exercises
• Writing a call option carries unlimited loss potential
Next, let’s try to combine the long position (buyer’s) and short position (seller’s) profit or
loss from a call option to get a clearer idea. (Combination of the above 2 scenarios).
If we consider the same example, the profit calculation would be:

If we draw the graphs:

Some conclusions of the P or L of call options for both long and short positions:

• If the stock stays below the strike price (e.g., Rs. 80 < Rs. 100), the buyer will not
exercise the option, since they can buy cheaper from the market. The Rs. 5 premium
becomes a sunk cost (irrecoverable loss).
• If the stock price goes above the strike price (e.g., Rs. 110 > Rs. 100),
the buyer will exercise the option and buy at Rs. 100, gaining from the difference.
 • For a Buyer (Holder) / Long position holder of a Call Option:
o Loss is limited to the premium paid (e.g., Rs. 5).
o Profits are unlimited if the stock price rises above the strike price.
• For a Seller (Writer) / short position holder of a Call Option:
o Loss is unlimited — as the stock price keeps rising, losses increase.
o Gain is limited to the premium received (e.g., Rs. 5).
• The profit/loss for both parties moves in opposite directions.

Let’s compare the profit or loss of a call option buyer (long call) with the profit or loss of
someone who takes a long position in a forward or futures contract.
If we say the agreed price of a forward contract = Rs. 100

Simple ChatGPT comparison:

Call Option (Long Call – Buyer):

• Has the right to buy, not the obligation

• Can choose not to exercise the option if the price is unfavorable

• Maximum loss is limited to the premium paid

 • Profit is unlimited if the stock price rises

• More flexible – the buyer can simply walk away

Forward/Futures Contract (Long Position – Buyer):

• Buyer is obligated to buy at the agreed price (e.g., Rs. 100)

• If the market price falls below Rs. 100, buyer must still buy, causing a loss

• No flexibility – the contract must be honored

• Profit is possible if the market price rises, but

• Loss is unlimited if prices fall sharply

Key Insight from Your Notes:

• “In forwards/futures, the buyer must go ahead even if it means a loss.”

• “In options, the buyer can skip exercising the right — only losing the premium.”

Now that we have analyzed the P and L of both positions of a call option, let’s move on to the put
option.

3. The buyer’s (long position) profit or loss of a put option

Suppose a trader buys a European put option at Rs 5 on HNB, strike price of Rs. 100
Step 1: Understanding the Setup

• Buying a put option means the trader gets the right to sell HNB stock at the strike
price of Rs. 100. This position is also called a long put.
• The option costs Rs. 5 (the premium), so the trader pays Rs. 5 upfront for the right to
sell HNB at Rs. 100.
Step 2: What Happens at Expiry?

• The stock price of HNB in the market at the time of expiry is called the terminal
stock price.
 • This terminal stock price can be either higher or lower than the strike price (Rs.
100).
• Since this option is a put option, the holder, or the buyer of the put option, would like
to sell the stock at the highest possible price to maximize their benefit.
• So, the trader will only exercise the option if the terminal stock price is below Rs.
100 at expiration.
• If the stock price is Rs. 100 or above, the option is worthless and won’t be
exercised. Because they can sell higher market price, than selling at the strike price.
But the Rs. 5 premium paid to buy the right to sell at Rs.100, becomes a loss

To understand further, let’s look at an example:

• Suppose the stock price at expiration is Rs. 90

• The trader has the right to sell at Rs. 100 (strike price)
• Even though the stock is worth only Rs. 90 in the market, the trader can sell it for Rs.
100, making a gain
• Gain = Rs. 100 – Rs. 90 = Rs. 10
• Since the trader paid Rs. 5 for the option,
Net profit = Rs. 10 – Rs. 5 = Rs. 5
• If the stock price is above Rs. 100, like Rs. 110, the trader will not exercise the option,
because selling at Rs. 100 doesn’t make sense — it’s better to sell at Rs. 110 in the
market.
• So the trader lets the option expire worthless and loses only Rs. 5 (the premium paid).

Step 3: Profit Calculation

 • We know that a put option will only be exercised by the buyer (long position holder) if
the market price (terminal stock price) is less than the strike price (Rs. 100).
• When the terminal stock price is greater than Rs. 100, the option is not exercised, and
the buyer incurs a loss equal to the premium paid (Rs. 5). This section is marked in
blue.
• However, if the stock price drops below Rs. 100, the buyer exercises the option and starts
making a profit.
• The lower the terminal stock price, the greater the profit.
• If the option is exercised:
Profit = Strike Price – Terminal Stock Price – Premium Paid
• If the option is not exercised:
Loss = Premium Paid
Example Calculations:

• If stock ends at Rs. 100 or above → Profit (Loss) = –5

• If stock ends at Rs. 90 → Profit = 100 – 90 – 5 = Rs. 5
• If stock ends at Rs. 80 → Profit = 100 – 80 – 5 = Rs. 15
• If stock ends at Rs. 70 → Profit = 100 – 70 – 5 = Rs. 25
• If stock ends at Rs. 60 → Profit = 100 – 60 – 5 = Rs. 35
• If stock ends at Rs. 50 → Profit = 100 – 50 – 5 = Rs. 45
• If stock ends at Rs. 40 → Profit = 100 – 40 – 5 = Rs. 55
We can see that,

• Profits (Loss) remain at -5 when the terminal stock price is Rs. 100 or above.
• Below Rs. 100, profits start increasing as the stock price drops.
• A put option benefits from a fall in the stock price in the market.

Step 4: Drawing the Graph

Observations:

• Flat loss line at –Rs. 5 until the stock price is Rs. 100 or above
• Upward slope after Rs. 100 moving left — showing increasing profit as the stock
price falls below Rs. 100
Some Conclusions:

• The maximum loss is limited to the premium paid (Rs. 5)

• Profits begin if the stock price falls below Rs. 100
• The lower the stock price drops, the greater the profit
• The buyer has the right to sell at Rs. 100 if the market price is lower
• Buying a put option is a good strategy when expecting the stock price to decline

4. The seller’s (short position) profit or loss of a put option

Suppose a trader writes/sells a European put option at Rs 5 on HNB with a strike price of Rs.
100.
Step 1: Understanding the Setup

• Writing a put option means the trader is giving someone else the right to sell HNB
stock to them at Rs. 100.
• This position is known as a short put.
• The trader receives Rs. 5 as a premium upfront for taking on this obligation.
Step 2: What Happens at Expiry?

• On expiry, the terminal stock price is the market price of HNB.

• The option buyer will only exercise the option if the market price is below Rs. 100
(to sell at the higher strike price).
• If the stock price is Rs. 100 or above, the option is not exercised, and the seller
keeps the Rs. 5 premium as profit.
• But if the price falls below Rs. 100, the option is exercised, and the seller must buy
the stock at Rs. 100, even though it is worth less in the market, resulting in a loss.
Example:

• If the stock price is Rs. 90, the seller must buy the stock at Rs. 100, while it’s worth
only Rs. 90 → Loss = Rs. 10
• Since the seller received Rs. 5 premium,
Net loss = Rs. 10 – Rs. 5 = Rs. 5
 • If the stock price is Rs. 110, the option is not exercised, and the seller keeps the Rs. 5
profits.

Step 3: Profit Calculation

• A put option is exercised only when the stock price < Rs. 100.
• If the option is exercised:
Profit (Loss) = Premium Received – (Strike Price – Terminal Stock Price)
• If the option is not exercised:
Profit = Premium Received (Rs. 5)
Example Calculations (Seller's Profit):

• If stock ends at Rs. 100 or above → Profit = Rs. 5

• If stock ends at Rs. 90 → Profit = 5 – (100 – 90) = –5
• If stock ends at Rs. 80 → Profit = 5 – (100 – 80) = –15
• If stock ends at Rs. 70 → Profit = 5 – (100 – 70) = –25
• If stock ends at Rs. 60 → Profit = 5 – (100 – 60) = –35
• If stock ends at Rs. 50 → Profit = 5 – (100 – 50) = –45
• If stock ends at Rs. 40 → Profit = 5 – (100 – 40) = –55
We can see that:

• Profits remain at Rs. 5 when the terminal stock price is Rs. 100 or above.
• When the stock price falls below Rs. 100, the seller begins to incur losses, which
increase as the price drops
Step 4: Drawing the Graph

Observations:

• Flat profit line at Rs. 5 until the stock price reaches Rs. 100 or above
• Downward slope as the stock price falls below Rs. 100 — showing increasing loss

Some Conclusions:

• The maximum profit is limited to the Rs. 5 premium received

• Losses begin if the stock price falls below Rs. 100
• The lower the stock price drops, the greater the loss
• The writer is obligated to buy the stock at Rs. 100 if the buyer exercises
• Writing a put option is risky if the trader expects the stock price to decline

Next, let’s try to combine the long position (buyer’s) and short position (seller’s) profit or
loss from a put option to get a clearer idea. (Combination of the above 2 scenarios).
If we consider the same example, the profit calculation would be:
If we draw the graphs:

Some Conclusions – Profit or Loss of Put Options (Buyer vs Seller):

• If the stock price stays above the strike price (e.g., Rs. 110 > Rs. 100), the buyer will
not exercise the put option, because they can sell at a better price in the market. The Rs.
5 premium becomes a loss (sunk cost), and the seller keeps the premium as profit.
• If the stock price drops below the strike price (e.g., Rs. 90 < Rs. 100), the buyer
exercises the option and sells at Rs. 100, gaining from the price difference. The seller
must buy at Rs. 100, even though the market value is lower, resulting in a loss.
• For the Buyer (Holder) / Long Put:
o Loss is limited to the premium paid (e.g., Rs. 5).
o Profits increase and are unlimited as the stock price falls further below the
strike price.
o Best used when expecting the stock price to go down.
• For the Seller (Writer) / Short Put:
o Profit is limited to the premium received (e.g., Rs. 5).
o Losses increase and are unlimited as the stock price falls further below the
strike price.
o Faces a higher risk if the stock drops sharply.
• The profit/loss outcomes for the buyer and seller are opposites — one’s gain is the
other’s loss.
We have discussed the profit and loss of the all 4 basic scenarios.
 Now let’s go deeper and consider a situation where both a put and a call option are sold
together by the seller (also called a short straddle), and what kind of profit or loss (P/L)
results at different stock prices.
Setup:

• The seller (SP) writes both a put and a call option at a strike price of Rs. 100.
• They receive Rs. 5 for each option, so a total of Rs. 10 premium is collected.
• The buyer can exercise either the call or the put, depending on whether the stock price
ends up above or below Rs. 100 — not both. If the buyer exercises the call option, put
option won’t be exercised. (Vise versa)

Explanations:
We are looking at what happens when both a call and a put option have been written (sold) by
the seller, and only one of them will be exercised, depending on the stock price at expiry. Here
let us consider the point of view the seller of the combined options.
1st let’s see what happens to the profit or loss of the short position holder of the options, when the
Market stock price = Rs. 80
Will the call option be exercised at Rs. 80?

• No, because the buyer has the right to buy at Rs. 100, but why would they buy at Rs.
100 when they can buy it in the market for Rs. 80?
• So the call option is not used (not exercised).
• The seller keeps the premium received from the call buyer: Rs. 5 profit.
• No loss from this side to the seller.
What about the put option?

• The buyer of the put option will exercise it, because they can sell at Rs. 100 even
though the market price is only Rs. 80.
• The seller (SP) now has to buy the stock at Rs. 100, even though it’s only worth Rs.
80.
 • That’s a loss of Rs. 20 to the seller. But he received a premium of Rs. 5, so the net
loss from the put option would be Rs. 15
Net Profit / Loss Calculation for Seller:

• Gain from call = Rs. 5

• Net loss from put = Rs. 15
• Net loss for the seller = 5 + (15) = (10)
Or you can calculate as,

• Loss from put = Rs. 20

• Total premiums = Rs. 10
• Net Loss for the seller = (20) + 10 = (10)

Likewise, we can calculate the P or L of the seller of the options (short position holder of call or
put options)
Note that:

• When the stock price = Rs. 100, neither option is exercised. The seller keeps the full
Rs. 10 premium = maximum profit.
• If the stock falls below Rs. 100, the put is exercised by the buyer and causes a loss
to the seller (since they have to buy at Rs. 100 even when the stock price in the
market is less than Rs. 100).
• If the stock goes above Rs. 100, the call is exercised, and again the seller loses (has
to sell at Rs. 100 while the market price is higher than Rs.100).
• But only one option is exercised, never both.
Now if we draw the graph:
Interpretations:

• Maximum profit of Rs. 10 occurs when the stock ends exactly at the strike price (Rs.
100), so neither option is exercised.
• As the stock price moves away from Rs. 100 (either up or down), losses increase.
• The seller takes on risk in both directions because one of the options will likely be
exercised.
• If the stock price is between Rs. 90 – Rs. 110, the seller will have a profit.
• This Rs. 90 to Rs. 110 range is called the spread — it’s the safe zone where the
seller doesn’t lose money and the spread depends on the stock price movements.
• Beyond this range, the seller loses.

Note that:

• In a short straddle, the seller is assumed to have sold both a call and a put option on
the same underlying asset at the same strike price (e.g., Rs. 100).
• For this, the seller collects Rs. 5 from each option, earning a total premium of Rs. 10.
• The premium depends on:
o The underlying asset price
o The time to maturity
o The volatility of the asset
• The premium received is a sunk cost for the buyer but income for the seller. Once paid,
it cannot be recovered if the option is not exercised.

Payoffs of Options at Maturity

• Know that P/L ≠ Payoffs

• Payoff means how much you gain or lose just from the option itself at expiry — it
doesn’t consider how much you paid to buy the option (or received from selling it) It
ignores the premium.
• Profit/Loss (P/L) means your actual outcome, including the initial cost of the option.
So:

• Payoff = Value from exercising the option

• Profit/Loss = Payoff minus the premium you paid (if you're the buyer)
We know that there are four basic Option Positions:
◼ A long position in a call option
◼ A long position in a put option
◼ A short position in a call option
◼ A short position in a put option
Note that:
• X = Strike Price (the agreed price in the option)
• ST = Terminal Stock Price (the price of the underlying asset at expiry)

Pay off a long position in a call option (buyer of a call option):

• Buyer of a call option has the right to buy stocks at the strike price , X.
• The buyer will exercise the option only if the stock price ST > X (i.e., the market price is
more than the strike price). Because then they can buy cheaper at the strike price.
• If the market price is less than or equal to the strike price (ST ≤ X), the buyer will not
exercise. Because then they can buy cheaper at the market price, than buying the strike
price.
• Payoff of a long call = max (ST - X, 0)
• The above formula means that if the stock price at the end (ST) is more than the strike
price (X), you get the difference as the payoff. If it's less, you get nothing (0).
• So, you either make a profit or no profit, but never a loss.
• Hence long call’s payoff is either positive or zero, but never negative.

Pay off a short position in a call option (seller of a call option):

• The seller (writer) of a call option has the obligation to sell stocks at the strike price, X, if
the buyer decides to exercise the option.
• The buyer will only exercise the option if the stock price ST > X, which means the seller
will have to sell at a lower price than the market.
• If ST ≤ X, the option won’t be exercised, and the seller keeps the premium.
• Payoff of a short call = - max (ST - X, 0) or min (X- ST ,0)
• The formula –max(ST – X, 0) or min(X – ST , 0) means the seller of a call option loses
money if the stock price goes above the strike price. If the stock price stays the same or
goes lower, the seller has no loss.
• You never gain from the option itself as the seller — best case, you break even.
• Hence, short call’s payoff is either negative or zero, but never positive.
Pay off a long position in a put option (buyer of a put option):
• Payoff = max(X − ST, 0)
You gain if the stock price falls below the strike price. Because then you can sell stocks at
a higher strike price than the price in the market. Otherwise, no payoff.
• Hence, a long put’s payoff is either positive or zero, but never negative.

Pay off a long position in a put option (buyer of a put option):

• Payoff = –max(X − ST, 0) or min(ST− X, 0)
You lose if the stock price falls below the strike price. Because then you have to buy the
stocks that the buyer of the put options sells at a higher strike price than the price in the
market. Otherwise, no loss.
• Hence, a short put’s payoff is either negative or zero, but never positive.
If we graph the above scenarios:
Now for further understanding of payoffs, let’s look at a numerical example:
Consider the strike price, X = Rs. 100.
First, let’s look at the call options' payoffs.

Example Calculations:
• ST = 80 to 100 →
o Long Call: max(80 – 100, 0) = 0
o Short Call: –max(80 – 100, 0) = 0
• ST = 105 →
o Long Call: max(105 – 100, 0) = 5
o Short Call: –max(105 – 100, 0) = –5
• ST = 110 →
o Long Call: max(110 – 100, 0) = 10
o Short Call: –max(110 – 100, 0) = –10
• ST = 120 →
o Long Call: max(120 – 100, 0) = 20
o Short Call: –max(120 – 100, 0) = –20
If we draw the graphs:

Next, let’s look at the put options' payoffs.

Example Calculations:
• ST = 80:
o Long Put = max(100 − 80, 0) = 20
o Short Put = −max(100 − 80, 0) = −20
• ST = 95:
o Long Put = max(100 − 95, 0) = 5
 o Short Put = −max(100 − 95, 0) = −5
• ST = 100:
o Long Put = max(100 − 100, 0) = 0
o Short Put = −max(100 − 100, 0) = 0
• ST = 105:
o Long Put = max(100 − 105, 0) = 0
o Short Put = −max(100 − 105, 0) = 0

If we draw the graphs:

4. Swaps
• A swap is an agreement to exchange cash flows at specified future times according to
certain specified rules.
• Since this is an agreement, it creates obligations to both parties.
• 2 famous swaps are,
o Interest rate swaps
o Currency swaps

Note on LIBOR ((London Interbank Offered Rate and SOPAR ((Secured Overnight
Financing Rate):

• Both of these 2 are → variable rates.

• However, the intermediaries can manipulate LIBOR.
• SOFR is not given by anybody, so it cannot be manipulated.

Example of an Interest Rate Swap:

Microsoft agrees to:
• Receive: the 6-month LIBOR (a floating interest rate)
• Pay: a fixed interest rate of 5% per annum, paid every 6 months
• The swap lasts for 3 years
• The interest is calculated on a notional principal of $100 million
In simple terms:
Microsoft is exchanging floating interest income (based on LIBOR) for fixed interest
payments (5%) — both calculated on $100 million, though the principal itself is not exchange
Explanation of the above slide:

• Microsoft receives a floating rate (6-month LIBOR).

• Microsoft pays: a fixed rate of 5% per annum, or 2.5% every 6 months
• The interest is based on a notional amount of $100 million
This table shows,

• The LIBOR rate for that 6-month period is given.

• The LIBOR rate shown in the table is annualized, meaning it's for a full year.
• But since the swap settles every 6 months, we use half of the annual rate to calculate
the interest for that 6-month period.
So for example:
If LIBOR = 4.2% (annual):
o For 6 months, the effective rate = 4.2% ÷ 2 = 2.1%
o On $100 million:
Interest received = 2.1% × $100 million = $2.10 million
The same logic applies to all the LIBOR rates listed.

• Microsoft pays a fixed 5% annual interest on a notional amount of $100 million.

Since the payments are every 6 months, they pay:
o 5% ÷ 2 = 2.5% every 6 months
o 2.5% of $100 million = $2.5 million

• The net cash flow is calculated as:

Floating Cash Flow Received - Fixed Cash Flow Paid

Example calculation:
Let’s look at Sept. 5 (with LIBOR at 4.8%):
• Floating interest received = 4.8% of $100 million / 2 = $2.10 million
• Fixed interest paid = 5% of $100 million / 2 = $2.50 million
• Net cash flow = $2.10 – $2.50 = –$0.40 million
So, Microsoft has a net loss of $0.40 million that period.
Conclusions:
• Microsoft benefits when LIBOR > 5% → Net positive cash flow
• Microsoft loses when LIBOR < 5% → Net negative cash flow
• The higher LIBOR goes, the more Microsoft earns
• All interest amounts are calculated on $100 million, though this principal is not
exchanged.

The question is, is the above swap agreement a hedging or a speculative agreement?
Answer: It can be either. It depends on the nature or the current position of Microsoft.
1st, we will look at how this swap can be a hedging agreement. Let’s say that,

• Microsoft has borrowed $100 million at a floating LIBOR rate and invested in a
fixed-income bond.
• So, income is fixed, but interest cost (LIBOR) is variable, which creates risk.
• If LIBOR rises, Microsoft might pay more interest than it earns → potential loss.
• So now, to mitigate or control this risk, you are planning to convert the LIOBOR /
Variable rate loan to a fixed rate loan.
• To do that, you have two ways.
1. Settle or restructure the loan, or
2. Enter into a swap agreement to convert the floating LIBOR-based loan into a fixed-
rate loan.
• If we go with entering into a swap agreement, you convert the LIBOR to a fixed interest
rate. You are receiving LIBOR that can be used to settle loan obligations and you pay a
fixed rate. (LIBOR → Fixed rate obligation as shown in the previous table)
• A swap lets you replace a floating interest rate like LIBOR with a fixed rate, so your loan
payments become predictable and stable.
• In this scenario, this swap agreement → hedging agreement, as the motive of it was to fix
the cost and control the risk.

Next, we will look at how this swap can be a speculative agreement. Let’s say that,

• A swap can be used to speculate (try to profit) if you expect LIBOR will rise — you lock
in a fixed payment and receive a variable one.
• If LIBOR goes up, you gain. If LIBOR goes down, you lose.
 • Hedging: If your goal is to reduce uncertainty and protect against rate increases, it's
hedging.
• Speculation: If you expect LIBOR to rise and enter the swap just to profit, it’s
speculation.
• The same swap agreement can be a hedge for one party (who wants stability) and a
speculative bet for another (who wants to profit from rate movements).

Other Derivatives
• The usual derivatives we've studied so far are called "plain vanilla" or "standard"
derivatives. These follow basic structures and are widely used.
• Since the 1980s, financial institutions have started creating more complex, customized
derivatives called "exotic options". These are tailored to specific client needs or
situations.
• Examples of exotic options:
o Used by financial institutions (FIs) for corporate clients.
o Linked to bond or stock issues that come with option features.
o ESOP (Employee share options)

1. Financial Intermediary (FI) – Corporate Clients

• Example: CPC (Ceylon Petroleum Corporation)

• CPC entered into a hedging agreement with a U.S. bank (3 local and 2 foreign banks
involved).
• The goal was to control oil price volatility.
• The banks designed a strategy combining both call and put options:
o CPC buys a call option (long position) by paying a premium.
▪ This sets a ceiling price for oil (e.g., $40 per barrel).
o CPC sells a put option.
▪ This gives intermediaries the right to sell oil at $100 if the price drops
below that.

2. Bond or Stock Issues with Options

• You can buy a stock with a put option attached.

o This gives the right to sell the stock at $100 after one year.
o If after a year the stock price is $75, you can still sell it at $100 using the put
option.
o This guarantees your investment.
 o If the stock price goes above $100, you can ignore the put and sell at a profit.
• In this setup:
o The issuing company takes the risk.
o Companies can issue either bonds or stocks with put options, but they bear the
financial risk.

3. ESOP (Employee Share Options)

• In an organization, the shareholders are the owners.

• Shareholders appoint a Board of Directors (BOD).
• The BOD hires managers.
• Managers aim to maximize their salary, while owners aim to maximize company
value.
• This creates a potential conflict of interest.
• ESOP helps align managers' goals with owners' goals (profit and value maximization).
• It reduces the risk of conflicting objectives.

How ESOP Works:

• You get the right to receive shares in the future—not the shares immediately.
• This right:

o Cannot be sold or transferred.

o Is only valid if you stay in the organization and exercise it.
o Will be lost if you leave the company.

• You benefit only if the share price goes up in the future.

Types of Traders

In derivative markets, we can identify 3 main types of traders.

1. Hedgers
2. Speculators
3. Arbitrageurs

• Hedgers use derivatives to reduce the risk that they face from potential future movements
in a market variable. Speculators use them to bet on the future direction of a market
 variable. Arbitrageurs take offsetting positions in two or more instruments to lock in a
profit.

Let’s briefly understand each type of trader.

1. Hedgers
• They try to offset investment risk by buying and selling derivatives
• They believe in uncertainties and don’t buy predictions
• Objective → to control the risk/volatility, not to make money using derivatives
• Long hedging → locks cost and short hedging → locks revenue.

2. Speculators
• They try to profit from buying and selling derivatives by anticipating future price
movements.
• They are risk takers.
• They believe and anticipate predictions.
• Objective → to make profits by using derivatives. They lose if the market goes
otherwise than they predicted.

3. Arbitrageurs
• They try to profit when the same asset is traded at different prices in two or more
markets.
• Neither hedge nor speculate.
• They look at the prices and try to identify whether there is any mispricing and try to
benefit from that.
• Aim for riskless profits.
• Purchase underpriced stocks and sell when they are overpriced.

❖ Even though someone may intend to hedge or do arbitrage (which are usually
safer strategies), they could accidentally become a speculator (taking more risk)
because everyone is using the same derivatives. This could happen without them
even realizing it. So there’s an additional risk for hedgers or arbitrageurs.
Hedging Examples:
Example 1 - Hedging using a forward contract (Currency Hedging):

• A US company has to pay £10 million to the UK in 3 months.

• It is worried the exchange rate might change (making it more expensive).
• So, it enters into a forward contract to "lock in" today’s exchange rate.
• This protects the company from currency risk.
Example 2 - Hedging using an option (Stock Hedging):

• An investor owns 1,000 Microsoft shares, currently worth $28 each.

• To protect against a price drop, they buy a put option with a strike price of $27.50,
which costs $1 per share.
• They buy 10 contracts (1 contract = 100 shares), covering all 1,000 shares.
• So total cost = 10 × 100 × $1 = $1,000
• This means if the stock price falls, the put option will limit their loss.
• So, even if the price crashes, the investor still gets:
o $27,500 from selling 1,000 shares
o Minus the cost of options → net = $26,500

Two Outcomes:
o If price falls below $27.50 →
Put options are exercised.
Investor gets $26,500 minimum.
1. If price stays above $27.50 →
Options expire unused.
But shares are worth more than $27.50.
Net value = stock value minus $1,000 option cost.

Now let’s compare the Value of Microsoft Shares with and without Hedging using the
following graph:
Explanations of the above graph:
• The investor owns 1,000 Microsoft shares.
• Current price per share = $28
• A put option is bought:
o Strike Price = $27.50
o Premium (Cost) = $1 per share
o So total option cost = 1,000 × $1 = $1,000

What the Graph Shows:

It compares two outcomes: With Hedging and Without Hedging based on various stock price
levels.
Calculations at Different Stock Prices:
Let’s say the stock price at the end of 2 months changes. Here’s what happens:
If Stock Price = $20 (↓ drop)
• Without Hedging:
Value = 1,000 × $20 = $20,000
• With Hedging:
Put option allows selling at $27.50
So, you get 1,000 × $27.50 = $27,500
Subtract premium cost: $27,500 – $1,000 = $26,500
❖ Hedging protects the value.
If Stock Price = $25
• Without Hedging = 1,000 × $25 = $25,000
• With Hedging:
Option still in the money:
Gain = $27.50 – $25 = $2.50 per share
So payoff = $2,500
Net value = $25,000 (shares) + $2,500 (option) – $1,000 = $26,500
❖ Still better than no hedge
If Stock Price = $28 (original price)
• Without Hedging = 1,000 × $28 = $28,000
• With Hedging:
Option is out-of-the-money → not exercised
So value = $28,000 – $1,000 = $27,000
❖ Hedging results in a small loss due to the premium paid.
If Stock Price = $35
• Without Hedging = 1,000 × $35 = $35,000
• With Hedging:
Option is useless (not exercised)
Net value = $35,000 – $1,000 = $34,000
❖ Hedging gives lower gain, but protected downside earlier.
If Stock Price = $40
• Without Hedging = 1,000 × $40 = $40,000
• With Hedging = $40,000 – $1,000 = $39,000
Summary:
• Hedging limits losses when the stock price falls.
• You sacrifice some profit when prices rise because of the premium cost.

Speculation Example (Speculating using Options):

Consider a situation where:
• The investor has $4,000
• They believe Amazon stock (currently $40) will go up in 2 months
• A 2-month call option (strike price $45) costs $2
There are 2 alternative strategies available to the investor:
1. Buy actual shares:
• At $40 each, they can buy 100 shares ($4,000 ÷ $40).
 • Profit if price rises above $40, as you can sell those shares at a higher price
and get a capital gain,
2. Buy call options instead:
• Each call option costs $2, so they can buy 2,000 options ($4,000 ÷ $2).
• If the stock goes above $45, they start profiting as they can buy stocks at 45
and sell them at a higher price in the market, making profits.

Now let’s think the stock price goes up to $47. Let us calculate the profits we can earn from each
strategy.
Strategy 1 – Buying actual shares:
• Bought 100 shares at $40
• Sold at $47 → Gain of $7 per share
• Total Profit = $700
Strategy 2 – Buying call options:
• Bought 2,000 call options at $2 each
• Use the call option and buy 2000 shares at $45 and sell them at $47, the market price.
• Gains = 2000*47 – 2000*45 = $4000
• But we paid $2000 earlier as the premium.
• Total Profit = $4000 - $2000 = $2000
Summary:

• Buying stock = safer, steady returns

• Buying call options = cheaper, riskier, but higher possible returns if price increases a
lot than the strike price.
• We can see how derivatives (options in here) were used by speculators to make profits.

Arbitrage Example:

• Stock price of a company in London = £100

• Same stock price in New York = $172
• Exchange rate £1 = $1.75
• So, the London price in USD = £100 × 1.75 = $175
• But in New York, the same stock is trading at $172, which is cheaper.
Arbitrage Step-by-Step:
1. Buy in New York at $172
2. Sell in London at $175 (converted price)
3. Profit = $175 − $172 = $3 per share (ignoring transaction costs)
You’ve made a profit by buying low in one market and selling high in another — that’s
arbitrage!