Page 133 - DCOM510_FINANCIAL_DERIVATIVES

Financial Derivatives

Notes such volatility: market volatility is always enhanced for one week before and two weeks after a
budget. Many investors simply do not want the fluctuations of these three weeks.

Notes One way to protect your portfolio from potential downside due to a market drop is
to buy insurance using put options.

Index and stock options are a cheap and can be easily implemented to seek insurance from the
market ups and downs. The idea is simple. To protect the value of your portfolio from falling
below a particular level, buy the right number of put options with the right strike price. If you
are only concerned about the value of a particular stock that you hold, buy put options on that
stock. If you are concerned about the overall portfolio, buy put options on the index. When the
stock price falls your stock will lose value and the put options bought by you will gain, effectively
ensuring that the total value of your stock plus put does not fall below a particular level.
This level depends on the strike price of the stock options chosen by you. Similarly when the
index falls, your portfolio will lose value and the put options bought by you will gain, effectively
ensuring that the value of your portfolio does not fall below a particular level. This level
depends on the strike price of the index options chosen by you. Portfolio insurance using put
options is of particular interest to mutual funds who already own well-diversified portfolios. By
buying puts, the fund can limit its downside in case of a market fall.

Speculation: Bullish security, buy calls or sell puts: There are times when investors believe that
security prices are going to rise. How does one implement a trading strategy to benefit from an
upward movement in the underlying security?
Using options there are two ways one can do this:
1. Buy call options; or
2. Sell put options

We have already seen the payoff of a call option. The downside to the buyer of the call option is
limited to the option premium he pays for buying the option. His upside however is potentially
unlimited. Suppose you have a hunch that the price of a particular security is going to rise in a
month’s time. Your hunch proves correct and the price does indeed rise, it is this upside that you
cash in on. However, if your hunch proves to be wrong and the security price plunges down,
what you lose is only the option premium. Given that there are a number of one-month calls
trading, each with a different strike price, the obvious question is: which strike should you
choose? Let us take a look at call options with different strike prices. Assume that the current
price level is 1250, risk-free rate is 12% per year and volatility of the underlying security is 30%.
The following options are available:
1. A one month call with a strike of 1200.

2. A one month call with a strike of 1225.
3. A one month call with a strike of 1250.
4. A one month call with a strike of 1275.
5. A one month call with a strike of 1300.

Which of these options you choose largely depends on how strongly you feel about the likelihood
of the upward movement in the price, and how much you are willing to lose should this upward
movement not come about. There are five one-month calls and five one-month puts trading in
the market. The call with a strike of 1200 is deep in-the-money and hence trades at a higher

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