Risk management in options trading

Morale is the character of the individual which can cause the risk may be non-visual yet deliberate.

Third category of hazard is Morale i. This includes the possibility of losing some or all of the original investment. The standard deviation of the historical returns or average returns of a specific investment is regarded as historical measure of risk. Financial risk may be market-dependent, determined by numerous market factors or operational, resulting from fraudulent behaviour also.

It is to be noted that in finance literature, risk has no one definition, but some theorists have defined quite general methods to assess risk as an expected after-the-fact level of regret. Such methods have been uniquely successful in limiting interest rate risk in financial markets. However, these methods are difficult to implement on newer financial products. Difficulties also arise such as on disclosure, valuation, transparency and purposes of such transactions.

Thus, the fundamental idea in finance is the relationship between risk and return. The greater the potential return one might seek, the greater the risk that one generally assumes. A free market reflects this principle in the pricing of an instrument: strong demand for a safer instrument drives its price higher and its return proportionately lower , while weak demand for a riskier instrument drives its price lower and its potential return thereby higher.

For example, firm might be concerned about movements in interest rates, foreign Exchange rates, Stock prices or commodity prices. If we use the Black —Scholes model value of call comes to But if we use the Binomial model value obtained is Thus most plain vanilla derivatives have little risks as compared to exotic transactions having lesser liquidity and higher risk.

This risk can effectively turn a swap into options, because the counter party simply walks away without paying if the market moves against it as the defender may assume there is hardly any law that can enforce recovery from him. Some times it may result due to govt. These effects can ripple through the entire financial system, leading to widespread panic and a meltdown of the whole system.

This is called systemic risk. This entails understanding strategies and their vulnerabilities, as well as assumptions built into an instrument, system, process, model or strategy. Key risks should be reviewed periodically as well as when significant events occur. Standard 8 - Setting Risk Limits Risk limits should be set for the aggregate portfolio and all individual portfolios. These may include limits on asset classes, individual instruments and specific types of risk. An option, just like a stock or bond, is a security.

Importance of Risk Management for Traders

It is also a binding contract with strictly defined terms and properties. There are two types of options which are calls and puts. A call gives the holder the right to buy an asset at a certain price within a specific period of time. Calls are similar to having a long position on a stock. Buyers of calls hope that Dr.

On the other hand, a put gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are very similar to having a short position on a stock. Buyers of puts hope that the price of the stock will fall before the options expire. Buyers are said to have long positions, and sellers are said to have short positions.

It must be noted that Call holders and put holders buyers are not obligated to buy or sell. They have the choice to exercise their rights if they choose. But, Call writers and put writers sellers , however, are obligated to buy or sell. This means that a seller may be required to make good on a promise to buy or sell. The price at which an underlying stock can be purchased or sold is called the strike price. This is the price a stock price must go above for calls or go below for puts before a position can be exercised for a profit.

All of this must occur before the expiration date. For call options, the options is said to be in-the-money if the share price is above the strike price. A put option is in-the-money when the share price is below the strike price. The amount by which an option is in-the-money is referred to as intrinsic value. The total cost the price of an option is called the premium.

This price is determined by factors including the stock price, strike price, time remaining until expiration time value and volatility. This was followed by approval for trading in options based on these two indices and options on individual securities. The trading in index options commenced in June and trading in options on individual securities commenced in July Futures contracts on individual stock were launched in November Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts.

A call options gives the right to buy and a put options gives the right to sell. The two commodity used swaps are interest rate swaps and currency swaps. Longer-dated options are called warrants and are generally traded over-the-counter.

Strategies

These are options having a maturity of up to three years. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is options to pay fixed and receive floating.

Through the use of derivative products, it is possible to partially or fully transfer price risks by locking in asset prices. However, by locking in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors. This instrument is used by all sections of businesses, such as corporate, SMEs, banks, financial institutions, retail investors, etc. According to the International Swaps and Derivatives Association, more than 90 percent of the global corporations use derivatives for hedging risks in interest rates, foreign exchange, and equities.

In the over-the-counter OTC markets, interest rates A brief discussion of the trading Dr. The subsequent ones will be known as February, March Futures, etc.

As one contract expires, a new 3-month contract is made available from the next day. Thus, at any one time, contracts of three different durations are available for trading.

The build-up is very slow during the first two months of a new contract. The contract has very little liquidity and very few participants during this period. The other contracts have very little trading. As a consequence, it is almost impossible to execute a trade during the initial two months of a new contract. When Mr. S sells one contract to Mr.

B, open interest equal to one contract will be created. In market parlance, Mr. The bulk of such open interest relates to the near-month contract. At the beginning of the month and for many days into the month, the open positions are almost wholly for the near-month contract. As open positions for the expiring month are squared up, new positions are opened for the subsequent month. By rolling over their open positions from near-month contract to next-month contract and so on, the traders can maintain their total open positions for almost any length of time.

The bulk of open positions get rolled over in this way. The pattern of open positions as well as of trading volume indicates very high concentration in the near-month contracts. In any case, the near-month contract always overwhelmingly dominates the futures open positions. As the month progresses, while the open position of the near-month contract decline, the open position of the other two contracts especially that of the next-month contract increases.

This limit is set by the cost of carrying. In the case of commodities, the warehousing and insurance costs could be an important part of the carrying costs, in addition to the interest costs on the funds locked up in holding stocks of commodities. Also, the price of the more distant futures contract will be higher that the price of the futures maturing earlier. Under abnormal conditions or due to special factors, the futures contract price may lie below the spot price. In the case of commodities, it is often due to seasonal factors.

The phenomenon of the futures price being lower than the spot price is called backwardation. Infact, pricing of derivatives is done by arbitrage. In other words, there are basic economics that dictates relationship between the price of the spot and the price of futures. If this relationship is violated, then an arbitrage opportunity is available, and when people exploit this opportunity, the price reverts to its economic value.