A derivative payoff diagram, often called a "profit and loss (P&L) diagram" or "payoff profile," is a graphical representation that shows the potential profit or loss of a derivative contract at different underlying asset prices, expiration dates, or other relevant variables. These diagrams are commonly used in options and futures trading to visually understand the potential outcomes of a position.
1. Call Option Payoff Diagram:
2. Put Option Payoff Diagram:
These are simplified payoff diagrams for individual options. More complex diagrams can be created for combinations of options and positions, such as spreads, straddles, and strangles, to visualize potential outcomes under various scenarios.
2. INTRODUCTION
The term "derivatives" refers to financial instruments that derive their value from some underlying assets.
The underlying assets could be equities (shares), debt (bonds, T-bills and notes), currencies, and even indices
of these various assets, such as the Nifty 50 Index, Bank Nifty and FinNifty.
Derivatives contracts are bought and sold by a large number of individuals, institutions and others for a variety
of purposes.
When the underlying price changes, the derivative’s value also changes. E.g. The value of the gold futures
contract is derived from the value of the underlying asset, i.e. gold.
3. INDIAN HISTORY OF DERIVATIVES
The Bombay Cotton Trade Association started future trading in 1875.
In 1952 the Govt. banned cash settlement and options trading.
In 1995, a prohibition of trading options was lifted.
In 1999, the Securities Contract (Regulation)Act of 1956 was amended, and derivatives could be
declared "securities".
NSE started trade in future & option (F/O) by 2005.
5. FORWARD CONTRACT
A forward contract or simply a forward is a contract between two parties to buy or sell an asset at a
certain future date for a ce rtain price that is pre-decided on the date of the contract.
The future date is referred to as expiry date and the pre-decided price is referred to as Forward
Price.
lt is the customized contract, in the sense that the term of the contract are agreed upon by the
individual parties.
Hence it is traded on Over The Counter (OTC).
Default risk, Credit risk & Counter-party risk involved in this type of contract.
7. FUTURE CONTRACT
Like a forward contract, a futures contract is an agreement between two parties in which the buyer
agrees to buy an underlying asset from the seller, at a future date at a price that is agreed upon today.
Unlike a forward contract, a futures contract is not a private transaction but gets traded on a
recognized stock exchange. In addition, a futures contract is standardized by the exchange.
Both buyer and seller of the futures contracts are protected against the counter party risk by an
entity called the Clearing Corporation.
9. OPTIONS
Like forwards and futures, options are derivative instruments that provide the opportunity to buy or
sell an underlying asset on a future date.
Options can be divided into two different categories depending upon the primary exercise styles
associated with options. These categories are American option & European option.
There are two types of options-call options and put options-which are explained below.
11. CALL OPTION
Call option gives the buyer the right but not the obligation to buy a given quantity of the underlying
assets, at a given price on or before a given future date.
If assets price is higher than the strike price - Option is in the money.
If assets price is exactly at the strike price - Option is at the money.
If assets price is below the strike price - Option is out of the money.
15. PUT OPTION
Put gives the buyer the right but not obligation to sell a given quantity of the underlying asset at a
given price on or before a given date.
If asset price is lower than the strike price - Option is in the money.
If asset price is exactly at the strike price - Option is at the money.
If asset price is higher than the strike price - Option is out of the money.