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Mastering Derivatives: BEP, Profit/Loss & Option Strategies Simplified

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Mastering Derivatives: BEP, Profit/Loss & Option Strategies Simplified

Introduction

In today’s financial world, derivatives are key instruments used for hedging risk, speculation, and smart investment strategies. Whether you're a CA student, a finance enthusiast, or preparing for Investment Banking interviews, this guide will help you master the fundamentals of derivatives—including Break-Even Point (BEP), Profit/Loss logic, and essential option strategies.

What Are Derivatives?

A derivative is a financial contract whose value is derived from another asset, called the underlying asset. Common underlying assets include:

  • Stocks (e.g., Infosys, TCS)
  • Commodities (e.g., Gold, Crude Oil)
  • Currency Pairs (e.g., USD/INR)
  • Indices (e.g., Nifty, Sensex)
  • Bonds or Interest Rates

Types of Derivatives

1. Forwards

  • Customized agreement between two parties
  • Buy/sell at a fixed price on a future date
  • Private contract (OTC), not traded on exchanges

2. Futures

  • Standardized version of forwards
  • Traded on regulated exchanges
  • Lower counterparty risk and more transparent

3. Options

Options give the right but not the obligation to buy/sell an asset at a specific price before expiry. Two types:

  • Call Option – Right to buy
  • Put Option – Right to sell

4. Swaps

  • Agreement to exchange cash flows (e.g., fixed vs. floating interest)
  • Commonly used by large institutions

Buyer’s Perspective: BEP, Profit & Loss

Call Option Buyer

  • Pays a premium for the right to buy the asset
  • Maximum Loss = Premium paid
  • Profit when the asset price rises above BEP

Formulas:

  • BEP = Strike Price + Premium Paid
  • Profit = Spot Price – Strike Price – Premium
  • Loss = Premium (if Spot < Strike)

Example:
Strike Price = ₹100, Premium = ₹10

  • BEP = ₹110
  • If Spot = ₹120 → Profit = ₹10
  • If Spot = ₹90 → Loss = ₹10

Put Option Buyer

  • Pays a premium for the right to sell the asset
  • Profit when the asset price falls below BEP

Formulas:

  • BEP = Strike Price – Premium Paid
  • Profit = Strike Price – Spot Price – Premium
  • Loss = Premium (if Spot > Strike)

Example:
Strike Price = ₹100, Premium = ₹5

  • BEP = ₹95
  • If Spot = ₹85 → Profit = ₹10
  • If Spot = ₹105 → Loss = ₹5

Seller’s (Writer’s) Perspective

  • Seller receives the premium upfront
  • If the option expires worthless, the premium is pure profit
  • If the option ends in the money, the seller bears loss

Important Note:
Buyer’s Profit = Seller’s Loss (and vice versa)

Moneyness: ITM, ATM & OTM

Moneyness tells whether an option is profitable at current market price.

For Call Options:

  • In The Money (ITM) – Spot > Strike
  • At The Money (ATM) – Spot = Strike
  • Out of The Money (OTM) – Spot < Strike

For Put Options:

  • In The Money (ITM) – Spot < Strike
  • At The Money (ATM) – Spot = Strike
  • Out of The Money (OTM) – Spot > Strike

Example:

  • Strike = ₹100
  • Call Option, Spot = ₹110 → ITM
  • Put Option, Spot = ₹90 → ITM

(Insert colorful moneyness image here for visual clarity)

Why Use Derivatives?

  • Hedging – Reduce risk from price volatility
  • Speculation – Predict market moves to earn profits
  • Arbitrage – Exploit price differences in markets
  • Leverage – Control large positions with small capital

Are Derivatives Risky?

Yes.

  • For buyers, loss is limited to the premium paid
  • For sellers, loss can be unlimited if the market moves unfavorably

Conclusion

Derivatives are essential financial tools. Mastering Futures, Options, BEP, and Profit/Loss concepts is crucial for academic success and finance careers alike. A clear understanding of moneyness and risk helps make informed decisions in markets.

Advanced concepts :

Options Trading Strategies: Covered Call, Protective Put & More


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