It is not important whether you

are right or wrong, but how much

money you make when you are
right & how much money you lose
when you are wrong is important.

George Soros

1
 TABLE OF CONTENTS

• Certificate
• Acknowledgement
• Executive Summary
• Objective of the Study
• Methodology
• Job Description

Chapter 1. Introduction of Sharekhan Limited

➢ About Sharekhan Limited

➢ Sharekhan Limited’s Management Team
➢ Products and Services of Sharekhan Limited
➢ Types of account in Sharekhan Limited
➢ How to open an account with Sharekhan Limited?
➢ Research section in Sharekhan Limited
➢ Awards and Achievements

2
Chapter 2. Introduction to Derivatives

➢ Derivatives defined
➢ Emergence of Derivatives
➢ History of Derivatives
➢ Global Derivative Markets
➢ Derivatives Market in India
➢ Participants and Functions
➢ Types of Derivative Instruments
➢ Derivative Market at NSE
➢ Approval for Derivative Trading
➢ Clearing and Settlements
➢ Index Derivatives
➢ Trading
➢ Order type and Condition
➢ SEBI Advisory Committee on Derivative

Chapter 3. Introduction to Futures and Options

➢ Forward Contracts
➢ Future Contracts
➢ Options
➢ Payoffs for Derivative Contracts

Chapter 4. Hedging, Arbitrage and Speculation Strategies

➢ Hedging Strategies with examples

➢ Arbitrage Strategies with examples
➢ Speculation Strategies with examples

3
 Chapter 5. Applicability of Derivative Instruments

➢ Risk Management: Concept and Definition

➢ Risk Management with Future Contract
➢ Risk Management with Options
➢ Introduction to Option Strategies

Chapter 6. Achievements in Futures and Options Segment

➢ Comparative Analysis of F&O Segment with Cash Segment

➢ NSE Position
➢ Top 5 Traded Symbols

Chapter 7. Conclusion

Chapter 8. Suggestions and Recommendations

Chapter 9. The Reference Material

➢ Glossary
➢ Bibliography

CERTIFICATE

This is to certify that Mr. Milton Sarkar, a student of Post Graduate Diploma in
Business Administration from Graduate School of Business & Administration,

4
Greater Noida has completed his summer training project titled, “A Study on
Applicability of Derivative Instruments in Indian Stock Market,” at
Sharekhan Ltd., Greater Kailash Branch, New Delhi under my guidance and
supervision from 15th of May 2008 to 21st of July 2008. This is his
original work and he has put a lot of effort into it. He is a very hard working
person and has patience to convince customers and also fulfill his secondary
objectives.

He has done good work with us and I wish him all the best for his bright
future.

Project Guide

Rakesh Kunwar
(Assistant Manager- sales)
Sharekhan Ltd.

CERTIFICATE OF ATTENDANCE

5
This is to certify that Mr. Milton Sarkar, who was engaged in our organization
as a Summer Trainee, has been regular & punctual. He has attended the
training from 15th of May to 21st of July.

Signature

Rakesh Kunwar
(Assistant Manager- sales)
Sharekhan Ltd.

6
 ACKNOWLEDGEMENT

A project is never the work of an individual. It is moreover a combination of ideas,

suggestions, review, contribution and work involving many folks. It cannot be
completed without guidelines.
It is my pleasure to acknowledge gratefully to all those honorable personalities
who helped me lot into the creation of this project and shared their
experiences.

I would like to express my sincere indebtedness to Dr. P.L. Maggu (Executive

Director, Graduate School of Business & Administration) for giving me the
opportunity to work on this project and make it a success.

I would like to express my deep sense of gratitude to my Industry guide, Mr.

Rakesh Kunwar, Asst. Manager Sales– Sharekhan Ltd., Greater Kailash
Branch, New Delhi, who spent his valuable time and guided me. I have
benefited a great deal from his incisive analysis and erudite suggestions. The
atmosphere of a learning organization that he has created along with his peers
in Greater Kailash Branch has not only helped me but all the other trainees.

Acknowledgements are also due to all the other staff members and executives
in Sharekhan Ltd., Greater Kailash Branch for providing information at
various point of the project, especially the discussions on the market.

I am also sincerely thankful to all the faculty members of Graduate School of

Business & Administration for providing their help and advice whenever it was
needed.

Finally I wish to extend my sincere acknowledgement to my parents for their

moral and financial support.

7
 Milton
Sarkar

EXECUTIVE SUMMARY

Conceptually the mechanism of stock market is very simple. People who are
exposed to the same risk come together and agree that if anyone of the person
suffers a loss the other will share the loss and make good to the person who
lost.

The initial part of the project focuses on the job and responsibilities I was
allotted as a summer trainee. It also makes the readers aware about the
techniques and methodology used to bring this report alive. It also describe
about the objective of this study.

It also enlightens the readers about Sharekhan Limited’s strategies to acquire

new customers. Further the project tells us about the profile of the company
(Sharekhan Ltd.). It provides knowledge to the readers regarding the
company’s history, mission, vision, customer base and the reasons to be
associated with the company. Also it gives special emphasis on the selling of
products and management of the company.
The next few chapters are devoted to the study of the Derivative Market and
Derivative Instruments in a very basic way. It also suggests some of the
strategies that can be applied to earn more even when the market is too much
volatile. The readers can also find the comparative analysis of the Derivative
Market and the Cash Market in the Indian context.
The next part of the project throws light upon my findings and analysis about
the company and the suggestions for the company for better performance.

8
 OBJECTIVE OF THE STUDY

To find out whether the Derivative Instruments are applicable in the Indian
Stock Market which can work both in good and bad times so that it can
minimize our risk and maximize our returns. As a result one can have
conviction in his portfolio in the hugely volatile stock market because a
difficult and serious problem for all investors today is that there is entirely too
much free information, hype, promotion, personal opinion, and advice about
derivative instruments are there in stock market. One get it from friends,
relatives, people at work, the Internet, brokers, stock analysts, advisers,
entertaining cable TV market programs, and other media. It can be very risky
and potentially dangerous.

Realistically, there are not too many people one can listen to if he want to
avoid confusing, contradictory, and faulty personal market opinions. So one
need to confine himself to just a very few sources of relevant facts and data
and a sound system that has proven to be accurate and profitable over time.

Therefore, the objective of the Dissertation is to do in depth research on these

derivative instruments.

9
 METHODOLOGY

During this project, I have analyzed the Futures and Options. I have tried to
analyze the instruments as per the Market Participant and the Market Trend.
Initially, I have given a brief introduction about the instruments, so that the
reader is aware of basics of the subject.

I have tried to identify various terms related to derivative trading, for which I
have introduced a separate chapter, “Terms related to derivative market”

Then I have tried to segregate the use of Instruments as per the Market
Participants and Market Trend. I identified hedging, arbitrage and speculation
strategies using both futures and options, and then segregated them into a
chapter each. Segregation involved a thorough study of the strategies and
possible use.

Then I have done a secondary data based study on growth of Indian Derivative
Market, which includes the comparison of derivative market with cash market,
data regarding the traded volume and number of contracts traded from
December 2007 till May 2008. I have also analyzed the top five most traded
symbols in futures and options segment.

10
 JOB DESCRIPTION

The company placed me as a Summer Trainee. I have been handling the

Following responsibilities:

➢ My job profile was to sale the products of the organization.

➢ My job profile was to coordinate the team and also help them to sale the
product and also help them in field.
➢ My job profile was to generate the leads by cold calling.
➢ My job profile was to understand customers’ needs and advising them to
make a portfolio as per their investment.
➢ My job profile was to do sales promotion through e-mails, canopies,
making cold calling, distributing pamphlets and etc.

AREA ASSIGNED

I covered areas like Delhi, Gurgaon, Ghaziabad, Faridabad and NCR.

11
TARGET ASSIGNED

• To sell 18 accounts per month.

TARGET MARKET
➢ Different properties dealers.
➢ Charted accountants.
➢ Lawyers
➢ Travel agencies
➢ Transport business
➢ House wives
➢ Businessmen
➢ Corporate Employees etc.

DAY TO DAY JOB DESCRIPTION

• Reporting time: 9.30 AM
• Fixing appointment with clients.
• Visit clients place.
• Demonstrate the product on Internet to the client.
• Completing the formalities like filling the application form and
documentation.
• Cold calling.

12
Chapter 1

13
Introductio
n of
Sharekhan
ltd.

14
 INTRODUCTION OF SHAREKHAN LTD.

ABOUT SHAREKHAN LIMITED

Sharekhan Ltd. is one of the leading retail stock broking house of SSKI Group
which is running successfully since 1922 in the country. It is the retail broking
arm of the Mumbai-based SSKI Group, which has over eight decades of
experience in the stock broking business. Sharekhan offers its customers a
wide range of equity related services including trade execution on BSE, NSE,
Derivatives, depository services, online trading, investment advice etc.
The firm’s online trading and investment site - www.sharekhan.com - was
launched on Feb 8, 2000. The site gives access to superior content and
transaction facility to retail customers across the country. Known for its
jargon-free, investor friendly language and high quality research, the site has a
registered base of over one lakh customers. The content-rich and research
oriented portal has stood out among its contemporaries because of its
steadfast dedication to offering customers best-of-breed technology and
superior market information. The objective has been to let customers make
informed decisions and to simplify the process of investing in stocks.
On April 17, 2002 Sharekhan launched Speed Trade, a net-based executable
application that emulates the broker terminals along with host of other
information relevant to the Day Traders. This was for the first time that a net-
based trading station of this caliber was offered to the traders. In the last six
months Speed Trade has become a de facto standard for the Day Trading
community over the net.
Sharekhan’s ground network includes over 640 centers in 280 cities in India
which provide a host of trading related services.

15
Sharekhan has always believed in investing in technology to build its business.
The company has used some of the best-known names in the IT industry, like
Sun Microsystems, Oracle, Microsoft, Cambridge Technologies, Nexgenix,
Vignette, Verisign Financial Technologies India Ltd, Spider Software Pvt Ltd. to
build its trading engine and content. The Morakhiya family holds a majority
stake in the company. HSBC, Intel & Carlyle are the other investors.
With a legacy of more than 80 years in the stock markets, the SSKI group
ventured into institutional broking and corporate finance 18 years ago.
Presently SSKI is one of the leading players in institutional broking and
corporate finance activities. SSKI holds a sizeable portion of the market in
each of these segments. SSKI’s institutional broking arm accounts for 7% of
the market for Foreign Institutional portfolio investment and 5% of all
Domestic Institutional portfolio investment in the country. It has 60
institutional clients spread over India, Far East, UK and US. Foreign
Institutional Investors generate about 65% of the organization’s revenue, with
a daily turnover of over US$ 2 million. The Corporate Finance section has a list
of very prestigious clients and has many ‘firsts’ to its credit, in terms of the
size of deal, sector tapped etc. The group has placed over US$ 1 billion in
private equity deals. Some of the clients include BPL Cellular Holding, Gujarat
Pipavav, Essar, Hutchison, Planetasia, and Shopper’s Stop.
PROFILE OF THE COMPANY
Name of the company: Sharekhan ltd.
Year of Establishment: 1925
Headquarter : ShareKhan SSKI
A-206 Phoenix House
Phoenix Mills Compound
Lower Parel
Mumbai - Maharashtra, INDIA- 400013

Nature of Business : Service Provider

Services : Depository Services, Online Services and

Technical Research.

Number of Employees : Over 3500

16
Revenue : Data Not Available

Website : www.sharekhan.com

Slogan : Your Guide to The Financial Jungle.

Vision

To be the best retail brokering Brand in the retail business of stock market.

Mission

To educate and empower the individual investor to make better investment

decisions through quality advice and superior service.

Sharekhan is infact-
• Among the top 3 branded retail service providers
• No. 1 player in online business
• Largest network of branded broking outlets in the country serving more
than 7,00,000 clients.

REASON TO CHOOSE SHAREKHAN LIMITED

Experience
SSKI has more than eight decades of trust and credibility in the Indian stock
market. In the Asia Money broker's poll held recently, SSKI won the 'India's
Best Broking House for 2004' award. Ever since it launched Sharekhan as its
retail broking division in February 2000, it has been providing institutional-
level research and broking services to individual investors.
Technology

17
With its online trading account one can buy and sell shares in an instant from
any PC with an internet connection. One can get access to its powerful online
trading tools that will help him take complete control over his investment in
shares.
Accessibility
Sharekhan provides ADVICE, EDUCATION, TOOLS AND EXECUTION services
for investors. These services are accessible through its centers across the
country over the internet (through the website www.sharekhan.com) as well as
over the Voice Tool.
Knowledge
In a business where the right information at the right time can translate into
direct profits, one can get access to a wide range of information on Sharekhan
limited’s content-rich portal. One can also get a useful set of knowledge-based
tools that will empower him to take informed decisions.
Convenience
One can call its Dial-N-Trade number to get investment advice and execute his
transactions. Sharekhan ltd. have a dedicated call-centre to provide this
service via a Toll Free Number 1800-22-7500 & 1800-22-7050 from anywhere
in India.
Customer Service
Sharekhan limited’s customer service team will assist one for any help that
one may require relating to transactions, billing, demat and other queries. Its
customer service can be contacted via a toll-free number, email or live chat on
www.sharekhan.com.
Investment Advice
Sharekhan has dedicated research teams of more than 30 people for
fundamental and technical researches. Its analysts constantly track the pulse
of the market and provide timely investment advice to its clients in the form of
daily research emails, online chat, printed reports and SMS on their mobile
phone.

18
SHAREKHAN LIMITED’S MANAGEMENT TEAM

➢ Dinesh Murikya : Owner of the company

➢ Tarun Shah : CEO of the company

➢ Shankar Vailaya : Director (Operations)

➢ Jaideep Arora : Director (Products & Technology)

➢ Pathik Gandotra : Head of Research

➢ Rishi Kohli : Vice President of Equity Derivatives

➢ Nikhil Vora : Vice President of Research

19
PRODUCTS AND SERVICES OF SHAREKHAN LIMITED
The different types of products and services offered by Sharekhan Ltd. are as
follows:
• Equity and derivatives trading
• Depository services
• Online services
• Commodities trading
• Dial-n-trade
• Portfolio management
• Share shops
• Fundamental research
• Technical research

20
TYPES OF ACCOUNT IN SHAREKHAN LIMITED
Sharekhan offers two types of trading account for its clints
➢ Classic Account (which include a feature known as Fast Trade Advanced
Classic Account for the online users) and
➢ Speed Trade Account

CLASSIC ACCOUNT
This is a User Friendly Product which allows the client to trade through
website www.sharekhan.com and is suitable for the retail investor who is

21
 risk-averse and hence prefers to invest in stocks or who does not trade
too frequently. This account allow investors to buy and sell stocks online
along with the following features like multiple watch lists, Integrated
Banking, Demat and digital contracts, Real-time portfolio tracking with
price alerts and Instant credit & transfer.

This account comes with the following features:

a. Online trading account for investing in Equities and Derivatives

b. Free trading through Phone (Dial-n-Trade)
I.Two dedicated numbers(1800-22-7500 and 39707500) for
placing the orders using cell phones or landline phones
II.Automatic funds transfer with phone banking facilities (for
Citibank and HDFC bank customers)
III.Simple and Secure Interactive Voice Response based
system for authentication
IV.get the trusted, professional advice of Sharekhan limited’s
Tele Brokers
V.After hours order placement facility between 8.00 am and
9.30 am
c. Integration of: Online Trading +Saving Bank + Demat Account.
d. Instant cash transfer facility against purchase & sale of shares.
e. IPO investments.
f. Instant order and trade confirmations by e-mail.
g. Single screen interface for cash and derivatives.

SPEED TRADE ACCOUNT

This is an internet-based software application, which enables one to buy and

sell in an instant. It is ideal for active traders and jobbers who transact
frequently during day’s session to capitalize on intra-day price movement.
This account comes with the following features:
a. Instant order Execution and Confirmation.

22
 b. Single screen trading terminal for NSE Cash, NSE F&O & BSE.
c. Technical Studies.
d. Multiple Charting.
e. Real-time streaming quotes, tic-by-tic charts.
f. Market summary (Cost traded scrip, highest value etc.)
g. Hot keys similar to broker’s terminal.
h. Alerts and reminders.
i. Back-up facility to place trades on Direct Phone lines.
j. Live market debts.
CHARGE STRUCTURE
Fee structure for General Individual:

Charge Classic Account Speed Trade Account

Account Opening Rs. 750/= Rs. 1000/=

Intra-day – 0.10 % Intra-day - 0.10%

Brokerage
Delivery - 0.50 % Delivery - 0.50%
Depository Charges:

Account Opening Charges Rs. NIL

Rs. NIL first year Rs. 300/= p.a. from
Annual Maintenance Charges
second calendar year onward

HOW TO OPEN AN ACCOUNT WITH SHARE KHAN

LIMITED?
For online trading with Sharekhan Ltd., investor has to open an account.
Following are the ways to open an account with Sharekhan Ltd.:

• One need to call them at phone number provided below and asks that he
want to open an account with them.

23
 a. One can call on the Toll Free Number: 1-800-22-7500 to speak to
a Customer Service executive
b. Or If one stays in Mumbai, he can call on 022-66621111

• One can visit any one of Sharekhan Limited’s nearest branches.

Sharekhan has a huge network all over India (640 centers in 280 cities).
One can also log on to “http://sharekhan.com/Locateus.aspx” link to
find out the nearest branch.

• One can send them an email at info@sharekhan.com to know about

their products and services.

• One can also visit the site www.sharekhan.com and click on the option
“Open an Account” to fill a small query form which will ask the
individual to give details regarding his name, city he lives in, his email
address, phone number, pin code of the city, his nearest Sharekhan Ltd.
shop and his preferences regarding the type of account he wants.

These information are compiled in the headquarter of the company that

is in Mumbai from where it is distributed through out the country’s
branches in the form of leads on the basis of cities and nearest share
shops. After that the executives of the respective branches contact the
prospective clients over phone or through email and give them
information regarding the various types of accounts and the documents
they need to open an account and then fix appointment with the
prospective clients to give them demonstration and making them
undergo the formalities to open the account. After that the forms that
has collected from the clients, is scrutinized in the branch and then it is
sent to Mumbai for further processing where after a few days the clients’
account are generated and activated. After the accounts are activated, a
Welcome Kit is dispatched from Mumbai to the clients’ address
mentioned in the documents provided by them. As soon as the clients
receive the Welcome Kit, which contains the clients’ Trading ID and
Trading Password, they can start trading and investing in shares.
Generally the process of opening an account follows the following steps:
LEAD MANAGEMENT SYSTEM (LMS) / REFERENCES

CONTACT THE PERSON OVER PHONE OR THROUGH EMAIL

24
 FIXING AN APPOINTMENT WITH THE PERSON
GIVING
DEMONST-
RATION

YES NO

DOCUMENTATION

FILLING UP THE FORM

SUBMISSION OF THE FORM

LOGIN OF THE FORM

SENDING ACCOUNT OPENING KIT TO THE CLIENT

TRADING

Apart from two passport size photographs, one needs to provide with the
following documents in order to open an account with Sharekhan Limited.:

• Photocopy of the clients’ PAN Card which should be duly attached

• Photo copy of any of the following documents duly attached which will
serve as correspondence address proof:

a. Passport (valid)
b. Voter’s ID Card
c. Ration Card
d. Driving License (valid)
e. Electricity Bill (should be latest and should be in the name of the
client)

25
 f. Telephone Bill (should be latest and should be in the name of the
client)
g. Flat Maintenance Bill (should be latest and should be in the name
of the client)
h. Insurance Policy (should be latest and should be in the name of
the client)
i. Lease or Rent Agreement.
j. Saving Bank Statement** (should be latest)

• Two cheques drawn in favour of Sharkhan Limited, one for the Account
Opening Fees and the other for the Margin Money (the minimum
margin money is Rs. 5000).

** A cancelled cheque should be given by the client if he provides Saving

Bank Statement as a proof for correspondence address.

NOTE: Only Saving Bank Account cheques are accepted for the purpose of
Opening an account.

RESEARCH SECTION IN SHAREKHAN LIMITED

Sharekhan Limited has its own in-house Research Organisation which is

known as Valueline. It comprises a team of experts who constantly keep an eye
on the share market and do research on the various aspects of the share
market. Generally the research is based on the Fundamentals and Technical
analysis of different companies and also taking into account various factors
relating to the economy.

26
Sharekhan Limited’s research on the volatile market has been found accurate
most of the time. Sharekhan's trading calls in the month of November 2007
has given 89% strike rate.

Out of 37 trading calls given by Sharekhan in the month of November 2007, 33

hit the profit target. These exclusive trading picks come only to Sharekhan
Online Trading Customer and are based on in-depth technical analysis.

As a customer of Sharekhan Limited, one receives daily 5-6 Research Reports

on their emails which they can use as tips for investing in the market. These
reports are named as Pre-Market Report, Eagle Eye, High Noon, Investors Eye,
Daring Derivatives and Post-Market Report. Apart from these, Sharekhan
Limited issues a monthly subscription by the name of Valueline which is easily
available in the market.

AWARDS AND ACHIEVEMENTS

27
• SSKI has been voted as the Top Domestic Brokerage House in the
research category, twice by Euromoney Survey and four times by
Asiamoney Survey.

• Sharekhan Limited won the CNBC AWARD for the year 2004.

POLL RESULTS: BROKER PREFERENCE

5paise 119 13.45%

Sharekhan 194 21.92%
Motilal oswal 38 4.29%
ICICI Direct 192 21.69%
HDFC 46 5.20%
Indiabulls 121 13.67%
Kotak 59 6.67%
Others 116 13.11%

28
Chapter 2

29
Introductio
n to
Derivatives

INTRODUCTION TO DERIVATIVES

30
The emergence of the market for derivative products, most notably forwards,
futures and options, can be traced back to the willingness of risk-averse
economic agents to guard themselves against uncertainties arising out of
fluctuations in asset prices. By their very nature, the financial markets are
marked by a very high degree of volatility. Through the use of derivative
products, it is possible to partially or fully transfer price risks by locking–in
asset prices. As instruments of risk management, these generally do not
influence the fluctuations in the underlying 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.

DERIVATIVES DEFINED

Derivative is a product whose value is derived from the value of one or more
basic variables, called bases (underlying asset, index, or reference rate), in a
contractual manner. The underlying asset can be equity, forex, commodity or
any other asset. For example, wheat farmers may wish to sell their harvest at a
future date to eliminate the risk of a change in prices by that date. Such
transaction is an example of a derivative. The price of this derivative is driven
by the spot price of wheat which is the “underlying”.

In simple word it can be said that Derivatives are financial contracts whose
value/price is dependent on the behavior of the price of one or more basic
underlying assets (often simply known as underlying). These contracts are
legally binding agreements, made on the trading screen of stock exchanges, to
buy or sell an asset in future. The asset can be a share, index, interest rate,
bond, rupee dollar exchange rate, sugar, crude oil, soybean, cotton, coffee, etc.

In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R) A)
defines “derivative” to include –
1. A security derived from a debt instrument, share, loan whether secured or
unsecured, risk instrument or contract for differences or any other form of
security.

31
2. A contract which derives its value from the prices, or index of prices, of
underlying securities.
A very simple example of derivatives is curd, which is derivative of milk. The
price of curd depends upon the price of milk which in turn depends upon the
demand and supply of milk.

EMERGENCE OF DERIVATIVES

Derivative products initially emerged as hedging devices against fluctuations in

commodity prices, and commodity-linked derivatives remained the sole form of
such products for almost three hundred years. Financial derivatives came into
spotlight in the post-1970 period due to growing instability in the financial
markets. However, since their emergence, these products have become very
popular and by 1990s, they accounted for about two-thirds of total transactions
in derivative products. In recent years, the market for financial derivatives has
grown tremendously in terms of variety of instruments available, their
complexity and also turnover. In the class of equity derivatives the world over,
futures and options on stock indices have gained more popularity than on
individual stocks, especially among institutional investors, who are major users
of index-linked derivatives. Even small investors find these useful due to high
correlation of the popular indexes with various portfolios and ease of use. The
lower costs associated with index derivatives vis–a–vis derivative products based
on individual securities is another reason for their growing use.

HISTORY OF DERIVATIVES

Early forward contracts in the US addressed merchants’ concerns about

ensuring that there were buyers and sellers for commodities. However “credit
risk” remained a serious problem. To deal with this problem, a group of Chicago
businessmen formed the Chicago Board of Trade (CBOT) in 1848. The primary
intention of the CBOT was to provide a centralized location known in advance
for buyers and sellers to negotiate forward contracts. In 1865, the CBOT went
one step further and listed the first “exchange traded” derivatives contract in
the US, these contracts were called “futures contracts”. In 1919, Chicago Butter

32
and Egg Board, a spin-off of CBOT, was reorganized to allow futures trading. Its
name was changed to Chicago Mercantile Exchange (CME). The CBOT and the
CME remain the two largest organized futures exchanges, indeed the two
largest “financial” exchanges of any kind in the world today.
The first stock index futures contract was traded at Kansas City Board of Trade.
Currently the most popular stock index futures contract in the world is based
on S&P 500 index, traded on Chicago Mercantile Exchange. During the mid
eighties, financial futures became the most active derivative instruments
generating volumes many times more than the commodity futures. Index
futures, futures on T-bills and Euro-Dollar futures are the three most popular
futures contracts traded today. Other popular international exchanges that
trade derivatives are LIFFE in England, DTB in Germany, SGX in Singapore,
TIFFE in Japan, MATIF in France, Eurex etc.

GLOBAL DERIVATIVE MARKETS

The derivatives markets have grown manifold in the last two decades..
According to the Bank for International Settlements (BIS), the approximate size
of global derivatives market was US$ 109.5 trillion as at end–December 2000.
The total estimated notional amount of outstanding over–the–counter (OTC)
contracts stood at US$ 95.2 trillion as at end–December 2000, an increase of
7.9% over end–December 1999. Growth in OTC derivatives market is mainly
attributable to the continued rapid expansion of interest rate contracts, which
reflected growing corporate bond markets and increased interest rate
uncertainty at the end of 2000. The amount outstanding in organized exchange
markets increased by 5.8% from US$ 13.5 trillion as at end December 1999 to
US$ 14.3 trillion as at end–December 2000.
The turnover data are available only for exchange–traded derivatives contracts.
The turnover in derivative contracts traded on exchanges has increased by 9.8%
during 2000 to US$ 384 trillion as compared to US$ 350 trillion in 1999(Table
1.2). While interest rate futures and options accounted for nearly 90% of total
turnover during 2000, the popularity of stock market index futures and options
grew modestly during the year. According to BIS, the turnover in exchange–
traded derivative markets rose by a record amount in the first quarter of 2001,
while there was some moderation in the OTC volumes.

33
DERIVATIVE MARKET IN INDIA

The first step towards introduction of derivatives trading in India was the
promulgation of the Securities Laws (Amendment) Ordinance, 1995, which
withdrew the prohibition on options in securities. The market for derivatives,
however, did not take off, as there was no regulatory framework to govern
trading of derivatives. SEBI set up a 24–member committee under the
Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate
regulatory framework for derivatives trading in India. The committee submitted
its report on March 17, 1998 prescribing necessary pre–conditions for
introduction of derivatives trading in India. The committee recommended that
derivatives should be declared as ‘securities’ so that regulatory framework
applicable to trading of ‘securities’ could also govern trading of securities. SEBI
also set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma, to
recommend measures for risk containment in derivatives market in India. The
report, which was submitted in October 1998, worked out the operational
details of margining system, methodology for charging initial margins, broker
net worth, deposit requirement and real–time monitoring requirements.

The SCRA was amended in December 1999 to include derivatives within the
ambit of ‘securities’ and the regulatory framework was developed for governing
derivatives trading. The act also made it clear that derivatives shall be legal and
valid only if such contracts are traded on a recognized stock exchange, thus
precluding OTC derivatives. The government also rescinded in March 2000, the
three–decade old notification, which prohibited forward trading in securities.

Derivatives trading commenced in India in June 2000 after SEBI granted the
final approval to this effect in May 2000. SEBI permitted the derivative
segments of two stock exchanges, NSE and BSE, and their clearing
house/corporation to commence trading and settlement in approved derivatives
contracts. To begin with, SEBI approved trading in index futures contracts
based on S&P CNX Nifty and BSE–30 (Sensex) index. This was followed by
approval for trading in options based on these two indexes and options on

34
individual securities. The trading in index options commenced in June 2001
and the trading in options on individual securities commenced in July 2001.
Futures contracts on individual stocks were launched in November 2001.
Trading and settlement in derivative contracts is done in accordance with the
rules, byelaws, and regulations of the respective exchanges and their clearing
house/corporation duly approved by SEBI and notified in the official gazette.

The derivatives trading on the exchange commenced with S&P CNX Nifty Index
futures on June 12, 2000. The trading in index options commenced on June 4,
2001 and trading in options on individual securities commenced on July 2,
2001. Single stock futures were launched on November 9, 2001. The index
futures and options contract on NSE are based on S&P CNX Nifty Index.
Currently, the futures contracts have a maximum of 3-month expiration cycles.
Three contracts are available for trading, with 1 month, 2 months and 3
months expiry. A new contract is introduced on the next trading day following
the expiry of the near month contract.

PARTICITANTS AND FUNCTIONS

PARTICIPANTS

Derivative contracts have several variants. The most common variants are
forwards, futures, options and swaps. The following three broad categories of
participants –

Hedgers: - Hedgers face risk associated with the price of an asset. They use
futures or options markets to reduce or eliminate this risk

Speculators: - Speculators wish to bet on future movements in the price of an

asset. Futures and options contracts can give them an extra leverage; that is,
they can increase both the potential gains and potential losses in a speculative
venture.

Arbitrageurs: - Arbitrageurs are in business to take advantage of a

discrepancy between prices in two different markets. If, for example, they see

35
the futures price of an asset getting out of line with the cash price, they will
take offsetting positions in the two markets to lock in a profit.

FUNCTIONS
The derivatives market performs a number of economic functions.

1. Prices in an organized derivatives market reflect the perception of market

participants about the future and lead the prices of underlying to the
perceived future level. The prices of derivatives converge with the prices
of the underlying at the expiration of the derivative contract.

2. The derivatives market helps to transfer risks from those who have them
but may not like them to those who have an appetite for them.

3. Derivatives, due to their inherent nature, are linked to the underlying

cash markets. With the introduction of derivatives, the underlying
market witnesses higher trading volumes because of participation by
more players who would not otherwise participate for lack of an
arrangement to transfer risk.

4. Speculative trades shift to a more controlled environment of derivatives

market. In the absence of an organized derivatives market, speculators
trade in the underlying cash markets. Margining, monitoring and
surveillance of the activities of various participants become extremely
difficult in these kind of mixed markets.

5. An important incidental benefit that flows from derivatives trading is

that it acts as a catalyst for new entrepreneurial activity. The derivatives
have a history of attracting many bright, creative, well-educated people
with an entrepreneurial attitude. They often energize others to create
new businesses, new products and new employment opportunities, the
benefit of which are immense.

36
 6. Derivatives markets help increase savings and investment in the long
run. Transfer of risk enables market participants to expand their volume
of activity.

TYPES OF DERIVATIVE INSTRUMENTS

Forwards: A forward contract is a customized contract between two entities,
where settlement takes place on a specific date in the future at today’s pre-
agreed price.
Futures: A futures contract is an agreement between two parties to buy or sell
an asset at a certain time in the future at a certain price. Futures contracts
are special types of forward contracts in the sense that the former are
standardized exchange-traded contracts.
Options: Options are of two types - calls and puts. Calls give the buyer the
right but not the obligation to buy a given quantity of the underlying asset, at
a given price on or before a given future date. Puts give the buyer the right, but
not the obligation to sell a given quantity of the underlying asset at a given
price on or before a given date.
Warrants: Options generally have lives of up to one year, the majority of
options traded on options exchanges having a maximum maturity of nine
months. Longer-dated options are called warrants and are generally traded
over-the-counter.
LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities.
These are options having a maturity of up to three years.
Baskets: Basket options are options on portfolios of underlying assets. The
underlying asset is usually a moving average of a basket of assets. Equity
index options are a form of basket options.
Swaps: Swaps are private agreements between two parties to exchange cash
flows in the future according to a prearranged formula. They can be regarded
as portfolios of forward contracts. The two commonly used swaps are:
a. Interest rate swaps: These entail swapping only the interest related cash
flows between the parties in the same currency.

37
b.Currency swaps: These entail swapping both principal and interest between
the parties, with the cash flows in one direction being in a different currency
than those in the opposite direction.
Swaptions: Swaptions are options to buy or sell a swap that will become
operative at the expiry of the options. 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 an option to pay fixed and
receive floating.

DERIVATIVE MARKET AT NSE

The derivatives trading on the exchange commenced with S&P CNX Nifty Index
futures on June 12, 2000. The trading in index options commenced on June 4,
2001 and trading in options on individual securities commenced on July 2,
2001. Single stock futures were launched on November 9, 2001. The index
futures and options contract on NSE are based on S&P CNX Nifty Index.
Currently, the futures contracts have a maximum of 3-month expiration
cycles.
Three contracts are available for trading, with 1 month, 2 months and 3
months expiry. A new contract is introduced on the next trading day following
the expiry of the near month contract.

APPROVAL FOR DERIVATIVE TRADING

TRADING MECHANISM
The futures and options trading system of NSE, called NEAT-F&O trading
system, provides a fully automated screen–based trading for Nifty futures &
options and stock futures & options on a nationwide basis and an online
monitoring and surveillance mechanism. It supports an anonymous order
driven market which provides complete transparency of trading operations and
operates on strict price–time priority. It is similar to that of trading of equities
in the Cash Market (CM) segment. The NEAT-F&O trading system is accessed
by two types of users.

38
The Trading Members(TM) have access to functions such as order entry, order
matching, and order and trade management. It provides tremendous flexibility
to users in terms of kinds of orders that can be placed on the system. Various
conditions like Good-till-Day, Good-till-Cancelled, Good till- Date, Immediate
or Cancel, Limit/Market price, Stop loss, etc. can be built into an order. The
Clearing Members (CM) uses the trader workstation for the purpose of
monitoring the trading member(s) for whom they clear the trades. Additionally,
they can enter and set limits to positions, which a trading member can take.

MEMBERSHIP CRITERIA
NSE admits members on its derivatives segment in accordance with the rules
and regulations of the exchange and the norms specified by SEBI. NSE follows
2–tier membership structure stipulated by SEBI to enable wider participation.
Those interested in taking membership on F&O segment are required to take
membership of CM and F&O segment or CM, WDM and F&O segment. Trading
and clearing members are admitted separately.
Essentially, a clearing member (CM) does clearing for all his trading members
(TMs), undertakes risk management and performs actual settlement. There are
three types of CMs:

• Self Clearing Member: A SCM clears and settles trades executed by him
only either on his own account or on account of his clients.
• Trading Member Clearing Member: TM–CM is a CM who is also a TM.
TM–CM may clear and settle his own proprietary trades and client’s
trades as well as clear and settle for other TMs.
• Professional Clearing Member: PCM is a CM who is not a TM.
Typically, banks or custodians could become a PCM and clear and settle
for TMs.
The TM–CM and the PCM are required to bring in additional security deposit in
respect of every TM whose trades they undertake to clear and settle. Besides
this, trading members are required to have qualified users and sales persons,
who have passed a Certification programme approved by SEBI.

CLEARING AND SETTLEMENTS

39
NSCCL undertakes clearing and settlement of all deals executed on the NSEs
F&O segment. It acts as legal counterparty to all deals on the F&O segment
and guarantees settlement.

Clearing:
The first step in clearing process is working out open positions or obligations
of members. A CM’s open position is arrived at by aggregating the open
position of all the TMs and all custodial participants clearing through him, in
the contracts in which they have traded. A TM’s open position is arrived at as
the summation of his proprietary open position and clients open positions, in
the contracts in which they have traded. TMs are required to identify the
orders, whether proprietary (if they are their own trades) or client (if entered on
behalf of clients). Proprietary positions are calculated on net basis (buy-sell) for
each contract. Clients’ positions are arrived at by summing together net (buy-
sell) positions of each individual client for each contract. A TM’s open position
is the sum of proprietary open position, client open long position and client
open short position.

Settlement:
All futures and options contracts are cash settled, i.e. through exchange of
cash. The underlying for index futures/options of the Nifty index cannot be
delivered. These contracts, therefore, have to be settled in cash. Futures and
options on individual securities can be delivered as in the spot market.
However, it has been currently mandated that stock options and futures would
also be cash settled. The settlement amount for a CM is netted across all their
TMs/clients in respect of MTM, premium and final exercise settlement. For the
purpose of settlement, all CMs are required to open a separate bank account
with NSCCL designated clearing banks for F&O segment.

INDEX DERIVATIVES

Index derivatives are derivative contracts which derive their value from an
underlying index. The two most popular index derivatives are index futures

40
and index options. Index derivatives have become very popular worldwide. In
his report, Dr.L.C.Gupta attributes the popularity of index derivatives to the
advantages they offer.

• Institutional and large equity-holders need portfolio-hedging facility.

Index–derivatives are more suited to them and more cost–effective than
derivatives based on individual stocks. Pension funds in the US are
known to use stock index futures for risk hedging purposes.
• Index derivatives offer ease of use for hedging any portfolio irrespective
of its composition.
• Stock index is difficult to manipulate as compared to individual stock
prices, more so in India, and the possibility of cornering is reduced. This
is partly because an individual stock has a limited supply, which can be
cornered.
• Stock index, being an average, is much less volatile than individual
stock prices. This implies much lower capital adequacy and margin
requirements.
• Index derivatives are cash settled, and hence do not suffer from
settlement delays and problems related to bad delivery, forged/fake
certificates.
Requirements for an index derivatives market

1. Index: The choice of an index is an important factor in determining the

extent to which the index derivative can be used for hedging, speculation and
arbitrage. A well diversified, liquid index ensures that hedgers and speculators
will not be vulnerable to individual or industry risk.

2. Clearing corporation settlement guarantee: The clearing corporation

eliminates counterparty risk on futures markets. The clearing corporation
interposes itself into every transaction, buying from the seller and selling to
the buyer. This insulates a participant from credit risk of another.

3. Strong surveillance mechanism: Derivatives trading brings a whole class

of leveraged positions in the economy. Hence the need to have strong

41
surveillance on the market both at the exchange level as well as at the
regulator level.

4. Education and certification: The need for education and certification in

the derivatives market can never be overemphasized. A critical element of
financial sector reforms is the development of a pool of human resources with
strong skills and expertise to provide quality intermediation to market
participants. With the entire above infrastructure in place, trading of index
futures and index options commenced at NSE in June 2000 and June 2001
respectively.

TRADING
Here, I shall take a brief look at the trading system for NSE’s futures and
options market. However, the best way to get a feel of the trading system is to
actually watch the screen and observe how it operates.

Futures and options trading system

The futures & options trading system of NSE, called NEAT-F&O trading
system, provides a fully automated screen-based trading for Nifty futures &
options and stock futures & options on a nationwide basis as well as an online
monitoring and surveillance mechanism. It supports an order driven market
and provides complete transparency of trading operations. It is similar to that
of trading of equities in the cash market segment.
The software for the F&O market has been developed to facilitate efficient and
transparent trading in futures and options instruments. Keeping in view the
familiarity of trading members with the current capital market trading system,
modifications have been performed in the existing capital market trading
system so as to make it suitable for trading futures and options.

Entities in the trading system

There are four entities in the trading system. Trading members, clearing
members, professional clearing members and participants.

42
1. Trading members: Trading members are members of NSE. They can trade
either on their own account or on behalf of their clients including participants.
The exchange assigns a Trading member ID to each trading member. Each
trading member can have more than one user. The number of users allowed
for each trading member is notified by the exchange from time to time. Each
user of a trading member must be registered with the exchange and is
assigned a unique user ID. The unique trading member ID functions as a
reference for all orders/trades of different users. This ID is common for all
users of a particular trading member. It is the responsibility of the trading
member to maintain adequate control over persons having access to the firm’s
User IDs.

2. Clearing members: Clearing members are members of NSCCL. They carry

out risk management activities and confirmation/inquiry of trades through the
trading system.

3. Professional clearing members: A professional clearing members is a

clearing member who is not a trading member. Typically, banks and
custodians become professional clearing members and clear and settle for
their trading members.

4. Participants: A participant is a client of trading members like financial

institutions. These clients may trade through multiple trading members but
settle through a single clearing member.

BASIS OF TRADING

The NEAT F&O system supports an order driven market, wherein orders
match automatically. Order matching is essentially on the basis of security, its
price, time and quantity. All quantity fields are in units and price in rupees.
The lot size on the futures market is for 200 Nifties. The exchange notifies the
regular lot size and tick size for each of the contracts traded on this segment
from time to time. When any order enters the trading system, it is an active
order. It tries to find a match on the other side of the book. If it finds a match,
a trade is generated. If it does not find a match, the order becomes passive and
goes and sits in the respective outstanding order book in the system.

43
ORDER TYPES AND CONDITIONS

The system allows the trading members to enter orders with various conditions
attached to them as per their requirements. These conditions are broadly
divided into the following categories:
• Time conditions
• Price conditions
• Other conditions
Several combinations of the above are allowed thereby providing enormous
flexibility to the users. The order types and conditions are summarized below.

Time conditions

• Day order: A day order, as the name suggests is an order which is valid
for the day on which it is entered. If the order is not executed during the
day, the system cancels the order automatically at the end of the day.

• Good till canceled (GTC): A GTC order remains in the system until the
user cancels it. Consequently, it spans trading days, if not traded on the
day the order is entered. The maximum number of days an order can
remain in the system is notified by the exchange from time to time after
which the order is automatically cancelled by the system. Each day
counted is a calendar day inclusive of holidays. The days counted are
inclusive of the day on which the order is placed and the order is
cancelled from the system at the end of the day of the expiry period.

• Good till days/date (GTD): A GTD order allows the user to specify the
number of days/date till which the order should stay in the system if not
executed. The maximum days allowed by the system are the same as in
GTC order. At the end of this day/date, the order is cancelled from the
system. Each day/date counted are inclusive of the day/date on which

44
 the order is placed and the order is cancelled from the system at the end
of the day/date of the expiry period.

• Immediate or Cancel(IOC): An IOC order allows the user to buy or sell

a contract as soon as the order is released into the system, failing which
the order is cancelled from the system. Partial match is possible for the
order, and the unmatched portion of the order is cancelled immediately.

Price condition

• Stop– loss: This facility allows the user to release an order into the
system, after the market price of the security reaches or crosses a
threshold price e.g. if for stop–loss buy order, the trigger is 1027.00, the
limit price is 1030.00 and the market (last traded) price is 1023.00, then
this order is released into the system once the market price reaches or
exceeds 1027.00. This order is added to the regular lot book with time of
triggering as the time stamp, as a limit order of 1030.00. For the stop–
loss sell order, the trigger price has to be greater than the limit price.

Other conditions

• Market price: Market orders are orders for which no price is specified at
the time the order is entered (i.e. price is market price). For such orders,
the system determines the price.

• Trigger price: Price at which an order gets triggered from the stop–loss
book.

• Limit price: Price of the orders after triggering from stop–loss book.

• Pro: Pro means that the orders are entered on the trading member’s own
account.

45
 • Cli: Cli means that the trading member enters the orders on behalf of a
client.

Inquiry window

The inquiry window enables the user to view information such as Market by
Order(MBO), Market by Price(MBP), Previous Trades(PT), Outstanding
Orders(OO), Activity log(AL), Snap Quote(SQ), Order Status(OS), Market
Movement(MM), Market Inquiry(MI), Net Position, On line backup, Multiple
index inquiry, Most active security and so on. Relevant information for the
selected contract/security can be viewed. We shall look in detail at the Market
by Price (MBP) and the Market Inquiry (MI) screens.

Placing orders on the trading system

For both the futures and the options market, while entering orders on the
trading system, members are required to identify orders as being proprietary or
client orders. Proprietary orders should be identified as ‘Pro’ and those of
clients should be identified as ‘Cli’. Apart from this, in the case of ‘Cli’ trades,
the client account number should also be provided.
The futures market is a zero sum game i.e. the total number of long in any
contract always equals the total number of short in any contract. The total
number of outstanding contracts (long/short) at any point in time is called the
“Open interest”. This Open interest figure is a good indicator of the liquidity in
every contract.
Based on studies carried out in international exchanges, it is found that open
interest is maximum in near month expiry contracts.

Market spread/combination order entry

The NEAT F&O trading system also enables to enter spread/combination

trades. shows the spread/combination screen. This enables the user to input

46
two or three orders simultaneously into the market. These orders will have the
condition attached to it that unless and until the whole batch of orders finds a
counter match, they shall not be traded. This facilitates spread and
combination trading strategies with minimum price risk.

Basket trading

In order to provide a facility for easy arbitrage between futures and cash
markets, NSE introduced basket-trading facility. Figure 10.4 shows the basket
trading screen. This enables the generation of portfolio offline order files in the
derivatives trading system and its execution in the cash segment. A trading
member can buy or sell a portfolio through a single order, once he determines
its size. The system automatically works out the quantity of each security to be
bought or sold in proportion to their weights in the portfolio.
Futures and options market instruments

The F&O segment of NSE provides trading facilities for the following derivative
instruments:
1. Index based futures
2. Index based options
3. Individual stock options
4. Individual stock futures

Contract specifications for index futures

NSE trades Nifty futures contracts having one-month, two-month and three-
month expiry cycles. All contracts expire on the last Thursday of every month.
Thus a January expiration contract would expire on the last Thursday of
January and a February expiry contract would cease trading on the last
Thursday of February. On the Friday following the last Thursday, a new
contract having a three-month expiry would be introduced for trading.
Depending on the time period for which you want to take an exposure in
index futures contracts, you can place buy and sell orders in the respective
contracts.

47
The Instrument type refers to “Futures contract on index” and Contract symbol
- NIFTY denotes a “Futures contract on Nifty index” and the Expiry date
represents the last date on which the contract will be available for trading.
Each futures contract has a separate limit order book. All passive orders are
stacked in the system in terms of price-time priority and trades take place at
the passive order price (similar to the existing capital market trading system).
The best buy order for a given futures contract will be the order to buy the
index at the highest index level whereas the best sell order will be the order to
sell the index at the lowest index level.
Trading is for a minimum lot size of 200 units. Thus if the index level is
around 1000, then the appropriate value of a single index futures contract
would be Rs.200,000. The minimum tick size for an index future contract is
0.05 units. Thus a single move in the index value would imply a resultant gain
or loss of Rs.10.00 (i.e. 0.05*200 units) on an open position of 200 units.

Contract specification for index options

On NSE’s index options market, contracts at different strikes, having one-
month, two-month and three-month expiry cycles are available for trading.
There are typically one-month, two-month and three-month options, each with
five different strikes available for trading.

Contract specifications for stock options

Trading in stock options commenced on the NSE from July 2001. These
contracts are American style and are settled in cash. The expiration cycle for
stock options is the same as for index futures and index options. A new
contract is introduced on the trading day following the expiry of the near
month contract. NSE provides a minimum of five strike prices for every option
type (i.e. call and put) during the trading month. There are at least two in–the–
money contracts, two out–of– the–money contracts and one at–the–money
contract available for trading.

Charges

48
The maximum brokerage chargeable by a TM in relation to trades effected in
the contracts admitted to dealing on the F&O segment of NSE is fixed at 2.5%
of the contract value in case of index futures and 2.5% of notional value of the
contract[(Strike price + Premium) * Quantity] in case of index options,
exclusive of statutory levies. The transaction charges payable by a TM for the
trades executed by him on the F&O segment are fixed at Rs.2 per lakh of
turnover (0.002%)(Each side) or Rs.1 lakh annually, whichever is higher. The
TMs contribute to Investor Protection Fund of F&O segment at the rate of
Rs.10 per crore of turnover (0.0001%).

SEBI ADVISORY COMMITTEE ON DERIVATIVES

The SEBI Board in its meeting on June 24, 2002 considered some important
issues relating to the derivative markets which include:
• Physical settlement of stock options and stock futures contracts.
• Review of the eligibility criteria of stocks on which derivative products
are
permitted.
• Use of sub-brokers in the derivative markets.
• Norms for use of derivatives by mutual funds.

The recommendations of the Advisory Committee on Derivatives on some of

these issues were also placed before the SEBI Board. The Board desired that
these issues be reconsidered by the Advisory Committee on Derivatives (ACD)
and requested a detailed report on the aforesaid issues for the consideration of
the Board.

REGULATORY OBJECTIVES

The LCGC outlined the goals of regulation admirably well in Paragraph 3.1 of
its report.
We endorse these regulatory principles completely and base our
recommendations also on these same principles. We therefore reproduce this
paragraph of the LCGC Report:

49
“The Committee believes that regulation should be designed to achieve specific,
Well-defined goals. It is inclined towards positive regulation designed to
encourage healthy activity and behavior. It has been guided by the following
objectives:
(a) Investor Protection: Attention needs to be given to the following four
aspects:
(i) Fairness and Transparency
(ii) Safeguard for clients’ moneys
(iii) Competent and honest service

(b) Quality of markets: The concept of “Quality of Markets” goes well beyond
market integrity and aims at enhancing important market qualities, such as
cost-efficiency, price-continuity, and price-discovery. This is a much broader
objective than market integrity.

(c) Innovation: While curbing any undesirable tendencies, the regulatory

framework should not stifle innovation which is the source of all economic
progress, more so because financial derivatives represent a new rapidly
developing area, aided by advancements in information technology.”

Chapter 3
50
Introductio
n to
Futures and
Options

51
 INTRODUCTION TO FUTURES AND
OPTIONS

In recent years, derivatives have become increasingly important in the field of

finance. While futures and options are now actively traded on many
exchanges, forward contracts are popular on the OTC market. In this chapter
we shall study in detail these three derivative contracts.

FORWARD CONTRACT

A forward contract is an agreement to buy or sell an asset on a specified date

for a specified price. One of the parties to the contract assumes a long position
and agrees to buy the underlying asset on a certain specified future date for a
certain specified price. The other party assumes a short position and agrees to
sell the asset on the same date for the same price. Other contract details like
delivery date, price and quantity are negotiated bilaterally by the parties to the
contract. The forward contracts are normally traded outside the exchanges.
The salient features of forward contracts are:
• They are bilateral contracts and hence exposed to counter–party risk.
• Each contract is custom designed, and hence is unique in terms of
contract size, expiration date and the asset type and quality.
• The contract price is generally not available in public domain.
• On the expiration date, the contract has to be settled by delivery of the
asset.
• If the party wishes to reverse the contract, it has to compulsorily go to
the same counterparty, which often results in high prices being charged.
Forward contracts are very useful in hedging and speculation. The classic
hedging application would be that of an exporter who expects to receive
payment in dollars three months later. He is exposed to the risk of exchange
rate fluctuations.

52
Limitations of forward markets
Forward markets world-wide are afflicted by several problems:
• Lack of centralization of trading,
• Illiquidity, and
• Counterparty risk
FUTURE CONTRACT

Futures markets were designed to solve the problems that exist in forward
markets. A futures contract is an agreement between two parties to buy or sell
an asset at a certain time in the future at a certain price. But unlike forward
contracts, the futures contracts are standardized and exchange traded. In
simple words, Futures are exchange-traded contracts to buy or sell an asset in
future at a price agreed upon today. The asset can be share, index, interest
rate, bond, rupee-dollar exchange rate, sugar, crude oil, soybean, cotton,
coffee etc.

To facilitate liquidity in the futures contracts, the exchange specifies certain

standard features of the contract. It is a standardized contract with standard
underlying instrument, a standard quantity and quality of the underlying
instrument that can be delivered, (or which can be used for reference purposes
in settlement) and a standard timing of such settlement.
A futures contract may be offset prior to maturity by entering into an equal
and opposite transaction. More than 99% of futures transactions are offset this
way.

The standardized items in a futures contract are:

• Quantity of the underlying asset
• Quality of the underlying assets (not required in case of financial
futures)
• The date and the month of delivery
• The units of price quotation (not the price)
• Minimum fluctuation in price (tick size)
• Location of settlement

53
 • Settlement style.

ADVANTAGES OF FUTURE TRADING IN INDIA

1. High Leverage: The primary attraction, of course, is the potential for large
profits in a short period of time. The reason that futures trading can be so
profitable is the high leverage. To ‘own’ a futures contract an investor only has
to put up a small fraction of the value of the contract (usually around 10-20%)
as ‘margin’.
2. Profit in Both Bull & Bear Markets: In futures trading, it is as easy to sell
(also referred to as going short) as it is to buy (also referred to as going long).
By choosing correctly, you can make money whether prices go up or down.

3. Lower Transaction Cost: Another advantage of futures trading is much

lower relative commissions. Your commission for trading a futures contract is
one tenth of a percent (0.10-0.20%).

4. High Liquidity: Most futures markets are very liquid, i.e. there are huge
amounts of contracts traded every day. This ensures that market orders can
be placed very quickly as there are always buyers and sellers for most
contracts.

USING FUTURES ON INDIVIDUAL SECURUTIES

Index futures began trading in India in June 2000. A year later, options on
index were available for trading. July 2001 saw the launch of options on
individual securities (herein referred to as stock options) and the onset of
rolling settlement. With the launch of futures on individual securities (herein
referred to as stock futures) on the 9th of November, 2001, the basic range of
equity derivative products in India seems complete. Of the above mentioned
products, stock futures are particularly appealing due to familiarity and ease
in understanding. A purchase or sale of futures on a security gives the trader
essentially the same price exposure as a purchase or sale of the security itself.

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In this regard, trading stock futures is no different from trading the security
itself. Besides speculation, stock futures can be effectively used for hedging
and arbitrage reasons.

DIFFERENCES BETWEEN FORWARD AND FUTURE CONTRACT

Forward contracts are often confused with futures contracts. The confusion is
primarily because both serve essentially the same economic functions of
allocating risk in the presence of future price uncertainty. However futures are
a significant improvement over the forward contracts. A future contract is
nothing but a form of forward contract. One can differentiate a forward
contract from a future contract on the following lines:

➢ Customized vs Standardized: Forward contracts are customized while

future contracts are standardized. Terms of forward contracts are
negotiated between the buyer and the seller. While the terms of future
contracts are decided by the exchange on which these are traded.

➢ Counter Party Risk: In forward contracts there is a risk of counter

party default. In case of futures, the exchange becomes counter party to
each trade and guarantees settlement.

➢ Liquidity: Futures are much more liquid and their price is transparent
as their price and volume are reported in media. But this is not so in
the case of forward contract.

➢ Squaring off: A forward contract can be reversed with only the same
counter party with whom it was entered into. A future contract can be
reversed on the screen of the exchange as the latter is the counter party
to all futures trades.

THEORETICAL WAY OF PRICING FUTURES

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The theoretical price of a futures contract is spot price of the underlying plus
the cost of carry. Please note that futures are not about predicting future
prices of the underlying assets.

In general, Futures Price = Spot Price + Cost of Carry

The Cost of Carry is the sum of all costs incurred if a similar position is taken
in cash market and carried to expiry of the futures contract less any revenue
that may arise out of holding the asset. The cost typically includes interest
cost in case of financial futures (insurance and storage costs are also
considered in case of commodity futures). Revenue may be in the form of
dividend.

Though one can calculate the theoretical price, the actual price may vary
depending upon the demand and supply of the underlying asset.

FUTURES TERMINOLOGIES

• Spot price: The price at which an asset trades in the spot market.

• Futures price: The price at which the futures contract trades in the
futures market.

• Contract cycle: The period over which a contract trades. The index
futures contracts on the NSE have one-month, two-months and three-
month expiry cycles which expire on the last Thursday of the month.
Thus a January expiration contract expires on the last Thursday of
January and a February expiration contract ceases trading on the last
Thursday of February. On the Friday following the last Thursday, a new
contract having a three-month expiry is introduced for trading.

• Expiry date: It is the date specified in the futures contract. This is the
last day on which the contract will be traded, at the end of which it will
cease to exist.

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 • Contract size: The amount of asset that has to be delivered less than
one contract. For instance, the contract size on NSE’s futures market is
200 Nifties.

• Basis: In the context of financial futures, basis can be defined as the

futures price minus the spot price. There will be a different basis for
each delivery month for each contract. In a normal market, basis will be
positive. This reflects that futures prices normally exceed spot prices.

• Cost of carry: The relationship between futures prices and spot prices
can be summarized in terms of what is known as the cost of carry. This
measures the storage cost plus the interest that is paid to finance the
asset less the income earned on the asset.

• Initial margin: The amount that must be deposited in the margin

account at the time a futures contract is first entered into is known as
initial margin.

• Marking-to-market: In the futures market, at the end of each trading

day, the margin account is adjusted to reflect the investor’s gain or loss
depending upon the futures closing price. This is called marking–to–
market.

• Maintenance margin: This is somewhat lower than the initial margin.

This is set to ensure that the balance in the margin account never
becomes negative. If the balance in the margin account falls below the
maintenance margin, the investor receives a margin call and is expected
to top up the margin account to the initial margin level before trading
commences on the next day.

OPTIONS
Options are fundamentally different from forward and futures contracts. An
option gives the holder of the option the right to do something. The holder does
not have to exercise this right. In contrast, in a forward or futures contract,

57
the two parties have committed themselves to doing something. Whereas it
costs nothing (except margin requirements) to enter into a futures contract,
the purchase of an option requires an up–front payment.

OPTIONS TERMINOLOGIES

• Index options: These options have the index as the underlying. Some
options are European while others are American. Like indexing futures
contracts, indexing options contracts are also cash settled.

• Stock options: Stock options are options on individual stocks. Options

currently trade on over 500 stocks in the United States. A contract
gives the holder the right to buy or sell shares at the specified price.

• Buyer of an option: The buyer of an option is the one who by paying

the option premium buys the right but not the obligation to exercise his
option on the seller/writer.

• Writer of an option: The writer of a call/put option is the one who

receives the option premium and is thereby obliged to sell/buy the
asset if the buyer exercises on him. There are two basic types of
options, call options and put options.

• Call option: A call option gives the holder the right but not the
obligation to buy an asset by a certain date for a certain price.

• Put option: A put option gives the holder the right but not the
obligation to sell an asset by a certain date for a certain price.

• Option price: Option price is the price, which the option buyer pays to
the option seller. It is also referred to as the option premium.

• Expiration date: The date specified in the options contract is known as

the expiration date, the exercise date, the strike date or the maturity.

• Strike price: The price specified in the options contract is known as

the strike price or the exercise price.

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• American options: American options are options that can be exercised
at any time upto the expiration date. Most exchange-traded options are
American.

• European options: European options are options that can be exercised

only on the expiration date itself. European options are easier to
analyze than American options, and properties of an American option
are frequently deduced from those of its European counterpart.

• In-the-money option: An in-the-money (ITM) option is an option that

would lead to a positive cash flow to the holder if it were exercised
immediately. A call option on the index is said to be in-the-money when
the current index stands at a level higher than the strike price (i.e. spot
price > strike price). If the index is much higher than the strike price,
the call is said to be deep ITM. In the case of a put, the put is ITM if the
index is below the strike price.

• At-the-money option: An at-the-money (ATM) option is an option that

would lead to zero cash flow if it were exercised immediately. An option
on the index is at-the-money when the current index equals the strike
price (i.e. spot price = strike price).

• Out-of-the-money option: An out-of-the-money (OTM) option is an

option that would lead to a negative cash flow if it were exercised
immediately. A call option on the index is out-of-the-money when the
current index stands at a level, which is less than the strike price (i.e.
spot price < strike price). If the index is much lower than the strike
price, the call is said to be deep OTM. In the case of a put, the put is
OTM if the index is above the strike price.

• Time value of an option: The time value of an option is the difference

between its premium and its intrinsic value. Both calls and puts have
time value. An option that is OTM or ATM has only time value. Usually,
the maximum time value exists when the option is ATM. The longer the
time to expiration, the greater is an option’s time value, all else equal.
At expiration, an option should have no time value.

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TYPES OF OPTIONS

1. Call Options- A call option gives the holder (buyer/ one who is long call),
the right to buy specified quantity of the underlying asset at the strike price on
or before expiration date. The seller (one who is short call) however, has the
obligation to sell the underlying asset if the buyer of the call option decides to
exercise his option to buy.

Example: An investor buys One European call option on Infosys at the strike
price of Rs. 3500 at a premium of Rs. 100. If the market price of Infosys on the
day of expiry is more than Rs. 3500, the option will be exercised.

The investor will earn profits once the share price crosses Rs. 3600 (Strike
Price + Premium i.e. 3500+100).

Suppose stock price is Rs. 3800, the option will be exercised and the investor
will buy 1 share of Infosys from the seller of the option at Rs 3500 and sell it in
the market at Rs 3800 making a profit of Rs. 200 {(Spot price - Strike price) -
Premium}.

In another scenario, if at the time of expiry stock price falls below Rs. 3500 say
suppose it touches Rs. 3000, the buyer of the call option will choose not to
exercise his option. In this case the investor loses the premium (Rs 100), paid
which should be the profit earned by the seller of the call option.

2. Put Options- A Put option gives the holder (buyer/ one who is long Put), the
right to sell specified quantity of the underlying asset at the strike price on or
before an expiry date. The seller of the put option (one who is short Put)
however, has the obligation to buy the underlying asset at the strike price if
the buyer decides to exercise his option to sell.

Example: An investor buys one European Put option on Reliance at the strike
price of Rs. 300/- , at a premium of Rs. 25/-. If the market price of Reliance,
on the day of expiry is less than Rs. 300, the option can be exercised as it is 'in
the money'. The investor's Break-even point is Rs. 275/ (Strike Price -
premium paid) i.e., investor will earn profits if the market falls below 275.

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Suppose stock price is Rs. 260, the buyer of the Put option immediately buys
Reliance share in the market @ Rs. 260/- & exercises his option selling the
Reliance share at Rs 300 to the option writer thus making a net profit of Rs. 15
{(Strike price - Spot Price) - Premium paid}.

In another scenario, if at the time of expiry, market price of Reliance is Rs

320/ -, the buyer of the Put option will choose not to exercise his option to sell
as he can sell in the market at a higher rate. In this case the investor loses the
premium paid (i.e. Rs 25/-), which shall be the profit earned by the seller of
the Put option. (Please see table)

THE OPTIONS GAME

Call Option Put Option

1.Option Buys the right to Buys the right to sell

buyer or buy the underlying the underlying asset
option holder asset at the at the specified price
specified price

2. Option Has the obligation to Has the obligation to

seller or sell the underlying buy the underlying
option writer asset (to the option asset (from the
holder) at the option holder) at the
specified price specified price

LEVERAGE AND RISK

Options can provide leverage. This means an option buyer can pay a
relatively small premium for market exposure in relation to the contract value
(usually 100 shares of underlying stock). An investor can see large percentage
gains from comparatively small, favorable percentage moves in the underlying

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index. Leverage also has downside implications. If the underlying stock price
does not rise or fall as anticipated during the lifetime of the option, leverage
can magnify the investment's percentage loss. Options offer their owners a
predetermined, set risk. However, if the owner's options expire with no value,
this loss can be the entire amount of the premium paid for the option. An
uncovered option writer, on the other hand, may face unlimited risk.

In-the-money, At-the-money, Out-of-the-money

An option is said to be ‘at-the-money’, when the option's strike price is equal to

the underlying asset price. This is true for both puts and calls.

A call option is said to be ‘in-the-money’ when the strike price of the option is
less than the underlying asset price. For example, a Sensex call option with
strike of 3900 is ‘in-the-money’, when the spot Sensex is at 4100 as the call
option has value. The call holder has the right to buy a Sensex at 3900, no
matter how much the spot market price has risen. And with the current price
at 4100, a profit can be made by selling Sensex at this higher price.

On the other hand, a call option is ‘out-of-the-money’ when the strike price is
greater than the underlying asset price. Using the earlier example of Sensex
call option, if the Sensex falls to 3700, the call option no longer has positive
exercise value. The call holder will not exercise the option to buy Sensex at
3900 when the current price is at 3700. (Please see table)

Striking the price

Call Option Put Option

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 1.In-the-money Strike Price less than Strike Price greater
Spot Price of than Spot Price of
underlying asset underlying asset

2. At-the-money Strike Price equal to Strike Price equal to

Spot Price of Spot Price of
underlying asset underlying asset

3. Out-of-the- Strike Price greater Strike Price less than

money than Spot Price of Spot Price of
underlying asset underlying asset

• A put option is in-the-money when the strike price of the option is

greater than the spot price of the underlying asset. For example, a
Sensex put at strike of 4400 is in-the-money when the Sensex is at
4100. When this is the case, the put option has value because the put
holder can sell the Sensex at 4400, an amount greater than the current
Sensex of 4100.

• Likewise, a put option is out-of-the-money when the strike price is

less than the spot price of underlying asset. In the above example, the
buyer of Sensex put option won't exercise the option when the spot is at
4800. The put no longer has positive exercise value.

Options are said to be deep in-the-money (or deep out-of-the-money) if

the exercise price is at significant variance with the underlying asset
price.

The amount by which an option, call or put, is in-the-money at any given

moment is called its intrinsic value. Thus, by definition, an at-the-money or
out-of-the-money option has no intrinsic value; the time value is the total
option premium. This does not mean, however, these options can be obtained
at no cost. Any amount by which an option's total premium exceeds intrinsic
value is called the time value portion of the premium.

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It is the time value portion of an option's premium that is affected by
fluctuations in volatility, interest rates, dividend amounts and the passage of
time. There are other factors that give options value, therefore affecting the
premium at which they are traded. Together, all of these factors determine
time value.

Option Premium = Intrinsic Value + Time Value

FACTORS THAT AFFECT THE VALUE OF AN OPTION PREMIUM

There are two types of factors that affect the value of the option premium:

Quantifiable Factors:

1. Underlying stock price,

2. The strike price of the option,

3. The volatility of the underlying stock,

4. The time to expiration and;

5. The risk free interest rate.

Non-Quantifiable Factors:

1. Market participants' varying estimates of the underlying asset's future

volatility

2. Individuals' varying estimates of future performance of the underlying

asset, based on fundamental or technical analysis

3. The effect of supply & demand- both in the options marketplace and in
the market for the underlying asset

4. The "depth" of the market for that option - the number of transactions
and the contract's trading volume on any given day.

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DIFFERENT PRICING MODELS FOR OPTIONS
The theoretical option pricing models are used by option traders for calculating
the fair value of an option on the basis of the earlier mentioned influencing
factors. An option pricing model assists the trader in keeping the prices of calls
& puts in proper numerical relationship to each other & helping the trader
make bids & offer quickly. The two most popular option pricing models are:

• Black Scholes Model which assumes that percentage change in the

price of underlying follows a normal distribution.

• Binomial Model which assumes that percentage change in price of the

underlying follows a binomial distribution.

Pricing models include the binomial options model for American options and
the Black-Scholes model for European options.

OPTIONS TRADING
As described earlier, four possible option selections exist for a trader:

a. long a call,

b. long a put,

c. short a call, and

d. short a put.

These four can be used independently, together, or in conjunction with other

financial instruments to create a number of option-trading strategies. These
combinations enable a trader to develop an option-trading model which meets
the trader's specific trading needs, expectations, and style, and enables him or
her to anticipate every conceivable situation in the market. This trading
structure can be adapted to handle any type of market outlook, whether it is
bullish, bearish, choppy, or neutral.

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Options are unique trading instruments. They can be used for a multitude of
purposes, providing tremendous versatility and utility. Among their multiple
applications are the following: to speculate on the movement of an asset; to
hedge an existing position in an asset; to hedge other option positions; to
generate income by writing options against different quantities of options
strategies that arise from these applications and the fact that the scope of this
book is limited, we will devote coverage to a cursory explanation of two of the
most popular strategies which are designed to take advantage of market
movement: spreads and straddles.

WHY TO USE OPTIONS?

There are two main reasons why an investor would use options:
• to Speculate and
• to Hedge.

Speculation
One can think of speculation as betting on the movement of a security. The
advantage of options is that one isn’t limited to making a profit only when the
market goes up. Because of the versatility of options, one can also make
money when the market goes down or even sideways.

Speculation is the territory in which the big money is made - and lost. The use
of options in this manner is the reason options have the reputation of being
risky. This is because when one buys an option; he have to be correct in
determining not only the direction of the stock's movement, but also the
magnitude and the timing of this movement. To succeed, he must correctly
predict whether a stock will go up or down, and he have to be right about how
much the price will change as well as the time frame it will take for all this to
happen.

So why do people speculate with options if the odds are so skewed? Aside from
versatility, it's all about using leverage. When one is controlling 100 shares
with one contract, it doesn't take much of a price movement to generate
substantial profits.

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Hedging
The other function of options is hedging. Think of this as an insurance policy.
Just as one insures his house or car, options can be used to insure your
investments against a downturn. Critics of options say that if he is so unsure
of his stock pick that he needs a hedge, he shouldn't make the investment. On
the other hand, there is no doubt that hedging strategies can be useful,
especially for large institutions.
Even the individual investor can benefit. One can imagine that he wanted to
take advantage of technology stocks and their upside, but say he also wanted
to limit any losses. By using options, he would be able to restrict his downside
while enjoying the full upside in a cost-effective way.

HOW OPTIONS WORKS?

Let's say that on May 1, the stock price of L&T is $67 and the premium (cost)
is $3.15 for a July 70 Call, which indicates that the expiration is the third
Friday of July and the strike price is $70. The total price of the contract is
$3.15 x 100 = $315. In reality, you'd also have to take commissions into
account, but we'll ignore them for this example.

Remember, a stock option contract is the option to buy 100 shares; that's why
you must multiply the contract by 100 to get the total price. The strike price of
$70 means that the stock price must rise above $70 before the call option is
worth anything; furthermore, because the contract is $3.15 per share, the
break-even price would be $73.15.

When the stock price is $67, it's less than the $70 strike price, so the option is
worthless. But don't forget that you've paid $315 for the option, so you are
currently down by this amount.

Three weeks later the stock price is $78. The options contract has increased
along with the stock price and is now worth $8.25 x 100 = $825. Subtract
what you paid for the contract, and your profit is ($8.25 - $3.15) x 100 = $510.
You almost doubled our money in just three weeks! You could sell your
options, which are called "closing your position," and take your profits -

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unless, of course, you think the stock price will continue to rise. For the sake
of this example, let's say we let it ride.

By the expiration date, the price drops to $62. Because this is less than our
$70 strike price and there is no time left, the option contract is worthless. We
are now down to the original investment of $315.

To recap, here is what happened to our option investment:

Date May 1 May 21 Expiry Date

Stock Price $67 $78 $62
Option Price $3.15 $8.25 worthless
Contract Value $315 $825 $0
Paper
$0 $510 -$315
Gain/Loss

The price swing for the length of this contract from high to low was $825,
which would have given us over double our original investment. This is
leverage in action.

Exercising Versus Trading-Out

So far we've talked about options as the right to buy or sell (exercise) the
underlying. This is true, but in reality, a majority of options are not actually
exercised. In our example, you could make money by exercising at $70 and
then selling the stock back in the market at $78 for a profit of $8 a share. You
could also keep the stock, knowing you were able to buy it at a discount to the
present value.

However, the majority of the time holders choose to take their profits by
trading out (closing out) their position. This means that holders sell their
options in the market, and writers buy their positions back to close. According
to the CBOE, about 10% of options are exercised, 60% are traded out, and
30% expire worthless.

Intrinsic Value and Time Value

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At this point it is worth explaining more about the pricing of options. In our
example the premium (price) of the option went from $3.15 to $8.25. These
fluctuations can be explained by intrinsic value and time value.

Basically, an option's premium is its intrinsic value + time value. Remember,

intrinsic value is the amount in-the-money, which, for a call option, means
that the price of the stock equals the strike price. Time value represents the
possibility of the option increasing in value. So, the price of the option in our
example can be thought of as the following:

Premium = Intrinsic Value + Time Value

$8.25 = $8 + $0.25

In real life options almost always trade above intrinsic value. If you are
wondering, we just picked the numbers for this example out of the air to
demonstrate how options work.

WHEN NOT TO BUY AN OPTION?

It is also important to consider the time or the date at which one should enter
the option market. Avoid trading in an illiquid option market.

• Avoid purchasing call options just prior to a stock going ex-dividend.

Avoid buying or selling options based upon anticipated news (buyouts in
particular). Besides bordering on unethical trading, the information
received is more likely to be rumor than correct.

• Avoid purchasing options well after the market has established a defined
trend - this is especially true when day trading, as any option premium
advantage will have dissipated.

• Avoid purchasing way out-of-the-money options when day trading, as

any favorable price movement will have a negligible effect upon
premium.

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 • Avoid purchasing call options when the underlying security is up for the
day versus the prior day's close, unless one intends to take a trend-
following stance.

• Avoid purchasing put options when the underlying security is down for
the day versus the prior day's close, unless one intends to take a trend-
following stance.

Be careful when holding long option positions beyond Friday's trading day's
close unless one is option position trading. Many option theoreticians
recalculate their volatility, delta, and time decay numbers once a week, usually
after the close of trading on Fridays or over the weekend. The resulting
adjustments in these values most often have a negative effect on the value of
the long option, which may be acceptable when holding an option over an
extended period of time but is detrimental when day trading.

HOW TO READ AN OPTION TABLE?

Column 1: Strike Price - This is the stated price per share for which an
underlying stock may be purchased (for a call) or sold (for a put) upon the
exercise of the option contract. Option strike prices typically move by
increments of $2.50 or $5 (even though in the above example it moves in $2
increments).

Column 2: Expiry Date - This shows the termination date of an option

contract. Remember that U.S.-listed options expire on the third Friday of the
expiry month.

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Column 3: Call or Put - This column refers to whether the option is a call (C)
or put (P).

Column 4: Volume - This indicates the total number of options contracts

traded for the day. The total volume of all contracts is listed at the bottom of
each table.

Column 5: Bid - This indicates the price someone is willing to pay for the
options contract.

Column 6: Ask - This indicates the price at which someone is willing to sell an
options contract.

Column 7: Open Interest - Open interest is the number of options contracts

that are open; these are contracts that have neither expired nor been
exercised.

PAYOFF FOR DERIVATIVES CONTRACT

A payoff is the likely profit/loss that would accrue to a market participant with
change in the price of the underlying asset. This is generally depicted in the

71
form of payoff diagrams which show the price of the underlying asset on the X–
axis and the profits/losses on the Y–axis.

PAYOFF FOR FUTURES

Futures contracts have linear payoffs. In simple words, it means that the
losses as well as profits for the buyer and the seller of a futures contract are
unlimited. These linear payoffs are fascinating as they can be combined with
options and the underlying to generate various complex payoffs.

Payoff for buyer of futures: Long futures

The payoff for a person who buys a futures contract is similar to the payoff for
a person who holds an asset. He has a potentially unlimited upside as well as
a potentially unlimited downside. Take the case of a speculator who buys a
two-month Nifty index futures contract when the Nifty stands at 1220. The
underlying asset in this case is the Nifty portfolio. When the index moves up,
the long futures position starts making profits, and when the index moves
down it starts making losses.

Payoff for seller of futures: Short futures

The payoff for a person who sells a futures contract is similar to the payoff for
a person who shorts an asset. He has a potentially unlimited upside as well as
a potentially unlimited downside. Take the case of a speculator who sells a
two-month Nifty index futures contract when the Nifty stands at 1220. The
underlying asset in this case is the Nifty portfolio. When the index moves
down, the short futures position starts making profits, and when the index
moves up, it starts making losses.

OPTIONS PAYOFF

The optionally characteristic of options results in a non-linear payoff for

options. In simple words, it means that the losses for the buyer of an option
are limited; however the profits are potentially unlimited. For a writer, the

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payoff is exactly the opposite. His profits are limited to the option premium;
however his losses are potentially unlimited. These non-linear payoffs are
fascinating as they lend themselves to be used to generate various payoffs by
using combinations of options and the underlying. We look here at the six
basic payoffs.

Payoff profile of buyer of asset: Long asset

In this basic position, an investor buys the underlying asset, Nifty for instance,
for 1220, and sells it at a future date at an unknown price, once it is
purchased, the investor is said to be “long” the asset.

Payoff profile for seller of asset: Short asset

In this basic position, an investor shorts the underlying asset, Nifty for
instance, for 1220, and buys it back at a future date at an unknown price.

Payoff profile le for buyer of call options: Long call

A call option gives the buyer the right to buy the underlying asset at the strike
price specified in the option. The profit/loss that the buyer makes on the
option depends on the spot price of the underlying. If upon expiration, the spot
price exceeds the strike price, he makes a profit. Higher the spot price more is
the profit he makes. If the spot price of the underlying is less than the strike
price, he lets his option expire un-exercised. His loss in this case is the
premium he paid for buying the option.

Payoff profile for writer of call options: Short call

A call option gives the buyer the right to buy the underlying asset at the strike
price specified in the option. For selling the option, the writer of the option
charges a premium. The profit/loss that the buyer makes on the option
depends on the spot price of the underlying. Whatever is the buyer’s profit is
the seller’s loss. If upon expiration, the spot price exceeds the strike price, the
buyer will exercise the option on the writer.

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Hence as the spot price increases the writer of the option starts making losses.
Higher the spot price more is the loss he makes. If upon expiration the spot
price of the underlying is less than the strike price, the buyer lets his option
expire unexercised and the writer gets to keep the premium.

Payoff profile for buyer of put options: Long put

A put option gives the buyer the right to sell the underlying asset at the strike
price specified in the option. The profit/loss that the buyer makes on the
option depends on the spot price of the underlying. If upon expiration, the spot
price is below the strike price, he makes a profit. Lower the spot price more is
the profit he makes. If the spot price of the underlying is higher than the strike
price, he lets his option expire un-exercised. His loss in this case is the
premium he paid for buying the option.

Payoff profile for writer of put options: Short put

A put option gives the buyer the right to sell the underlying asset at the strike
price specified in the option. For selling the option, the writer of the option
charges a premium. The profit/loss that the buyer makes on the option
depends on the spot price of the underlying. Whatever is the buyer’s profit is
the seller’s loss. If upon expiration, the spot price happens to be below the
strike price, the buyer will exercise the option on the writer. If upon expiration
the spot price of the underlying is more than the strike price, the buyer lets his
option expire un-exercised and the writer gets to keep the premium.

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 Chapter 4

Hedging,
Arbitrage
and
75
 Speculatio
n
Strategies

HEDGING, ARBITRAGE AND SPECULATION

STRATEGIES
HEDGING
Hedging is a way of reducing some of the risk involved in holding an
investment. There are many different risks against which one can hedge and
many different methods of hedging. When someone mentions hedging, think of
insurance. A hedge is just a way of insuring an investment against risk.
Consider a simple (perhaps the simplest) case. Much of the risk in holding any
particular stock is market risk; i.e. if the market falls sharply, chances are that

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any particular stock will fall too. So if you own a stock with good prospects but
you think the stock market in general is overpriced, you may be well advised to
hedge your position.
There are many ways of hedging against market risk. The simplest, but most
expensive method, is to buy a put option for the stock you own. (It's most
expensive because you're buying insurance not only against market risk but
against the risk of the specific security as well.)
If you're trying to hedge an entire portfolio, futures are probably the cheapest
way to do so. But keep in mind the following points.
• The efficiency of the hedge is strongly dependent on your estimate
of the correlation between your high-beta portfolio and the broad market
index.
• If the market goes up, you may need to advance more margin to
cover your short position, and will not be able to use your stocks to cover
the margin calls.
If the market moves up, you will not participate in the rally, because by
intention, you've set up your futures position as a complete hedge.

HEDGING STRATEGIES WITH EXAMPLES

Hedging: Long security, short Nifty futures

Investors studying the market often come across a security which they believe
is intrinsically undervalued. It may be the case that the profits and the quality
of the company make it seem worth a lot more than what the market thinks. A
stock picker carefully purchases securities based on a sense that they are worth
more than the market price. When doing so, he faces two kinds of risks:

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1. His understanding can be wrong, and the company is really not worth more
than the market price; or,

2. The entire market moves against him and generates losses even though the
underlying idea was correct.

The second outcome happens all the time. A person may buy SBI at Rs.670
thinking that it would announce good results and the security price would rise.
A few days later, Nifty drops, so he makes losses, even if his understanding of
SBI was correct.
There is a peculiar problem here. Every buy position on a security is
simultaneously a buy position on Nifty. This is because a LONG SBI position
generally gains if Nifty rises and generally loses if Nifty drops. In this sense, a
LONG SBI position is not a focused play on the valuation of SBI. It carries a
LONG NIFTY position along with it, as incidental baggage. The stock picker may
be thinking he wants to be LONG SBI, but a long position on SBI effectively
forces him to be LONG SBI + LONG NIFTY.

There is a simple way out. Every time you adopt a long position on a security,
you should sell some amount of Nifty futures. This offsets the hidden Nifty
exposure that is inside every long–security position. Once this is done, you will
have a position, which is purely about the performance of the security. The
position LONG SBI+ SHORT NIFTY is a pure play on the value of SBI, without
any extra risk from fluctuations of the market index. When this is done, the
stock picker has “hedged away” his index exposure. The basic point of this
hedging strategy is that the stock picker proceeds with his core skill, i.e. picking
securities, at the cost of lower risk.

Methodology

1. We need to know the “beta” of the security, i.e. the average impact
of a 1% move in Nifty upon the security. If betas are not known, it is
generally safe to assume the beta is 1. Suppose we take SBIN, where the
beta is 1.2, and suppose we have a LONG SBIN position of Rs.3,33,000.

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 2. The size of the position that we need on the index futures market,
to completely remove the hidden Nifty exposure, is 1.2 *3,33,000, i.e. Rs
4.00.000

3. Suppose Nifty is at 2000, and the market lot on the futures market
is 200. Hence each market lot of Nifty is Rs 4,00,000. To short
Rs.4,00,000 of Nifty we need to sell one market lot.

4. We sell one market lot of Nifty (200 nifties) to get the position:
LONG SBIN Rs.3,33,000
SHORT NIFTY Rs.4,00,000
This position will be essentially immune to fluctuations of Nifty. The
profits/losses position will fully reflect price changes intrinsic to SBIN, hence
only successful forecasts about SBIN will benefit from this position. Returns
on the position will be roughly neutral to movements of Nifty.

Hedging: Have portfolio, short Nifty futures

The only certainty about the capital market is that it fluctuates! A lot of
investors who own portfolios experience the feeling of discomfort about overall
market movements. Sometimes, they may have a view that security prices will
fall in the near future. At other times, they may see that the market is in for a
few days or weeks of massive volatility, and they do not have an appetite for this
kind of volatility. The union budget is a common and reliable source of 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.
This is particularly a problem if you need to sell shares in the near future, for
example, in order to finance a purchase of a house. This planning can go wrong
if by the time you sell shares, Nifty has dropped sharply.
When you have such anxieties, there are two alternatives:
• Sell shares immediately. This sentiment generates “panic selling”
which is rarely optimal for the investor.

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 • Do nothing, i.e. suffer the pain of the volatility. This leads to
political pressures for government to “do something” when security prices
fall.

In addition, with the index futures market, a third and remarkable alternative
becomes available:
• Remove your exposure to index fluctuations temporarily using
index futures. This allows rapid response to market conditions, without
“panic selling” of shares. It allows an investor to be in control of his risk,
instead of doing nothing and suffering the risk.

The idea here is quite simple. Every portfolio contains a hidden index exposure.
This statement is true for all portfolios, whether a portfolio is composed of index
securities or not. In the case of portfolios, most of the portfolio risk is accounted
for by index fluctuations (unlike individual securities, where only 30–60% of the
securities risk is accounted for by index fluctuations).Hence a position LONG
PORTFOLIO + SHORT NIFTY can often become one–tenth as risky as the LONG
PORTFOLIO position!
Suppose we have a portfolio of Rs.1 million which has a beta of 1.25. Then a
complete hedge is obtained by selling Rs.1.25 million of Nifty futures.

Methodology

1. We need to know the “beta” of the portfolio, i.e. the average impact
of a 1% move in Nifty upon the portfolio. It is easy to calculate the
portfolio beta: it is the weighted average of securities betas. Suppose we
have a portfolio composed of Rs.1 million of Hindalco, which has a beta of
1.4 and Rs.2 million of Hindustan Lever, which has a beta of 0.8, then
the portfolio beta is (1 * 1.4 + 2 * 0.8)/3 or 1. If the beta of any securities
is not known, it is safe to assume that it is 1.

2. The complete hedge is obtained by adopting a position on the index

futures market, which completely removes the hidden Nifty exposure. In
the above case, the portfolio is Rs.3 million with a beta of 1, hence we
would need a position of Rs.3 million on the Nifty futures.

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 3. Suppose Nifty is 1250, and the market lot on the futures market is
200. Each market lot of Nifty costs Rs.250,000. Hence we need to sell 12
market lots, i.e. 2400 Nifties to get the position: LONG PORTFOLIO
Rs.3,000,000 SHORT NIFTY Rs.3,000,000.

This position will be essentially immune to fluctuations of Nifty. If Nifty goes up,
the portfolio gains and the futures lose. If Nifty goes down, the futures gain and
the portfolio loses. In either case, the investor has no risk from market
fluctuations when he is completely hedged. The investor should adopt this
strategy for the short periods of time where (a) the market volatility that he
anticipates makes him uncomfortable, or (b) when his financial planning
involves selling shares at a future date and would be affected if Nifty drops. It
does not make sense to use this strategy for long periods of time – if a two–year
hedging is desired, it is better to sell the shares, invest the proceeds, and buy
back shares after two years. This strategy makes the most sense for rapid
adjustments.
Another important choice for the investor is the degree of hedging. Complete
hedging eliminates all risk of gain or loss. Sometimes the investor may be
willing to tolerate some risk of loss so as to hang on to some risk of gain. In that
case, partial hedging is appropriate. The complete hedge may require selling
Rs.3 million of the futures, but the investor may choose to only sell Rs.2 million
of the futures. In this case, two–thirds of his portfolio is hedged and one– third
of the portfolio is held unhedged. The exact degree of hedging chosen depends
upon the appetite for risk that the investor has.

Hedging: Have funds, buy Nifty futures

Have you ever been in a situation where you had funds, which needed to get
invested in equity? Or of expecting to obtain funds in the future which will get
invested in equity. Some common occurrences of this include:
_

• A closed-end fund, which just finished its initial public offering, has
cash, which is not yet invested.

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 • Suppose a person plans to sell land and buy shares. The land deal
is slow and takes weeks to complete. It takes several weeks from the date
that it becomes sure that the funds will come to the date that the funds
actually are in hand.
• An open-ended fund has just sold fresh units and has received
funds.

Getting invested in equity ought to be easy but there are three problems:

1. A person may need time to research securities, and carefully pick

securities that are expected to do well. This process takes time. For that
time, the investor is partly invested in cash and partly invested in
securities. During this time, he is exposed to the risk of missing out if the
overall market index goes up.

2. A person may have made up his mind on what portfolio he seeks to

buy, but going to the market and placing market orders would generate
large ‘impact costs’. The execution would be improved substantially if he
could instead place limit orders and gradually accumulate the portfolio at
favorable prices. This takes time, and during this time, he is exposed to
the risk of missing out if the Nifty goes up.

3. In some cases, such as the land sale above, the person may simply
not have cash to immediately buy shares, hence he is forced to wait even
if he feels that Nifty is unusually cheap. He is exposed to the risk of
missing out if Nifty rises.

So far, in India, we have had exactly two alternative strategies, which an

investor can adopt: to buy liquid securities in a hurry, or to suffer the risk of
staying in cash. With Nifty futures, a third alternative becomes available:

• The investor would obtain the desired equity exposure by buying

index futures, immediately. A person who expects to obtain Rs.5 million
by selling land would immediately enter into a position LONG NIFTY
worth Rs.5 million. Similarly, a closed-end fund, which has just finished

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 its initial public offering and has cash, which is not yet invested, can
immediately enter into a LONG NIFTY to the extent it wants to be invested
in equity. The index futures market is likely to be more liquid than
individual securities so it is possible to take extremely large positions at a
low impact cost.
• Later, the investor/closed-end fund can gradually acquire
securities (either based on detailed research and/or based on aggressive
limit orders). As and when shares are obtained, one would scale down the
LONG NIFTY position correspondingly. No matter how slowly securities
are purchased, this strategy would fully capture a rise in Nifty, so there is
no risk of missing out on a broad rise in the securities market while this
process is taking place. Hence, this strategy allows the investor to take
more care and spend more time in choosing securities and placing
aggressive limit orders.

Hedging is often thought of as a technique that is used in the context of equity

exposure. It is common for people to think that the owner of shares needs index
futures to hedge against a drop in Nifty. Holding money in hand, when you
want to be invested in shares, is a risk because Nifty may rise. Hence it is
equally important for the owner of money to use index futures to hedge against
a rise in Nifty!

Methodology

1. A person obtained Rs.4.8 million on 13th March 2005. He made a

list of 14 securities to buy, at 13 March prices, totaling Rs.4.8 million.

2. At that time Nifty was at 2000. He entered into a LONG NIFTY

MARCH FUTURES position for 2400 Nifties, i.e. his long position was
worth 4,80,000.

3. From 14 March 2005 to 25 March 2005 he gradually acquired the

securities. On each day, he purchased one securities and sold off a
corresponding amount of futures.

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 4. On each day, the securities purchased were at a changed price (as
compared to the price prevalent on 13 March). On each day, he obtained
or paid the ‘mark–to–market margin’ on his outstanding futures position,
thus capturing the gains on the index.

5. By 25 Mar 2005 he had fully invested in all the shares that he

wanted (as of 13 Mar) and had no futures position left.

ARBITRAGE

Arbitrage is the practice of taking advantage of a state of imbalance between

two (or possibly more) markets. A combination of matching deals are struck
that exploit the imbalance, the profit being the difference between the market
prices. A person who engages in arbitrage is called an arbitrageur.

Arbitrage is the safest way to make money in the market. However, the scope
for making money is diminutive. With the help of the arbitrage strategies
discussed above, we can exploit the market condition and earn risk-free return.

Arbitrage is game of strategy and also funds. A participant with ample funds
can easily earn risk-free returns. On the other hand, a strategist can make risk-
less profits by making use of mispricing in the market.

Arbitrage could be inter-exchange, NSE and BSE. Arbitrage could also be

between two segments of the market, Cash and F&O.

Borrowing and lending is a common practice in arbitrage transaction, therefore,

bank and financial institution are very active in arbitrage activities.

The below stated strategies cover all the types of arbitrage possibilities using
equity derivatives.

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ARBITRAGE STRATEGIES WITH EXAMPLES

Arbitrage: Have funds, lend them to the market.

Most people would like to lend funds into the security market, without suffering
the risk. Traditional methods of loaning money into the security market suffer
from (a) price risk of shares and (b) credit risk of default of the counter-party.
What is new about the index futures market is that it supplies a technology to
lend money into the market without suffering any exposure to Nifty, and
without bearing any credit risk.
The basic idea is simple. The lender buys all 50 securities of Nifty on the cash
market, and simultaneously sells them at a future date on the futures market.
It is like a repo. There is no price risk since the position is perfectly hedged.
There is no credit risk since the counter party on both legs is the NSCCL which
supplies clearing services on NSE. It is an ideal lending vehicle for entities
which are shy of price risk and credit risk, such as traditional banks and the
most conservative corporate treasuries.

Methodology

1. Calculate a portfolio which buys all the 50 securities in Nifty in

correct proportion, i.e. where the money invested in each security is
proportional to its market capitalization.

2. Round off the number of shares in each security.

3. Using the NEAT or BOLT software, a single keystroke can fire off
these 50 orders in rapid succession into the NSE or BSE trading system.
This gives you the buy position
4. A moment later, sell Nifty futures of equal value. Now you are
completely hedged, so fluctuations in Nifty do not affect you.
5. A few days later, you will have to take delivery of the 50 securities
and pay for them. This is the point at which you are “loaning money to
the market”.

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 6. Some days later (anytime you want), you will unwind the entire
transaction.
7. At this point, use NEAT to send 50 sell orders in rapid succession
to sell off all the 50 securities.
8. A moment later, reverse the futures position. Now your position is
down to 0.
9. A few days later, you will have to make delivery of the 50 securities
and receive money for them. This is the point at which “your money is
repaid to you”.

What is the interest rate that you will receive? We will use one specific case,
where you will unwind the transaction on the expiration date of the futures. In
this case, the difference between the futures price and the cash Nifty is the
return to the moneylender, with two complications: the moneylender
additionally earns any dividends that the 50 shares pay while he has held
them, and the moneylender suffers transactions costs (impact cost, brokerage)
in doing these trades. On 1 March 2005, if the Nifty spot is 2100, and the Nifty
March 2005 futures are at 2142 then the difference (2% for 30 days) is the
return that the moneylender obtains.

Example
On 1 August, Nifty is at 2400. A futures contract is trading with 27th August
expiration for 2460. A person wants to earn this return (60/2400 for 27 days).

1. He buys Rs.3 million of Nifty on the spot market. In doing this, he

places 50 market orders and ends up paying slightly more. His average
cost of purchase is 0.3% higher, i.e. he has obtained the Nifty spot for
2407.

2. He sells Rs.3 million of the futures at 2460. The futures market is

extremely liquid so the market order for Rs.3 million goes through at
near–zero impact cost. He takes delivery of the shares and waits.

3. While waiting, a few dividends come into his hands. The dividends
work out to Rs.14,000.

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 4. On 27 August, at 3:15, he puts in market orders to sell off his Nifty
portfolio, putting 50 market orders to sell off all the shares. Nifty happens
to have closed at 2420 and his sell orders (which suffer impact cost) goes
through at 2413.

5. The futures position spontaneously expires on 27 August at 2420

(the value of the futures on the last day is always equal to the Nifty spot).

6. Hehas gained Rs.6 (0.25%) on the spot Nifty and Rs.40 (1.63%) on
the futures for a return of near 1.88% In addition, he has gained
Rs.14000 or 0.23% owing to the dividends for a total return of 2.11% for
27 days, risk free.

It is easier to make a rough calculation of the return. To do this, we ignore the

gain from dividends and we assume that transactions costs account for 0.4%.
In the above case, the return is roughly 2460/2400 or 2.5% for 27 days, and we
subtract 0.4% for transactions costs giving 2.1% for 27 days.

Arbitrage: Have securities, lend them to the market

Owners of a portfolio of shares often think in terms of juicing up their returns

by earning revenues from stocklending. However, stocklending schemes that
are widely accessible do not exist in India.
The index futures market offers a riskless mechanism for (effectively) loaning
out shares and earning a positive return for them. It is like a repo; you would
sell off your certificates and contract to buy them back in the future at a fixed
price. There is no price risk (since you are perfectly hedged) and there is no
credit risk (since your counterparty on both legs of the transaction is the
NSCCL).
The basic idea is quite simple. You would sell off all 50 securities in Nifty
and buy them back at a future date using the index futures. You would soon
receive money for the shares you have sold. You can deploy this money, as you

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like until the futures expiration. On this date, you would buy back your shares,
and pay for them.

Methodology

Suppose you have Rs.5 million of the NSE-50 portfolio (in their correct
proportion, with each share being present in the portfolio with a weight that is
proportional to its market capitalization).

1. Sell off all 50 shares on the cash market. This can be done using a
single keystroke using the NEAT software.

2. Buy index futures of an equal value at a future date.

3. A few days later, you will receive money and have to make delivery
of the 50 shares.

4. Invest this money at the riskless interest rate.

5. On the date that the futures expire, at 3:15 PM, put in 50 orders
(using NEAT again) to buy the entire NSE-50 portfolio.

6. A few days later, you will need to pay in the money and get back
your shares.

When is this worthwhile? When the spot-futures basis (the difference between
spot Nifty and the futures Nifty) is smaller than the riskless interest rate that
you can find in the economy. If the spot–futures basis is 2.5% per month and
you are loaning out the money at 1.5% per month, it is not profitable.
Conversely, if the spot-futures basis is 1% per month and you are loaning out
money at 1.2% per month, this stock lending could be profitable
It is easy to approximate the return obtained in stock lending. To do this, we
assume that transactions costs account for 0.4%. Suppose the spot–futures
basis is X% and suppose the rate at which funds can be invested is Y %. Then
the total return is (Y - X% - 0.4%) over the time that the position is held.

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This can also be interpreted as a mechanism to obtain a cash loan using your
portfolio of Nifty shares as collateral. In this case, it may be worth doing even if
the spot–futures basis is somewhat wider.

Example

Suppose the Nifty spot is 1100 and the two–month futures are trading at 1110.
Hence the spot– futures basis (10/1100) is 0.9%. Assume that the transactions
costs are 0.4%. Suppose cash can be riskless invested at 1% per month. Over
two months, funds invested at 1% per month yield 2.01%. Hence the total
return that can be obtained in stock lending is 2.01-0.9-0.4 or 0.71% over the
two–month period. Let us make this concrete using a specific sequence of
trades. Suppose a person has Rs.4 million of the Nifty portfolio, which he would
like to lend to the market.

1. He puts in sell orders for Rs.4 million of Nifty using the feature in
NEAT to rapidly place 50 market orders in quick succession. The seller
always suffers impact cost; suppose he obtains an actual execution at
1098.

2. A moment later, he puts in a market order to buy Rs.4 million of

the Nifty futures. The order executes at 1110. At this point, he is
completely hedged.

3. A few days later, he makes delivery of shares and receives Rs.3.99

million (assuming an impact cost of 2/1100).

4. Suppose helends this out at 1% per month for two months. At the
end of two months, he get back Rs.40,70,199. Translated in terms of
Nifty, this is 1098* or 1120.

5. On the expiration date of the futures, he puts in 50 orders, using

NEAT, placing market orders to buy back his Nifty portfolio. Suppose
Nifty has moved up to 1150 by this time. This makes shares are costlier

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 in buying back, but the difference is exactly offset by profits on the
futures contract.
6. When the market order is placed, suppose he ends up paying 1153
and not 1150, owing to impact cost. He has funds in hand of 1120, and
the futures contract pays 40 (1150-1110) so he ends up with a clean
profit, on the entire transaction, of 1120 + 40 - 1153 or 7. On a base of
Rs.4 million, this is Rs.25,400.

Arbitrage: Overpriced futures: buy spot, sell futures

As we discussed earlier, the cost-of-carry ensures that the futures price stay in
tune with the spot price. Whenever the futures price deviates substantially from
its fair value, arbitrage opportunities arise.
If you notice that futures on a security that you have been observing seem
overpriced, how can you cash in on this opportunity to earn riskless profits?
Say for instance, ABB trades at Rs.1000. One–month ABB futures trade at
Rs.1025 and seem overpriced. As an arbitrageur, you can make riskless profit
by entering into the following set of transactions.

1. On day one, borrow funds; buy the security on the cash/spot

market at 1000.

2. Simultaneously, sell the futures on the security at 1025.

3. Take delivery of the security purchased and hold the security for a
month.

4. On the futures expiration date, the spot and the futures price
converge. Now unwind the position.

5. Say the security closes at Rs.1015. Sell the security.

6. Futures position expires with profit of Rs.10.

7. The result is a riskless profit of Rs.15 on the spot position and

Rs.10 on the futures position.

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 8. Return the borrowed funds.

When does it make sense to enter into this arbitrage? If your cost of borrowing
funds to buy the security is less than the arbitrage profit possible, it makes
sense for you to arbitrage. This is termed as cash–and–carry arbitrage.
Remember however, that exploiting an arbitrage opportunity involves trading
on the spot and futures market. In the real world, one has to build in the
transactions costs into the arbitrage strategy.

Arbitrage: Underpriced futures: buy futures, sell spot

Whenever the futures price deviates substantially from its fair value, arbitrage
opportunities arise. It could be the case that you notice the futures on a
security you hold seem underpriced. How can you cash in on this opportunity
to earn riskless profits? Say for instance, ABB trades at Rs.1000. One–month
ABB futures trade at Rs. 965 and seem underpriced. As an arbitrageur, you can
make riskless profit by entering into the following set of transactions.

1. On day one, sell the security in the cash/spot market at 1000.

2. Make delivery of the security.
3. Simultaneously, buy the futures on the security at 965.
4. On the futures expiration date, the spot and the futures price
converge. Now unwind the position.
5. Say the security closes at Rs.975. Buy back the security.
6. The futures position expires with a profit of Rs.10.
7. The result is a riskless profit of Rs.25 on the spot position and
Rs.10 on the futures position.

If the returns you get by investing in riskless instruments is less than the
return from the arbitrage trades, it makes sense for you to arbitrage. This is
termed as reverse–cash–and–carry arbitrage. It is this arbitrage activity that
ensures that the spot and futures prices stay in line with the cost–of–carry. As
we can see, exploiting arbitrage involves trading on the spot market. As more
and more players in the market develop the knowledge and skills to do cash–

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and–carry and reverse cash–and–carry, we will see increased volumes and lower
spreads in both the cash as well as the derivatives market.

SPECULATIONS
Speculation has a lot of risks involved. Specially speculation in derivates is even
more riskier as the derivatives are leveraged instruments.
Speculator is responsible for liquidity in the market. Major part of the market
volumes come from speculation, be it cash market or the F&O segment.

Market participants to speculate extensively use Index futures and stock

futures.
Index futures attract the maximum volumes in the derivatives segment.
Speculation in option is not very common, because buying an option is highly
leveraged transaction.

Speculation in options is naked positions, which are very risky.

Speculation in the market index is very common, index is less volatile and index
movement is easy to analyze than the individual stock movements.

Speculation in individual securities attracts highest risk, are individual

securities are more volatile than the market index. The above-discussed
strategies are responsible for liquidity in the Derivatives segment hence leading
to volumes in the cash segment also.

SPECULATION STRATEGIES WITH EXAMPLES

Speculation: Bullish Index, long nifty futures

Sometimes we think that the market index is going to rise and that we can
make a profit by adopting a position on the index. After a good budget, or good
corporate results, or the onset of a stable government, many people feel that the

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index would go up. How does one implement a trading strategy to benefit from
an upward movement in the index? Today, a person has two choices:

1. Buy selected liquid securities which move with the index, and sell
them at a later date: or,

2. Buy the entire index portfolio and then sell it at a later date.

The first alternative is widely used – a lot of the trading volume on liquid
securities is based on using these liquid securities as an index proxy. However,
these positions run the risk of making losses owing to company–specific news;
they are not purely focused upon the index. The second alternative is
cumbersome and expensive in terms of transactions costs.
Taking a position on the index is effortless using the index futures market.
Using index futures, an investor can “buy” or “sell” the entire index by trading
on one single security. Once a person is LONG NIFTY using the futures market,
he gains if the index rises and loses if the index falls.

Methodology

When you think the index will go up, buy the Nifty futures. The minimum
market lot is 200 Nifties. Hence, if Nifty is at 1200, the investment is done in
units of Rs.240,000. When the trade takes place, the investor is only required to
pay up the initial margin, which is something like Rs.20,000. Hence, by paying
an initial margin of Rs.20,000, the investor gets a claim on the index worth
Rs.240,000. Similarly, by paying up Rs.200,000, the investor gets a claim on
Nifty worth Rs.2.4 million.
Futures are available at several different expirations. The investor can choose
any of them to implement this position. The choice is basically about the
horizon of the investor. Longer dated futures go well with long–term forecasts
about the movement of the index. Shorter dated futures tend to be more liquid.

Example

93
 1. On 1 July 2001, a person feels the index will rise.

2. He buys 200 Nifties with expiration date on 31st July 2001.

3. At this time, the Nifty July contract costs Rs.960 so his position is
worth Rs.192,000.

4. On 14 July 2001, Nifty has risen to 967.35.

3. The Nifty July contract has risen to Rs.980.

4. He sells off his position at Rs.980.

5. His profits from the position are Rs.4000.

Speculation: Bearish index, short Nifty futures

Sometimes we think that the market index is going to fall and that we can make
profit by adopting a position on the index. After a bad budget, or bad corporate
results, or the onset of a coalition government, many people feel that the index
would go down. How does one implement a trading strategy to benefit from a
downward movement in the index? Today a person has two choices:
1. Sell selected liquid securities which move with the index, and buy
them at a later date: or,
2. Sell the entire index portfolio and then buy it at a later date.

The first alternative is widely used – a lot of the trading volume on liquid
securities is based on using these securities as an index proxy. However, these
positions run the risk of making losses owing to company–specific news; they
are not purely focused upon the index.
The second alternative is hard to implement. This strategy is also cumbersome
and expensive in terms of transactions costs. Taking a position on the index is
effortless using the index futures market. Using index futures, an investor can
“buy” or “sell” the entire index by trading on one single security. Once a person

94
is SHORT NIFTY using the futures market, he gains if the index falls and loses
if the index rises.

Methodology

When you think the index will go down, sell the Nifty futures. The minimum
market lot is 200 Nifties. Hence, if Nifty is at 1200, the investment is done in
units of Rs.240,000. When the trade takes place, the investor is only required to
pay up the initial margin, which is something like Rs.20,000. Hence, by paying
an initial margin of Rs.20,000 the investor gets a claim on the index worth
Rs.240,000. Similarly, by paying up Rs.200,000, the investor gets a claim on
Nifty worth Rs.2.4 million.
Futures are available at several different expirations. The investor can choose
any of them to implement this position. The choice is basically about the
horizon of the investor. Longer dated futures go well with long–term forecasts
about the movement of the index. Shorter dated futures tend to be more liquid.

Example

1. On 1 June 2001, a person feels the index will fall.

2. He sells 200 Nifties with a expiration date of 26th June 2001.

3. At this time, the Nifty June contract costs Rs.1,060 so his position
is worth Rs.212,000.

4. On 10 June 2001, Nifty has fallen to 962.90.

5. The Nifty June contract has fallen to Rs.990. he squares off his
position.

His profits from the position work out to be Rs.14,000.

95
Chapter 5

96
Applicabilit
y of
Derivative
Instruments

APPLICABILITY OF DERIVATIVE
INSTRUMENTS
97
RISK MANAGEMENT: CONCEPT AND DEFINATION
In recent years mangers have become increasingly aware of how their
organizations can be affected by risks beyond their control. In many cases
fluctuations in economic and financial variables such as exchange rates,
interest rates and commodity prices have destabilizing affects on performance
and corporate strategy.

WHAT IS RISK?

Risks are defined as internal or external causes of and reasons for deviations
in actual results and forecasts/budgets, or factors that can lead to changes in
the forecast. They are possibilities not included in forecast/budget and
represent an upside or downside to the forecast/ budget.

WHAT IS RISK MANAGEMENT?

Risk management embraces the whole spectrum of activities and measures

associated with the identification, evaluation and handling of opportunities
and risks.

OBJECTIVES AND BENEFITS OF RISK MANAGEMENT

The key objectives of Risk Management are:

• Providing a basis for informed decision making as a consequence of

creating transparency in the company’s risk situation.
• Identifying threats to the company, its assets and its financial and
earning potential.
• Implementing proper mechanism for the identification, analysis and
mitigation of potential risks.
• Clearly prioritizing risks to the company and their mitigation strategies:
and

98
 • Creating opportunities through improving risk mitigation capabilities.

Effective and systematic Risk Management yields the following key benefits:

• Forward, rigorous, responsible thinking, so the organization is prepared

for what might happen and is better prepared for making decisions to
improve the effectiveness and efficiency of performance.
• Balance thinking – a trade – off must be struck between the cost of
managing risk, the benefits to be gained, and what level of Risk
Management it is prudent to apply; and
• The organization is encouraged to manage proactively rather than
reactively.
It helps to speed up the decision making process, giving clear priorities to each
type of activity or project requiring management attention and thus giving a
clear cut advantage to the business.

RISK MANAGEMENT PROCESS

The objective of risk management process is to identify and evaluate the key
risks, treat and monitor these risks efficiently and effectively, and ensure
ongoing reporting for informed decision making. It embraces the whole
spectrum of activities and measures concerned with systematic management
of risks within the organization.
The overall objective of the risk management process is to optimize the risk
return relationship and reject unacceptable risks. The process contains four
main stages:

• Risk Identification
• Risk Evaluation
• Risk Handling; and
• Risk Controlling

Controlling the Risk Management Process means monitoring whether the

management process is actively and effectively lived throughout the

99
organization. The efficiency of the process is the responsibility of all managers
within the organization and cannot be viewed as the sole responsibility of the
Risk Manager. All levels of management should manage risks.

The risk management process must be established as a permanent and

integral part of business process if it to be fully effective. Furthermore, since
risks and risk structures change continuously, the risk management process
must remain sufficiently flexible to accommodate new situations as they arise.

Opportunity/Risk
Risk
Risk
RiskIdentification
Evaluation
Controlling
Handling
Risk Management Process
Ongoing reporting
Evaluation
Measures and
of risks
mechanisms
and
monitoring
for influencing
concerning of
Identification risks
ofrisks.
their and
impact
risks the
and& of
handling
Objectives,
mechanism.
strategies, organization of the company
their sources
probability

RISK MANAGEMENT WITH FUTURES CONTRACT

100
As the futures are exchange-traded, the clearing corporation of the exchange
by granting credit guarantee nullifies the counter party risk. Also the strict
margining system followed in the futures market worldwide, reduces the
default risk associated with the futures. The general margining system that is
followed in the futures market is as follows.
Depending on the position taken an initial margin is charged on the investor.
This is determined by the exposure limit assigned to the investor. This can be
interpreted as an advance payment made to take a larger position. For
example, if the exposure limit is 33 times the base capital given by the
investor, then it means that an initial margin of 3.33 is required.
More than the initial margin collected, the net profit or loss on a position is
paid out to or in by the investor on the very same day in the form of daily
mark-to-market margins (MTM). The MTM is made compulsory to remove any
default on large losses if the position is accumulated for several days.
Calculating the net loss associated with a position does the calculation of MTM
margin. This is paid up each evening after trading ends. The focus is on
calculating the net loss on all contracts entered by the client.

ADVANTAGES AND RISKS OF TRADING IN FUTURES OVER

CASH

• The biggest advantage of futures is that short selling is allowed without

having stock and position can be carried for a long time, which is not
possible in the cash segment because of rolling settlement. Conversely
futures can be bought and position can be carried for a long time
without taking delivery, unlike in the cash segment where it delivery has
to be taken because of rolling settlement.

• Further futures positions are leveraged positions, meaning a position

can be taken for Rs100 by paying Rs25 margin and daily mark-to-
market loss, if any. This can enhance the return on capital deployed.

• For example, the expectation for a Rs100 stock is to go up by Rs10. One

way is to buy the stock in the cash segment by paying Rs100. In this
way the profit will be Rs10 on investment of Rs100, giving about 10%

101
 returns. Alternatively, futures position in the stock by paying about
Rs30 toward initial and mark-to-market margin the same profit of Rs10
can be made on the investment of Rs30, i.e. about 33% returns. Please
note that taking leveraged position is very risky, you can even lose your
full capital in case the price moves against your position.

RISK MANAGEMENT WITH OPTIONS

Risk is concerned with the unknown. Upside risk is the possibility of gain.
Downside risk is the possibility of loss. One half the reasons to use options
(like other derivatives) is to reduce risk. Certainty is exchanged with other
players who assume the risk in hope of big gains. It is wrong to state that
"options are risky."

• Reduce risk: The seller of a covered call exchanges his upside risk
(gains above the strike price) for the certainty of cash in hand (the
premium). The buyer of a covered put limits his downside risk for a price
- just like buying fire insurance for your house.

• Increase risk: The buyer of a call wants the upside risk of an asset, but
will only pay a small percentage of its current value, so his returns are
leveraged. The seller of a put accepts the downside risk of locking in his
purchase price of an asset, in exchange for the premium.

To understand risk, look at the four standard graphs of options (put-call-buy-

sell). The value of the options in the interim between purchase and expiration
will not be exactly like these graphs, but close enough. In all cases, the
premium was a certainty.

• Buyers start out-of-pocket. But going forward, the option buyer has no
downside risk. The graph either flat lines or goes up on either side of the
spot price.

102
 • Sellers start with a gain. Going forward, they have no upside risk. These
graphs either flat line or go down on either side of the spot price.

The extent of risk varies. Buyers/sellers of calls have unlimited

upside/downside risk as the asset price increases. Buyers/sellers of puts have
upside/downside risk limited to the spot price of the asset (less the premium).

Long Call
A trader who believes that a stock's price will increase might buy the right to
purchase the stock (a call option) rather than just buy the stock. He would
have no obligation to buy the stock, only the right to do so until the expiry
date. If the stock price increases over the exercise price by more than the
premium paid, he will profit.
If the stock price decreases, he will let the call contract expire worthless, and
only lose the amount of the premium. A trader might buy the option instead of
shares, because for the same amount of money, he can obtain a larger number
of options than shares. If the stock rises, he will thus realize a larger gain than
if he had purchased shares. This is an example of the principle of leverage.

Payoffs and profits from a long call.

Short Call (Naked short call)

A trader who believes that a stock's price will decrease can short sell the stock
or instead sell a call. Both tactics are generally considered inappropriate for
small investors. The trader selling a call has an obligation to sell the stock to
the call buyer at the buyer's option. If the stock price decreases, the short call
position will make a profit in the amount of the premium.

103
If the stock price increases over the exercise price by more than the amount of
the premium, the short will lose money. Unless a trader already owns the
shares which he may be required to provide, the potential loss is unlimited.
However, such a trader who sells a call option for those shares he already
owns has sold a covered call.

Payoffs and profits from a short call.

Long Put
A trader who believes that a stock's price will decrease can buy the right to sell
the stock at a fixed price. He will be under no obligation to sell the stock, but
has the right to do so until the expiry date. If the stock price decreases below
the exercise price by more than the premium paid, he will profit. If the stock
price increases, he will just let the put contract expire worthless and only lose
his premium paid.

Payoffs and profits from a long put.

Short Put (Naked put)

A trader who believes that a stock's price will increase can sell the right to sell
the stock at a fixed price. The trader now has the obligation to purchase the
stock at a fixed price. The trader has sold insurance to the buyer of the put
requiring the trader to insure the stockholder below the fixed price. This trade
is generally considered inappropriate for a small investor. If the stock price

104
increases, the short put position will make a profit in the amount of the
premium. If the stock price decreases below the exercise price by more than
the premium, the short position will lose money.

Payoffs and profits from a short put.

INTRODUCTION TO OPTIONS STRATEGIES

Bullish Strategies

Bullish options strategies are employed when the options trader expects the
underlying stock price to move upwards. It is necessary to assess how high the
stock price can go and the timeframe in which the rally will occur in order to
select the optimum trading strategy.

The most bullish of options trading strategies is the simple call buying strategy
used by most novice options traders.

In most cases, stocks seldom go up by leaps and bounds. Moderately bullish

options traders usually set a target price for the Bull Run and utilize bull
spreads to reduce risk. While maximum profit is capped for these strategies,
they usually cost less to employ. The bull call spread and the bull put spread
are common examples of moderately bullish strategies.

Mildly bullish trading strategies are options strategies that make money as
long as the underlying stock prices do not go down on options expiration date.
These strategies usually provide a small downside protection as well. Writing
out-of-the-money covered calls is a good example of such a strategy.

105
Bearish Strategies

Bearish options strategies are employed when the options trader expects the
underlying stock price to move downwards. It is necessary to assess how low
the stock price can go and the timeframe in which the decline will happen in
order to select the optimum trading strategy.

The most bearish of options trading strategies is the simple put buying
strategy utilized by most novice options traders.

In most cases, stock price seldom make steep downward moves. Moderately
bearish options traders usually set a target price for the expected decline and
utilize bear spreads to reduce risk. While maximum profit is capped for these
strategies, they usually cost less to employ. The bear call spread and the bear
put spread are common examples of moderately bearish strategies.

Mildly bearish trading strategies are options strategies that make money as
long as the underlying stock prices do not go up on options expiration date.
These strategies usually provide a small upside protection as well.

Neutral or Non-Directional Strategies

Neutral strategies in options trading are employed when the options trader
does not know whether the underlying stock price will rise or fall. Also known
as non-directional strategies, they are so named because the potential to profit
does not depend on whether the underlying stock price will go upwards or
downwards. Rather, the correct neutral strategy to employ depends on the
expected volatility of the underlying stock price.

Bullish on Volatility

Neutral trading strategies those are bullish on volatility profit when the
underlying stock price experience big moves upwards or downwards. They
include the long straddle, long strangle, and short condor and short butterfly.

106
Bearish on Volatility

Neutral trading strategies those are bearish on volatility profit when the
underlying stock price experiences little or no movement. Such strategies
include the short straddle, short strangle, ratio spreads, long condor and long
butterfly.

Combining any of the four basic kinds of option trades (possibly with different
exercise prices) and the two basic kinds of stock trades (long and short) allows
a variety of options strategies. Simple strategies usually combine only a few
trades, while more complicated strategies can combine several.

OPTIONS TRADING STRATEGIES

There are several basic Options Trading Strategies, but in order to execute any
of them successfully an investor new to options will need to know some
elementary concepts.

The most basic are the call and the put. Buying a call confers the right, but
not the obligation, to buy at a pre-set price. Puts grant the buyer the right to
sell at a pre-set price. But options are sold as well as bought.

That seller grants the buyer the right, and takes on an obligation to fulfill the
other side of the trade.

There are several basic variations.

Long Calls

The most basic, and easiest to understand, is the (long) call. MSFT (Microsoft),
currently trading at $28, have June 31 options that expire on the third Friday
of June, with a strike price (pre-set, 'if exercised, must-be-bought-at-price') of
$31.

Short ('Naked') Calls

When the option seller (the 'writer') doesn't own the underlying stock he's
obligated to sell (if the option is exercised), he is said to be selling a 'naked'

107
call. Since he's on the selling side of the contract, his position is said to be
'short'.

If the market price of the underlying asset decreases, the short call position
will profit by the amount of the premium. The price rises above the strike price
by more than the premium, the short position incurs a loss.

Long Put

Traders who anticipate that the future market price of an asset, say a stock,
will fall prior to expiration can buy the right to sell the stock at a fixed price.
The put buyer has no obligation to sell the stock, but simply the right.

If, in fact, the market price does fall below the strike price (prior to expiration
of the option) by more than the premium paid, he profits. If the price
increases, or doesn't fall enough to cover the premium, the trader lets the
contract 'expire worthless'.

Short Put

Traders who speculate that the future market price will increase, can sell the
right to sell an asset at a pre-determined price.

If the asset's market price rises, the short put position makes a profit equal to
the amount of the premium. (Excluding any transaction costs, such as
commissions.) If the price falls below the strike price by more than the
premium, the 'writer' loses money.

Several basic trading strategies utilize the characteristics of these four basc
positions. These strategies are either pure profit plays - speculating on coming
out on the plus side of the equation - or combinations of speculation and
hedging.

Hedging involves taking positions that tend to move in opposite directions.

They profit less than pure speculation, but make up for it by offloading some
risk.

108
'Bull spreads', for example, use a long call with a low strike price in
combination with a short call at a higher strike price and a short put with a
higher strike price.

'Bear spreads', by contrast, involve a short call with a low strike price and a
long call with a higher strike price. An alternative method uses a short put
with low strike price and a long put with a higher strike price.

Options trading software can demonstrate several concrete examples of how

any of these - under different assumptions about future prices, volume, etc in
combination with different expiration dates and strike prices - can result in
profit (or loss).

Current Strategies

1. LONG CALL

Market Potential
View Profit Potential Loss
Bullish Unlimited Limited

Purchasing calls has remained the most popular strategy with investors since
listed options were first introduced. Before moving into more complex bullish
and bearish strategies, an investor should thoroughly understand the
fundamentals about buying and holding call options.

Situation: On 1 November, L&T is quoting at Rs 254 and the January 260

(strike price) call costs Rs 14 (premium). You expect the share price to rise
significantly and want to profit from the increase

Action: Buy 1 L&T call at 14. Net outlay is Rs 14,000 If the L&T shares do go
up you can close your position either by selling the option back to the market
or exercising your right to buy the underlying shares at the exercise price.

Share Price Option Market

109
 1-Nov Rs. 254 Buy 1 Jan 260 call at Rs 14, Cost =14,000
20-Jan Rs. 300 1. Sell 1Jan contract (Expiry)
2. Net Gain 40
(300 - 260 x 1000 units = 40,000)
Analysi Rises by Your gain is:
s Return
Rs.46 18% Option sale = 40,000
Premium paid = (14,000)
Net profit= 26,000
Return 186%

Possible Outcomes at expiry

Share Price Option worth 40,000. Closing the position now will
300 produce a net profit of 26,000
Share price < Option expires worthless. The loss is Rs. 14,000
260 (premium)
Stock price > Net profit = intrinsic value of (Break even = 260+14) option
274 i.e. by whatever amount the share price exceeds 274

Although the profit is on expiry day, the investor is obviously able to sell his
option at any time prior to expiry, and such sale will result in the receipt of
time value in addition to any intrinsic value.

2. LONG PUT

Market Potential
View Profit Potential Loss
Bearish Unlimited Limited

A long put can be an ideal tool for an investor who wishes to participate
profitably from a downward price move in the underlying stock. Before moving
into more complex bearish strategies, an investor should thoroughly
understand the fundamentals about buying and holding put options.

Situation: An investor thinks L&T, currently trading at Rs 270, is overvalued

and may fall substantially. He therefore decides to buy Puts to gain exposure
to its anticipated fall.

110
Action: Buy 1 L&T October 260 Put at Rs 8 for a total consideration of Rs
8,000. If the L&T shares do go down you can close your position either by
selling the option back to the market or exercising your right to buy the
underlying shares at the exercise price.

Share Price Option Market

1-Aug Rs. 270 Buy 1 L&T Oct 260 put at Rs 8 Total Outlay
= 8,000
20-Oct Rs. 240 1. Sell 1 Oct contract.
2. Net gain 20 (260 - 240 x 1000 = 20,000)
Analysi Fall of Effective profits
s effective
profit Rs 30 Option purchase (8,000)
Option sale 20,000
Net profit 12,000 or 150%

Possible Outcomes at expiry

Share Price 240 The 260 put will be trading at Rs 20 which gives a
profit of Rs 12 (20-8), if the position is closed out.
Share price 240- Recover intrinsic value of premium.
260
Stock price > 240 The 260 put will be trading at Rs 20 which gives a
profit of Rs
12 (20-8), if the position is closed out.

Although the profit is on expiry day, the investor is obviously able to sell his
option at any time prior to expiry, and such sale will result in the receipt of
time value in addition to any intrinsic value.

3. Short Call
Naked short call / Covered short call

Market Potential
View Profit Potential Loss
Bullish Limited Unlimited

111
The covered call is a strategy in which an investor writes a call option contract
while at the same time owning an equivalent number of shares of the
underlying stock. If this stock is purchased simultaneously with writing the
call con-tract, the strategy is commonly referred to as a "buy-write." If the
shares are already held from a previous purchase, it is commonly referred to
an "overwrite." In either case, the stock is generally held in the same brokerage
account from which the investor writes the call, and fully collateralizes, or
"covers," the obligation conveyed by writing a call option contract. This strategy
is the most basic and most widely used strategy combining the flexibility of
listed options with stock ownership.

Situation: It is 1 November and L&T share is trading at Rs 254. An investor

holds 10000 shares but does not expects their price to move very much over
the next few months so decides to write call option against this shareholding.

Action: The January 260 calls are trading at 14 and investor sells 10
contracts (one contract is 1,000 shares). He receives an option premium equal
to Rs 1,40,000 and takes on the obligation to deliver 10000 share at 260 each
if the holder exercise the option.

Share Price Option Market

1-Nov Rs. 254 Sell 10 Jan 260 calls @ Rs 14
Income 1,40,000
20-Jan Rs. 254 Option expire worthless
Analysi No change to Effective profits
s shareholding Profit =1,40,000 (option value of
premium)

Possible Outcomes at expiry

Share Price > The holder will exercise his position and if called,
260 the investor as a writer will sell shares originally
purchased for Rs 254 at 274 (260+14), a return
of 7.8% over 3 months.

112
 Share price < The option expires worthless
240

4. Short Put
Naked Short Put / Covered Short Put

Market Potential
View Profit Potential Loss
Bearish Limited Unlimited

According to the terms of a put contract, a put writer is obligated to purchase

an equivalent number of underlying shares at the put's strike price if assigned
an exercise notice on the written contract. Many investors write puts because
they are willing to be assigned and acquire shares of the underlying stock in
exchange for the premium received from the put's sale. For this discussion, a
put writer will be considered "covered" if he has on deposit with his brokerage
firm a cash amount (or other approved collateral) sufficient to cover such a
purchase.

Situation: An investor owns 10,000 shares and also has a cash holding of
around 60,00,000. In early March he feels that the share price of NIIT will
either remain constant or, possibly, rise slightly.

Action: The Investor decides to generate some additional income on his

portfolio and writes 10 NIIT 550 puts at Rs 40. Thus he received premium of
4,00,000.

Possible Outcomes at expiry

Share Price =/ > The investor's expectation is correct and the put
550 will expire without being exercised. Initial income
remains as profit.
Share price < The put option will be exercised and the stock will
550 have to be purchased, effectively for 51,00,000
(55,00,000- 4,00,000).

113
In relation to the Indian markets, this strategy requires a substantial
investment. The net outflow in this situation is: Future Margin – Option
Premium.

5. Bull Call Spread

Market Potential
View Profit Potential Loss
Bullish Limited Limited

Establishing a bull call spread involves the purchase of a call option on a

particular underlying stock, while simultaneously writing a call option on the
same underlying stock with the same expiration month, at a higher strike
price. Both the buy and the sell sides of this spread are opening transactions,
and are always the same number of contracts.
This spread is sometimes more broadly categorized as a "vertical spread": a
family of spreads involving options of the same stock, same expiration month,
but different strike prices. They can be created with either all calls or all puts,
and be bullish or bearish. The bull call spread, as any spread, can be executed
as a "unit" in one single transaction, not as separate buy and sell transactions.

Situation: On 1 November, the share price of L&T is 204. Buy 1 L&T July 200
call option at Rs 16 and sell 1 July 220 call at Rs 8. Total outlay and
maximum loss is 8. Break even is Rs 208 (200+8). Maximum profit is 12 (220-
200-8).

Possible Outcomes at expiry

Share Price < Both the 200 and 220 calls are worthless and the
200 maximum loss is equal to the net cost of
establishing the spread i.e Rs 8

114
 Share price 200- The 200 call gains intrinsic value and profit is
220 equal to the intrinsic value of the 200 calls less
the net debit of Rs 8. Maximum profit is therefore
realized at 220, the point just before which the
220 calls may be exercised.
Stock price > The position can be closed for a maximum profit
220 of Rs 12 above 220 i.e. difference in intrinsic value
of two calls less than net debit (20-8).

Note: the long call position always covers the risk on the short call position. Eg. if
the short option is exercised against you, it is possible to exercise the long
position and acquire stock in order to satisfy the short position.

Advantages
Position established for less cost than a long call and breaks even more
quickly.
Limited loss.

6. Bear Put Spread

Market Potential
View Profit Potential Loss
Bullish Limited Limited

Establishing a bear put spread involves the purchase of a put option on a

particular underlying stock, while simultaneously writing a put option on the
same underlying stock with the same expiration month, but with a lower strike
price. Both the buy and the sell sides of this spread are opening transactions,
and are always the same number of contracts. This spread is sometimes more
broadly categorized as a "vertical spread": a family of spreads involving options
of the same stock, same expiration month, but different strike prices. They can
be created with either all calls or all puts, and be bullish or bearish. The bear
put spread, as any spread, can be executed as a "package" in one single
transaction, not as separate buy and sell transactions.

115
Expectation: This strategy is appropriate when anticipating a fall in the price
of the underlying share.

Situation: The share of Tata Tea is trading at 228. You buy 1 Tata Tea Oct
240 put at Rs 16 and sell 1 Tata 220 put at Rs 7. Maximum profit is Rs 11 and
maximum loss Rs 9.

Possible Outcomes at expiry

Share Price > Both puts are worthless and the maximum loss
240 is equal to the net cost of establishing the spread
i.e Rs 9
Share price The position can be closed out for the intrinsic
240-220 value of the Rs. 240 put.
Stock price The maximum potential profit of Rs 11 is
220 realized just before the level at which the 220
put may be exercised by the holder
Stock price < The position can be closed for the difference in
220 the intrinsic value of two puts, so the profit is 11
(240-220-9)

Advantages
Position established for less cost than a long put and breaks even more
quickly.
Limited loss.

7. Long Straddle

Market Potential
View Profit Potential Loss
Mixed Unlimited Limited

116
For aggressive investors who expect short-term volatility yet have no bias up or
down (i.e., a neutral bias), the long straddle is an excellent strategy. This
position involves buying both a put and a call with the same strike price,
expiration, and underlying. The potential loss is limited to the initial
investment. The potential profit is unlimited as the stock moves up or down.

Expectation: Purchasing a straddle is appropriate when anticipating

significant volatility in the underlying but when uncertain about direction.

Situation: Buy 1 L&T Apr 260 call at Rs 21 and Buy 1 L&T Apr 260 Put at Rs
9.

Upside breakeven = 290 (Exercise price 260 + net debit 30)

Downside breakeven = 230 (260 - 30 net debit)
Profit is unlimited, loss potential is limited, maximum loss Rs 30.

Possible Outcomes at expiry

Share Price < The call expires worthless and profit is equal to
260 the intrinsic valued of the 260 put less the
premium paid
Share price > Profit is equal to the intrinsic value of the 260
260 Premium less the paid
Although profit opportunities are unlimited below Rs 230 and above Rs 290,
the underlying share, in this example, has to move 11% before the strategy
breaks even. Normally, however, once the direction of the underlying becomes
clear the other 'leg' is closed which effectively reduces the break even.

Advantages
Profit potential open ended in either direction.
Maximum Loss limited to the premium paid.

8. Short Straddle

Market Potential
View Profit Potential Loss

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 Mixed Unlimited Unlimited

For aggressive investors who don't expect much short-term volatility, the short
straddle can be a risky, but profitable strategy. This strategy involves selling a
put and a call with the same strike price, expiration, and underlying. In this
case, the profit is limited to the initial credit received by selling options. The
potential loss is unlimited as the market moves up or down.
Expectation: Generally undertaken with a view that the underlying share
price will trade between break even points.

Action: Sell 1 L&T April 260 call at Rs21, sell 1 L&T April 260 put at Rs 9.
Upside breakeven = 290 (Exercise price 260 + net credit 30)
Downside breakeven = 230 (260 - 30 net credit)
Maximum profit is 30, maximum loss unlimited.

Possible Outcomes at expiry

Share Price 260 Maximum profit potential is realized as both
calls and put are worthless.

The risk is, of course, that if the underlying does prove to be volatile, the short
straddle position exposes an investor in both direction it is important that the
stock and cash should be in place to cover the call and put legs respectively.

Alternatively, to prevent such exposures a stop loss facility could be

implemented. In the example above, if the investor felt that there was a
possibility of a sharp downward movement the 240 puts could be purchased to
protect downside. Conversely a sharp upward movement could be protected by
buying the 280 calls. Normally a stop loss would only be implemented on one
side leaving the other exposed.

Nevertheless, the short straddle is particularly appropriate when taking the

view that the underlying will trade in the range between the breakeven points
and when prepared to deliver stock, in this example, at Rs 290 or alternatively
take delivery of stock at Rs 230.

118
Advantages
Generation of earnings from premium received.
Secure known purchase and sale price.

9.Long Strangle

Market Potential
View Profit Potential Loss
Mixed Unlimited Limited

For aggressive investors who expect short-term volatility yet have no bias up or
down (i.e., a neutral bias), the long strangle is another excellent strategy. This
strategy typically involves buying out-of-the-money calls and puts with the
same expiration and underlying. The potential loss is limited to the initial
investment while the potential profit is unlimited as the market moves up or
down.

Situation: The share of L&T is currently standing at 247. Buy 1 L&T Oct 260
call at Rs 12, buy 1 Oct 240 put at Rs10.
Upside breakeven = 282 (Exercise price 260 + net debit 22)
Downside breakeven = 218 (240 - 22 net debit)

Possible Outcomes at expiry

Share Price > Profit from the call is equal to its intrinsic value
260 less the premium paid
Share price Both call and put are out of money. Maximum
240-260 loss of 22 premium paid.
Stock price < Profit potential unlimited.
240

Advantages
Profit potential open ended in either direction.

119
Loss limited to total premium paid.

10.Short Strangle

Market Potential
View Profit Potential Loss
Mixed Limited Unlimited

For aggressive investors who don't expect much short-term volatility, the short
strangle can be a risky, but profitable strategy. This strategy typically involves
selling out-of the-money puts and calls with the same expiration and
underlying. The profit is limited to the credit received by selling options. The
potential loss is unlimited as the market moves up or down.

Situation: L&T shares are currently standing at Rs 247 and you sell 1 October
260 call at Rs 12 and sell 1 October 240 put at Rs 10.
Upside breakeven = 282 (Exercise price 260 + net debit 22)
Downside breakeven = 218 (240 - 22 net debit)
Your maximum profit is Rs 22 and loss is unlimited.

Possible Outcomes at expiry

Share Price > The call is exercisec by the holder and the seller
260 delivers stock at 282. (260+22).
Share price Both the call and put would expire worthless.
240-260 The 22 credit is retained
Stock price < The put is exercised. The seller takes delivery of
240 the stock at 218.

Advantages
Generation of earnings from premium received.
Secure know sale and purchase prices.

120
Disadvantages
Loss is unlimited
In the Indian Markets, the investment required for such a strategy is very
high and should only be attempted by people with huge funds and an
appetite for large losses.

11.Butterfly

Market Potential
View Profit Potential Loss
Mixed Limited Unlimited

Ideal for investors who prefer limited risk, limited reward strategies. When
investors expect stable prices, they can buy the butterfly by selling two options
at the middle strike and buying one option at the higher and lower strikes. The
options, which must be all calls or all puts, must also have the same
expiration and underlying.

Situation: L&T shares are currently trading at 240. You buy one Jan 220 call
at Rs. 40, sell two Jan 240 calls at Rs. 30, and buy one Jan 260 call at 25.
This is called "buying a butterfly." The opposite would be to sell the butterfly.
Upside breakeven = 255
Downside breakeven = 225
The maximum profit is 240-220-5 = Rs.15

Possible Outcomes at expiry

Share Price > The loss is Rs.5 i.e. net debit
260
Stock price 240 The maximum profit would be at this level. The
net profit would be 240-220-5 = Rs.15
Advantages
Potential loss is limited

Disadvantages

121
Can be difficult to execute such strategies quickly.
Requires big margin to execute this strategy.

12.Collar
A collar can be established by holding shares of an underlying stock,
purchasing a protective put and writing a covered call on that stock. The
option portions of this strategy are referred to as a combination. Generally, the
put and the call are both out of-the-money when this combination is
established, and have the same expiration month.

Both the buy and the sell sides of this combination are opening transactions,
and are always the same number of contracts. In other words, one collar
equals one long put and one written call along with owning 100 shares of the
underlying stock.
Expectation: An investor will employ this strategy after accruing unrealized
profits from the underlying shares, and wants to protect these gains with the
purchase of a protective put. At the same time, the investor is willing to sell his
stock at a price higher than the current market price so an out-of-the-money
call contract is written, covered in this case by the underlying stock
Situation: Suppose you purchased 100 shares of L&T ltd. at Rs.240 in may
and would like a way to protect your downside with little or no cost. You would
create a collar by buying one May 220 put at 10 and selling one May 260 call
at 15. Net credit is Rs.5
Maximum profit: When share is at 260.
Maximum loss: When the share is at or below 220.

Possible Outcomes at expiry

Share Price The profit from the put offsets the loss from the
@220 stock.
Stock price The profit would be equal to the net inflow i.e.
@240 Rs.5
Stock price The profit on the stock is exactly offset by the
@260 loss on the call option that was sold.
Advantages

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The collar strategy is best used for investors looking for a conservative
strategy that can offer a reasonable rate of return with managed risk and
potential tax advantages.
Disadvantages
The primary concern in employing a collar is protection of profits accrued
from underlying shares rather than increasing returns on the upside.

13. Condor Spread

The Condor Spread strategy is a neutral strategy similar to the Butterfly. In
the Iron Condor, an investor will combine a Bear-Call Credit Spread and a
Bull-Put Credit Spread on the same underlying security. By doing this, an
investor will potentially be able to double the credit obtained over a single
spread position. Since there are two spreads involved in the strategy (four
options), there is an upper break even and a lower break even. A profit is made
if the stock remains above the lower break even point or below the upper break
even point.
Expectation: The long condor can be a great strategy to use when your feeling
on a stock is generally neutral because it's been trading in a narrow range.
Like the butterfly, the condor is a limited risk, limited reward strategy that
profits in stagnant markets.
Situation: Imagine that L&T ltd. is trading at Rs. 240 and has been relatively
flat for some time. If you think the situation is unlikely to change,

Action
Sell 1 240 call @ 20
Sell 1 260 call @ 15
Buy 1 220 call @ 30& buy 1 280 @ 10 call as a hedge in case the market
moved against you.
Maximum profit: When the stock price is between 240 & 260
Maximum loss: When the stock price is above 280 or below 220

Possible Outcomes at expiry

Share Price The loss would be of Rs. 5 (initial debit)
<220

123
 Stock price The profit would be equal to 20-5= Rs.15
240-260
Stock The loss would be Rs. 5 (initial debit)
price>260

Advantages:
The double credit achieved helps lower the potential risk.
Losses are limited if the stock goes against you one way or the other.
If you are facing a large gain or drop in the underlying you could only close
one leg of the four legs in the position.

Disadvantages:
Commission costs to open the position are higher since there are four trades,
might be cost prohibitive to trade iron condors that are low net credits.

14. Calendar Spread

Calendar spreads take advantage of the different rates at which time value
erodes. Since the time value element of an option’s premium erodes faster in
the near month series than the far month series, a spread opens up between
the two. The more rapid erosion in the near month series works to the
advantage of the writer and the strategy is therefore particularly appropriate
when the near month series is overpriced.

Expectation: A calendar spread involves the sale of a near dated call (put) and
the purchase of a longer dated call (put) at the same exercise price. Calls are
used when market view is moderately bullish and puts are used when market
view is moderately bearish.

Situation: On 1 May the shares of L&T ltd. are trading at Rs.288 and the May
280 Call is available @ Rs.24 and the Jun Call is available @ Rs. 30

Action:
Sell 1 L&T Ltd. May 280 call @ Rs.24.
Buy 1 L&T Ltd. Jun 280 call @ Rs.30.
Net debit is Rs. 6

124
 Possible Outcomes at expiry
Share Price The May 280 call expires worthless leaving the
<280 position long 1 Jun 280 call at a reduced cost of
6.
Stock price Maximum profit potential is realized. The May
@280 280 call expires worthless but the Jun 280 call
will have 1 month time value remaining.
Stock price Both calls will have intrinsic value, but the true
>280 value of the Jun 280 call is likely to be lower.

A calendar spread using puts could be established in the same way to suit a
neutral to moderately bearish strategy. Alternatively, if the May calls were
purchased and the Jun calls sold then the risks and rewards would be
reversed. This is generally known as a reverse calendar spread.
Advantages
Limited loss, i.e. initial debit.

Disadvantages
Limited profit.
Position may be disrupted by early exercise.

125
Chapter 6

126
Achieveme
nts in
Future and
Options
Segment
127
ACHIEVEMENTS IN FUTURE AND
OPTIONS SEGMENT

128
129
130
COMPARATIVE ANALYSIS OF F&O SEGMENT AND
CASH SEGMENT

131
TOP 5 TRADED SYMBOL IN THE FUTURES SEGMENT
FOR THE MONTH OF MAY 2008

132
TOP 5 TRADED SYMBOL IN THE OPTIONS SEGMENT
FOR THE MONTH OF MAY 2008

133
134
 Chapter 7

Conclusio
n

135
 CONCLUSION

The Indian stock market witnesses both the good as well as the bad time. Most
of the people keep them away from bad times that lead to low liquidity in the
markets. But for the rest who want to remain in the markets without loosing
much of their capital and take leverage of the market movements in both north
and south directions, Derivatives Instruments are the tools to be with.

By studying and applying various Derivative Instruments like Futures,

Forwards and Option strategies, I came to a conclusion that these instruments
are the best ones to turn the bad time into a good one i.e. to earn profits in any
market direction.

Therefore, Derivative Instruments are a very good tool that will help us to
minimize our risk and maximize our returns so that one can have conviction in
his portfolio in the hugely volatile stock market

136
Finally, the objective of the study is accomplished and I recommend that one
should use the Derivative Instruments, as it is very much applicable in the
Indian Stock Market.

Chapter 8

137
 Suggestions
and
Recommend
ations

138
SUGGESTIONS AND RECOMMENDATIONS

139
Chapter 9

140
 The
Reference
Materials

THE REFERENCE MATERIALS

GLOSSARY
141
ADJUSTED STRIKE PRICE: Strike price of an option, created as the result of
a special event such as stock split or a stock dividend. The adjusted strike
price can differ from the regular intervals prescribed for strike prices.

AMERICAN STYLE OPTION: A call or put option contract that can be

exercised at any time before the expiration of the contract.

ARBITRAGE: A trading technique that involves the simultaneous purchase

and sale of identical assets or of equivalent assets in two different markets
with the intent of profiting by the price discrepancy.

ASSIGNMENT: Notification by Stock Exchange Clearing to a clearing member

and the writer of an option that an owner of the option has exercised the
option and that the terms of settlement must be met. Assignments are made
on a random basis by the Stock Exchange Clearing. The writer of a call option
is obligated to sell the underlying asset at the strike price of the call option; the
writer of a put option is obligated to buy the underlying at the strike price of
the put option.

AT PRICE: When you enter a prospective trade into a trade parameter, the "At
Price" (At. Pr) is automatically computed and displayed. It is the price at which
the program expects you can actually execute the trade, taking into account
"slippage" and the current Bid/Ask, if available.

AT-THE-MONEY (ATM): An at-the-money option is one whose strike price is

equal to (or, in practice, very close to) the current price of the underlying.

AVERAGING DOWN: Buying more of a stock or an option at a lower price than

the original purchase so as to reduce the average cost.

BACK MONTH: A back month contract is any exchange-traded derivatives

contract for a future period beyond the front month contract. Also called FAR
MONTH.

BEAR, BEARISH: A bear is someone with a pessimistic view on a market or

particular asset, e.g. believes that the price will fall. Such views are often
described as bearish.

142
BINOMIAL PRICING MODEL: Methodology employed in some option pricing
models which assumes that the price of the underlying can either rise or fall
by a certain amount at each pre-determined interval until expiration For more
information, see COX-ROSS-RUBINSTEIN model.

BLACK-SCHOLES PRICING MODEL: A formula used to compute the

theoretical value of European-style call and put options from the following
inputs: stock price, strike price, interest rates, dividends, time of expiration,
and volatiity. It was invented by Fischer Black and Myron Scholes.

BOX SPREAD: A four-sided option spread that involves a long call and short
put at one strike price as well as a short call and long put at another strike
price. In other words, this is a synthetic long stock position at one strike price
and a synthetic short stock position at another strike price.

BREAK-EVEN POINT: A stock price at option expiration at which an option

strategy results in neither a profit or a loss.

BULL, BULLISH: A bull is someone with an optimistic view on a market or

particular

CANCELED ORDER: A buy or sell order that is canceled before it has been
executed. In most cases, a limit order can be canceled at any time as long as it
has not been executed. (A market order may be canceled if the order is placed
after market hours and is then canceled before the market opens the following
day). A request for cancel can be made at anytime before execution.

CARRYING COST: The interest expense on money borrowed to finance a stock

or option position.

CASH SETTLEMENT: The process by which the terms of an option contract

are fulfilled through the payment or receipt in Rupees of the amount by which
the option is in-the-money as opposed to delivering or receiving the underlying
stock.

CLOSING TRANSACTION: To sell a previously purchased position or to buy

back a previously purchased position, effectively canceling out the position.

143
COLLATERAL: This is the legally required amount of cash or securities
deposited with a brokerage to insure that an investor can meet all potential
obligations. Collateral (or margin) is required on investments with open-ended
loss potential such as writing naked options.

COMMISSION: This is the charge paid to a broker for transacting the

purchase or the sale of stock, options, or any other security.

COMMODITY: A raw material or primary product used in manufacturing or

industrial processing or consumed in its natural form.

CONTRACT SIZE: The number of units of an underlying specified in a

contract. In stock options the standard contract size is 100 shares of stock. In
futures options the contract size is one futures contract. In index options the
contract size is an amount of cash equal to parity times the multiplier. In the
case of currency options it varies.

COST OF CARRY: This is the interest cost of holding an asset for a period of
time. It is either the cost of funds to finance the purchase (real cost), or the
loss of income because funds are diverted from one investment to another
(opportunity cost).

DAY ORDER: An order to purchase or sell a security, usually at a specified

price, that is good for just the trading session on which it is given. It is
automatically cancelled on the close of the session if it is not executed.

DAY TRADE: A position that is opened and closed on the same day.

DEBIT: The amount you pay for placing a trade. A net outflow of cash from
your account as the result of a trade.

DIRECTIONAL TRADE: A trade designed to take advantage of an expected

movement in price.

DISCOUNT: An adjective used to describe an option that is trading below its

intrinsic value.

144
DYNAMIC HEDGING: A short-term trading strategy generally using futures
contracts to replicate some of the characteristics of option contracts. The
strategy takes into account the replicated option's delta and often requires
adjusting.

EARLY EXERCISE: A feature of American-style options that allows the owner

to exercise an option at any time prior to its expiration date.

EQUITY OPTION: An option on shares of an individual common stock. Also

known as a stock option.

EUROPEAN STYLE OPTION: An option that can only be exercised on the

expiration date of the contract.

EX-DIVIDEND DATE: The day before which an investor must have purchased
the stock in order to receive the dividend. On the ex-dividend date, the
previous day's closing price is reduced by the amount of the dividend because
purchasers of the stock on the ex-dividend date will not receive the dividend
payment.

EXCHANGE TRADED: The generic term used to describe futures, options and
other derivative instruments that are traded on an organized exchange.

EXERCISE: The act by which the holder of an option takes up his rights to
buy or sell the underlying at the strike price. The demand of the owner of a call
option that the number of units of the underlying specified in the contract be
delivered to him at the specified price. The demand by the owner of a put
option contract that the number of units of the underlying asset specified be
bought from him at the specified price.

EXOTIC OPTIONS: Various over-the-counter options whose terms are very

specific, and sometimes unique. Examples include Bermuda options
(somewhere between American and European type, this option can be
exercised only on certain dates) and look-back options (whose strike price is
set at the option's expiration date and varies depending on the level reached by
the underlying security).

145
FILL: When an order has been completely executed, it is described as filled.

FILL OR KILL (FOK) ORDER: This means do it now if the option (or stock) is
available in the crowd or from the specialist, otherwise kill the order
altogether. Similar to an all-or-none (AON) order, except it is "killed"
immediately if it cannot be completely executed as soon as it is announced.
Unlike an AON order, the FOK order cannot be used as part of a GTC order.

FLEXIBLE EXCHANGE OPTIONS (FLEX): Customized equity and equity index

options. The user can specify, within certain limits, the terms of the options,
such as exrcise price, expiration date, exercise type, and settlement
calculation. Can only be traded in a minimum size, which makes FLEX an
institutional product.

FRONT MONTH: The first month of those listed by an exchange - this is

usually the most actively traded contract, but liquidity will move from this to
the second month contract as the front month nears expiration. Also known as
the NEAR MONTH.

FRONTRUNNING: An illegal securities transaction based on prior nonpublic

knowledge of a forthcoming transaction that will affect the price of a stock.

FOLLOW-UP ACTION: Term used to describe the trades an investor makes

subsequent to implementing a strategy. Through these adjustments, the
investor transforms one strategy into a different one in response to price
changes in the underlying.

GUTS: The purchase (or sale) of both an in-the-money call and in-the-money
put. A box spread can be viewed as the combination of an in-the-money
strangle and an out-of-the-money strangle. To differentiate between these two
strangles, the term guts refer to the in-the-money strangle. See box spread and
strangle.

HAIRCUT: Similar to margin required of public customers this term refers to

the equity required of floor traders on equity option exchanges. Generally, one
of the advantages of being a floor trader is that the haircut is less than margin
requirements for public customers.

146
HEDGE: A position established with the specific intent of protecting an
existing position. Example: an owner of common stock buys a put option to
hedge against a possible stock price decline.

IMMEDIATE-OR-CANCEL (IOC) ORDER: An option order that gives the

trading floor an opportunity to partially or totally execute an order with any
remaining balance immediately cancelled.

ILLIQUID: An illiquid market is one that cannot be easily traded without even
relatively small orders tending to have a disproportionate impact on prices.
This is usually due to a low volume of transactions and/or a small number of
participants.

INDEX: The compilation of stocks and their prices into a single number. E.g.
The BSE SENSEX / S&P CNX NSE NIFTY.

INDEX OPTION: An option that has an index as the underlying. These are
usually cash-settled.

IN-THE-MONEY (ITM): Term used when the strike price of an option is less
than the price of the underlying for a call option, or greater than the price of
the underlying for a put option. In other words, the option has an intrinsic
value greater than zero.

INTRINSIC VALUE: Amount of any favorable difference between the strike

price of an option and the current price of the underlying (i.e., the amount by
which it is in-the-money). The intrinsic value of an out-of-the-money option is
zero.

LEAPS: Long-term Equity Anticipation Securities, also known as long-dated

options. Calls and puts with expiration as long as 2-5 years. Only about 10%
of equities have LEAPs. Currently, equity LEAPS have two series at any time,
always with January expirations. Some indexes also have LEAPs.

LEGGING: Term used to describe a risky method of implementing or closing

out a spread strategy one side ("leg") at a time. Instead of utilizing a "spread
order" to insure that both the written and the purchased options are filled

147
simultaneously, an investor gambles a better deal can be obtained on the price
of the spread by implementing it as two separate orders.

LEVERAGE: A means of increasing return or worth without increasing

investment. Using borrowed funds to increase one's investment return, for
example buying stocks on margin. Option contracts are leveraged as they
provide the prospect of a high return with little investment.

MARGIN: The minimum equity required to support an investment position. To

buy on margin refers to borrowing part of the purchase price of a security from
a brokerage firm.

MARKET BASKET: A group of common stocks whose price movement is

expected to closely correlate with an index.

MARK TO MARKET: The revaluation of a position at its current market price.

MARKET MAKER: A trader or institution that plays a leading role in a market

by being prepared to quote a two way price (Bid and Ask) on request - or
constantly in the case of some screen based markets - during normal market
hours.

NAKED: An investment in which options sold short are not matched with a
long position in either the underlying or another option of the same type that
expires at the same time or later than the options sold. The loss potential of
naked strategies can be virtually unlimited.

NET MARGIN REQUIREMENT: The equity required in a margin account to

support an option position after deducting the premium received from sold
options.

NEUTRAL: An adjective describing the belief that a stock or the market in

general will neither rise nor decline significantly.

ONE-CANCELS-THE-OTHER (OCO) ORDER: Type of order which treats two or

more option orders as a package, whereby the execution of any one of the
orders causes all the orders to be reduced by the same amount. Can be placed
as a day or GTC order.

148
OPTION CHAIN: A list of the options available for a given underlying.

OPTIONS CLEARING CORPORATION (OCC): A corporation owned by the

exchanges that trade listed stock options; OCC is an intermediary between
option buyers and sellers. OCC issues and guarantees all option contracts.

OUT-OF-THE-MONEY (OTM): An out-of-the-money option is one whose strike

price is unfavorable in comparison to the current price of the underlying. This
means when the strike price of a call is greater than the price of the
underlying, or the strike price of a put is less than the price of the underlying.
An out-of-the-money option has no intrinsic value, only time value.

OVERVALUED: An adjective used to describe an option that is trading at a

price higher that its theoretical value. It must be remembered that this is a
subjective evaluation, because theoretical value depends on one subjective
input - the volatility estimate.

PARITY: An adjective used to describe the difference between the stock price
and the strike price of an in-the-money option. When an option is trading at its
intrinsic value, it is said to be trading at parity.

PUT/CALL RATIO: This ratio is used by many as a leading indicator. It is

computed by dividing the 4-day average of total put VOLUME by the 4-day
average of total call VOLUME.

RATIO CALENDAR COMBINATION: A term used loosely to describe any

variation on an investment strategy that involves both puts and calls in
unequal quantities and at least two different strike prices and two different
expirations.

REALIZED GAINS AND LOSSES: The profit or losses received or paid when a
closing transaction is made and matched together with an opening
transaction.

ROLLOVER: Moving a position from one expiration date to another further

into the future. As the front month approaches expiration, traders wishing to

149
maintain their positions will often move them to the next contract month. This
is accomplished by a simultaneous sale of one and purchase of the other.

SCALPER: A trader on the floor of an exchange who hopes to buy on the bid
price, sell on the ask price, and profit from moment to moment price
movements. Risk is limited by the very short time duration (usually 10 seconds
to 3 minutes) of maintaining any one position.

SEC: The Securities and Exchange Commission. The SEC is the United States
federal government agency that regulates the securities industry.

SECTOR INDICES: Indices that measure the performance of a narrow market

segment, such as biotechnology or small capitalization stocks.

SETTLEMENT PRICE: The official price at the end of a trading session. This
price is established by The Options Clearing Corporation and is used to
determine changes in account equity, margin requirements, and for other
purposes. See mark-to-market.

STRIKE PRICE: The price at which the holder of an option has the right to
buy or sell the underlying. This is a fixed price per unit and is specified in the
option contract. Also known as striking price or exercise price.

SYNTHETIC: A strategy that uses options to mimic the underlying asset. Both
long and short synthetics are strategies in the Trade Finder. The long synthetic
combines a long call and a short put to mimic a long position in the
underlying. The short synthetic combines a short call and a long put to mimic
a short position in the underlying. In both cases, both the call and put have
the same strike price, the same expiration, and are on the same underlying.

TECHNICAL ANALYSIS: Method of predicting future price movements based

on historical market data such as (among others) the prices themselves,
trading volume, open interest, the relation of advancing issues to declining
issues, and short selling volume.

150
TICK: The smallest unit price change allowed in trading a specific security.
This varies by security, and can also be dependent on the current price of the
security.

TIME DECAY: Term used to describe how the theoretical value of an option
"erodes" or reduces with the passage of time. Time decay is quantified by
Theta.

TRADING PIT: A specific location on the trading floor of an exchange

designated for the trading of a specific option class or stock.

TRANSACTION COSTS: All charges associated with executing a trade and

maintaining a position, including brokerage commissions, fees for exercise
and/or assignment, and margin interest.

UNCOVERED: A short option position that is not fully collateralized if

notification of assignment is received. See also NAKED.

UNREALIZED GAIN OR LOSS: The difference between the original cost of an

open position and its current market price. Once the position is closed, it
becomes a realized gain or loss.

VOLATILITY: Volatility is a measure of the amount by which an asset has

fluctuated, or is expected to fluctuate, in a given period of time. Assets with
greater volatility exhibit wider price swings and their options are higher in
price than less volatile assets. Volatility is not equivalent to BETA.

VOLATILITY TRADE: A trade designed to take advantage of an expected

change in volatility.

WASH SALE: When an investor repurchases an asset within 30 days of the

sale date and reports the original sale as a tax loss. The Internal Revenue
Service prohibits wash sales since no change in ownership takes place.

WASTING ASSET: An investment with a finite life, the value of which

decreases over time if there is no price fluctuation in the underlying asset.

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BIBLIOGRAPHY

Books:

• Derivatives: Valuation and Risk Management By David A. Dubofsky and

Thomas W. Miller, JR., Published by Oxford University Press.

• Financial Engineering: A Complete Guide to Financial Innovation By

John F. Marshall and Vipul K. Bansal, Published by Printice Hall of
India.

Newspapers:-

• The Times of India

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 • The Economic Times

Internet:

• www.economictimes.com

• www.moneycontrol.com

• www.bseindia.com

• www.nseindia.com

• www.sebi.gov.in

• www.investors.com

• www.investopedia.com

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