Professional Documents
Culture Documents
George Soros
1
TABLE OF CONTENTS
• Certificate
• Acknowledgement
• Executive Summary
• Objective of the Study
• Methodology
• Job Description
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
➢ Forward Contracts
➢ Future Contracts
➢ Options
➢ Payoffs for Derivative Contracts
3
Chapter 5. Applicability of Derivative Instruments
Chapter 7. Conclusion
➢ 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
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.
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.
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.
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
AREA ASSIGNED
11
TARGET ASSIGNED
TARGET MARKET
➢ Different properties dealers.
➢ Charted accountants.
➢ Lawyers
➢ Travel agencies
➢ Transport business
➢ House wives
➢ Businessmen
➢ Corporate Employees etc.
12
Chapter 1
13
Introductio
n of
Sharekhan
ltd.
14
INTRODUCTION OF SHAREKHAN LTD.
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
16
Revenue : Data Not Available
Website : www.sharekhan.com
Vision
To be the best retail brokering Brand in the retail business of stock market.
Mission
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.
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
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.
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:
• 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 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.
24
FIXING AN APPOINTMENT WITH THE PERSON
GIVING
DEMONST-
RATION
YES NO
DOCUMENTATION
TRADING
Apart from two passport size photographs, one needs to provide with the
following documents in order to open an account with Sharekhan Limited.:
• 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).
NOTE: Only Saving Bank Account cheques are accepted for the purpose of
Opening an account.
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.
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.
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
HISTORY OF DERIVATIVES
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.
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.
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
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.
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.
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.
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.
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.
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.
41
surveillance on the market both at the exchange level as well as at the
regulator level.
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.
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.
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.
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.
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.
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
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.
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%).
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.
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.
Chapter 3
50
Introductio
n to
Futures and
Options
51
INTRODUCTION TO FUTURES AND
OPTIONS
FORWARD CONTRACT
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.
53
• Settlement style.
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.
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.
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.
54
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.
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:
➢ 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.
55
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.
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.
56
• 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.
• 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.
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.
• 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.
58
• American options: American options are options that can be exercised
at any time upto the expiration date. Most exchange-traded options are
American.
59
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.
60
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}.
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
61
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.
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)
62
1.In-the-money Strike Price less than Strike Price greater
Spot Price of than Spot Price of
underlying asset underlying asset
63
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.
There are two types of factors that affect the value of the option premium:
Quantifiable Factors:
Non-Quantifiable Factors:
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.
64
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:
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,
d. short a put.
65
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.
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.
66
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.
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 -
67
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.
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.
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.
68
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.
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.
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 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.
69
• 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.
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).
70
Column 3: Call or Put - This column refers to whether the option is a call (C)
or put (P).
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.
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.
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.
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.
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
72
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.
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.
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.
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.
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.
73
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.
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.
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.
74
Chapter 4
Hedging,
Arbitrage
and
75
Speculatio
n
Strategies
76
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.
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:
77
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.
78
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.
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.
79
• 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.
80
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.
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.
81
• 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:
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.
82
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.
Methodology
83
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.
ARBITRAGE
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.
The below stated strategies cover all the types of arbitrage possibilities using
equity derivatives.
84
ARBITRAGE STRATEGIES WITH EXAMPLES
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
85
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).
3. While waiting, a few dividends come into his hands. The dividends
work out to Rs.14,000.
86
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.
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.
87
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.
3. A few days later, you will receive money and have to make delivery
of the 50 shares.
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.
88
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.
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.
89
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.
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.
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.
90
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.
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.
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–
91
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.
Speculation in the market index is very common, index is less volatile and index
movement is easy to analyze than the individual stock movements.
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
92
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.
3. At this time, the Nifty July contract costs Rs.960 so his position is
worth Rs.192,000.
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
3. At this time, the Nifty June contract costs Rs.1,060 so his position
is worth Rs.212,000.
5. The Nifty June contract has fallen to Rs.990. he squares off his
position.
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.
98
• Creating opportunities through improving risk mitigation capabilities.
Effective and systematic Risk Management yields the following key benefits:
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
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.
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
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.
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.
• 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.
• 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.
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.
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.
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.
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.
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 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.
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.
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.
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.
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.
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.
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.
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%
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.
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.
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.
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.
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
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.
113
In relation to the Indian markets, this strategy requires a substantial
investment. The net outflow in this situation is: Future Margin – Option
Premium.
Market Potential
View Profit Potential Loss
Bullish Limited Limited
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).
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.
Market Potential
View Profit Potential Loss
Bullish Limited Limited
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.
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.
Situation: Buy 1 L&T Apr 260 call at Rs 21 and Buy 1 L&T Apr 260 Put at Rs
9.
Advantages
Profit potential open ended in either direction.
Maximum Loss limited to the premium paid.
8. Short Straddle
Market Potential
View Profit Potential Loss
117
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.
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.
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)
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.
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
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.
122
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.
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
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.
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.
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
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.
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.
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.
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.
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.
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.
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 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.
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.
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.
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.
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.
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.
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.
147
simultaneously, an investor gambles a better deal can be obtained on the price
of the spread by implementing it as two separate orders.
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.
148
OPTION CHAIN: A list of the options available for a given underlying.
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.
REALIZED GAINS AND LOSSES: The profit or losses received or paid when a
closing transaction is made and matched together with an opening
transaction.
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.
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.
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.
151
BIBLIOGRAPHY
Books:
Newspapers:-
152
• 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
153
154