It is not important whether you are right or wrong, but how much money you make when you

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

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TABLE OF CONTENTS
      Certificate Acknowledgement Executive Summary Objective of the Study Methodology Job Description

Chapter 1. Introduction of Sharekhan Limited        About Sharekhan Limited Sharekhan Limited‟s Management Team Products and Services of Sharekhan Limited Types of account in Sharekhan Limited How to open an account with Sharekhan Limited? Research section in Sharekhan Limited Awards and Achievements

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

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Chapter 3. Introduction to Futures and Options     Forward Contracts Future Contracts Options Payoffs for Derivative Contracts

Chapter 4. Hedging, Arbitrage and Speculation Strategies  Hedging Strategies with examples  Arbitrage Strategies with examples  Speculation Strategies with examples Chapter 5. Applicability of Derivative Instruments     Risk Management: Concept and Definition Risk Management with Future Contract Risk Management with Options Introduction to Option Strategies

Chapter 6. Achievements in Futures and Options Segment  Comparative Analysis of F&O Segment with Cash Segment  NSE Position  Top 5 Traded Symbols Chapter 7. Conclusion Chapter 8. Suggestions and Recommendations Chapter 9. The Reference Material  Glossary  Bibliography

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mission. Also it gives special emphasis on the selling of products and management of the company. It provides knowledge to the readers regarding the company‟s history. It also describe about the objective of this study. vision.EXECUTIVE SUMMARY Conceptually the mechanism of stock market is very simple. It also suggests some of the strategies that can be applied to earn more even when the market is too much 4 . customer base and the reasons to be associated with the company. 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. Further the project tells us about the profile of the company (Sharekhan Ltd. The next few chapters are devoted to the study of the Derivative Market and Derivative Instruments in a very basic way. It also enlightens the readers about Sharekhan Limited‟s strategies to acquire new customers. 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.

the Internet. and advice about derivative instruments are there in stock market. there are not too many people one can listen to if he want to avoid confusing. 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. the objective of the Dissertation is to do in depth research on these derivative instruments. Therefore. 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. Realistically. people at work. It can be very risky and potentially dangerous. hype. promotion. brokers. advisers.volatile. The next part of the project throws light upon my findings and analysis about the company and the suggestions for the company for better performance. personal opinion. entertaining cable TV market programs. The readers can also find the comparative analysis of the Derivative Market and the Cash Market in the Indian context. 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. and faulty personal market opinions. and other media. One get it from friends. 5 . contradictory. relatives. stock analysts.

I have tried to identify various terms related to derivative trading. arbitrage and speculation strategies using both futures and options. 6 . I have given a brief introduction about the instruments. Segregation involved a thorough study of the strategies and possible use. data regarding the traded volume and number of contracts traded from December 2007 till May 2008. so that the reader is aware of basics of the subject. I identified hedging. which includes the comparison of derivative market with cash market. I have tried to analyze the instruments as per the Market Participant and the Market Trend. “Terms related to derivative market” Then I have tried to segregate the use of Instruments as per the Market Participants and Market Trend. Then I have done a secondary data based study on growth of Indian Derivative Market. I have also analyzed the top five most traded symbols in futures and options segment.METHODOLOGY During this project. Initially. and then segregated them into a chapter each. I have analyzed the Futures and Options. for which I have introduced a separate chapter.

I have been handling the Following responsibilities:  My job profile was to sale the products of the organization. Ghaziabad. canopies.  My job profile was to coordinate the team and also help them to sale the product and also help them in field.  My job profile was to do sales promotion through e-mails. 7 . AREA ASSIGNED I covered areas like Delhi. making cold calling. distributing pamphlets and etc. Faridabad and NCR.  My job profile was to generate the leads by cold calling.  My job profile was to understand customers‟ needs and advising them to make a portfolio as per their investment.JOB DESCRIPTION The company placed me as a Summer Trainee. Gurgaon.

30 AM Fixing appointment with clients. TARGET MARKET         Different properties dealers. 8 .TARGET ASSIGNED  To sell 18 accounts per month. Cold calling. Visit clients place. Lawyers Travel agencies Transport business House wives Businessmen Corporate Employees etc. Completing the formalities like filling the application form and documentation. Charted accountants. Demonstrate the product on Internet to the client. DAY TO DAY JOB DESCRIPTION       Reporting time: 9.

Chapter 1 9 .

online trading. investment advice etc. NSE.Introduction of Sharekhan ltd.www. Derivatives. The site gives access to superior content and transaction facility to retail customers across the country. ABOUT SHAREKHAN LIMITED Sharekhan Ltd. Known for its 10 . The firm‟s online trading and investment site .com . is one of the leading retail stock broking house of SSKI Group which is running successfully since 1922 in the country. which has over eight decades of experience in the stock broking business. INTRODUCTION OF SHAREKHAN LTD. It is the retail broking arm of the Mumbai-based SSKI Group. Sharekhan offers its customers a wide range of equity related services including trade execution on BSE.sharekhan.was launched on Feb 8. 2000. depository services.

jargon-free. It has 60 institutional clients spread over India. Verisign Financial Technologies India Ltd. Planetasia. Presently SSKI is one of the leading players in institutional broking and corporate finance activities. Spider Software Pvt Ltd. the site has a registered base of over one lakh customers. UK and US. like Sun Microsystems. With a legacy of more than 80 years in the stock markets. The company has used some of the best-known names in the IT industry. Oracle. the SSKI group ventured into institutional broking and corporate finance 18 years ago. SSKI holds a sizeable portion of the market in each of these segments. Sharekhan has always believed in investing in technology to build its business. PROFILE OF THE COMPANY 11 . 2002 Sharekhan launched Speed Trade. On April 17. a net-based executable application that emulates the broker terminals along with host of other information relevant to the Day Traders. Cambridge Technologies. and Shopper‟s Stop. The group has placed over US$ 1 billion in private equity deals. The content-rich and research oriented portal has stood out among its contemporaries because of its steadfast dedication to offering customers best-of-breed technology and superior market information. in terms of the size of deal. Essar. sector tapped etc. In the last six months Speed Trade has become a de facto standard for the Day Trading community over the net. Hutchison. This was for the first time that a netbased trading station of this caliber was offered to the traders. Sharekhan‟s ground network includes over 640 centers in 280 cities in India which provide a host of trading related services. Microsoft. investor friendly language and high quality research. Gujarat Pipavav. to build its trading engine and content. The objective has been to let customers make informed decisions and to simplify the process of investing in stocks. Intel & Carlyle are the other investors. Foreign Institutional Investors generate about 65% of the organization‟s revenue. The Corporate Finance section has a list of very prestigious clients and has many „firsts‟ to its credit. Some of the clients include BPL Cellular Holding. Far East. 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. The Morakhiya family holds a majority stake in the company. HSBC. Nexgenix. Vignette. with a daily turnover of over US$ 2 million.

Name of the company: Year of Establishment: Headquarter :

Sharekhan ltd. 1925 ShareKhan SSKI A-206 Phoenix House Phoenix Mills Compound Lower Parel Mumbai - Maharashtra, INDIA- 400013 Service Provider Depository Services, Online Services and Technical Research. Over 3500 Data Not Available www.sharekhan.com Your Guide to The Financial Jungle.

Nature of Business Services

: :

Number of Employees : Revenue Website Slogan : : :

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

Mission
To educate and empower the individual investor to make better investment decisions through quality advice and superior service.

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

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REASON TO CHOOSE SHAREKHAN LIMITED

Experience SSKI has more than eight decades of trust and credibility in the Indian stock market. In the Asia Money broker's poll held recently, SSKI won the 'India's Best Broking House for 2004' award. Ever since it launched Sharekhan as its retail broking division in February 2000, it has been providing institutionallevel research and broking services to individual investors. Technology 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 13

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.

SHAREKHAN LIMITED’S MANAGEMENT TEAM   
Dinesh Murikya Tarun Shah Shankar Vailaya : : : : : : : Owner of the company CEO of the company Director (Operations) Director (Products & Technology) Head of Research Vice President of Equity Derivatives Vice President of Research

 Jaideep Arora  Pathik Gandotra  Rishi Kohli  Nikhil Vora

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are as follows:          Equity and derivatives trading Depository services Online services Commodities trading Dial-n-trade Portfolio management Share shops Fundamental research Technical research 15 .PRODUCTS AND SERVICES OF SHAREKHAN LIMITED The different types of products and services offered by Sharekhan Ltd.

com and is suitable for the retail investor who is 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.sharekhan.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. Integrated 16 .

17 . NSE F&O & BSE. f. Demat and digital contracts. tic-by-tic charts. highest value etc. e. e. Online trading account for investing in Equities and Derivatives b. b. which enables one to buy and sell in an instant. d. This account comes with the following features: a.30 am c.) Hot keys similar to broker‟s terminal. It is ideal for active traders and jobbers who transact frequently during day‟s session to capitalize on intra-day price movement.Banking. This account comes with the following features: a. Instant cash transfer facility against purchase & sale of shares. get the trusted. After hours order placement facility between 8. Instant order Execution and Confirmation. Automatic funds transfer with phone banking facilities (for Citibank and HDFC bank customers) III. Free trading through Phone (Dial-n-Trade) I. professional advice of Sharekhan limited‟s Tele Brokers V. Two dedicated numbers(1800-22-7500 and 39707500) for placing the orders using cell phones or landline phones II. f. Real-time streaming quotes. Simple and Secure Interactive Voice Response based system for authentication IV. Technical Studies. d. g. Market summary (Cost traded scrip. c. Real-time portfolio tracking with price alerts and Instant credit & transfer. g.00 am and 9. Multiple Charting. Single screen trading terminal for NSE Cash. IPO investments. Instant order and trade confirmations by e-mail. Integration of: Online Trading +Saving Bank + Demat Account. Single screen interface for cash and derivatives. SPEED TRADE ACCOUNT This is an internet-based software application.

h.10% HOW TO OPEN AN ACCOUNT WITH SHARE KHAN LIMITED? For online trading with Sharekhan Ltd. NIL first year Rs. from second calendar year onward Delivery .  18 . investor has to open an account. j.:  One need to call them at phone number provided below and asks that he want to open an account with them.10 % Brokerage Delivery . Or If one stays in Mumbai. 750/= Intra-day – 0.0. Sharekhan has a huge network all over India (640 centers in 280 cities). he can call on 022-66621111 One can visit any one of Sharekhan Limited‟s nearest branches.a. Live market debts. One can call on the Toll Free Number: 1-800-22-7500 to speak to a Customer Service executive b.. CHARGE STRUCTURE Fee structure for General Individual: Charge Account Opening Classic Account Rs. Following are the ways to open an account with Sharekhan Ltd.50 % Depository Charges: Account Opening Charges Annual Maintenance Charges Rs. 300/= p. One can also log on to “http://sharekhan. Alerts and reminders.0. 1000/= Intra-day . Back-up facility to place trades on Direct Phone lines.0. i. NIL Rs.com/Locateus.50% Speed Trade Account Rs.aspx” link to find out the nearest branch. a.

sharekhan. a Welcome Kit is dispatched from Mumbai to the clients‟ address mentioned in the documents provided by them.com to know about their products and services. is scrutinized in the branch and then it is sent to Mumbai for further processing where after a few days the clients‟ account are generated and activated. pin code of the city. shop and his preferences regarding the type of account he wants.  Generally the process of opening an account follows the following steps: LEAD MANAGEMENT SYSTEM (LMS) / REFERENCES CONTACT THE PERSON OVER PHONE OR THROUGH EMAIL FIXING AN APPOINTMENT WITH THE PERSON GIVING DEMONSTRATION YES 19 NO . These information are compiled in the headquarter of the company that is in Mumbai from where it is distributed through out the country‟s branches in the form of leads on the basis of cities and nearest share shops. One can send them an email at info@sharekhan. they can start trading and investing in shares. One can also visit the site www. After that the executives of the respective branches contact the prospective clients over phone or through email and give them information regarding the various types of accounts and the documents they need to open an account and then fix appointment with the prospective clients to give them demonstration and making them undergo the formalities to open the account. After that the forms that has collected from the clients. After the accounts are activated. his email address. city he lives in.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. phone number. his nearest Sharekhan Ltd. As soon as the clients receive the Welcome Kit. which contains the clients‟ Trading ID and Trading Password.

DOCUMENTATION FILLING UP THE FORM SUBMISSION OF THE FORM LOGIN OF THE FORM SENDING ACCOUNT OPENING KIT TO THE CLIENT TRADING Apart from two passport size photographs. c. one needs to provide with the following documents in order to open an account with Sharekhan Limited. Flat Maintenance Bill (should be latest and should be in the name of the client) 20 . d. Passport (valid) Voter‟s ID Card Ration Card Driving License (valid) Electricity Bill (should be latest and should be in the name of the client) f. b.:   Photocopy of the clients‟ PAN Card which should be duly attached Photo copy of any of the following documents duly attached which will serve as correspondence address proof: a. e. Telephone Bill (should be latest and should be in the name of the client) g.

5000). one for the Account Opening Fees and the other for the Margin Money (the minimum margin money is Rs. Eagle Eye. 33 hit the profit target. Investors Eye. 21 . Lease or Rent Agreement. ** A cancelled cheque should be given by the client if he provides Saving Bank Statement as a proof for correspondence address. High Noon. Out of 37 trading calls given by Sharekhan in the month of November 2007. These exclusive trading picks come only to Sharekhan Online Trading Customer and are based on in-depth technical analysis. j.h. Insurance Policy (should be latest and should be in the name of the client) i. It comprises a team of experts who constantly keep an eye on the share market and do research on the various aspects of the share market. Sharekhan's trading calls in the month of November 2007 has given 89% strike rate. RESEARCH SECTION IN SHAREKHAN LIMITED Sharekhan Limited has its own in-house Research Organisation which is known as Valueline. These reports are named as Pre-Market Report. one receives daily 5-6 Research Reports on their emails which they can use as tips for investing in the market. Saving Bank Statement** (should be latest)  Two cheques drawn in favour of Sharkhan Limited. Generally the research is based on the Fundamentals and Technical analysis of different companies and also taking into account various factors relating to the economy. Sharekhan Limited‟s research on the volatile market has been found accurate most of the time. As a customer of Sharekhan Limited. NOTE: Only Saving Bank Account cheques are accepted for the purpose of Opening an account.

69% 121 13. twice by Euromoney Survey and four times by Asiamoney Survey. Sharekhan Limited won the CNBC AWARD for the year 2004.20% 6. AWARDS AND ACHIEVEMENTS  SSKI has been voted as the Top Domestic Brokerage House in the research category.29% 5.Daring Derivatives and Post-Market Report.67% 192 21.  POLL RESULTS: BROKER PREFERENCE 5paise Sharekhan Motilal oswal ICICI Direct HDFC Indiabulls Kotak Others 119 13.45% 194 21.67% 22 116 13.92% 38 46 59 4.11% . Apart from these. Sharekhan Limited issues a monthly subscription by the name of Valueline which is easily available in the market.

Chapter 2 23 .

However. most notably forwards. it is possible to partially or fully transfer price risks by locking–in asset prices. By their very nature. by lockingin asset prices.Introduction to Derivatives INTRODUCTION TO DERIVATIVES The emergence of the market for derivative products. these generally do not influence the fluctuations in the underlying asset prices. can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. 24 . futures and options. the financial markets are marked by a very high degree of volatility. As instruments of risk management. Through the use of derivative products. derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors.

A contract which derives its value from the prices. etc. EMERGENCE OF DERIVATIVES Derivative products initially emerged as hedging devices against fluctuations in commodity prices. in a contractual manner. crude oil. rupee dollar exchange rate. wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. The price of this derivative is driven by the spot price of wheat which is the “underlying”. and commodity-linked derivatives remained the sole form of such products for almost three hundred years. bond. soybean. since their emergence. For example. Financial derivatives came into spotlight in the post-1970 period due to growing instability in the financial markets. However. A very simple example of derivatives is curd. commodity or any other asset. index. index. 2. they accounted for about two-thirds of total transactions in derivative products. their 25 . which is derivative of milk. or index of prices. coffee. risk instrument or contract for differences or any other form of security. the market for financial derivatives has grown tremendously in terms of variety of instruments available. A security derived from a debt instrument. sugar. share. to buy or sell an asset in future. The asset can be a share. In recent years. interest rate. Such transaction is an example of a derivative. 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). loan whether secured or unsecured. These contracts are legally binding agreements. called bases (underlying asset. In the Indian context the Securities Contracts (Regulation) Act. these products have become very popular and by 1990s. or reference rate). cotton. made on the trading screen of stock exchanges. of underlying securities. forex. The underlying asset can be equity. The price of curd depends upon the price of milk which in turn depends upon the demand and supply of milk. 1956 (SC(R) A) defines “derivative” to include – 1.DERIVATIVES DEFINED Derivative is a product whose value is derived from the value of one or more basic variables.

futures and options on stock indices have gained more popularity than on individual stocks. indeed the two largest “financial” exchanges of any kind in the world today. the approximate size of global derivatives market was US$ 109. The CBOT and the CME remain the two largest organized futures exchanges. HISTORY OF DERIVATIVES Early forward contracts in the US addressed merchants‟ concerns about ensuring that there were buyers and sellers for commodities. who are major users of index-linked derivatives. In 1865. According to the Bank for International Settlements (BIS). However “credit risk” remained a serious problem.5 trillion as at end–December 2000. In 1919. Its name was changed to Chicago Mercantile Exchange (CME). The primary intention of the CBOT was to provide a centralized location known in advance for buyers and sellers to negotiate forward contracts. MATIF in France. Chicago Butter and Egg Board. GLOBAL DERIVATIVE MARKETS The derivatives markets have grown manifold in the last two decades.complexity and also turnover. The lower costs associated with index derivatives vis–a–vis derivative products based on individual securities is another reason for their growing use. 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. Even small investors find these useful due to high correlation of the popular indexes with various portfolios and ease of use. financial futures became the most active derivative instruments generating volumes many times more than the commodity futures. In the class of equity derivatives the world over. SGX in Singapore. these contracts were called “futures contracts”. especially among institutional investors. traded on Chicago Mercantile Exchange. TIFFE in Japan. was reorganized to allow futures trading. The total estimated notional amount of outstanding over–the–counter (OTC) contracts 26 . the CBOT went one step further and listed the first “exchange traded” derivatives contract in the US. futures on T-bills and Euro-Dollar futures are the three most popular futures contracts traded today. a group of Chicago businessmen formed the Chicago Board of Trade (CBOT) in 1848. DTB in Germany. During the mid eighties. Index futures.. Eurex etc. a spin-off of CBOT. To deal with this problem. Other popular international exchanges that trade derivatives are LIFFE in England.

Growth in OTC derivatives market is mainly attributable to the continued rapid expansion of interest rate contracts. The report.J.2). the turnover in exchange– traded derivative markets rose by a record amount in the first quarter of 2001. however. which reflected growing corporate bond markets and increased interest rate uncertainty at the end of 2000. The turnover data are available only for exchange–traded derivatives contracts. as there was no regulatory framework to govern trading of derivatives.3 trillion as at end–December 2000. The amount outstanding in organized exchange markets increased by 5. According to BIS. The SCRA was amended in December 1999 to include derivatives within the ambit of „securities‟ and the regulatory framework was developed for governing 27 . The market for derivatives. methodology for charging initial margins.8% from US$ 13. 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. did not take off.L. deposit requirement and real–time monitoring requirements. SEBI set up a 24–member committee under the Chairmanship of Dr.9% over end–December 1999. SEBI also set up a group in June 1998 under the Chairmanship of Prof. 1995.C. which was submitted in October 1998.8% during 2000 to US$ 384 trillion as compared to US$ 350 trillion in 1999(Table 1.stood at US$ 95. an increase of 7. to recommend measures for risk containment in derivatives market in India. The turnover in derivative contracts traded on exchanges has increased by 9. While interest rate futures and options accounted for nearly 90% of total turnover during 2000. The committee submitted its report on March 17. the popularity of stock market index futures and options grew modestly during the year.Gupta on November 18.Varma. DERIVATIVE MARKET IN INDIA The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance.R. worked out the operational details of margining system.2 trillion as at end–December 2000. which withdrew the prohibition on options in securities. 1996 to develop appropriate regulatory framework for derivatives trading in India.5 trillion as at end December 1999 to US$ 14. broker net worth. 1998 prescribing necessary pre–conditions for introduction of derivatives trading in India. while there was some moderation in the OTC volumes.

Three contracts are available for trading. PARTICITANTS AND FUNCTIONS PARTICIPANTS Derivative contracts have several variants. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recognized stock exchange. the three–decade old notification. byelaws. The trading in index options commenced on June 4. The government also rescinded in March 2000. The derivatives trading on the exchange commenced with S&P CNX Nifty Index futures on June 12. 2001. To begin with. The following three broad categories of participants – 28 . thus precluding OTC derivatives. with 1 month. 2001. futures. 2001 and trading in options on individual securities commenced on July 2. the futures contracts have a maximum of 3-month expiration cycles. and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. SEBI permitted the derivative segments of two stock exchanges. and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and notified in the official gazette. 2000. Trading and settlement in derivative contracts is done in accordance with the rules. which prohibited forward trading in securities. This was followed by approval for trading in options based on these two indexes and options on individual securities. Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2000. A new contract is introduced on the next trading day following the expiry of the near month contract. Currently. NSE and BSE. The trading in index options commenced in June 2001 and the trading in options on individual securities commenced in July 2001. 2 months and 3 months expiry. The most common variants are forwards. Futures contracts on individual stocks were launched in November 2001. The index futures and options contract on NSE are based on S&P CNX Nifty Index. Single stock futures were launched on November 9.derivatives trading. SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE–30 (Sensex) index. options and swaps.

3. 1. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. They use futures or options markets to reduce or eliminate this risk Speculators: . monitoring and surveillance of the activities of various participants become extremely difficult in these kind of mixed markets. Derivatives. for example. that is. speculators trade in the underlying cash markets. they will take offsetting positions in the two markets to lock in a profit. the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk. Arbitrageurs: .Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. due to their inherent nature.Hedgers: . FUNCTIONS The derivatives market performs a number of economic functions. 29 . are linked to the underlying cash markets. Speculative trades shift to a more controlled environment of derivatives market. 2. If. Margining. they see the futures price of an asset getting out of line with the cash price. In the absence of an organized derivatives market. Prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. they can increase both the potential gains and potential losses in a speculative venture. Futures and options contracts can give them an extra leverage. 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. 4.Hedgers face risk associated with the price of an asset. With the introduction of derivatives.Speculators wish to bet on future movements in the price of an asset.

An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. Transfer of risk enables market participants to expand their volume of activity. The two commonly used swaps are: 30 . 6. at a given price on or before a given future date. Puts give the buyer the right. They can be regarded as portfolios of forward contracts. The underlying asset is usually a moving average of a basket of assets.calls and puts. but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. the majority of options traded on options exchanges having a maximum maturity of nine months. Equity index options are a form of basket options. where settlement takes place on a specific date in the future at today‟s preagreed price. Options: Options are of two types . LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset. They often energize others to create new businesses. Longer-dated options are called warrants and are generally traded over-the-counter. Baskets: Basket options are options on portfolios of underlying assets. These are options having a maturity of up to three years. Derivatives markets help increase savings and investment in the long run. Warrants: Options generally have lives of up to one year. creative. TYPES OF DERIVATIVE INSTRUMENTS Forwards: A forward contract is a customized contract between two entities. new products and new employment opportunities. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts. well-educated people with an entrepreneurial attitude. the benefit of which are immense. Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula.5. The derivatives have a history of attracting many bright.

and order and trade management. Thus a swaption is an option on a forward swap. A payer swaption is an option to pay fixed and receive floating. 2001.a. with the cash flows in one direction being in a different currency than those in the opposite direction. 2 months and 3 months expiry. called NEAT-F&O trading system. A new contract is introduced on the next trading day following the expiry of the near month contract.Currency swaps: These entail swapping both principal and interest between the parties. Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency. 2001 and trading in options on individual securities commenced on July 2. 2001. It is similar to that of trading of equities in the Cash Market (CM) segment. the swaptions market has receiver swaptions and payer swaptions. Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. The NEAT-F&O trading system is accessed by two types of users. Three contracts are available for trading. the futures contracts have a maximum of 3-month expiration cycles. A receiver swaption is an option to receive fixed and pay floating. The trading in index options commenced on June 4. It supports an anonymous order driven market which provides complete transparency of trading operations and operates on strict price–time priority. APPROVAL FOR DERIVATIVE TRADING TRADING MECHANISM The futures and options trading system of NSE. with 1 month. The index futures and options contract on NSE are based on S&P CNX Nifty Index. Currently. 2000. provides a fully automated screen–based trading for Nifty futures & options and stock futures & options on a nationwide basis and an online monitoring and surveillance mechanism. It provides tremendous flexibility 31 . b. Rather than have calls and puts. DERIVATIVE MARKET AT NSE The derivatives trading on the exchange commenced with S&P CNX Nifty Index futures on June 12. Single stock futures were launched on November 9. order matching. The Trading Members(TM) have access to functions such as order entry.

It acts as legal counterparty to all deals on the F&O segment and guarantees settlement. Good till.  Trading Member Clearing Member: TM–CM is a CM who is also a TM. banks or custodians could become a PCM and clear and settle for TMs. etc.  Professional Clearing Member: PCM is a CM who is not a TM. undertakes risk management and performs actual settlement. Trading and clearing members are admitted separately. 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. Limit/Market price. TM–CM may clear and settle his own proprietary trades and client‟s trades as well as clear and settle for other 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.  CLEARING AND SETTLEMENTS NSCCL undertakes clearing and settlement of all deals executed on the NSEs F&O segment. Typically. trading members are required to have qualified users and sales persons. Additionally. The Clearing Members (CM) uses the trader workstation for the purpose of monitoring the trading member(s) for whom they clear the trades.Date. Stop loss. Those interested in taking membership on F&O segment are required to take membership of CM and F&O segment or CM. which a trading member can take. can be built into an order. Essentially. 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. Immediate or Cancel. Good-till-Cancelled.to users in terms of kinds of orders that can be placed on the system. WDM and F&O segment. who have passed a Certification programme approved by SEBI. NSE follows 2–tier membership structure stipulated by SEBI to enable wider participation. a clearing member (CM) does clearing for all his trading members (TMs). Besides this. they can enter and set limits to positions. Various conditions like Good-till-Day. Clearing: 32 .

therefore. A CM‟s open position is arrived at by aggregating the open position of all the TMs and all custodial participants clearing through him. However. These contracts. Dr. all CMs are required to open a separate bank account with NSCCL designated clearing banks for F&O segment. The underlying for index futures/options of the Nifty index cannot be delivered. have to be settled in cash. A TM‟s open position is the sum of proprietary open position. in the contracts in which they have traded.  Institutional and large equity-holders need portfolio-hedging facility. INDEX DERIVATIVES Index derivatives are derivative contracts which derive their value from an underlying index. whether proprietary (if they are their own trades) or client (if entered on behalf of clients). In his report. Pension funds in the US are known to use stock index futures for risk hedging purposes. Index–derivatives are more suited to them and more cost–effective than derivatives based on individual stocks. The two most popular index derivatives are index futures and index options.C.Gupta attributes the popularity of index derivatives to the advantages they offer.The first step in clearing process is working out open positions or obligations of members. Futures and options on individual securities can be delivered as in the spot market. A TM‟s open position is arrived at as the summation of his proprietary open position and clients open positions. premium and final exercise settlement.e. client open long position and client open short position. it has been currently mandated that stock options and futures would also be cash settled. Index derivatives offer ease of use for hedging any portfolio irrespective of its composition. in the contracts in which they have traded. The settlement amount for a CM is netted across all their TMs/clients in respect of MTM. Settlement: All futures and options contracts are cash settled. Clients‟ positions are arrived at by summing together net (buy-sell) positions of each individual client for each contract. i. For the purpose of settlement.L. Proprietary positions are calculated on net basis (buy-sell) for each contract. Index derivatives have become very popular worldwide.  33 . through exchange of cash. TMs are required to identify the orders.

This implies much lower capital adequacy and margin requirements. 34 . is much less volatile than individual stock prices. This insulates a participant from credit risk of another. liquid index ensures that hedgers and speculators will not be vulnerable to individual or industry risk. and the possibility of cornering is reduced. which can be cornered. TRADING Here. This is partly because an individual stock has a limited supply. A well diversified. 3. Hence the need to have strong surveillance on the market both at the exchange level as well as at the regulator level. 4. the best way to get a feel of the trading system is to actually watch the screen and observe how it operates. Index derivatives are cash settled. forged/fake certificates. buying from the seller and selling to the buyer. and hence do not suffer from settlement delays and problems related to bad delivery. 2. The clearing corporation interposes itself into every transaction. trading of index futures and index options commenced at NSE in June 2000 and June 2001 respectively. more so in India. being an average. Index: The choice of an index is an important factor in determining the extent to which the index derivative can be used for hedging. A critical element of financial sector reforms is the development of a pool of human resources with strong skills and expertise to provide quality intermediation to market participants. Strong surveillance mechanism: Derivatives trading brings a whole class of leveraged positions in the economy. Requirements for an index derivatives market 1. With the entire above infrastructure in place. Education and certification: The need for education and certification in the derivatives market can never be overemphasized. Clearing corporation settlement guarantee: The clearing corporation eliminates counterparty risk on futures markets. Stock index. I shall take a brief look at the trading system for NSE‟s futures and options market. However. speculation and arbitrage.   Stock index is difficult to manipulate as compared to individual stock prices.

The exchange assigns a Trading member ID to each trading member. professional clearing members and participants. They carry out risk management activities and confirmation/inquiry of trades through the trading system. Professional clearing members: A professional clearing members is a clearing member who is not a trading member. Entities in the trading system There are four entities in the trading system. modifications have been performed in the existing capital market trading system so as to make it suitable for trading futures and options. They can trade either on their own account or on behalf of their clients including participants. banks and custodians become professional clearing members and clear and settle for their trading members. called NEAT-F&O trading system. Trading members. It is similar to that of trading of equities in the cash market segment. Each trading member can have more than one user. provides a fully automated screen-based trading for Nifty futures & options and stock futures & options on a nationwide basis as well as an online monitoring and surveillance mechanism. 3. Typically. clearing members. It is the responsibility of the trading member to maintain adequate control over persons having access to the firm‟s User IDs. It supports an order driven market and provides complete transparency of trading operations. 1.Futures and options trading system The futures & options trading system of NSE. This ID is common for all users of a particular trading member. 2. Clearing members: Clearing members are members of NSCCL. Each user of a trading member must be registered with the exchange and is assigned a unique user ID. 35 . Trading members: Trading members are members of NSE. The number of users allowed for each trading member is notified by the exchange from time to time. Keeping in view the familiarity of trading members with the current capital market trading system. The software for the F&O market has been developed to facilitate efficient and transparent trading in futures and options instruments. The unique trading member ID functions as a reference for all orders/trades of different users.

The exchange notifies the regular lot size and tick size for each of the contracts traded on this segment from time to time. Order matching is essentially on the basis of security. The lot size on the futures market is for 200 Nifties. wherein orders match automatically. if not traded on the day the order is entered. These clients may trade through multiple trading members but settle through a single clearing member. as the name suggests is an order which is valid for the day on which it is entered. Consequently. Participants: A participant is a client of trading members like financial institutions. BASIS OF TRADING The NEAT F&O system supports an order driven market. it spans trading days. it is an active order. Time conditions  Day order: A day order. the system cancels the order automatically at the end of the day.4. the order becomes passive and goes and sits in the respective outstanding order book in the system. If the order is not executed during the day. 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. If it does not find a match. The order types and conditions are summarized below. time and quantity. It tries to find a match on the other side of the book. its price. If it finds a match. Good till canceled (GTC): A GTC order remains in the system until the user cancels it. a trade is generated. When any order enters the trading system. All quantity fields are in units and price in rupees. The maximum number of days an order can  36 . ORDER TYPES AND CONDITIONS The system allows the trading members to enter orders with various conditions attached to them as per their requirements.

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

Immediate or Cancel(IOC): An IOC order allows the user to buy or sell a contract as soon as the order is released into the system, failing which the order is cancelled from the system. Partial match is possible for the order, and the unmatched portion of the order is cancelled immediately.

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

Other conditions

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

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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.

 

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

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

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

Market spread/combination order entry
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The NEAT F&O trading system also enables to enter spread/combination trades. shows the spread/combination screen. This enables the user to input two or three orders simultaneously into the market. These orders will have the condition attached to it that unless and until the whole batch of orders finds a counter match, they shall not be traded. This facilitates spread and combination trading strategies with minimum price risk.

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

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

Contract specifications for index futures
NSE trades Nifty futures contracts having one-month, two-month and threemonth 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.

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Each futures contract has a separate limit order book. exclusive 40 . each with five different strikes available for trading.The Instrument type refers to “Futures contract on index” and Contract symbol . 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). then the appropriate value of a single index futures contract would be Rs. Trading is for a minimum lot size of 200 units. contracts at different strikes.10.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.200. Contract specifications for stock options Trading in stock options commenced on the NSE from July 2001. Contract specification for index options On NSE‟s index options market.e.e. NSE provides a minimum of five strike prices for every option type (i. The expiration cycle for stock options is the same as for index futures and index options. Charges 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. two-month and three-month expiry cycles are available for trading. Thus if the index level is around 1000. Thus a single move in the index value would imply a resultant gain or loss of Rs.5% of notional value of the contract[(Strike price + Premium) * Quantity] in case of index options. The minimum tick size for an index future contract is 0.05 units. These contracts are American style and are settled in cash. having onemonth. 0. A new contract is introduced on the trading day following the expiry of the near month contract.05*200 units) on an open position of 200 units. two out–of– the–money contracts and one at–the–money contract available for trading. call and put) during the trading month. two-month and three-month options.000. There are typically one-month. There are at least two in–the– money contracts.00 (i.5% of the contract value in case of index futures and 2. 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.

The Board desired that these issues be reconsidered by the Advisory Committee on Derivatives (ACD) and requested a detailed report on the aforesaid issues for the consideration of the Board.1 of its report. The TMs contribute to Investor Protection Fund of F&O segment at the rate of Rs.of statutory levies.  Norms for use of derivatives by mutual funds.002%)(Each side) or Rs. The transaction charges payable by a TM for the trades executed by him on the F&O segment are fixed at Rs.0001%).10 per crore of turnover (0. whichever is higher. Well-defined goals. We therefore reproduce this paragraph of the LCGC Report: “The Committee believes that regulation should be designed to achieve specific.  Use of sub-brokers in the derivative markets. REGULATORY OBJECTIVES The LCGC outlined the goals of regulation admirably well in Paragraph 3.2 per lakh of turnover (0. 2002 considered some important issues relating to the derivative markets which include:  Physical settlement of stock options and stock futures contracts.1 lakh annually. SEBI ADVISORY COMMITTEE ON DERIVATIVES The SEBI Board in its meeting on June 24. The recommendations of the Advisory Committee on Derivatives on some of these issues were also placed before the SEBI Board. 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 41 .  Review of the eligibility criteria of stocks on which derivative products are permitted. It is inclined towards positive regulation designed to encourage healthy activity and behavior. We endorse these regulatory principles completely and base our recommendations also on these same principles.

(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.” Chapter 3 42 . (c) Innovation: While curbing any undesirable tendencies. the regulatory framework should not stifle innovation which is the source of all economic progress. This is a much broader objective than market integrity. more so because financial derivatives represent a new rapidly developing area. such as cost-efficiency. aided by advancements in information technology. and price-discovery. price-continuity.

While futures and options are now actively traded on many exchanges. FORWARD CONTRACT 43 .Introduction to Futures and Options INTRODUCTION TO FUTURES AND OPTIONS In recent years. forward contracts are popular on the OTC market. In this chapter we shall study in detail these three derivative contracts. derivatives have become increasingly important in the field of finance.

 Each contract is custom designed. index. the contract has to be settled by delivery of the asset. sugar. He is exposed to the risk of exchange rate fluctuations. Forward contracts are very useful in hedging and speculation.  Illiquidity. the futures contracts are standardized and exchange traded. crude oil. Other contract details like delivery date. which often results in high prices being charged. The salient features of forward contracts are:  They are bilateral contracts and hence exposed to counter–party risk. soybean. But unlike forward contracts. interest rate. In simple words. price and quantity are negotiated bilaterally by the parties to the contract.  If the party wishes to reverse the contract. Futures are exchange-traded contracts to buy or sell an asset in future at a price agreed upon today. The classic hedging application would be that of an exporter who expects to receive payment in dollars three months later. expiration date and the asset type and quality. and hence is unique in terms of contract size. The other party assumes a short position and agrees to sell the asset on the same date for the same price. it has to compulsorily go to the same counterparty. bond. coffee etc.  The contract price is generally not available in public domain. The asset can be share. 44 . 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. and  Counterparty risk FUTURE CONTRACT Futures markets were designed to solve the problems that exist in forward markets. rupee-dollar exchange rate. The forward contracts are normally traded outside the exchanges.  On the expiration date.A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. cotton. Limitations of forward markets Forward markets world-wide are afflicted by several problems:  Lack of centralization of trading. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price.

4. of course.10-0. the exchange specifies certain standard features of the contract. 2. Profit in Both Bull & Bear Markets: In futures trading. High Leverage: The primary attraction. High Liquidity: Most futures markets are very liquid. ADVANTAGES OF FUTURE TRADING IN INDIA 1. Lower Transaction Cost: Another advantage of futures trading is much lower relative commissions. 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‟. This ensures that market orders can be placed very quickly as there are always buyers and sellers for most contracts. (or which can be used for reference purposes in settlement) and a standard timing of such settlement.20%). a standard quantity and quality of the underlying instrument that can be delivered. you can make money whether prices go up or down. The reason that futures trading can be so profitable is the high leverage. More than 99% of futures transactions are offset this way. i. 3.To facilitate liquidity in the futures contracts.e. 45 . By choosing correctly. is the potential for large profits in a short period of time. Your commission for trading a futures contract is one tenth of a percent (0. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. The standardized items in a futures contract are:  Quantity of the underlying asset  Quality of the underlying assets (not required in case of financial futures)  The date and the month of delivery  The units of price quotation (not the price)  Minimum fluctuation in price (tick size)  Location of settlement  Settlement style. it is as easy to sell (also referred to as going short) as it is to buy (also referred to as going long). there are huge amounts of contracts traded every day. It is a standardized contract with standard underlying instrument.

The confusion is primarily because both serve essentially the same economic functions of allocating risk in the presence of future price uncertainty. the exchange becomes counter party to each trade and guarantees settlement. July 2001 saw the launch of options on individual securities (herein referred to as stock options) and the onset of rolling settlement. DIFFERENCES BETWEEN FORWARD AND FUTURE CONTRACT Forward contracts are often confused with futures contracts. 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. But this is not so in the case of forward contract. However futures are a significant improvement over the forward contracts.  Counter Party Risk: In forward contracts there is a risk of counter party default. Besides speculation. stock futures are particularly appealing due to familiarity and ease in understanding. In case of futures. A future contract is nothing but a form of forward contract. A year later. One can differentiate a forward contract from a future contract on the following lines:  Customized vs Standardized: Forward contracts are customized while future contracts are standardized. With the launch of futures on individual securities (herein referred to as stock futures) on the 9th of November. options on index were available for trading. Of the above mentioned products. In this regard. 2001. 46 . Terms of forward contracts are negotiated between the buyer and the seller. the basic range of equity derivative products in India seems complete.  Liquidity: Futures are much more liquid and their price is transparent as their price and volume are reported in media. stock futures can be effectively used for hedging and arbitrage reasons. While the terms of future contracts are decided by the exchange on which these are traded. trading stock futures is no different from trading the security itself.USING FUTURES ON INDIVIDUAL SECURUTIES Index futures began trading in India in June 2000.

The index futures contracts on the NSE have one-month. Futures price: The price at which the futures contract trades in the futures market. On the Friday following the last Thursday. Squaring off: A forward contract can be reversed with only the same counter party with whom it was entered into. FUTURES TERMINOLOGIES   Spot price: The price at which an asset trades in the spot market.  47 . In general. a new contract having a three-month expiry is introduced for trading. Revenue may be in the form of dividend. the actual price may vary depending upon the demand and supply of the underlying asset. Futures Price = Spot Price + Cost of Carry The Cost of Carry is the sum of all costs incurred if a similar position is taken in cash market and carried to expiry of the futures contract less any revenue that may arise out of holding the asset. 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. Though one can calculate the theoretical price. THEORETICAL WAY OF PRICING FUTURES The theoretical price of a futures contract is spot price of the underlying plus the cost of carry. Contract cycle: The period over which a contract trades. two-months and threemonth expiry cycles which expire on the last Thursday of the month. The cost typically includes interest cost in case of financial futures (insurance and storage costs are also considered in case of commodity futures). A future contract can be reversed on the screen of the exchange as the latter is the counter party to all futures trades. Please note that futures are not about predicting future prices of the underlying assets.

This reflects that futures prices normally exceed spot prices. For instance. the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day. the contract size on NSE‟s futures market is 200 Nifties. Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin. basis can be defined as the futures price minus the spot price. at the end of which it will cease to exist. the margin account is adjusted to reflect the investor‟s gain or loss depending upon the futures closing price. An option gives the holder of the option the right to do something. This is called marking–to– market. Marking-to-market: In the futures market. the 48 . Maintenance margin: This is somewhat lower than the initial margin.       OPTIONS Options are fundamentally different from forward and futures contracts. basis will be positive. 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 is the last day on which the contract will be traded. This is set to ensure that the balance in the margin account never becomes negative. Contract size: The amount of asset that has to be delivered less than one contract. There will be a different basis for each delivery month for each contract. Basis: In the context of financial futures. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset. If the balance in the margin account falls below the maintenance margin. In a normal market. at the end of each trading day. Expiry date: It is the date specified in the futures contract. In contrast. in a forward or futures contract. The holder does not have to exercise this right.

which the option buyer pays to the option seller. 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. There are two basic types of options. Expiration date: The date specified in the options contract is known as the expiration date. the purchase of an option requires an up–front payment. call options and put options. Like indexing futures contracts. It is also referred to as the option premium. Stock options: Stock options are options on individual stocks.         49 . Writer of an option: The writer of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him. the exercise date. Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer. Strike price: The price specified in the options contract is known as the strike price or the exercise price. the strike date or the maturity. Whereas it costs nothing (except margin requirements) to enter into a futures contract. Some options are European while others are American. Option price: Option price is the price. indexing options contracts are also cash settled. Options currently trade on over 500 stocks in the United States. 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. A contract gives the holder the right to buy or sell shares at the specified price.two parties have committed themselves to doing something. OPTIONS TERMINOLOGIES  Index options: These options have the index as the underlying.

the call is said to be deep OTM. the call is said to be deep ITM. At expiration. In the case of a put. The longer the time to expiration. Most exchange-traded options are American. An option on the index is at-the-money when the current index equals the strike price (i. An option that is OTM or ATM has only time value. If the index is much lower than the strike price. A call option on the index is out-of-the-money when the current index stands at a level. the greater is an option‟s time value. the put is ITM if the index is below the strike price. spot price > strike price).e. Both calls and puts have time value. Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. In the case of a put. which is less than the strike price (i. If the index is much higher than the strike price. Usually. the maximum time value exists when the option is ATM. spot price = strike price).e.e. Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cash flow if it were exercised immediately. American options: American options are options that can be exercised at any time upto the expiration date. spot price < strike price). the put is OTM if the index is above the strike price. an option should have no time value.      TYPES OF OPTIONS 50 . European options are easier to analyze than American options. At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cash flow if it were exercised immediately. In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cash flow to the holder if it were exercised immediately. and properties of an American option are frequently deduced from those of its European counterpart. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i. all else equal. European options: European options are options that can be exercised only on the expiration date itself.

Suppose stock price is Rs. Call Options. 300.e. 25/-. 51 .& exercises his option selling the Reliance share at Rs 300 to the option writer thus making a net profit of Rs. if at the time of expiry stock price falls below Rs. If the market price of Infosys on the day of expiry is more than Rs. at a premium of Rs. paid which should be the profit earned by the seller of the call option. 260/. on the day of expiry is less than Rs.. Put Options.1. 3000. The seller of the put option (one who is short Put) however. the option will be exercised. 2.. 3600 (Strike Price + Premium i. the option can be exercised as it is 'in the money'. The seller (one who is short call) however. In this case the investor loses the premium (Rs 100). 3500. The investor will earn profits once the share price crosses Rs. 200 {(Spot price .A call option gives the holder (buyer/ one who is long call).Spot Price) . 300/. the right to buy specified quantity of the underlying asset at the strike price on or before expiration date. the buyer of the call option will choose not to exercise his option. 3500+100).Strike price) Premium}. Suppose stock price is Rs. 3800. has the obligation to buy the underlying asset at the strike price if the buyer decides to exercise his option to sell. The investor's Break-even point is Rs. 260.Premium paid}. Example: An investor buys one European Put option on Reliance at the strike price of Rs. 3500 at a premium of Rs.e. 275/ (Strike Price . the right to sell specified quantity of the underlying asset at the strike price on or before an expiry date. 15 {(Strike price . If the market price of Reliance. investor will earn profits if the market falls below 275. In another scenario. 100.premium paid) i. the buyer of the Put option immediately buys Reliance share in the market @ Rs. 3500 say suppose it touches Rs. Example: An investor buys One European call option on Infosys at the strike price of Rs.A Put option gives the holder (buyer/ one who is long Put). 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. has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy.

An uncovered option writer. which shall be the profit earned by the seller of the Put option.e. may face unlimited risk. Rs 25/-). In this case the investor loses the premium paid (i. if the owner's options expire with no value. set risk. if at the time of expiry. Option Has the obligation to Has the obligation to seller or sell the underlying buy the underlying option writer asset (to the option asset (from the holder) at the option holder) at the specified price specified price LEVERAGE AND RISK Options can provide leverage. on the other hand. this loss can be the entire amount of the premium paid for the option. Options offer their owners a predetermined. Leverage also has downside implications.Option Buys the right to buyer or buy the underlying option holder asset at the specified price Buys the right to sell the underlying asset at the specified price 2. 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). 52 . An investor can see large percentage gains from comparatively small. the buyer of the Put option will choose not to exercise his option to sell as he can sell in the market at a higher rate. leverage can magnify the investment's percentage loss. If the underlying stock price does not rise or fall as anticipated during the lifetime of the option. market price of Reliance is Rs 320/ -.In another scenario. (Please see table) THE OPTIONS GAME Call Option Put Option 1. However. favorable percentage moves in the underlying index.

A call option is said to be „in-the-money‟ when the strike price of the option is less than the underlying asset price. Out-of-the-money An option is said to be „at-the-money‟. (Please see table) Striking the price Call Option Put Option 1. if the Sensex falls to 3700. a call option is „out-of-the-money‟ when the strike price is greater than the underlying asset price. the call option no longer has positive exercise value. For example. At-the-money Strike Price equal to Spot Price of underlying asset Strike Price equal to Spot Price of underlying asset 53 . The call holder has the right to buy a Sensex at 3900. no matter how much the spot market price has risen. when the option's strike price is equal to the underlying asset price. a Sensex call option with strike of 3900 is „in-the-money‟. Using the earlier example of Sensex call option. a profit can be made by selling Sensex at this higher price. The call holder will not exercise the option to buy Sensex at 3900 when the current price is at 3700. when the spot Sensex is at 4100 as the call option has value. On the other hand.In-the-money Strike Price less than Strike Price greater Spot Price of than Spot Price of underlying asset underlying asset 2. At-the-money. And with the current price at 4100.In-the-money. This is true for both puts and calls.

is in-the-money at any given moment is called its intrinsic value. an amount greater than the current Sensex of 4100.3. a put option is out-of-the-money when the strike price is less than the spot price of underlying asset. the time value is the total option premium. a Sensex put at strike of 4400 is in-the-money when the Sensex is at 4100. therefore affecting the premium at which they are traded.  Options are said to be deep in-the-money (or deep out-of-the-money) if the exercise price is at significant variance with the underlying asset price. Out-of-themoney Strike Price greater than Spot Price of underlying asset Strike Price less than Spot Price of underlying asset  A put option is in-the-money when the strike price of the option is greater than the spot price of the underlying asset. by definition. Option Premium = Intrinsic Value + Time Value FACTORS THAT AFFECT THE VALUE OF AN OPTION PREMIUM 54 . This does not mean. It is the time value portion of an option's premium that is affected by fluctuations in volatility. all of these factors determine time value. Likewise. Thus. these options can be obtained at no cost. The put no longer has positive exercise value. the buyer of Sensex put option won't exercise the option when the spot is at 4800. interest rates. Together. dividend amounts and the passage of time. the put option has value because the put holder can sell the Sensex at 4400. call or put. Any amount by which an option's total premium exceeds intrinsic value is called the time value portion of the premium. For example. an at-the-money or out-of-the-money option has no intrinsic value. however. In the above example. The amount by which an option. When this is the case. There are other factors that give options value.

5. Non-Quantifiable Factors: 1.There are two types of factors that affect the value of the option premium: Quantifiable Factors: 1. 55  . The time to expiration and. The strike price of the option. The risk free interest rate. based on fundamental or technical analysis 3. 4. The two most popular option pricing models are:  Black Scholes Model which assumes that percentage change in the price of underlying follows a normal distribution. 2.both in the options marketplace and in the market for the underlying asset 4. Market participants' varying estimates of the underlying asset's future volatility 2.the number of transactions and the contract's trading volume on any given day. Binomial Model which assumes that percentage change in price of the underlying follows a binomial distribution. Underlying stock price. The volatility of the underlying stock. The effect of supply & demand. The "depth" of the market for that option . 3. 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. Individuals' varying estimates of future performance of the underlying asset. 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.

56 . whether it is bullish.Pricing models include the binomial options model for American options and the Black-Scholes model for European options. together. These combinations enable a trader to develop an option-trading model which meets the trader's specific trading needs. They can be used for a multitude of purposes. and style. long a put. to hedge an existing position in an asset. to hedge other option positions. choppy. b. OPTIONS TRADING As described earlier. or in conjunction with other financial instruments to create a number of option-trading strategies. short a put. or neutral. 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. c. Options are unique trading instruments. four possible option selections exist for a trader: a. WHY TO USE OPTIONS? There are two main reasons why an investor would use options:  to Speculate and  to Hedge. and enables him or her to anticipate every conceivable situation in the market. These four can be used independently. bearish. 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. providing tremendous versatility and utility. expectations. This trading structure can be adapted to handle any type of market outlook. and d. long a call. Among their multiple applications are the following: to speculate on the movement of an asset. short a call.

Even the individual investor can benefit. So why do people speculate with options if the odds are so skewed? Aside from versatility. Because of the versatility of options. especially for large institutions.Speculation One can think of speculation as betting on the movement of a security. you'd also have to take commissions into account. it doesn't take much of a price movement to generate substantial profits. This is because when one buys an option. one can also make money when the market goes down or even sideways. On the other hand. which indicates that the expiration is the third Friday of July and the strike price is $70.and lost. but also the magnitude and the timing of this movement. 57 . there is no doubt that hedging strategies can be useful. One can imagine that he wanted to take advantage of technology stocks and their upside. To succeed. he shouldn't make the investment. he must correctly predict whether a stock will go up or down. Speculation is the territory in which the big money is made . Critics of options say that if he is so unsure of his stock pick that he needs a hedge.15 x 100 = $315. HOW OPTIONS WORKS? Let's say that on May 1. 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. The total price of the contract is $3. it's all about using leverage. In reality. Hedging The other function of options is hedging. he have to be correct in determining not only the direction of the stock's movement.15 for a July 70 Call. but we'll ignore them for this example. Just as one insures his house or car. By using options. When one is controlling 100 shares with one contract. the stock price of L&T is $67 and the premium (cost) is $3. The advantage of options is that one isn‟t limited to making a profit only when the market goes up. he would be able to restrict his downside while enjoying the full upside in a cost-effective way. The use of options in this manner is the reason options have the reputation of being risky. but say he also wanted to limit any losses. options can be used to insure your investments against a downturn. Think of this as an insurance policy.

the option contract is worthless. so the option is worthless. of course. When the stock price is $67. You almost doubled our money in just three weeks! You could sell your options. let's say we let it ride.Remember. a stock option contract is the option to buy 100 shares. here is what happened to our option investment: Date Stock Price Option Price Paper Gain/Loss May 1 $67 $3. Exercising Versus Trading-Out So far we've talked about options as the right to buy or sell (exercise) the underlying.25 x 100 = $825. furthermore.unless. For the sake of this example. We are now down to the original investment of $315. Subtract what you paid for the contract.25 $825 $510 Expiry Date $62 worthless $0 -$315 Contract Value $315 $0 The price swing for the length of this contract from high to low was $825.25 . the break-even price would be $73. But don't forget that you've paid $315 for the option.$3.15) x 100 = $510. By the expiration date. and your profit is ($8. the price drops to $62. This is leverage in action.15 per share." and take your profits . but in reality. it's less than the $70 strike price. The options contract has increased along with the stock price and is now worth $8. To recap. because the contract is $3. The strike price of $70 means that the stock price must rise above $70 before the call option is worth anything. a majority of options are not actually 58 . you think the stock price will continue to rise. so you are currently down by this amount.15. This is true. which are called "closing your position. which would have given us over double our original investment. that's why you must multiply the contract by 100 to get the total price. Because this is less than our $70 strike price and there is no time left. Three weeks later the stock price is $78.15 May 21 $78 $8.

and 30% expire worthless. Avoid buying or selling options based upon anticipated news (buyouts in particular). Time value represents the possibility of the option increasing in value. If you are wondering. Besides bordering on unethical trading.exercised. Remember. WHEN NOT TO BUY AN OPTION? It is also important to consider the time or the date at which one should enter the option market. This means that holders sell their options in the market. intrinsic value is the amount in-the-money. However. Avoid trading in an illiquid option market. an option's premium is its intrinsic value + time value.15 to $8. In our example. the price of the option in our example can be thought of as the following: Premium = Intrinsic Value + Time Value $8. 60% are traded out. These fluctuations can be explained by intrinsic value and time value. the information received is more likely to be rumor than correct. Basically. for a call option. knowing you were able to buy it at a discount to the present value. which. about 10% of options are exercised.25 In real life options almost always trade above intrinsic value. means that the price of the stock equals the strike price. 59 . So.25. According to the CBOE. Intrinsic Value and Time Value At this point it is worth explaining more about the pricing of options.25 = $8 + $0. You could also keep the stock. In our example the premium (price) of the option went from $3. the majority of the time holders choose to take their profits by trading out (closing out) their position. we just picked the numbers for this example out of the air to demonstrate how options work. and writers buy their positions back to close. 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.  Avoid purchasing call options just prior to a stock going ex-dividend.

Avoid purchasing options well after the market has established a defined trend - this is especially true when day trading, as any option premium advantage will have dissipated. Avoid purchasing way out-of-the-money options when day trading, as any favorable price movement will have a negligible effect upon premium. 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 trendfollowing 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 trendfollowing stance.

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

HOW TO READ AN OPTION TABLE?
Column 1: Strike Price - This is the stated price per share for which an underlying stock may be purchased (for a call) or sold (for a put) upon the exercise of the option contract. Option strike prices typically move by increments of $2.50 or $5 (even though in the above example it moves in $2 increments). Column 2: Expiry Date - This shows the termination date of an option contract. Remember that U.S.-listed options expire on the third Friday of the expiry month.

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

Column 4: Volume - This indicates the total number of options contracts traded for the day. The total volume of all contracts is listed at the bottom of each table. Column 5: Bid - This indicates the price someone is willing to pay for the options contract. Column 6: Ask - This indicates the price at which someone is willing to sell an options contract. Column 7: Open Interest - Open interest is the number of options contracts that are open; these are contracts that have neither expired nor been exercised.

PAYOFF FOR DERIVATIVES CONTRACT
A payoff is the likely profit/loss that would accrue to a market participant with change in the price of the underlying asset. This is generally depicted in the form of payoff diagrams which show the price of the underlying asset on the X– axis and the profits/losses on the Y–axis.

PAYOFF FOR FUTURES
Futures contracts have linear payoffs. In simple words, it means that the losses as well as profits for the buyer and the seller of a futures contract are 61

unlimited. These linear payoffs are fascinating as they can be combined with options and the underlying to generate various complex payoffs. Payoff for buyer of futures: Long futures The payoff for a person who buys a futures contract is similar to the payoff for a person who holds an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who buys a twomonth Nifty index futures contract when the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio. When the index moves up, the long futures position starts making profits, and when the index moves down it starts making losses. Payoff for seller of futures: Short futures The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who sells a twomonth Nifty index futures contract when the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio. When the index moves down, the short futures position starts making profits, and when the index moves up, it starts making losses.

OPTIONS PAYOFF
The optionally characteristic of options results in a non-linear payoff for options. In simple words, it means that the losses for the buyer of an option are limited; however the profits are potentially unlimited. For a writer, the payoff is exactly the opposite. His profits are limited to the option premium; however his losses are potentially unlimited. These non-linear payoffs are fascinating as they lend themselves to be used to generate various payoffs by using combinations of options and the underlying. We look here at the six basic payoffs. Payoff profile of buyer of asset: Long asset In this basic position, an investor buys the underlying asset, Nifty for instance, for 1220, and sells it at a future date at an unknown price, once it is purchased, the investor is said to be “long” the asset. 62

the writer of the option charges a premium. His loss in this case is the premium he paid for buying the option. Payoff profile for writer of call options: Short call A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. Payoff profile for buyer of put options: Long put A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. the spot price is below the strike price. the spot price exceeds the strike price. If upon expiration the spot price of the underlying is less than the strike price. 63 . for 1220. Hence as the spot price increases the writer of the option starts making losses. and buys it back at a future date at an unknown price. If upon expiration. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. For selling the option. If the spot price of the underlying is less than the strike price. His loss in this case is the premium he paid for buying the option. the buyer lets his option expire unexercised and the writer gets to keep the premium. he lets his option expire un-exercised. Whatever is the buyer‟s profit is the seller‟s loss. Lower the spot price more is the profit he makes. Payoff profile le for buyer of call options: Long call A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. an investor shorts the underlying asset. Higher the spot price more is the profit he makes. If upon expiration. the spot price exceeds the strike price. the buyer will exercise the option on the writer. If the spot price of the underlying is higher than the strike price. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. he makes a profit.Payoff profile for seller of asset: Short asset In this basic position. If upon expiration. Nifty for instance. he makes a profit. Higher the spot price more is the loss he makes. he lets his option expire un-exercised.

If upon expiration the spot price of the underlying is more than the strike price. For selling the option.Payoff profile for writer of put options: Short put A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. the buyer lets his option expire un-exercised and the writer gets to keep the premium. the spot price happens to be below the strike price. Whatever is the buyer‟s profit is the seller‟s loss. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. the writer of the option charges a premium. If upon expiration. Chapter 4 64 . the buyer will exercise the option on the writer.

65 . When someone mentions hedging. Arbitrage and Speculation Strategies HEDGING. A hedge is just a way of insuring an investment against risk. ARBITRAGE AND SPECULATION STRATEGIES HEDGING Hedging is a way of reducing some of the risk involved in holding an investment.Hedging. There are many different risks against which one can hedge and many different methods of hedging. think of insurance.

chances are that any particular stock will fall too. because by intention. you may be well advised to hedge your position.  If the market moves up. So if you own a stock with good prospects but you think the stock market in general is overpriced. When doing so. you may need to advance more margin to cover your short position. i. (It's most expensive because you're buying insurance not only against market risk but against the risk of the specific security as well. short Nifty futures Investors studying the market often come across a security which they believe is intrinsically undervalued. but most expensive method. There are many ways of hedging against market risk.e. you will not participate in the rally. A stock picker carefully purchases securities based on a sense that they are worth more than the market price. and will not be able to use your stocks to cover the margin calls. HEDGING STRATEGIES WITH EXAMPLES Hedging: Long security. The efficiency of the hedge is strongly dependent on your estimate of the correlation between your high-beta portfolio and the broad market index. Much of the risk in holding any particular stock is market risk. 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. is to buy a put option for the stock you own. you've set up your futures position as a complete hedge. if the market falls sharply. he faces two kinds of risks: 66 . The simplest.Consider a simple (perhaps the simplest) case. But keep in mind the following points.  If the market goes up.) If you're trying to hedge an entire portfolio. futures are probably the cheapest way to do so.

A person may buy SBI at Rs. There is a simple way out. to completely remove the hidden Nifty exposure. i.e. The position LONG SBI+ SHORT NIFTY is a pure play on the value of SBI. 2. 2.000 67 . you will have a position.00. We need to know the “beta” of the security. Nifty drops. When this is done.e.000. at the cost of lower risk.1. Rs 4. is 1. as incidental baggage. a LONG SBI position is not a focused play on the valuation of SBI.2 *3.000. and suppose we have a LONG SBIN position of Rs. This offsets the hidden Nifty exposure that is inside every long–security position. In this sense. 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 peculiar problem here. you should sell some amount of Nifty futures. A few days later. picking securities.33.670 thinking that it would announce good results and the security price would rise.2. Once this is done. or. the stock picker has “hedged away” his index exposure. so he makes losses.3. the average impact of a 1% move in Nifty upon the security. The entire market moves against him and generates losses even though the underlying idea was correct.33. i. Methodology 1. The basic point of this hedging strategy is that the stock picker proceeds with his core skill.e. It carries a LONG NIFTY position along with it. The second outcome happens all the time. i. which is purely about the performance of the security. it is generally safe to assume the beta is 1. Every buy position on a security is simultaneously a buy position on Nifty. If betas are not known. even if his understanding of SBI was correct. Suppose we take SBIN. The size of the position that we need on the index futures market. and the company is really not worth more than the market price. where the beta is 1. His understanding can be wrong. This is because a LONG SBI position generally gains if Nifty rises and generally loses if Nifty drops. Every time you adopt a long position on a security. without any extra risk from fluctuations of the market index.

without “panic selling” of shares.000 of Nifty we need to sell one market lot.00. they may see that the market is in for a few days or weeks of massive volatility. with the index futures market. 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. and the market lot on the futures market is 200. We sell one market lot of Nifty (200 nifties) to get the position: LONG SBIN Rs.33. In addition. 4. Nifty has dropped sharply. This is particularly a problem if you need to sell shares in the near future. Suppose Nifty is at 2000. This sentiment generates “panic selling” which is rarely optimal for the investor. Hedging: Have portfolio. i. suffer the pain of the volatility.3. Hence each market lot of Nifty is Rs 4. and they do not have an appetite for this kind of volatility. 68 .00. Sometimes. When you have such anxieties. This leads to political pressures for government to “do something” when security prices fall. short Nifty futures The only certainty about the capital market is that it fluctuates! A lot of investors who own portfolios experience the feeling of discomfort about overall market movements. It allows an investor to be in control of his risk. there are two alternatives:  Sell shares immediately. instead of doing nothing and suffering the risk.4. in order to finance a purchase of a house.3. This allows rapid response to market conditions. Returns on the position will be roughly neutral to movements of Nifty. for example.  Do nothing. hence only successful forecasts about SBIN will benefit from this position.00.000 This position will be essentially immune to fluctuations of Nifty. To short Rs. a third and remarkable alternative becomes available:  Remove your exposure to index fluctuations temporarily using index futures. This planning can go wrong if by the time you sell shares. they may have a view that security prices will fall in the near future. At other times.000.000 SHORT NIFTY Rs.4. The profits/losses position will fully reflect price changes intrinsic to SBIN.e.

25 million of Nifty futures. Every portfolio contains a hidden index exposure. then the portfolio beta is (1 * 1.3 million on the Nifty futures. Hence we need to sell 12 market lots. which has a beta of 0. This statement is true for all portfolios. the portfolio is Rs.250. most of the portfolio risk is accounted for by index fluctuations (unlike individual securities. the futures gain and the portfolio loses.e.1 million of Hindalco.2 million of Hindustan Lever. the portfolio gains and the futures lose.000. Suppose we have a portfolio composed of Rs. If the beta of any securities is not known. This position will be essentially immune to fluctuations of Nifty. which completely removes the hidden Nifty exposure. It is easy to calculate the portfolio beta: it is the weighted average of securities betas.The idea here is quite simple.8)/3 or 1.4 and Rs. The complete hedge is obtained by adopting a position on the index futures market. i. In the case of portfolios. hence we would need a position of Rs. which has a beta of 1. In either case.3. Then a complete hedge is obtained by selling Rs. If Nifty goes down.e.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. In the above case. i.4 + 2 * 0. Each market lot of Nifty costs Rs. and the market lot on the futures market is 200. 2.25. Suppose Nifty is 1250. or (b) when his financial planning involves selling shares at a future date and would be affected if Nifty drops. where only 30–60% of the securities risk is accounted for by index fluctuations). The investor should adopt this strategy for the short periods of time where (a) the market volatility that he anticipates makes him uncomfortable. 3.000.3 million with a beta of 1.3. 2400 Nifties to get the position: LONG PORTFOLIO Rs.1 million which has a beta of 1. It does not make sense to use this strategy for long periods of time – if a two–year 69 . whether a portfolio is composed of index securities or not. If Nifty goes up. Methodology 1.000. it is safe to assume that it is 1. We need to know the “beta” of the portfolio.8.1.000. the investor has no risk from market fluctuations when he is completely hedged. the average impact of a 1% move in Nifty upon the portfolio.000 SHORT NIFTY Rs.

For that time. A person may have made up his mind on what portfolio he seeks to buy. The land deal is slow and takes weeks to complete. The complete hedge may require selling Rs. partial hedging is appropriate. two–thirds of his portfolio is hedged and one– third of the portfolio is held unhedged. The execution would be improved substantially if he 70 . he is exposed to the risk of missing out if the overall market index goes up.hedging is desired. the investor is partly invested in cash and partly invested in securities. Complete hedging eliminates all risk of gain or loss. In that case. but the investor may choose to only sell Rs. Some common occurrences of this include: _  A closed-end fund. 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. Another important choice for the investor is the degree of hedging.3 million of the futures. buy Nifty futures Have you ever been in a situation where you had funds. 2. This process takes time.2 million of the futures. which just finished its initial public offering. and carefully pick securities that are expected to do well. and buy back shares after two years. This strategy makes the most sense for rapid adjustments. Hedging: Have funds. which needed to get invested in equity? Or of expecting to obtain funds in the future which will get invested in equity. The exact degree of hedging chosen depends upon the appetite for risk that the investor has. but going to the market and placing market orders would generate large „impact costs‟. invest the proceeds. has cash. which is not yet invested. it is better to sell the shares.  Suppose a person plans to sell land and buy shares. Sometimes the investor may be willing to tolerate some risk of loss so as to hang on to some risk of gain. During this time. A person may need time to research securities. In this case. Getting invested in equity ought to be easy but there are three problems: 1.

As and when shares are obtained. one would scale down the LONG NIFTY position correspondingly. This takes time. In some cases. or to suffer the risk of staying in cash.5 million. With Nifty futures. Similarly. A person who expects to obtain Rs.  Later. he is exposed to the risk of missing out if the Nifty goes up. No matter how slowly securities are purchased. Hence it is equally important for the owner of money to use index futures to hedge against a rise in Nifty! 71 . which has just finished its initial public offering and has cash. can immediately enter into a LONG NIFTY to the extent it wants to be invested in equity. and during this time. such as the land sale above. in India. this strategy allows the investor to take more care and spend more time in choosing securities and placing aggressive limit orders. Hedging is often thought of as a technique that is used in the context of equity exposure.5 million by selling land would immediately enter into a position LONG NIFTY worth Rs. So far. Hence. a closed-end fund. It is common for people to think that the owner of shares needs index futures to hedge against a drop in Nifty. immediately. He is exposed to the risk of missing out if Nifty rises. Holding money in hand. the person may simply not have cash to immediately buy shares. which is not yet invested. is a risk because Nifty may rise. this strategy would fully capture a rise in Nifty. 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. 3. a third alternative becomes available:  The investor would obtain the desired equity exposure by buying index futures. we have had exactly two alternative strategies.could instead place limit orders and gradually accumulate the portfolio at favorable prices. so there is no risk of missing out on a broad rise in the securities market while this process is taking place. the investor/closed-end fund can gradually acquire securities (either based on detailed research and/or based on aggressive limit orders). when you want to be invested in shares. hence he is forced to wait even if he feels that Nifty is unusually cheap. which an investor can adopt: to buy liquid securities in a hurry.

ARBITRAGE Arbitrage is the practice of taking advantage of a state of imbalance between two (or possibly more) markets. he obtained or paid the „mark–to–market margin‟ on his outstanding futures position. the profit being the difference between the market prices.8 million. thus capturing the gains on the index. With the help of the arbitrage strategies discussed above. By 25 Mar 2005 he had fully invested in all the shares that he wanted (as of 13 Mar) and had no futures position left. a strategist can make risk-less profits by making use of mispricing in the market. his long position was worth 4. we can exploit the market condition and earn risk-free return. totaling Rs. Arbitrage is the safest way to make money in the market. A person who engages in arbitrage is called an arbitrageur.e. At that time Nifty was at 2000. 4. A combination of matching deals are struck that exploit the imbalance. From 14 March 2005 to 25 March 2005 he gradually acquired the securities. On each day. He entered into a LONG NIFTY MARCH FUTURES position for 2400 Nifties. 5. the scope for making money is diminutive.4.80. On each day. 72 . He made a list of 14 securities to buy.8 million on 13th March 2005. the securities purchased were at a changed price (as compared to the price prevalent on 13 March). at 13 March prices. 2. i. Arbitrage is game of strategy and also funds. 3. However.Methodology 1.000. he purchased one securities and sold off a corresponding amount of futures. A person obtained Rs.4. On each day. On the other hand. A participant with ample funds can easily earn risk-free returns.

2. There is no credit risk since the counter party on both legs is the NSCCL which supplies clearing services on NSE. a single keystroke can fire off these 50 orders in rapid succession into the NSE or BSE trading system. 3. Methodology 1. The below stated strategies cover all the types of arbitrage possibilities using equity derivatives. Using the NEAT or BOLT software. and simultaneously sells them at a future date on the futures market. Round off the number of shares in each security. such as traditional banks and the most conservative corporate treasuries. bank and financial institution are very active in arbitrage activities. It is an ideal lending vehicle for entities which are shy of price risk and credit risk. This gives you the buy position 73 . It is like a repo. The lender buys all 50 securities of Nifty on the cash market. and without bearing any credit risk. Borrowing and lending is a common practice in arbitrage transaction. 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. Cash and F&O. ARBITRAGE STRATEGIES WITH EXAMPLES Arbitrage: Have funds. NSE and BSE. There is no price risk since the position is perfectly hedged. lend them to the market. therefore. i. Calculate a portfolio which buys all the 50 securities in Nifty in correct proportion. The basic idea is simple.Arbitrage could be inter-exchange. 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. Arbitrage could also be between two segments of the market. without suffering the risk. where the money invested in each security is proportional to its market capitalization.e. Most people would like to lend funds into the security market.

A person wants to earn this return (60/2400 for 27 days). 5. At this point. A few days later.3% higher. A moment later. He sells Rs. In this case. so fluctuations in Nifty do not affect you. Nifty is at 2400. if the Nifty spot is 2100. Some days later (anytime you want).4. the difference between the futures price and the cash Nifty is the return to the moneylender. Now your position is down to 0. He buys Rs. 9. What is the interest rate that you will receive? We will use one specific case. he has obtained the Nifty spot for 2407.e. with two complications: the moneylender additionally earns any dividends that the 50 shares pay while he has held them. 8. sell Nifty futures of equal value. 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”. This is the point at which you are “loaning money to the market”. brokerage) in doing these trades. 7. In doing this. A few days later. He takes delivery of the shares and waits. Example On 1 August. A moment later. and the moneylender suffers transactions costs (impact cost. he places 50 market orders and ends up paying slightly more. where you will unwind the transaction on the expiration date of the futures. 1. you will have to take delivery of the 50 securities and pay for them. 74 . On 1 March 2005. His average cost of purchase is 0. i. The futures market is extremely liquid so the market order for Rs.3 million goes through at near–zero impact cost. Now you are completely hedged.3 million of the futures at 2460. and the Nifty March 2005 futures are at 2142 then the difference (2% for 30 days) is the return that the moneylender obtains.3 million of Nifty on the spot market. A futures contract is trading with 27th August expiration for 2460. 6. reverse the futures position. you will unwind the entire transaction. 2. use NEAT to send 50 sell orders in rapid succession to sell off all the 50 securities.

88% In addition. You would sell off all 50 securities in Nifty and buy them back at a future date using the index futures.14. You can deploy this money. The index futures market offers a riskless mechanism for (effectively) loaning out shares and earning a positive return for them. The futures position spontaneously expires on 27 August at 2420 (the value of the futures on the last day is always equal to the Nifty spot). 75 . and pay for them.6 (0. In the above case. He has gained Rs. On 27 August.000. The basic idea is quite simple.3. The dividends work out to Rs.4%.40 (1. 4. risk free. you would buy back your shares. On this date. Nifty happens to have closed at 2420 and his sell orders (which suffer impact cost) goes through at 2413. It is like a repo. the return is roughly 2460/2400 or 2.14000 or 0. 6. he has gained Rs. putting 50 market orders to sell off all the shares. and we subtract 0. as you like until the futures expiration. Arbitrage: Have securities.23% owing to the dividends for a total return of 2.4% for transactions costs giving 2. To do this. However. you would sell off your certificates and contract to buy them back in the future at a fixed price. 5. While waiting.25%) on the spot Nifty and Rs. It is easier to make a rough calculation of the return. at 3:15. stocklending schemes that are widely accessible do not exist in India.63%) on the futures for a return of near 1. he puts in market orders to sell off his Nifty portfolio. we ignore the gain from dividends and we assume that transactions costs account for 0. lend them to the market Owners of a portfolio of shares often think in terms of juicing up their returns by earning revenues from stocklending. You would soon receive money for the shares you have sold. There is no price risk (since you are perfectly hedged) and there is no credit risk (since your counterparty on both legs of the transaction is the NSCCL). a few dividends come into his hands.11% for 27 days.5% for 27 days.1% for 27 days.

4.X% . This can also be interpreted as a mechanism to obtain a cash loan using your portfolio of Nifty shares as collateral. if the spot-futures basis is 1% per month and you are loaning out money at 1.0.5% per month and you are loaning out the money at 1. 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. at 3:15 PM. with each share being present in the portfolio with a weight that is proportional to its market capitalization). A few days later. 6. 2. 3. Buy index futures of an equal value at a future date. This can be done using a single keystroke using the NEAT software. Example 76 . Invest this money at the riskless interest rate.5 million of the NSE-50 portfolio (in their correct proportion. Sell off all 50 shares on the cash market. Suppose the spot–futures basis is X% and suppose the rate at which funds can be invested is Y %. we assume that transactions costs account for 0. To do this. you will receive money and have to make delivery of the 50 shares. 5. 1.4%. this stock lending could be profitable It is easy to approximate the return obtained in stock lending. On the date that the futures expire.2% per month. you will need to pay in the money and get back your shares. Then the total return is (Y . In this case.Methodology Suppose you have Rs. Conversely.5% per month. put in 50 orders (using NEAT again) to buy the entire NSE-50 portfolio.4%) over the time that the position is held. it is not profitable. If the spot–futures basis is 2. A few days later. it may be worth doing even if the spot–futures basis is somewhat wider.

this is 1098* or 1120. he puts in 50 orders. Suppose a person has Rs. he makes delivery of shares and receives Rs. sell futures 77 . 4.71% over the two–month period.1153 or 7. he puts in a market order to buy Rs.4 million of Nifty using the feature in NEAT to rapidly place 50 market orders in quick succession. On a base of Rs. The seller always suffers impact cost.400. on the entire transaction. Suppose cash can be riskless invested at 1% per month.4 or 0.9-0.Suppose the Nifty spot is 1100 and the two–month futures are trading at 1110. owing to impact cost.9%.99 million (assuming an impact cost of 2/1100).3. A moment later. he get back Rs. funds invested at 1% per month yield 2. but the difference is exactly offset by profits on the futures contract.4 million of the Nifty futures. At the end of two months. he is completely hedged.4%. Assume that the transactions costs are 0. suppose he ends up paying 1153 and not 1150. Hence the spot– futures basis (10/1100) is 0. this is Rs. A few days later. 3. which he would like to lend to the market. 6.4 million. of 1120 + 40 .4 million of the Nifty portfolio. On the expiration date of the futures.01-0. Suppose Nifty has moved up to 1150 by this time.199.40.25. Translated in terms of Nifty. Let us make this concrete using a specific sequence of trades. placing market orders to buy back his Nifty portfolio. He puts in sell orders for Rs. The order executes at 1110.01%. He has funds in hand of 1120.70. Hence the total return that can be obtained in stock lending is 2. and the futures contract pays 40 (1150-1110) so he ends up with a clean profit. 1. Suppose he lends this out at 1% per month for two months. 5. Over two months. using NEAT. Arbitrage: Overpriced futures: buy spot. This makes shares are costlier in buying back. At this point. suppose he obtains an actual execution at 1098. 2. When the market order is placed.

Arbitrage: Underpriced futures: buy futures. how can you cash in on this opportunity to earn riskless profits? Say for instance. 2. If you notice that futures on a security that you have been observing seem overpriced.1015.1025 and seem overpriced.1000. Whenever the futures price deviates substantially from its fair value. Simultaneously. The result is a riskless profit of Rs. borrow funds. sell spot 78 . ABB trades at Rs. one has to build in the transactions costs into the arbitrage strategy. As an arbitrageur. Sell the security. 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. 4. Remember however. you can make riskless profit by entering into the following set of transactions.15 on the spot position and Rs. 6. Return the borrowed funds. the spot and the futures price converge. One–month ABB futures trade at Rs.10 on the futures position. 3. On day one. This is termed as cash–and–carry arbitrage. the cost-of-carry ensures that the futures price stay in tune with the spot price. 8. sell the futures on the security at 1025. 7. In the real world. it makes sense for you to arbitrage. On the futures expiration date.10. Now unwind the position.As we discussed earlier. buy the security on the cash/spot market at 1000. Futures position expires with profit of Rs. Say the security closes at Rs. Take delivery of the security purchased and hold the security for a month. arbitrage opportunities arise. 1. 5. that exploiting an arbitrage opportunity involves trading on the spot and futures market.

because buying an option is highly leveraged transaction. 79 . Simultaneously. On day one. we will see increased volumes and lower spreads in both the cash as well as the derivatives market. The futures position expires with a profit of Rs.1000. This is termed as reverse–cash–and–carry arbitrage. Speculation in option is not very common. arbitrage opportunities arise. Major part of the market volumes come from speculation. Say the security closes at Rs.Whenever the futures price deviates substantially from its fair value. The result is a riskless profit of Rs.10 on the futures position. As more and more players in the market develop the knowledge and skills to do cash–and–carry and reverse cash–and–carry. Make delivery of the security. sell the security in the cash/spot market at 1000.975. Now unwind the position. 4. It is this arbitrage activity that ensures that the spot and futures prices stay in line with the cost–of–carry. it makes sense for you to arbitrage. As we can see. Market participants to speculate extensively use Index futures and stock futures. SPECULATIONS Speculation has a lot of risks involved. Speculator is responsible for liquidity in the market. As an arbitrageur. exploiting arbitrage involves trading on the spot market. 3. 2. 1. buy the futures on the security at 965.10. On the futures expiration date. 7. Buy back the security. Specially speculation in derivates is even more riskier as the derivatives are leveraged instruments. 965 and seem underpriced. If the returns you get by investing in riskless instruments is less than the return from the arbitrage trades. the spot and the futures price converge. How can you cash in on this opportunity to earn riskless profits? Say for instance. One–month ABB futures trade at Rs. be it cash market or the F&O segment. you can make riskless profit by entering into the following set of transactions.25 on the spot position and Rs. Index futures attract the maximum volumes in the derivatives segment. It could be the case that you notice the futures on a security you hold seem underpriced. ABB trades at Rs. 5. 6.

Methodology 80 . Buy selected liquid securities which move with the index. Once a person is LONG NIFTY using the futures market. and sell them at a later date: or. After a good budget. SPECULATION STRATEGIES WITH EXAMPLES Speculation: Bullish Index. Speculation in individual securities attracts highest risk. However. he gains if the index rises and loses if the index falls. Taking a position on the index is effortless using the index futures market. The above-discussed strategies are responsible for liquidity in the Derivatives segment hence leading to volumes in the cash segment also.Speculation in options is naked positions. index is less volatile and index movement is easy to analyze than the individual stock movements. these positions run the risk of making losses owing to company–specific news. Buy the entire index portfolio and then sell it at a later date. which are very risky. or the onset of a stable government. 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. Using index futures. a person has two choices: 1. many people feel that the index would go up. The second alternative is cumbersome and expensive in terms of transactions costs. an investor can “buy” or “sell” the entire index by trading on one single security. are individual securities are more volatile than the market index. they are not purely focused upon the index. Speculation in the market index is very common. long nifty futures Sometimes we think that the market index is going to rise and that we can make a profit by adopting a position on the index. 2. How does one implement a trading strategy to benefit from an upward movement in the index? Today. or good corporate results.

which is something like Rs. short Nifty futures Sometimes we think that the market index is going to fall and that we can make profit by adopting a position on the index. if Nifty is at 1200.240. After a bad budget.980. Hence.000.35. Sell selected liquid securities which move with the index. The Nifty July contract has risen to Rs.000. Example 1.980. 5. Nifty has risen to 967.000.When you think the index will go up. and buy them at a later date: or. 3.20. Speculation: Bearish index. 4.000. Shorter dated futures tend to be more liquid. He sells off his position at Rs.192. The choice is basically about the horizon of the investor.4000. The investor can choose any of them to implement this position.4 million.20. When the trade takes place. His profits from the position are Rs. the Nifty July contract costs Rs. or bad corporate results. 2. Futures are available at several different expirations. the investor gets a claim on the index worth Rs. buy the Nifty futures. At this time. Similarly. Longer dated futures go well with long–term forecasts about the movement of the index.960 so his position is worth Rs. How does one implement a trading strategy to benefit from a downward movement in the index? Today a person has two choices: 1.200. the investment is done in units of Rs. by paying up Rs. 81 . On 14 July 2001. 4. The minimum market lot is 200 Nifties. the investor gets a claim on Nifty worth Rs. On 1 July 2001. Hence. He buys 200 Nifties with expiration date on 31st July 2001. many people feel that the index would go down.240.000. or the onset of a coalition government. by paying an initial margin of Rs.000. a person feels the index will rise. the investor is only required to pay up the initial margin.2. 3.

000. which is something like Rs. Hence.060 so his position is worth Rs. Shorter dated futures tend to be more liquid. 2. 4. the investor is only required to pay up the initial margin. Once a person is SHORT NIFTY using the futures market. On 10 June 2001.90. Example 1.212.200. Taking a position on the index is effortless using the index futures market. Nifty has fallen to 962.000.990. This strategy is also cumbersome and expensive in terms of transactions costs. an investor can “buy” or “sell” the entire index by trading on one single security.20. if Nifty is at 1200. by paying an initial margin of Rs. The second alternative is hard to implement. he squares off his position. The investor can choose any of them to implement this position. the investor gets a claim on Nifty worth Rs. He sells 200 Nifties with a expiration date of 26th June 2001. When the trade takes place. The choice is basically about the horizon of the investor. Methodology When you think the index will go down. these positions run the risk of making losses owing to company–specific news.240.4 million. a person feels the index will fall. 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.2.000. On 1 June 2001. by paying up Rs. the investment is done in units of Rs. the Nifty June contract costs Rs. Using index futures. 5. Similarly. 3.2.20. Longer dated futures go well with long–term forecasts about the movement of the index.000.1. Futures are available at several different expirations. they are not purely focused upon the index. 82 .000. Hence. At this time.000 the investor gets a claim on the index worth Rs. sell the Nifty futures. However. The minimum market lot is 200 Nifties.240. The Nifty June contract has fallen to Rs. Sell the entire index portfolio and then buy it at a later date. he gains if the index falls and loses if the index rises.

000.14.His profits from the position work out to be Rs. Chapter 5 83 .

Applicability of Derivative Instruments APPLICABILITY OF DERIVATIVE INSTRUMENTS 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. interest rates and commodity prices have destabilizing affects on performance and corporate strategy. In many cases fluctuations in economic and financial variables such as exchange rates. 84 .

and The organization is encouraged to manage proactively rather than reactively. the benefits to be gained. and what level of Risk Management it is prudent to apply. Effective and systematic Risk Management yields the following key benefits:  Forward. Identifying threats to the company. OBJECTIVES AND BENEFITS OF RISK MANAGEMENT The key objectives of Risk Management are:      Providing a basis for informed decision making as a consequence of creating transparency in the company‟s risk situation. Clearly prioritizing risks to the company and their mitigation strategies: and Creating opportunities through improving risk mitigation capabilities. They are possibilities not included in forecast/budget and represent an upside or downside to the forecast/ budget. Balance thinking – a trade – off must be struck between the cost of managing risk. WHAT IS RISK MANAGEMENT? Risk management embraces the whole spectrum of activities and measures associated with the identification. its assets and its financial and earning potential.WHAT IS RISK? Risks are defined as internal or external causes of and reasons for deviations in actual results and forecasts/budgets. Implementing proper mechanism for the identification. responsible thinking. so the organization is prepared for what might happen and is better prepared for making decisions to improve the effectiveness and efficiency of performance.   85 . evaluation and handling of opportunities and risks. or factors that can lead to changes in the forecast. analysis and mitigation of potential risks. rigorous.

It embraces the whole spectrum of activities and measures concerned with systematic management of risks within the organization. Furthermore. organization of the company Risk Identification Identification of risks and of their sources 86 Risk Evaluation Evaluation of risks concerning their impact & probability . and ensure ongoing reporting for informed decision making.It helps to speed up the decision making process. 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. giving clear priorities to each type of activity or project requiring management attention and thus giving a clear cut advantage to the business. strategies. the risk management process must remain sufficiently flexible to accommodate new situations as they arise. The process contains four main stages:     Risk Risk Risk Risk Identification Evaluation Handling. since risks and risk structures change continuously. The overall objective of the risk management process is to optimize the risk return relationship and reject unacceptable risks. Risk Management Process Objectives. All levels of management should manage risks. The risk management process must be established as a permanent and integral part of business process if it to be fully effective. treat and monitor these risks efficiently and effectively. and Controlling Controlling the Risk Management Process means monitoring whether the management process is actively and effectively lived throughout the organization. RISK MANAGEMENT PROCESS The objective of risk management process is to identify and evaluate the key risks.

This can be interpreted as an advance payment made to take a larger position. This is determined by the exposure limit assigned to the investor. For example. Also the strict margining system followed in the futures market worldwide. Depending on the position taken an initial margin is charged on the investor. Calculating the net loss associated with a position does the calculation of MTM margin. The focus is on calculating the net loss on all contracts entered by the client. if the exposure limit is 33 times the base capital given by the investor. This is paid up each evening after trading ends.33 is required. 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). reduces the default risk associated with the futures. The MTM is made compulsory to remove any default on large losses if the position is accumulated for several days. then it means that an initial margin of 3. ADVANTAGES AND RISKS OF TRADING IN FUTURES OVER CASH 87 . the clearing corporation of the exchange by granting credit guarantee nullifies the counter party risk. The general margining system that is followed in the futures market is as follows.RISK MANAGEMENT WITH FUTURES CONTRACT As the futures are exchange-traded. More than the initial margin collected.

This can enhance the return on capital deployed. about 33% returns. so his returns are leveraged. Increase risk: The buyer of a call wants the upside risk of an asset. which is not possible in the cash segment because of rolling settlement. The biggest advantage of futures is that short selling is allowed without having stock and position can be carried for a long time. 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. in exchange for the premium."  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). Upside risk is the possibility of gain. i.just like buying fire insurance for your house. Certainty is exchanged with other players who assume the risk in hope of big gains. Alternatively. One half the reasons to use options (like other derivatives) is to reduce risk. 88  .e. One way is to buy the stock in the cash segment by paying Rs100. if any. For example. Downside risk is the possibility of loss. In this way the profit will be Rs10 on investment of Rs100. It is wrong to state that "options are risky.   RISK MANAGEMENT WITH OPTIONS Risk is concerned with the unknown. giving about 10% returns. Further futures positions are leveraged positions. you can even lose your full capital in case the price moves against your position. unlike in the cash segment where it delivery has to be taken because of rolling settlement. The seller of a put accepts the downside risk of locking in his purchase price of an asset. meaning a position can be taken for Rs100 by paying Rs25 margin and daily mark-to-market loss. but will only pay a small percentage of its current value. the expectation for a Rs100 stock is to go up by Rs10. Conversely futures can be bought and position can be carried for a long time without taking delivery. The buyer of a covered put limits his downside risk for a price . Please note that taking leveraged position is very risky.

 Buyers start out-of-pocket. because for the same amount of money. A trader might buy the option instead of shares.To understand risk. Both tactics are generally considered inappropriate for 89 . These graphs either flat line or go down on either side of the spot price. only the right to do so until the expiry date. But going forward. If the stock price decreases. he will thus realize a larger gain than if he had purchased shares. He would have no obligation to buy the stock. he will profit. look at the four standard graphs of options (put-call-buysell). This is an example of the principle of leverage. they have no upside risk. In all cases. If the stock price increases over the exercise price by more than the premium paid. the premium was a certainty. 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 will let the call contract expire worthless. Buyers/sellers of calls have unlimited upside/downside risk as the asset price increases. he can obtain a larger number of options than shares. Going forward. and only lose the amount of the premium.  The extent of risk varies. the option buyer has no downside risk. but close enough. If the stock rises. Sellers start with a gain. The graph either flat lines or goes up on either side of the spot price. The value of the options in the interim between purchase and expiration will not be exactly like these graphs. Short Call (Naked short call) A trader who believes that a stock's price will decrease can short sell the stock or instead sell a call. Payoffs and profits from a long call. Buyers/sellers of puts have upside/downside risk limited to the spot price of the asset (less the premium).

Short Put (Naked put) A trader who believes that a stock's price will increase can sell the right to sell the stock at a fixed price. The trader selling a call has an obligation to sell the stock to the call buyer at the buyer's option. However. the short will lose money.small investors. Unless a trader already owns the shares which he may be required to provide. Payoffs and profits from a short call. This trade is generally considered inappropriate for a small investor. If the stock price decreases below the exercise price by more than the premium paid. If the stock price increases over the exercise price by more than the amount of the premium. he will just let the put contract expire worthless and only lose his premium paid. If the stock price increases. If the stock price increases. He will be under no obligation to sell the stock. the short put position will make a profit in the amount of the 90 . The trader now has the obligation to purchase the stock at a fixed price. the short call position will make a profit in the amount of the premium. the potential loss is unlimited. he will profit. The trader has sold insurance to the buyer of the put requiring the trader to insure the stockholder below the fixed price. such a trader who sells a call option for those shares he already owns has sold a covered call. If the stock price decreases. but has the right to do so until the expiry date. Long Put A trader who believes that a stock's price will decrease can buy the right to sell the stock at a fixed price. Payoffs and profits from a long put.

Writing out-of-the-money covered calls is a good example of such a strategy. 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 bull call spread and the bull put spread are common examples of moderately bullish strategies. Mildly bullish trading strategies are options strategies that make money as long as the underlying stock prices do not go down on options expiration date. INTRODUCTION TO OPTIONS STRATEGIES Bullish Strategies Bullish options strategies are employed when the options trader expects the underlying stock price to move upwards. they usually cost less to employ. Payoffs and profits from a short put. the short position will lose money. In most cases.premium. Moderately bullish options traders usually set a target price for the Bull Run and utilize bull spreads to reduce risk. While maximum profit is capped for these strategies. Bearish Strategies Bearish options strategies are employed when the options trader expects the underlying stock price to move downwards. The most bullish of options trading strategies is the simple call buying strategy used by most novice options traders. It is necessary to assess how low 91 . These strategies usually provide a small downside protection as well. If the stock price decreases below the exercise price by more than the premium. stocks seldom go up by leaps and bounds.

long strangle. short strangle. stock price seldom make steep downward moves. ratio spreads. Bullish on Volatility Neutral trading strategies those are bullish on volatility profit when the underlying stock price experience big moves upwards or downwards. These strategies usually provide a small upside protection as well. 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. long condor and long butterfly. They include the long straddle. 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. The most bearish of options trading strategies is the simple put buying strategy utilized by most novice options traders. Bearish on Volatility Neutral trading strategies those are bearish on volatility profit when the underlying stock price experiences little or no movement. Neutral or Non-Directional Strategies Neutral strategies in options trading are employed when the options trader does not know whether the underlying stock price will rise or fall. the correct neutral strategy to employ depends on the expected volatility of the underlying stock price. and short condor and short butterfly. While maximum profit is capped for these strategies. they usually cost less to employ. Moderately bearish options traders usually set a target price for the expected decline and utilize bear spreads to reduce risk.the stock price can go and the timeframe in which the decline will happen in order to select the optimum trading strategy. Such strategies include the short straddle. Rather. In most cases. 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 92 . The bear call spread and the bear put spread are common examples of moderately bearish strategies.

while more complicated strategies can combine several. 'if exercised. with a strike price (pre-set. The put buyer has no obligation to sell the stock. That seller grants the buyer the right. will fall prior to expiration can buy the right to sell the stock at a fixed price. The price rises above the strike price by more than the premium. to buy at a pre-set price. must-be-bought-at-price') of $31. he is said to be selling a 'naked' call. Long Put Traders who anticipate that the future market price of an asset. Long Calls The most basic. Short ('Naked') Calls When the option seller (the 'writer') doesn't own the underlying stock he's obligated to sell (if the option is exercised). Buying a call confers the right. 93 . Since he's on the selling side of the contract. the short call position will profit by the amount of the premium. The most basic are the call and the put. MSFT (Microsoft). but not the obligation.a variety of options strategies. and takes on an obligation to fulfill the other side of the trade. say a stock. and easiest to understand. but in order to execute any of them successfully an investor new to options will need to know some elementary concepts. OPTIONS TRADING STRATEGIES There are several basic Options Trading Strategies. but simply the right. have June 31 options that expire on the third Friday of June. currently trading at $28. If the market price of the underlying asset decreases. his position is said to be 'short'. But options are sold as well as bought. Puts grant the buyer the right to sell at a pre-set price. There are several basic variations. Simple strategies usually combine only a few trades. the short position incurs a loss. is the (long) call.

he profits.) If the price falls below the strike price by more than the premium. the 'writer' loses money. 'Bear spreads'. the short put position makes a profit equal to the amount of the premium. Several basic trading strategies utilize the characteristics of these four basc positions. If the price increases. If the asset's market price rises. (Excluding any transaction costs. volume.can result in profit (or loss). 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.speculating on coming out on the plus side of the equation . These strategies are either pure profit plays . etc in combination with different expiration dates and strike prices . but make up for it by offloading some risk. Hedging involves taking positions that tend to move in opposite directions. for example. involve a short call with a low strike price and a long call with a higher strike price. the trader lets the contract 'expire worthless'.or combinations of speculation and hedging. They profit less than pure speculation. or doesn't fall enough to cover the premium. Options trading software can demonstrate several concrete examples of how any of these . LONG CALL 94 . Short Put Traders who speculate that the future market price will increase. 'Bull spreads'. can sell the right to sell an asset at a pre-determined price. such as commissions.If. Current Strategies 1. in fact. the market price does fall below the strike price (prior to expiration of the option) by more than the premium paid. by contrast. An alternative method uses a short put with low strike price and a long put with a higher strike price.under different assumptions about future prices.

46 18% Share Price 300 Share price < 260 Stock price > 274 Possible Outcomes at expiry Option worth 40. L&T is quoting at Rs 254 and the January 260 (strike price) call costs Rs 14 (premium). Sell 1Jan contract (Expiry) 2. Before moving into more complex bullish and bearish strategies. 254 Rs. Situation: On 1 November.Market View Bullish Potential Profit Unlimited Potential Loss Limited Purchasing calls has remained the most popular strategy with investors since listed options were first introduced. Cost =14.260 x 1000 units = 40. 14. 300 Option Market Buy 1 Jan 260 call at Rs 14.000 Return 186% 1-Nov 20-Jan Analysis Rises by Return Rs.000 (premium) Net profit = intrinsic value of (Break even = 260+14) option i.000) Net profit= 26. an investor should thoroughly understand the fundamentals about buying and holding call options.000. The loss is Rs.000) Your gain is: Option sale = 40. You expect the share price to rise significantly and want to profit from the increase Action: Buy 1 L&T call at 14. Closing the position now will produce a net profit of 26.000 Premium paid = (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. Net Gain 40 (300 .000 1. by whatever amount the share price exceeds 274 95 . Net outlay is Rs 14. Share Price Rs.000 Option expires worthless.e.

Recover intrinsic value of premium. 96 . an investor should thoroughly understand the fundamentals about buying and holding put options. 2. Before moving into more complex bearish strategies.000 1.000 Net profit 12. Share Price Rs. 270 Rs.Although the profit is on expiry day. Situation: An investor thinks L&T. 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.240 x 1000 = 20. He therefore decides to buy Puts to gain exposure to its anticipated fall. the investor is obviously able to sell his option at any time prior to expiry. 240 Option Market Buy 1 L&T Oct 260 put at Rs 8 Total Outlay = 8. currently trading at Rs 270.000) Effective profits Option purchase (8. 2.000) Option sale 20.000. Net gain 20 (260 . LONG PUT Market View Bearish Potential Profit Unlimited Potential Loss 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. and such sale will result in the receipt of time value in addition to any intrinsic value. Action: Buy 1 L&T October 260 Put at Rs 8 for a total consideration of Rs 8. Sell 1 Oct contract. is overvalued and may fall substantially. if the position is closed out.000 or 150% 1-Aug 20-Oct Analysis Fall of profit Rs effective 30 Share Price 240 Share price 240260 Possible Outcomes at expiry The 260 put will be trading at Rs 20 which gives a profit of Rs 12 (20-8).

3." the obligation conveyed by writing a call option contract. or "covers. and such sale will result in the receipt of time value in addition to any intrinsic value. the investor is obviously able to sell his option at any time prior to expiry. He receives an option premium equal to Rs 1. the strategy is commonly referred to as a "buy-write. 254 Option Market Sell 10 Jan 260 calls @ Rs 14 Income 1. If this stock is purchased simultaneously with writing the call con-tract." In either case. Action: The January 260 calls are trading at 14 and investor sells 10 contracts (one contract is 1.000 97 .40. the stock is generally held in the same brokerage account from which the investor writes the call.000 shares).40. Share Price 1-Nov Rs." If the shares are already held from a previous purchase. and fully collateralizes. Situation: It is 1 November and L&T share is trading at Rs 254. Although the profit is on expiry day. Short Call Naked short call / Covered short call Market View Bullish Potential Profit Limited Potential Loss Unlimited 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.000 and takes on the obligation to deliver 10000 share at 260 each if the holder exercise the option. if the position is closed out. it is commonly referred to an "overwrite.Stock price > 240 The 260 put will be trading at Rs 20 which gives a profit of Rs 12 (20-8). This strategy is the most basic and most widely used strategy combining the flexibility of listed options with stock ownership. An investor holds 10000 shares but does not expects their price to move very much over the next few months so decides to write call option against this shareholding.

a put writer will be considered "covered" if he has on deposit with his brokerage firm a cash amount (or other approved collateral) sufficient to cover such a purchase.000. Action: The Investor decides to generate some additional income on his portfolio and writes 10 NIIT 550 puts at Rs 40. Possible Outcomes at expiry 98 . possibly. a return of 7. 254 Option expire worthless Analysis No change to Effective profits shareholding Profit =1. The option expires worthless Share Price > 260 Share price < 240 4.000 (option value of premium) Possible Outcomes at expiry The holder will exercise his position and if called. Many investors write puts because they are willing to be assigned and acquire shares of the underlying stock in exchange for the premium received from the put's sale.00.40.8% over 3 months. For this discussion. Short Put Naked Short Put / Covered Short Put Market View Bearish Potential Profit Limited Potential Loss Unlimited According to the terms of a put contract.00. Situation: An investor owns 10.000. rise slightly. Thus he received premium of 4.20-Jan Rs. the investor as a writer will sell shares originally purchased for Rs 254 at 274 (260+14). In early March he feels that the share price of NIIT will either remain constant or.000 shares and also has a cash holding of around 60. a put writer is obligated to purchase an equivalent number of underlying shares at the put's strike price if assigned an exercise notice on the written contract.

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. can be executed as a "unit" in one single transaction. effectively for 51. Bull Call Spread Market View Bullish Potential Profit Limited Potential Loss Limited Establishing a bull call spread involves the purchase of a call option on a particular underlying stock. not as separate buy and sell transactions. the share price of L&T is 204. this strategy requires a substantial investment.00. The put option will be exercised and the stock will have to be purchased. same expiration month. while simultaneously writing a call option on the same underlying stock with the same expiration month. as any spread.4. Initial income remains as profit. Maximum profit is 12 (220-200-8). at a higher strike price. This spread is sometimes more broadly categorized as a "vertical spread": a family of spreads involving options of the same stock.00. In relation to the Indian markets.Share Price =/ > 550 Share price < 550 The investor's expectation is correct and the put will expire without being exercised. The bull call spread. but different strike prices.000).e Rs 8 99 . Break even is Rs 208 (200+8). Possible Outcomes at expiry Share Price < 200 Both the 200 and 220 calls are worthless and the maximum loss is equal to the net cost of establishing the spread i.00. Situation: On 1 November. Both the buy and the sell sides of this spread are opening transactions.000. They can be created with either all calls or all puts. 5. The net outflow in this situation is: Future Margin – Option Premium. and be bullish or bearish.000 (55. and are always the same number of contracts.

but with a lower strike price. They can be created with either all calls or all puts. Advantages Position established for less cost than a long call and breaks even more quickly. and be bullish or bearish. Expectation: This strategy is appropriate when anticipating a fall in the price of the underlying share. Maximum profit is therefore realized at 220. while simultaneously writing a put option on the same underlying stock with the same expiration month.e. it is possible to exercise the long position and acquire stock in order to satisfy the short position. can be executed as a "package" in one single transaction. 6. difference in intrinsic value of two calls less than net debit (20-8). as any spread. Both the buy and the sell sides of this spread are opening transactions. Note: the long call position always covers the risk on the short call position. This spread is sometimes more broadly categorized as a "vertical spread": a family of spreads involving options of the same stock. but different strike prices.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. The bear put spread. Limited loss. not as separate buy and sell transactions. if the short option is exercised against you. Stock price > The position can be closed for a maximum profit 220 of Rs 12 above 220 i. Eg.Share price 200. and are always the same number of contracts. same expiration month. the point just before which the 220 calls may be exercised. Bear Put Spread Market View Bullish Potential Profit Limited Potential Loss Limited Establishing a bear put spread involves the purchase of a put option on a particular underlying stock. 100 .

Possible Outcomes at expiry Both puts are worthless and the maximum loss is equal to the net cost of establishing the spread i.Situation: The share of Tata Tea is trading at 228. 101 . The potential loss is limited to the initial investment. The maximum potential profit of Rs 11 is realized just before the level at which the 220 put may be exercised by the holder The position can be closed for the difference in the intrinsic value of two puts. 240 put. a neutral bias). and underlying. 7.e Rs 9 The position can be closed out for the intrinsic value of the Rs. so the profit is 11 (240-220-9) Share Price > 240 Share price 240-220 Stock price 220 Stock price < 220 Advantages Position established for less cost than a long put and breaks even more quickly. Expectation: Purchasing a straddle is appropriate when anticipating significant volatility in the underlying but when uncertain about direction. Maximum profit is Rs 11 and maximum loss Rs 9.. Limited loss. the long straddle is an excellent strategy.e. The potential profit is unlimited as the stock moves up or down. You buy 1 Tata Tea Oct 240 put at Rs 16 and sell 1 Tata 220 put at Rs 7. Long Straddle Market View Mixed Potential Profit Unlimited Potential Loss Limited For aggressive investors who expect short-term volatility yet have no bias up or down (i. expiration. This position involves buying both a put and a call with the same strike price.

This strategy involves selling a put and a call with the same strike price. once the direction of the underlying becomes clear the other 'leg' is closed which effectively reduces the break even. Upside breakeven = 290 (Exercise price 260 + net credit 30) 102 . expiration. loss potential is limited.Situation: Buy 1 L&T Apr 260 call at Rs 21 and Buy 1 L&T Apr 260 Put at Rs 9. maximum loss Rs 30. and underlying. Short Straddle Market View Mixed Potential Profit Unlimited Potential Loss Unlimited For aggressive investors who don't expect much short-term volatility. In this case. sell 1 L&T April 260 put at Rs 9. Expectation: Generally undertaken with a view that the underlying share price will trade between break even points.30 net debit) Profit is unlimited. however. in this example. the short straddle can be a risky. the underlying share. Normally. but profitable strategy. The potential loss is unlimited as the market moves up or down. Possible Outcomes at expiry Share Price < The call expires worthless and profit is equal to 260 the intrinsic valued of the 260 put less the premium paid Share price > Profit is equal to the intrinsic value of the 260 260 Premium less the paid Although profit opportunities are unlimited below Rs 230 and above Rs 290. Action: Sell 1 L&T April 260 call at Rs21. 8. has to move 11% before the strategy breaks even. Maximum Loss limited to the premium paid. Advantages Profit potential open ended in either direction. the profit is limited to the initial credit received by selling options. Upside breakeven = 290 (Exercise price 260 + net debit 30) Downside breakeven = 230 (260 .

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. of course. at Rs 290 or alternatively take delivery of stock at Rs 230. Share Price 260 The risk is. if the investor felt that there was a possibility of a sharp downward movement the 240 puts could be purchased to protect downside. Possible Outcomes at expiry Maximum profit potential is realized as both calls and put are worthless. The potential loss is limited to the initial investment while the potential profit is unlimited as the market moves up or down. Nevertheless. to prevent such exposures a stop loss facility could be implemented. maximum loss unlimited. In the example above. Alternatively.Long Strangle Market View Mixed Potential Profit Unlimited Potential Loss Limited For aggressive investors who expect short-term volatility yet have no bias up or down (i. Secure known purchase and sale price.e. in this example. a neutral bias). Advantages Generation of earnings from premium received. Conversely a sharp upward movement could be protected by buying the 280 calls.Downside breakeven = 230 (260 . 9. This strategy typically involves buying out-of-the-money calls and puts with the same expiration and underlying.. 103 . the long strangle is another excellent strategy. Normally a stop loss would only be implemented on one side leaving the other exposed.30 net credit) Maximum profit is 30. the short straddle is particularly appropriate when taking the view that the underlying will trade in the range between the breakeven points and when prepared to deliver stock. that if the underlying does prove to be volatile.

the short strangle can be a risky. Share Price > 260 Share price 240-260 Stock price < 240 Advantages Profit potential open ended in either direction. Upside breakeven = 282 (Exercise price 260 + net debit 22) Downside breakeven = 218 (240 . but profitable strategy.Situation: The share of L&T is currently standing at 247. The profit is limited to the credit received by selling options. Loss limited to total premium paid. Profit potential unlimited. 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. Maximum loss of 22 premium paid. This strategy typically involves selling out-of the-money puts and calls with the same expiration and underlying. 10. Buy 1 L&T Oct 260 call at Rs 12. The potential loss is unlimited as the market moves up or down. buy 1 Oct 240 put at Rs10. 104 . Upside breakeven = 282 (Exercise price 260 + net debit 22) Downside breakeven = 218 (240 .22 net debit) Possible Outcomes at expiry Profit from the call is equal to its intrinsic value less the premium paid Both call and put are out of money.Short Strangle Market View Mixed Potential Profit Limited Potential Loss Unlimited For aggressive investors who don't expect much short-term volatility.22 net debit) Your maximum profit is Rs 22 and loss is unlimited.

This is called "buying a butterfly. 11." The opposite would be to sell the butterfly. When investors expect stable prices. sell two Jan 240 calls at Rs. 40. which must be all calls or all puts. and buy one Jan 260 call at 25. 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. You buy one Jan 220 call at Rs. Disadvantages Loss is unlimited In the Indian Markets. limited reward strategies. Situation: L&T shares are currently trading at 240. (260+22).Butterfly Market View Mixed Potential Profit Limited Potential Loss Unlimited Ideal for investors who prefer limited risk. Both the call and put would expire worthless. 30. The seller takes delivery of the stock at 218. Advantages Generation of earnings from premium received. Secure know sale and purchase prices. must also have the same expiration and underlying. The 22 credit is retained The put is exercised. they can buy the butterfly by selling two options at the middle strike and buying one option at the higher and lower strikes.Share Price > 260 Share price 240-260 Stock price < 240 Possible Outcomes at expiry The call is exercisec by the holder and the seller delivers stock at 282. Upside breakeven = 255 Downside breakeven = 225 105 . The options.

purchasing a protective put and writing a covered call on that stock.e. Expectation: An investor will employ this strategy after accruing unrealized profits from the underlying shares.Collar A collar can be established by holding shares of an underlying stock. At the same time. Generally.240 in may and would like a way to protect your downside with little or no cost. The loss is Rs.The maximum profit is 240-220-5 = Rs. and wants to protect these gains with the purchase of a protective put. covered in this case by the underlying stock Situation: Suppose you purchased 100 shares of L&T ltd.5 Maximum profit: When share is at 260. the put and the call are both out of-the-money when this combination is established. one collar equals one long put and one written call along with owning 100 shares of the underlying stock. The option portions of this strategy are referred to as a combination. Both the buy and the sell sides of this combination are opening transactions.15 Disadvantages Stock price < The loss is Rs. and are always the same number of contracts. 220 Requires big margin to execute this strategy. 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. The net profit would be 240-220-5 = Rs. net debit Advant ages Potential loss is limited Share Price @220 106 . 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. Possible Outcomes at expiry The profit from the put offsets the loss from the stock. 12. and have the same expiration month.5 i. at Rs.5 i.e. Maximum loss: When the share is at or below 220. net debit Can be difficult to execute such strategies quickly.15 Possible Outcomes at expiry Share Price > 260 Stock price 240 The maximum profit would be at this level. In other words.

5 (initial debit) Share Price <220 107 . Maximum profit: When the stock price is between 240 & 260 Maximum loss: When the stock price is above 280 or below 220 Possible Outcomes at expiry The loss would be of Rs. Expectation: The long condor can be a great strategy to use when your feeling on a stock is generally neutral because it's been trading in a narrow range. Situation: Imagine that L&T ltd. 240 and has been relatively flat for some time. there is an upper break even and a lower break even. A profit is made if the stock remains above the lower break even point or below the upper break even point. an investor will potentially be able to double the credit obtained over a single spread position. limited reward strategy that profits in stagnant markets.Stock price @240 Stock price @260 The profit would be equal to the net inflow i. is trading at Rs. the condor is a limited risk. 13. Advantages 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. Like the butterfly.e. If you think the situation is unlikely to change. Since there are two spreads involved in the strategy (four options). an investor will combine a Bear-Call Credit Spread and a Bull-Put Credit Spread on the same underlying security. 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. By doing this. In the Iron Condor. Disadvantages The primary concern in employing a collar is protection of profits accrued from underlying shares rather than increasing returns on the upside. Rs. Condor Spread The Condor Spread strategy is a neutral strategy similar to the Butterfly.5 The profit on the stock is exactly offset by the loss on the call option that was sold.

might be cost prohibitive to trade iron condors that are low net credits. Jun 280 call @ Rs.288 and the May 280 Call is available @ Rs. Calendar Spread Calendar spreads take advantage of the different rates at which time value erodes.15 The loss would be Rs.30. Losses are limited if the stock goes against you one way or the other. Situation: On 1 May the shares of L&T ltd. Buy 1 L&T Ltd. 6 Possible Outcomes at expiry 108 . Disadvantages: Commission costs to open the position are higher since there are four trades.24.24 and the Jun Call is available @ Rs. The more rapid erosion in the near month series works to the advantage of the writer and the strategy is therefore particularly appropriate when the near month series is overpriced.Stock price 240-260 Stock price>260 The profit would be equal to 20-5= Rs. 14. Net debit is Rs. Since the time value element of an option‟s premium erodes faster in the near month series than the far month series. 30 Action: Sell 1 L&T Ltd. are trading at Rs. 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. 5 (initial debit) Advantages: The double credit achieved helps lower the potential risk. 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. a spread opens up between the two. May 280 call @ Rs. Calls are used when market view is moderately bullish and puts are used when market view is moderately bearish.

This is generally known as a reverse calendar spread. Advantages Limited loss. Alternatively. initial debit. Both calls will have intrinsic value. The May 280 call expires worthless but the Jun 280 call will have 1 month time value remaining. Disadvantages Limited profit. Position may be disrupted by early exercise. Maximum profit potential is realized. 109 .Share Price <280 Stock price @280 Stock price >280 The May 280 call expires worthless leaving the position long 1 Jun 280 call at a reduced cost of 6. i. but the true 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. if the May calls were purchased and the Jun calls sold then the risks and rewards would be reversed.e.

Chapter 6 110 .

Achievements in Future and Options Segment ACHIEVEMENTS IN FUTURE AND OPTIONS SEGMENT 111 .

112 .

COMPARATIVE ANALYSIS OF F&O SEGMENT AND CASH SEGMENT 113 .

TOP 5 TRADED SYMBOL IN THE FUTURES SEGMENT FOR THE MONTH OF MAY 2008 114 .

TOP 5 TRADED SYMBOL IN THE OPTIONS SEGMENT FOR THE MONTH OF MAY 2008 115 .

116 .

Chapter 7 Conclusion CONCLUSION 117 .

Most of the people keep them away from bad times that lead to low liquidity in the markets.e. 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. Forwards and Option strategies. By studying and applying various Derivative Instruments like Futures. 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. I came to a conclusion that these instruments are the best ones to turn the bad time into a good one i.The Indian stock market witnesses both the good as well as the bad time. to earn profits in any market direction. Therefore. Derivative Instruments are a very good tool that will help us to minimize our risk and maximize our returns so that one can have conviction in his portfolio in the hugely volatile stock market Finally. Derivatives Instruments are the tools to be with. 118 .

Chapter 8 Suggestions and Recommendations SUGGESTIONS AND RECOMMENDATIONS 119 .

120 .

Chapter 9 The Reference Materials THE REFERENCE MATERIALS GLOSSARY 121 .

created as the result of a special event such as stock split or a stock dividend. AT PRICE: When you enter a prospective trade into a trade parameter. BEAR. It is the price at which the program expects you can actually execute the trade. very close to) the current price of the underlying. Assignments are made on a random basis by the Stock Exchange Clearing. e.g. taking into account "slippage" and the current Bid/Ask. Also called FAR MONTH. BACK MONTH: A back month contract is any exchange-traded derivatives contract for a future period beyond the front month contract. BINOMIAL PRICING MODEL: Methodology employed in some option pricing models which assumes that the price of the underlying can either rise or fall by 122 .ADJUSTED STRIKE PRICE: Strike price of an option. Pr) is automatically computed and displayed. if available. AT-THE-MONEY (ATM): An at-the-money option is one whose strike price is equal to (or. in practice. The adjusted strike price can differ from the regular intervals prescribed for strike prices. ASSIGNMENT: Notification by Stock Exchange Clearing to a clearing member and the writer of an option that an owner of the option has exercised the option and that the terms of settlement must be met. Such views are often described as bearish. AMERICAN STYLE OPTION: A call or put option contract that can be exercised at any time before the expiration of the contract. AVERAGING DOWN: Buying more of a stock or an option at a lower price than the original purchase so as to reduce the average cost. the "At Price" (At. The writer of a call option is obligated to sell the underlying asset at the strike price of the call option. ARBITRAGE: A trading technique that involves the simultaneous purchase and sale of identical assets or of equivalent assets in two different markets with the intent of profiting by the price discrepancy. the writer of a put option is obligated to buy the underlying at the strike price of the put option. believes that the price will fall. BEARISH: A bear is someone with a pessimistic view on a market or particular asset.

(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). CASH SETTLEMENT: The process by which the terms of an option contract are fulfilled through the payment or receipt in Rupees of the amount by which the option is in-the-money as opposed to delivering or receiving the underlying stock. BREAK-EVEN POINT: A stock price at option expiration at which an option strategy results in neither a profit or a loss.a certain amount at each pre-determined interval until expiration For more information. In most cases. 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. A request for cancel can be made at anytime before execution. BULL. effectively canceling out the position. CARRYING COST: The interest expense on money borrowed to finance a stock or option position. dividends. Collateral (or margin) is required on investments with open-ended loss potential such as writing naked options. CLOSING TRANSACTION: To sell a previously purchased position or to buy back a previously purchased position. see COX-ROSS-RUBINSTEIN model. strike price. 123 . and volatiity. a limit order can be canceled at any time as long as it has not been executed. BULLISH: A bull is someone with an optimistic view on a market or particular CANCELED ORDER: A buy or sell order that is canceled before it has been executed. In other words. 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. this is a synthetic long stock position at one strike price and a synthetic short stock position at another strike price. interest rates. time of expiration. BLACK-SCHOLES PRICING MODEL: A formula used to compute the theoretical value of European-style call and put options from the following inputs: stock price. It was invented by Fischer Black and Myron Scholes.

DISCOUNT: An adjective used to describe an option that is trading below its intrinsic value. DAY TRADE: A position that is opened and closed on the same day. It is automatically cancelled on the close of the session if it is not executed. COMMODITY: A raw material or primary product used in manufacturing or industrial processing or consumed in its natural form. DAY ORDER: An order to purchase or sell a security. or any other security. In futures options the contract size is one futures contract. It is either the cost of funds to finance the purchase (real cost). EARLY EXERCISE: A feature of American-style options that allows the owner to exercise an option at any time prior to its expiration date. 124 . DYNAMIC HEDGING: A short-term trading strategy generally using futures contracts to replicate some of the characteristics of option contracts. DEBIT: The amount you pay for placing a trade. In stock options the standard contract size is 100 shares of stock. that is good for just the trading session on which it is given. options. DIRECTIONAL TRADE: A trade designed to take advantage of an expected movement in price. COST OF CARRY: This is the interest cost of holding an asset for a period of time. or the loss of income because funds are diverted from one investment to another (opportunity cost). In the case of currency options it varies. A net outflow of cash from your account as the result of a trade. usually at a specified price. CONTRACT SIZE: The number of units of an underlying specified in a contract. In index options the contract size is an amount of cash equal to parity times the multiplier. The strategy takes into account the replicated option's delta and often requires adjusting.COMMISSION: This is the charge paid to a broker for transacting the purchase or the sale of stock.

within certain limits.EQUITY OPTION: An option on shares of an individual common stock. EXCHANGE TRADED: The generic term used to describe futures. and sometimes unique. FILL: When an order has been completely executed. the terms of the options. FLEXIBLE EXCHANGE OPTIONS (FLEX): Customized equity and equity index options. On the ex-dividend date. EXOTIC OPTIONS: Various over-the-counter options whose terms are very specific. 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 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. expiration date. the FOK order cannot be used as part of a GTC order. EXERCISE: The act by which the holder of an option takes up his rights to buy or sell the underlying at the strike price. except it is "killed" immediately if it cannot be completely executed as soon as it is announced. Similar to an all-or-none (AON) order. Also known as a stock option. options and other derivative instruments that are traded on an organized exchange. it is described as filled. Unlike an AON order. Examples include Bermuda options (somewhere between American and European type. FILL OR KILL (FOK) ORDER: This means do it now if the option (or stock) is available in the crowd or from the specialist. such as exrcise price. this option can be exercised only on certain dates) and look-back options (whose strike price is set at the option's expiration date and varies depending on the level reached by the underlying security). The user can specify. EX-DIVIDEND DATE: The day before which an investor must have purchased the stock in order to receive the dividend. 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. otherwise kill the order altogether. EUROPEAN STYLE OPTION: An option that can only be exercised on the expiration date of the contract. exercise type. and settlement 125 .

one of the advantages of being a floor trader is that the haircut is less than margin requirements for public customers. This is usually due to a low volume of transactions and/or a small number of participants. 126 . FRONT MONTH: The first month of those listed by an exchange . GUTS: The purchase (or sale) of both an in-the-money call and in-the-money put. the term guts refer to the in-the-money strangle. Through these adjustments. HAIRCUT: Similar to margin required of public customers this term refers to the equity required of floor traders on equity option exchanges. HEDGE: A position established with the specific intent of protecting an existing position. A box spread can be viewed as the combination of an in-the-money strangle and an out-of-the-money strangle. Generally. FOLLOW-UP ACTION: Term used to describe the trades an investor makes subsequent to implementing a strategy. Also known as the NEAR MONTH.this is usually the most actively traded contract. which makes FLEX an institutional product. FRONTRUNNING: An illegal securities transaction based on prior nonpublic knowledge of a forthcoming transaction that will affect the price of a stock. IMMEDIATE-OR-CANCEL (IOC) ORDER: An option order that gives the trading floor an opportunity to partially or totally execute an order with any remaining balance immediately cancelled. Can only be traded in a minimum size. the investor transforms one strategy into a different one in response to price changes in the underlying. Example: an owner of common stock buys a put option to hedge against a possible stock price decline. but liquidity will move from this to the second month contract as the front month nears expiration.calculation. ILLIQUID: An illiquid market is one that cannot be easily traded without even relatively small orders tending to have a disproportionate impact on prices. See box spread and strangle. To differentiate between these two strangles.

To buy on margin refers to borrowing part of the purchase price of a security from a brokerage firm. Instead of utilizing a "spread order" to insure that both the written and the purchased options are filled simultaneously. also known as long-dated options. INDEX OPTION: An option that has an index as the underlying. equity LEAPS have two series at any time. MARKET BASKET: A group of common stocks whose price movement is expected to closely correlate with an index. always with January expirations. LEVERAGE: A means of increasing return or worth without increasing investment. These are usually cash-settled. an investor gambles a better deal can be obtained on the price of the spread by implementing it as two separate orders. 127 . Option contracts are leveraged as they provide the prospect of a high return with little investment. The BSE SENSEX / S&P CNX NSE NIFTY. the amount by which it is in-the-money).INDEX: The compilation of stocks and their prices into a single number.. Some indexes also have LEAPs. E. Using borrowed funds to increase one's investment return. 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. for example buying stocks on margin. MARGIN: The minimum equity required to support an investment position. INTRINSIC VALUE: Amount of any favorable difference between the strike price of an option and the current price of the underlying (i. or greater than the price of the underlying for a put option. the option has an intrinsic value greater than zero. LEAPS: Long-term Equity Anticipation Securities. Only about 10% of equities have LEAPs.e. LEGGING: Term used to describe a risky method of implementing or closing out a spread strategy one side ("leg") at a time. MARK TO MARKET: The revaluation of a position at its current market price. In other words. Currently.g. The intrinsic value of an out-of-the-money option is zero. Calls and puts with expiration as long as 2-5 years.

OCC issues and guarantees all option contracts. 128 . or the strike price of a put is less than the price of the underlying. OPTIONS CLEARING CORPORATION (OCC): A corporation owned by the exchanges that trade listed stock options.MARKET MAKER: A trader or institution that plays a leading role in a market by being prepared to quote a two way price (Bid and Ask) on request . ONE-CANCELS-THE-OTHER (OCO) ORDER: Type of order which treats two or more option orders as a package. OCC is an intermediary between option buyers and sellers. whereby the execution of any one of the orders causes all the orders to be reduced by the same amount. OPTION CHAIN: A list of the options available for a given underlying. An out-of-the-money option has no intrinsic value. Can be placed as a day or GTC order. The loss potential of naked strategies can be virtually unlimited. NEUTRAL: An adjective describing the belief that a stock or the market in general will neither rise nor decline significantly.during normal market hours.the volatility estimate. OUT-OF-THE-MONEY (OTM): An out-of-the-money option is one whose strike price is unfavorable in comparison to the current price of the underlying. NET MARGIN REQUIREMENT: The equity required in a margin account to support an option position after deducting the premium received from sold options. only time value. because theoretical value depends on one subjective input . OVERVALUED: An adjective used to describe an option that is trading at a price higher that its theoretical value. 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.or constantly in the case of some screen based markets . It must be remembered that this is a subjective evaluation. This means when the strike price of a call is greater than the price of the underlying.

and profit from moment to moment price movements. ROLLOVER: Moving a position from one expiration date to another further into the future. See mark-to-market. such as biotechnology or small capitalization stocks. SECTOR INDICES: Indices that measure the performance of a narrow market segment. REALIZED GAINS AND LOSSES: The profit or losses received or paid when a closing transaction is made and matched together with an opening transaction. This is accomplished by a simultaneous sale of one and purchase of the other. As the front month approaches expiration. margin requirements. When an option is trading at its intrinsic value. It is computed by dividing the 4-day average of total put VOLUME by the 4-day average of total call VOLUME.PARITY: An adjective used to describe the difference between the stock price and the strike price of an in-the-money option. sell on the ask price. and for other purposes. it is said to be trading at parity. This is a fixed price per unit and is specified in the option contract. This price is established by The Options Clearing Corporation and is used to determine changes in account equity. STRIKE PRICE: The price at which the holder of an option has the right to buy or sell the underlying. PUT/CALL RATIO: This ratio is used by many as a leading indicator. 129 . The SEC is the United States federal government agency that regulates the securities industry. Also known as striking price or exercise price. traders wishing to maintain their positions will often move them to the next contract month. SEC: The Securities and Exchange Commission. Risk is limited by the very short time duration (usually 10 seconds to 3 minutes) of maintaining any one position. SCALPER: A trader on the floor of an exchange who hopes to buy on the bid price. SETTLEMENT PRICE: The official price at the end of a trading session. RATIO CALENDAR COMBINATION: A term used loosely to describe any variation on an investment strategy that involves both puts and calls in unequal quantities and at least two different strike prices and two different expirations.

and short selling volume. and margin interest. trading volume. Once the position is closed.SYNTHETIC: A strategy that uses options to mimic the underlying asset. the relation of advancing issues to declining issues. and can also be dependent on the current price of the security. including brokerage commissions. UNCOVERED: A short option position that is not fully collateralized if notification of assignment is received. The long synthetic combines a long call and a short put to mimic a long position in the underlying. in a given period of time. Both long and short synthetics are strategies in the Trade Finder. fees for exercise and/or assignment. This varies by security. Volatility is not equivalent to BETA. TIME DECAY: Term used to describe how the theoretical value of an option "erodes" or reduces with the passage of time. Assets with greater volatility exhibit wider price swings and their options are higher in price than less volatile assets. In both cases. or is expected to fluctuate. it becomes a realized gain or loss. TRADING PIT: A specific location on the trading floor of an exchange designated for the trading of a specific option class or stock. The short synthetic combines a short call and a long put to mimic a short position in the underlying. VOLATILITY: Volatility is a measure of the amount by which an asset has fluctuated. VOLATILITY TRADE: A trade designed to take advantage of an expected change in volatility. both the call and put have the same strike price. TECHNICAL ANALYSIS: Method of predicting future price movements based on historical market data such as (among others) the prices themselves. and are on the same underlying. 130 . TRANSACTION COSTS: All charges associated with executing a trade and maintaining a position. Time decay is quantified by Theta. UNREALIZED GAIN OR LOSS: The difference between the original cost of an open position and its current market price. the same expiration. open interest. See also NAKED. TICK: The smallest unit price change allowed in trading a specific security.

Published by Printice Hall of India. The Internal Revenue Service prohibits wash sales since no change in ownership takes place. Published by Oxford University Press. the value of which decreases over time if there is no price fluctuation in the underlying asset. Dubofsky and Thomas W. BIBLIOGRAPHY Books:  Derivatives: Valuation and Risk Management By David A. WASTING ASSET: An investment with a finite life.  131 . Miller. Financial Engineering: A Complete Guide to Financial Innovation By John F.. JR. Marshall and Vipul K.WASH SALE: When an investor repurchases an asset within 30 days of the sale date and reports the original sale as a tax loss. Bansal.

in www.moneycontrol.sebi.gov.com www.com www.investors.com 132 .Newspapers:  The Times of India The Economic Times Internet:        www.com www.economictimes.nseindia.com www.investopedia.com www.bseindia.

133 .

TOP 5 TRADED SYMBOL IN THE OPTIONS SEGMENT FOR THE MONTH OF MAY 2008 134 .

135 .

Chapter 7 Conclusio n 136 .

Most of the people keep them away from bad times that lead to low liquidity in the markets. the objective of the study is accomplished and I recommend that one should use the Derivative Instruments. By studying and applying various Derivative Instruments like Futures. Derivatives Instruments are the tools to be with. Forwards and Option strategies. 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. I came to a conclusion that these instruments are the best ones to turn the bad time into a good one i. 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 Finally. 137 . as it is very much applicable in the Indian Stock Market.CONCLUSION The Indian stock market witnesses both the good as well as the bad time.e. to earn profits in any market direction. Therefore.

Chapter 8 138 .

Suggestions and Recommend ations 139 .

SUGGESTIONS AND RECOMMENDATIONS 140 .

Chapter 9 141 .

The Reference Materials THE REFERENCE MATERIALS 142 .

The adjusted strike price can differ from the regular intervals prescribed for strike prices.GLOSSARY ADJUSTED STRIKE PRICE: Strike price of an option. 143 . It is the price at which the program expects you can actually execute the trade. Pr) is automatically computed and displayed. very close to) the current price of the underlying. Also called FAR MONTH. taking into account "slippage" and the current Bid/Ask. Assignments are made on a random basis by the Stock Exchange Clearing. if available. AVERAGING DOWN: Buying more of a stock or an option at a lower price than the original purchase so as to reduce the average cost. AT PRICE: When you enter a prospective trade into a trade parameter. AT-THE-MONEY (ATM): An at-the-money option is one whose strike price is equal to (or. BACK MONTH: A back month contract is any exchange-traded derivatives contract for a future period beyond the front month contract. ASSIGNMENT: Notification by Stock Exchange Clearing to a clearing member and the writer of an option that an owner of the option has exercised the option and that the terms of settlement must be met. the "At Price" (At. AMERICAN STYLE OPTION: A call or put option contract that can be exercised at any time before the expiration of the contract. created as the result of a special event such as stock split or a stock dividend. The writer of a call option is obligated to sell the underlying asset at the strike price of the call option. the writer of a put option is obligated to buy the underlying at the strike price of the put option. ARBITRAGE: A trading technique that involves the simultaneous purchase and sale of identical assets or of equivalent assets in two different markets with the intent of profiting by the price discrepancy. in practice.

In other words. 144 . dividends.BEAR. see COX-ROSS-RUBINSTEIN model. 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. and volatiity. CARRYING COST: The interest expense on money borrowed to finance a stock or option position. BLACK-SCHOLES PRICING MODEL: A formula used to compute the theoretical value of European-style call and put options from the following inputs: stock price. A request for cancel can be made at anytime before execution. (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). believes that the price will fall. strike price. BEARISH: A bear is someone with a pessimistic view on a market or particular asset. interest rates. 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. BULL. BULLISH: A bull is someone with an optimistic view on a market or particular CANCELED ORDER: A buy or sell order that is canceled before it has been executed.g. Such views are often described as bearish. a limit order can be canceled at any time as long as it has not been executed. e. this is a synthetic long stock position at one strike price and a synthetic short stock position at another strike price. time of expiration. BREAK-EVEN POINT: A stock price at option expiration at which an option strategy results in neither a profit or a loss. In most cases. It was invented by Fischer Black and Myron Scholes.

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. 145 . CLOSING TRANSACTION: To sell a previously purchased position or to buy back a previously purchased position. In index options the contract size is an amount of cash equal to parity times the multiplier. or any other security. that is good for just the trading session on which it is given. In futures options the contract size is one futures contract. In the case of currency options it varies. COMMODITY: A raw material or primary product used in manufacturing or industrial processing or consumed in its natural form. It is automatically cancelled on the close of the session if it is not executed. CONTRACT SIZE: The number of units of an underlying specified in a contract. It is either the cost of funds to finance the purchase (real cost). Collateral (or margin) is required on investments with openended loss potential such as writing naked options.CASH SETTLEMENT: The process by which the terms of an option contract are fulfilled through the payment or receipt in Rupees of the amount by which the option is in-the-money as opposed to delivering or receiving the underlying stock. COST OF CARRY: This is the interest cost of holding an asset for a period of time. options. effectively canceling out the position. usually at a specified price. In stock options the standard contract size is 100 shares of stock. 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. COMMISSION: This is the charge paid to a broker for transacting the purchase or the sale of stock. DAY ORDER: An order to purchase or sell a security.

EX-DIVIDEND DATE: The day before which an investor must have purchased the stock in order to receive the dividend. Also known as a stock option. 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. options and other derivative instruments that are traded on an organized exchange. DISCOUNT: An adjective used to describe an option that is trading below its intrinsic value. EXERCISE: The act by which the holder of an option takes up his rights to buy or sell the underlying at the strike price. EQUITY OPTION: An option on shares of an individual common stock. DYNAMIC HEDGING: A short-term trading strategy generally using futures contracts to replicate some of the characteristics of option contracts. 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. On the ex-dividend date.DEBIT: The amount you pay for placing a trade. EUROPEAN STYLE OPTION: An option that can only be exercised on the expiration date of the contract. The demand by the 146 . EARLY EXERCISE: A feature of American-style options that allows the owner to exercise an option at any time prior to its expiration date. EXCHANGE TRADED: The generic term used to describe futures. The strategy takes into account the replicated option's delta and often requires adjusting. A net outflow of cash from your account as the result of a trade. DIRECTIONAL TRADE: A trade designed to take advantage of an expected movement in price.

The user can specify. otherwise kill the order altogether. but liquidity will move from this to the second month contract as the front month nears expiration. Unlike an AON order. within certain limits. FRONT MONTH: The first month of those listed by an exchange . it is described as filled. EXOTIC OPTIONS: Various over-the-counter options whose terms are very specific. except it is "killed" immediately if it cannot be completely executed as soon as it is announced. Examples include Bermuda options (somewhere between American and European type. and settlement calculation. Similar to an all-or-none (AON) order. FILL: When an order has been completely executed. and sometimes unique. expiration date. the FOK order cannot be used as part of a GTC order. the investor transforms one strategy into a different one in response to price changes in the underlying. this option can be exercised only on certain dates) and look-back options (whose strike price is set at the option's expiration date and varies depending on the level reached by the underlying security). Also known as the NEAR MONTH.this is usually the most actively traded contract. which makes FLEX an institutional product. exercise type. FRONTRUNNING: An illegal securities transaction based on prior nonpublic knowledge of a forthcoming transaction that will affect the price of a stock. FOLLOW-UP ACTION: Term used to describe the trades an investor makes subsequent to implementing a strategy. 147 . FLEXIBLE EXCHANGE OPTIONS (FLEX): Customized equity and equity index options. FILL OR KILL (FOK) ORDER: This means do it now if the option (or stock) is available in the crowd or from the specialist. such as exrcise price. Can only be traded in a minimum size.owner of a put option contract that the number of units of the underlying asset specified be bought from him at the specified price. the terms of the options. Through these adjustments.

These are usually cash-settled. To differentiate between these two strangles. IMMEDIATE-OR-CANCEL (IOC) ORDER: An option order that gives the trading floor an opportunity to partially or totally execute an order with any remaining balance immediately cancelled. HAIRCUT: Similar to margin required of public customers this term refers to the equity required of floor traders on equity option exchanges. INDEX OPTION: An option that has an index as the underlying. The BSE SENSEX / S&P CNX NSE NIFTY.g.GUTS: The purchase (or sale) of both an in-the-money call and in-the-money put. ILLIQUID: An illiquid market is one that cannot be easily traded without even relatively small orders tending to have a disproportionate impact on prices. HEDGE: A position established with the specific intent of protecting an existing position. This is usually due to a low volume of transactions and/or a small number of participants. Example: an owner of common stock buys a put option to hedge against a possible stock price decline. one of the advantages of being a floor trader is that the haircut is less than margin requirements for public customers. the option has an intrinsic value greater than zero. the term guts refer to the in-the-money strangle. 148 . In other words. 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. Generally. A box spread can be viewed as the combination of an in-the-money strangle and an out-of-the-money strangle. E. INDEX: The compilation of stocks and their prices into a single number. See box spread and strangle. or greater than the price of the underlying for a put option.

Calls and puts with expiration as long as 2-5 years. Currently. 149 . To buy on margin refers to borrowing part of the purchase price of a security from a brokerage firm. an investor gambles a better deal can be obtained on the price of the spread by implementing it as two separate orders.or constantly in the case of some screen based markets . LEAPS: Long-term Equity Anticipation Securities. MARK TO MARKET: The revaluation of a position at its current market price. The intrinsic value of an out-of-the-money option is zero. LEVERAGE: A means of increasing return or worth without increasing investment. MARKET BASKET: A group of common stocks whose price movement is expected to closely correlate with an index.. the amount by which it is in-the-money). MARKET MAKER: A trader or institution that plays a leading role in a market by being prepared to quote a two way price (Bid and Ask) on request .e. Using borrowed funds to increase one's investment return. Only about 10% of equities have LEAPs. always with January expirations. equity LEAPS have two series at any time. Option contracts are leveraged as they provide the prospect of a high return with little investment. also known as long-dated options.INTRINSIC VALUE: Amount of any favorable difference between the strike price of an option and the current price of the underlying (i. Instead of utilizing a "spread order" to insure that both the written and the purchased options are filled simultaneously. for example buying stocks on margin.during normal market hours. LEGGING: Term used to describe a risky method of implementing or closing out a spread strategy one side ("leg") at a time. Some indexes also have LEAPs. MARGIN: The minimum equity required to support an investment position.

OPTION CHAIN: A list of the options available for a given underlying. or the strike price of a put is less than the price of the underlying. only time value.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 volatility estimate. Can be placed as a day or GTC order. OCC is an intermediary between option buyers and sellers. NEUTRAL: An adjective describing the belief that a stock or the market in general will neither rise nor decline significantly. OUT-OF-THE-MONEY (OTM): An out-of-the-money option is one whose strike price is unfavorable in comparison to the current price of the underlying. OVERVALUED: An adjective used to describe an option that is trading at a price higher that its theoretical value. because theoretical value depends on one subjective input . An out-of-the-money option has no intrinsic value. OPTIONS CLEARING CORPORATION (OCC): A corporation owned by the exchanges that trade listed stock options. 150 . ONE-CANCELS-THE-OTHER (OCO) ORDER: Type of order which treats two or more option orders as a package. The loss potential of naked strategies can be virtually unlimited. NET MARGIN REQUIREMENT: The equity required in a margin account to support an option position after deducting the premium received from sold options. It must be remembered that this is a subjective evaluation. whereby the execution of any one of the orders causes all the orders to be reduced by the same amount. This means when the strike price of a call is greater than the price of the underlying. OCC issues and guarantees all option contracts.

SECTOR INDICES: Indices that measure the performance of a narrow market segment. PUT/CALL RATIO: This ratio is used by many as a leading indicator. ROLLOVER: Moving a position from one expiration date to another further into the future. REALIZED GAINS AND LOSSES: The profit or losses received or paid when a closing transaction is made and matched together with an opening transaction. such as biotechnology or small capitalization stocks. it is said to be trading at parity. SCALPER: A trader on the floor of an exchange who hopes to buy on the bid price. This is accomplished by a simultaneous sale of one and purchase of the other. This price is established by The Options Clearing Corporation and is used to 151 . and profit from moment to moment price movements. RATIO CALENDAR COMBINATION: A term used loosely to describe any variation on an investment strategy that involves both puts and calls in unequal quantities and at least two different strike prices and two different expirations. When an option is trading at its intrinsic value. It is computed by dividing the 4-day average of total put VOLUME by the 4-day average of total call VOLUME. Risk is limited by the very short time duration (usually 10 seconds to 3 minutes) of maintaining any one position.PARITY: An adjective used to describe the difference between the stock price and the strike price of an in-the-money option. traders wishing to maintain their positions will often move them to the next contract month. SETTLEMENT PRICE: The official price at the end of a trading session. sell on the ask price. The SEC is the United States federal government agency that regulates the securities industry. As the front month approaches expiration. SEC: The Securities and Exchange Commission.

Time decay is quantified by Theta. This varies by security. Also known as striking price or exercise price. TRADING PIT: A specific location on the trading floor of an exchange designated for the trading of a specific option class or stock. both the call and put have the same strike price. fees for exercise and/or assignment. including brokerage commissions. The long synthetic combines a long call and a short put to mimic a long position in the underlying. STRIKE PRICE: The price at which the holder of an option has the right to buy or sell the underlying. and for other purposes. TECHNICAL ANALYSIS: Method of predicting future price movements based on historical market data such as (among others) the prices themselves. The short synthetic combines a short call and a long put to mimic a short position in the underlying.determine changes in account equity. and are on the same underlying. SYNTHETIC: A strategy that uses options to mimic the underlying asset. TIME DECAY: Term used to describe how the theoretical value of an option "erodes" or reduces with the passage of time. 152 . Both long and short synthetics are strategies in the Trade Finder. TRANSACTION COSTS: All charges associated with executing a trade and maintaining a position. This is a fixed price per unit and is specified in the option contract. and margin interest. and can also be dependent on the current price of the security. the relation of advancing issues to declining issues. margin requirements. trading volume. the same expiration. In both cases. open interest. and short selling volume. TICK: The smallest unit price change allowed in trading a specific security. See mark-to-market.

in a given period of time. WASTING ASSET: An investment with a finite life. VOLATILITY TRADE: A trade designed to take advantage of an expected change in volatility. the value of which decreases over time if there is no price fluctuation in the underlying asset.UNCOVERED: A short option position that is not fully collateralized if notification of assignment is received. UNREALIZED GAIN OR LOSS: The difference between the original cost of an open position and its current market price. VOLATILITY: Volatility is a measure of the amount by which an asset has fluctuated. WASH SALE: When an investor repurchases an asset within 30 days of the sale date and reports the original sale as a tax loss. it becomes a realized gain or loss. 153 . Volatility is not equivalent to BETA. or is expected to fluctuate. The Internal Revenue Service prohibits wash sales since no change in ownership takes place. Once the position is closed. Assets with greater volatility exhibit wider price swings and their options are higher in price than less volatile assets. See also NAKED.

gov.com 154 .com www.investors.sebi. Marshall and Vipul K.com www. JR. Published by Printice Hall of India. Dubofsky and Thomas W.BIBLIOGRAPHY Books: • Derivatives: Valuation and Risk Management By David A.in www. Miller. Bansal.com www.com www.moneycontrol. Published by Oxford University Press.bseindia. • Newspapers:• • The Times of India The Economic Times Internet: • • • • • • www.economictimes..nseindia. Financial Engineering: A Complete Guide to Financial Innovation By John F.

• www.investopedia.com 155 .

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