FUTURES AND OPTIONS

UNIVERSITY OF MUMBAI
M.L. DAHANUKAR COLLEGE OF COMMERCE VILE PARLE (EAST), MUMBAI – 400057 A PROJECT ON FUTURES & OPTIONS SUBMITTED BY DEEPALI.N.DALVI SUBMISSION FOR: BACHELOR OF MANAGEMENT STUDIES T.Y.B.M.S SEMESTER V UNDER THE GUIDANCE OF PROF. NACHIKET PATVARDHAN ACADEMIC YEAR 2009-2010

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FUTURES AND OPTIONS

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FUTURES AND OPTIONS

DECLARATION

I, DEEPALI.N.DALVI, of M.L. Dahanukar College of Commerce, T.Y.B.M.S (Semester Vth), hereby declare that I have completed this project on “FUTURES & OPTIONS” in the academic year 2009-2010

The Information Submitted Is True And Original To The Best Of My Knowledge.

{DEEPALI DALVI}

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FUTURES AND OPTIONS

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Prof. for his valuable assistance in completion of this project. 5 .Pethe. The Principal. Last but not the least. I take this opportunity to express my sincere gratitude to respected Prof. ARCHANA ZINGADE. I thank to my Family and Friends who have directly or indirectly helped me in completing my project. M.NACHIKET PATVARDHAN.Dahanukar College of Commerce and our course coordinator.FUTURES AND OPTIONS Acknowledgement It gives me pleasure to submit this project to the University of Mumbai as a part of curriculum of BMS course.L. M. My respect and grateful thanks to Prof.

We will find the futures and options related to almost all types of markets. Futures and Options are also important for the national economy since it is a very effective risk management tool. Futures and options have brought various nations of the world commercially nearer to each other. metals. agriculture produce etc. finance.-stocks. E.g.FUTURES AND OPTIONS PREFACE Futures and Options are the well developed trading instrument in the complex markets of today. 6 . Futures and Options shield the manufacturers & farmers from risk of loss due to unforeseen circumstances so that they can concentrate on their core business of manufacturing and farming.

12. 12. 3. 10. 2. 5.1 11.1 Purpose of futures market Advantage of Arbitrage Clearing Mechanism Types of orders Futures Terminology Difference between Forward and Futures contract Options History Option Terminology Call option Buying a call 24-25 26-30 31-32 33-34 35 36 37 38 39-45 46 47 7 . 1. 8. No. 6. 10. 9-10 11-12 13-15 16 17 18 19 20-23 Relationship between spot and futures price 4. 7.1 3.1 1.2 Introduction History of derivatives Understanding derivatives Forward contract History of forward contract Futures market History of futures market Topic Page No. 9.FUTURES AND OPTIONS TABLE OF CONTENT Sr. 1.1 3.2 2.

Derivatives are also a kind of contract between two counterparties to exchange payments linked to the prices of underlying assets. 17 18. 22. 16. 15. foreign currencies. 21. Writing a call Put option Buying a put Writing a put Advantages and Disadvantages of Options Risk & Return with equity options Option Trading Strategies Margins Stock Index Futures NSE’s derivative market Futures V/S Options Conclusion Bibliography 48-49 50 51 52 53-56 57-63 64-71 72-73 74-80 81-83 84-85 86 87 Introduction Derivatives are defined as financial instruments whose value derived from the prices of one or more other assets such as equity securities. 13.FUTURES AND OPTIONS 122 13. or commodities. 20.1 13. 19. 8 .2 14. fixed-income securities.

It is a contract which derives its value from the prices. options. warrants and convertible bonds. or index of prices. derivatives-wittingly or unwittingly.  Foreign exchange rate  Bonds Short-term debt securities such as T-bills Derivative can also be defined as a financial instrument that does not constitute ownership. risk instrument or contract for differences or any other form of security.FUTURES AND OPTIONS The term Derivative has been defined in Securities Contracts (Regulations) Act. share. the derivatives range is only limited by the imagination of investment banks. The most common types of derivatives that ordinary investors are likely to come across are futures.  Precious metals like gold and silver. etc. but a promise to convey ownership. It is likely that any person who has funds invested an insurance policy or a pension fund that they are investing in. as “A security derived from a debt instrument. of underlying securities The underlying can be :  Stocks (Equity)  Agriculture Commodities including grains. Beyond this. 9 . coffee beans. and exposed to. loan. whether secured or unsecured.

FUTURES AND OPTIONS 10 .

NSE also became the first exchange to launch trading in options on individual securities from July 2. the largest derivative exchange in the world. was established in 1848 where forward contracts on various commodities were standardized around 1865. the advent of modern day derivative contracts is attributed to the need for farmers to protect themselves from any decline in the price of their crops due to delayed monsoon. Some texts even find the existence of the characteristics of derivative contracts in incidents of Mahabharata. NSE and BSE. However. The commodity derivative market has been functioning in India since the nineteenth century with organized trading in cotton through the establishment of Cotton Trade Association in 1875. Traces of derivative contracts can even be found in incidents that date back to the ages before Jesus Christ. The Chicago Board of Trade (CBOT). Japan around 1650. 2001. The National Stock Exchange of India Limited (NSE) commenced trading in derivatives with the launch of index futures on June 12. or overproduction. which made them much like today's futures. 2000. Exchange traded financial derivatives were introduced in India in June 2000 at the two major stock exchanges. The futures contracts are based on the popular benchmark S&P CNX Nifty Index. Since then contracts on various other commodities have been introduced as well.FUTURES AND OPTIONS History The history of derivatives is surprisingly longer than what most people think. From then on. as we know them today. Derivatives have had a long presence in India. The Exchange introduced trading in Index Options (also based on Nifty) on June 4. These were evidently standardized contracts. The first 'futures' contracts can be traced to the Yodoya rice market in Osaka. There are various contracts currently traded on these exchanges. futures contracts have remained more or less in the same form. 11 .

With the opening of the economy to multinationals and the adoption of the liberalized economic policies. CNX NIFTY JUNIOR. The Exchange provides trading in other indices i. . interest rate risk. CNX-IT. especially at NSE. 2001. to provide a platform for commodities trading. CNX 100 and NIFTY MIDCAP 50 indices. the economy is driven more towards the free market economy.e.FUTURES AND OPTIONS 2001. BANK NIFTY. It exposes the clients. The size of the derivatives market has become important in the last 15 years or so.2008. economic risk and political risk. In 2007 the total world derivatives market expanded to $516 trillion. The Exchange is now introducing mini derivative (futures and options) contracts on S&P CNX Nifty index in January 1. The derivatives market in India has grown exponentially. Futures and Options on individual securities are available on 227 securities stipulated by SEBI. The complex nature of financial structuring itself involves the utilization of multi currency transactions. National Commodity & Derivatives Exchange Limited (NCDEX) started its operations in December 2003. 12 . Futures on individual securities were introduced on November 9. particularly corporate clients to various risks such as exchange rate risk. Stock Futures are the most highly traded contracts.

Now. 13 . Let's say the cost of production is Rs 8. Derivatives are contracts that originated from the need to minimize risk. The contract also has a fixed expiry period mostly in the range of 3 to 12 months from the date of commencement of the contract. a farmer fears that the price of soybean (underlying).000 per ton. The value of the contract depends on the expiry period and also on the price of the underlying asset. when his crop is ready for delivery will be lower than his cost of production. If the selling price of soybean goes down to Rs 7.000. who agrees to buy the crop at a certain price (exercise price). For example. a derivative of the shares of Infosys (underlying). the contract becomes even more valuable.000 per ton. he enters into a contract (derivative) with a merchant.FUTURES AND OPTIONS UNDERSTANDING DERIVATIVES The primary objectives of any investor are to maximize returns and minimize risks. a derivative contract on soybean depends on the price of soybean. which is known as the underlying. The word 'derivative' originates from mathematics and refers to a variable. say the merchant agrees to buy the crop at Rs 9. In this case. They derive their value from the value of some other asset. which has been derived from another variable. the value of this derivative contract will increase as the price of soybean decreases and vice-a-versa. the derivative contract will be more valuable for the farmer. Derivatives are so called because they have no value of their own. will derive its value from the share price (value) of Infosys. Derivatives are specialized contracts which signify an agreement or an option to buy or sell the underlying asset of the derivate up to a certain time in the future at a prearranged price. In order to overcome this uncertainty in the selling price of his crop.000 per ton. Similarly. For example. and if the price of soybean goes down to Rs 6. when the crop is ready in three months time (expiry period). the exercise price.

he can either go to a food merchant and enter into a derivatives contract to sell 150 quintals of soybean in three months time at Rs 9.9000 per ton even though the market price is much less. etc. Such derivatives are called exchange-traded derivatives. and buy a standard contract on soybean. pepper. the value of the derivative is dependent on the value of the underlying. However. if he thinks that the total production from his land will be around 150 quintals. Such derivatives are called over-the-counter (OTC) derivatives. wheat. equity shares. 14 . cotton. like the National Commodity and Derivatives Exchange Limited. then the derivative is known as a commodity derivative. Or they can be customized as per the needs of the user by negotiating with the other party involved. So the farmer will be left with 50 quintals of soybean uncovered for price fluctuations. If the underlying is a financial asset like debt instruments. The standard contract on soybean has a size of 100 quintals.000 per ton. precious stone or for that matter even weather. Or the farmer can go to a commodities exchange. Derivative contracts can be standardized and traded on the stock exchange. currency.FUTURES AND OPTIONS This is because the farmer can sell the soybean he has produced at Rs . silver. Continuing with the example of the farmer above. which may exceed the cost associated with leaving a part of the production uncovered. Thus. exchange traded derivatives have some advantages like low transaction costs and no risk of default by the other party. If the underlying asset of the derivative contract is coffee. the derivative is known as a financial derivative. gold. share price index.

e. Derivatives Forwards Futures Options Swaps The most commonly used derivatives contracts are Forward. Futures and Options. 15 . Options and swaps. Forwards.FUTURES AND OPTIONS TYPES OF DERIVATIVES: There are mainly four types of derivatives i. Here some derivatives contracts that have come to be used are covered. Futures.

generally considered in the form of a profit. Each contract is custom designed. except they are not marked to market. or defined on 16 . thereby reducing transaction costs and increasing transactions volume. Forwards. or to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive. which is the price at which the asset changes hands on the spot date.    The contract price is generally not available in public domain. the contract has to be settled by delivery of the asset. This process of standardization reaches its limit in the organized futures market. The difference between the spot and the forward price is the forward premium or forward discount. can be used to hedge risk (typically currency or exchange rate risk). On the expiration date. The other party assumes a short position and agrees to sell the asset on the same date for the same price. One of the parties to contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a specified price. and hence is unique in terms of contract size. Other contract details like delivery date. If the party wishes to reverse the contract. A closely related contract is a futures contract. and quantity are negotiated bilaterally by the parties to the contracts are normally traded outside the exchanges. Forward contracts are very similar to futures contracts. it has to compulsorily go to the same counterparty. as in case of foreign exchange.FUTURES AND OPTIONS Forward contract A forward contract is an agreement to buy or sell an asset on a specified price. like other derivative securities. price. The salient features of forward contract are:  They are bilateral contracts and hence exposed to counter-party risk. The forward price of is commonly contrasted with the spot price. However forward contracts in certain markets have become very standardized. expiration date and the asset type and quality. exchange traded. which often results in high price being charged. as a means of speculation. by the purchasing party. or loss. they differ in certain respects.

Forwards also typically have no interim partial settlements or "true-ups" in margin requirements like futures . 180 * 12/100 *6/12) Arbitraging opportunities The current price per share in the futures market-6 months is Rs. 180 + (Rs. 180 RS. 195 and the theoretical minimum price of 6-months forward is Rs. Theoretical Minimum Price = Rs. A forward contract arrangement might call for the loss party to pledge collateral or additional collateral to better secure the party at gain.180 by borrowing at 12% 17 Rs.such that the parties do not exchange additional property securing the party at gain and the entire unrealized gain or loss builds up while the contract is open. 190. 1.80.80 . The arbitrage opportunities exist for the ABC Ltd’s share.FUTURES AND OPTIONS standardized assets.Calculation of Theoretical Minimum Price of a 6-month Forward contract Explain if any arbitraging opportunities exist. An arbitrageur can invest in ABC Ltd’s share shares at Rs. 195 It is possible to borrow money in the market for securities transactions at the rate of 12% per annum Q. 190. The following data relates to ABC Ltd’s share prices: Current price per share Price per share in the futures market-6 months Rs. Solution: Calculation of Theoretical Minimum Price of a 6-month Forward contract Current share price Interest rate prevailing in money market for securities transactions Then.

190. these are pre-determined contracts entered today for a date in the future) 18 . the exchange specifies certain standard features of the contract.80 and can record a profit of Rs. futures are derivative contracts that give the holder the opportunity to buy or sell the underlying at a pre-specified price sometime in the future. 2. A futures contract may be defined offset prior to maturity by entering into an equal and opposite transaction. Futures contract is a standardized form with fixed expiry time.20 (i. the buyer and the seller to fulfill the terms of the contract (i.FUTURES AND OPTIONS p. the futures contracts are standardized and exchange traded. after 6 months period the arbitrageur can collect Rs. 195 and pay off Rs. It involves an obligation on both the parties i.80) FUTURE CONTRACT As the name suggests. To facilitate liquidity in the futures contract. 195.e. Rs. But unlike forwards contract.e.a. contract size and price. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures markets were designed to solve the problems that exist in forward markets.e.195-Rs190. More than 99% of futures transactions are offset this way. On the expiry date i.e. for 6 months and at same time he can sell the share in the futures market at Rs.

and their success transformed Chicago almost overnight into the risk-transfer capital of the world. the Chicago Mercantile Exchange sold contracts whose value was counted in millions. and the Chicago Board Options Exchange.FUTURES AND OPTIONS HISTORY OF FUTURES CONTRACT Merton Miller. the 1990 Nobel laureate had said that ‘financial future represents the most significant innovation of the last twenty years.’ The first exchange that traded financial derivatives was launched in Chicago in the year 1972. 19 . These currency futures paved the way for the successful marketing of a dizzying array of similar products at Chicago Mercantile Exchange. A division of the Chicago Mercantile Exchange. acknowledged as the “father of financial services” who was then the chairman of the Chicago Mercantile Exchange. Chicago Board of Trade. The brain behind this was a man called Leo Melamed. the underlying value of all contracts traded at the Chicago Mercantile Exchange totaled 50 trillion dollars. these exchanges were trading futures and options on everything from Asian and American stock indexes to interest-rate swaps. By 1990. By the 1990s. it was called the International Monetary Market (IMM) and traded currency futures. Before IMM opened in 1972.

Basis = Futures Price . In case this happens.Spot Price In a normal market. there might be factors other than cost-of-carry. The cost-of-carry model in financial futures. which may influence this relationship. especially in case of financial futures there may be carry returns like dividends. The process of the basis approaching zero is called Convergence. basis can be defined as the futures price minus the spot price. Such a market. In a normal market. then basis become positive and the market under such circumstances is termed as a Backwardation Market or Inverted Market. Basis can become positive. the relationship between futures price and cash price is determined by the cost-of-carry. is 20 .e.e.FUTURES AND OPTIONS Relationship between Spot and Futures Price The price of a commodity (here we are not restricting ourselves to equity stock as the underlying asset) is. i. in addition to carrying costs. the spot price can exceed the futures price only if there are factors other than the cost-of-carry to influence the futures price. the spot price is less than the futures price (which includes the full cost-ofcarry) and accordingly the basis would be negative. There will be a different basis for each delivery month for each contract. is known as the Contango Market. a function of: Demand and supply position of the commodity Storability – depending on whether the commodity is perishable or not Seasonality of the commodity Basis In the context of financial futures. the spot and futures prices converge as the date of expiry of the contract approaches. in which the basis is decided solely by the cost-of-carry. basis will be positive. thus. i. However. As already explained above. Basis will approach zero towards the expiry of the contract. among other things. This reflects that futures prices normally exceed spot prices.

10 Based on the above information. 225. for March 2001 was Rs. the futures price is Rs.25% payable before 31. which is less than the actual price of Rs.a. Annual Dividend on the stock .25 x 10) = Rs. This would give rise to arbitrage opportunities and consequently the two prices will tend to converge 21 . 220 and the futures price on the same stock on the same date.15 x 0.2001 Face value of the stock . Other features of the contract and related information are as follows: Time of expiration Borrowing rate . the futures price for ACC stock on 31st December 2000 should be: = 220 + (220 x 0. etc. 230 in February 2001. 225.03.FUTURES AND OPTIONS Futures price = Spot price + Carrying costs – Returns (dividends.Rs.75 Thus.3 months (0.) The price of ACC stocks on 31st December 2000 was Rs.15% p. as per the ‘cost of carry’ criteria.25 year) . 230.25) – (0.75.

Expiry day The last Thursday of the expiry month or the previous trading day if the last Thursday is a trading holiday. 22 .FUTURES AND OPTIONS Contract specification: S&P CNX Nifty Futures Underlying index S&P CNX Nifty Exchange of trading National Stock Exchange of India Limited Security descriptor N FUTIDX NIFTY Contract size Permitted lot size shall be 100 (minimum value Rs. the next month (two) and the far month (three).the near month (one). New contract will be introduced on the next trading day following the expiry of near month contract.2 lakh) Price bands Not applicable Trading cycle The futures contracts will have a maximum of three month trading cycle .

Settlement price Daily settlement price will be the closing price of the futures contracts for the trading day and the final settlement price shall be the closing value of the underlying index on the last trading day.FUTURES AND OPTIONS Settlement basis Mark to market and final settlement will be cash settled on T+1 basis. 23 .

consumption and inventory. Since these low cost instruments lead to a specified delivery of goods at a specified price on a specified date. their efficiency has to be of the highest quantity. the futures trade has to have a market to facilitate buying and selling. some of which are as follows: Quick and Low Cost Transactions: Futures contracts can be created quickly at low cost to facilitate exchange of money for goods to be delivered at future date. Advantage to Informed Individuals: 24 . The costs involved in entering into futures contracts is insignificant as compared to the value of commodities being traded underlying these contracts. Futures markets are relevant because of various reasons. Price Discovery Function: The pricing of futures contracts incorporates a set of information based on which the producers and the consumers can get a fair idea of the future demand and supply position of the commodity and consequently the future spot price.FUTURES AND OPTIONS PURPOSE OF FUTURES CONTRACT As in any other trade. The future price of a commodity is a function of various commodities related and market related factors and their inter-play determines the existence of a futures contract and its price. which allows a holistic approach to the price mechanism involved in futures contracts. it becomes easy for the finance managers to take optimal decisions in regard to protection. As the futures markets involve the operation and execution of financial deals of an enormous magnitude. Futures markets provide flexibility to an otherwise rigid spot market because of their very concept. This is known as the ‘price discovery’ function of future. Not only the size of the monetary operation that a futures market handles but also the critical significance it has on the equilibrium of the commodities / stocks is what makes the operation of the market so crucial.

technology changes. ADVANTAGE OF ARGITRAGE 25 . the trader will lose on sale of copper but will recoup through futures. leads to a more efficient allocation of resources. market behavior. who have superior information in regard to factors like commodity demand-supply. can operate in a futures market and impart efficiency to the commodity’s price determination process.FUTURES AND OPTIONS Individuals. he may sell copper futures if he foresees fall in copper prices. Hedging Advantage: Adverse price changes. will need to enter into a transaction which could protect him in the event of such an adverse change. An individual who is exposed to the risk of an adverse price change while holding a position. Thus.. can be adequately and efficiently hedged against through futures contract. This. either long or short. which may lead to losses.g. in turn. For e. the trader will honors the delivery of the futures contract through the imported copper stocks already available with him.. through their function of risk management and price discovery. In case copper prices actually fall. futures markets provide economic as well as social benefits. a trader who has imported a consignment of copper and the shipment is to reach within a fortnight. etc. On the contrary if prices rise.

with the markets getting choppy. means getting risk-free returns by seeking price differentials between markets. These are the arbitragers. Now. derivatives. These funds are fast gathering investor attention. However. especially from the retail segment of the market. A person who engages in arbitrage is called an arbitrageur such as a bank or brokerage firm. In economics and finance. the returns are strong. there is a set of people who enjoy such volatilities. stocks. commodities and currencies. So the returns are risk-free.FUTURES AND OPTIONS What do you mean by Arbitrage? …. arbitrage is the practice of taking advantage of a price differential between two or more markets: striking a combination of matching deals that capitalize upon the imbalance. such as bonds. By its very definition. Returns from arbitrage funds have been good. They have been fast gaining currency in the investment market by providing a steady performance. The attraction of the arbitrage fund comes from the fact that there are near risk-free returns to be made here. The term is mainly applied to trading in financial instruments. In today’s scenario when markets world over have become highly volatile and choppy because of Subprime Issue & Credit crises faced by US we very often get to see a gap -up opening or a gap down opening. arbitrage. They are waiting for volatile times in a bull market and are mawkishly waiting for mispricing opportunities to be created so that they could gain from mispricing in the cash and futures markets. And even better than many other exiting fixed income investment options. Modus operandi!!! 26 . the profit being the difference between the market prices.

However. so this type of arbitrage is not all that attractive now. Buy in one and simultaneously sell in the other to gain from the difference. The game now takes place in the spot (cash) and the futures market. the pricing advantage has been nullified to a great extent. The price differential is now very narrow and one would require huge amounts to really gain. one having prices of stocks listed on the National Stock Exchange and the other the Bombay Stock Exchange.FUTURES AND OPTIONS But are arbitrage funds totally risk-free? Before we dwell into this question. The idea was to spot price differences between these markets. the arbitrager would sit across two monitors. knowing how an astute arbitrage works is important. Volatile prices and overall excitement-led activity often create strong pricing mismatches between the spot and futures market. 27 . Earlier. the transaction costs having risen. with markets getting sharper and the security transaction tax (STT) coming in.

This is the second leg of the transaction. There are other gains to be made while rolling the contract over and taking advantage of further mispricing 28 . the arbitrager can make risk-free profit by selling a futures contract of XYZ at Rs 110 and at the same time buying an equivalent number of shares in the cash market at Rs 100. At this time. and has now become Rs 200. So this is the first leg of the transaction which involves selling a futures contract and buying in the cash segment. And the quotation of price in the futures segment in the derivatives market is Rs 110.FUTURES AND OPTIONS Suppose the stock price of XYZ company is now is quoting at Rs 100. Now after waiting for a month. Sell in the cash market and buy a futures contract of the same security. And if the price declines to Rs 50. There could be two possibilities in such a situation. the arbitrager will reverse the position. the share price has risen substantially in the holding period. In such a case. In that case. it is obvious that the future and the cash price tend to converge. or the contract expiration period. the arbitrager makes money on the profit on the sale of Rs 100 share at Rs 200 and a loss on the sale of the futures contract. on the settlement day. then the arbitrager will gain from the sale of the derivatives contract and take a loss on the sale of the shares in the spot market. there is a gain. One. Either ways.

On the futures expiration date. how can you cash in on this opportunity to earn risk less profits? Say for instance. One–month ACC futures trade at Rs. Sell the security.10. ACC Ltd. buy the security on the cash/spot market at 1000. arbitrage opportunities arise!!! Arbitrage . sell the futures on the security at 1025. Simultaneously. sell futures If you notice that futures on a security that you have been observing seem overpriced. Say the security closes at Rs.1000.1025 and seem overpriced. 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. trades at Rs. Take delivery of the security purchased and hold the security for a month.FUTURES AND OPTIONS Whenever the futures price deviates substantially from its fair value.Overpriced futures: buy spot. it makes sense for you to arbitrage. Now unwind the position. On day one. Futures position expires with profit of Rs.1015.10 on the futures position. As an arbitrageur. the spot and the futures price converge. you can make risk less profit by entering into the following set of transactions. 29 . This is termed as cash–and–carry arbitrage. The result is a risk less profit of Rs. borrow funds. Return the borrowed funds.15 on the spot position and Rs.

The result is a riskless profit of Rs.10 on the futures position.Underpriced futures: buy futures. Simultaneously. How can you cash in on this opportunity to earn riskless profits? Say for instance. Buy back the security. As an arbitrageur. buy the futures on the security at 965. sell the security in the cash/spot market at 1000. On day one. As we can see. Say the security closes at Rs. 30 . exploiting arbitrage involves trading on the spot market. As more and more players in the market develop the knowledge and skills to do cash–and–carry and reverse cash–and–carry. we will see increased volumes and lower spreads in both the cash as well as the derivatives market. The futures position expires with a profit of Rs. 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. On the futures expiration date. ABC Ltd.975. sell spot It could be the case that you notice the futures on a security you hold seem underpriced. If the returns you get by investing in riskless instruments is more than the return from the arbitrage trades. 965 and seem underpriced. Now unwind the position. trades at Rs.25 on the spot position and Rs. This is termed as reverse–cash–and–carry arbitrage. Make delivery of the security. the spot and the futures price converge. you can make riskless profit by entering into the following set of transactions.FUTURES AND OPTIONS Arbitrage .10. One–month ABC futures trade at Rs.1000.

the buyer and the seller do not get into the contract directly. This exchange acts as a seller for the buyer and a buyer for the seller in the process of execution of a futures contract. and Seller sells to the clearing house. 2. In order to achieve this. The solvency requirements normally imposed by the clearing house on their members are broadly as follows. The clearing house monitors the solvency of its members by specifying solvency norms. Buyer buys from the clearing house. in effect. Thus. the moment the buyer and the seller agree to enter into a contract. The idea is to secure the interest of both. Net Position Limits Such limits are imposed to contain the exposure threshold of each member. For example. This solvency is achieved through imposing on its members. The sum total of these limits. 1. 31 . cash margins and/or bank guarantees or other collaterals. in other words. The extent of capital adequacy has to be market specific and would vary accordingly.FUTURES AND OPTIONS CLEARING MECHANISM A clearing house is an inseparable part of a futures exchange. there is no counter party risk. is the exposure limit of the clearing association as a whole and the net position limits are meant to diversify the association’s risk. the clearing house has to be solvent enough. Capital Adequacy Capital adequacy norms are imposed on the clearing members to ensure that only financially sound firms could become members. which are encashable fast. such that. the clearing house steps in and bifurcates the transaction.

Daily Price Limits These limits set up the upper and the lower limits for the futures price on a particular day and incase these limits are touched the trading in those futures is stopped for the day.FUTURES AND OPTIONS 3. In order to secure their own interest as well as that of the entire system responsible for the smooth functioning of the market.e.e. Daily maintenance margins on both. 32 . The stock exchanges impose margins as follows: Initial margins on both the buyer as well as the seller. clearing houses and the banks involved. the members collect margins from their clients as may be stipulated by the stock exchanges from time to time. i. a mandatory minimum margin is obtained by the members from the customers. Such a step insures the market against serious liquidity crisis arising out of possible defaults by the clearing members owing to insufficient margin retention. The members pass on the margins to the clearing house on the net basis i. 4. Customer Margins In order to avoid unhealthy competition among clearing members in reducing margins to attract customers. The accounts of the buyer and the seller are marked to the market daily. separately on purchases and sales. at a stipulated percentage of the net purchases and sale position while they collect the margins from clients on gross basis. comprising the stock exchanges.

as the name suggests is an order which is valid for the day on which it is entered. if for stop–loss buy order.FUTURES AND OPTIONS TYPES OF ORDERS The system allows the trading members to enter orders with various conditions attached to them as per their requirements. after the market price of the security reaches or crosses a threshold price.00 and the market(last traded) price is 1023.00.g. the trigger is 1027. the limit price is 1030. Price condition -Stop–loss: This facility allows the user to release an order into the system.00. If the order is not executed during the day. – 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. then this order is released into the system once the 33 . and the unmatched portion of the order is cancelled immediately. The order types and conditions are summarized below. Partial match is possible for the order. E. failing which the order is cancelled from the system. the system cancels the order automatically at the end of 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. Time conditions – Day order: A day order.

FUTURES AND OPTIONS market price reaches or exceeds 1027. The total number of outstanding contracts (long/short) at any point in time is called the “Open interest”. For both the futures and the options market. – Cli: Cli means that the trading member enters the orders on behalf of a client. the trigger price has to be greater than the limit price.00. while entering orders on the trading system. in the case of ‘Cli’ trades. as a limit order of 1030. Other conditions – Market price: Market orders are orders for which no price is specified at the time the order is entered (i. For such orders. For the stop–loss sell order. price is market price). the total number of long in any contract always equals the total number of short in any contract. – Trigger price: Price at which an order gets triggered from the stop–loss book. it is found that open interest is maximum in near month expiry contracts 34 . This order is added to the regular lot book with time of triggering as the time stamp. This Open interest figure is a good indicator of the liquidity in every contract.e. Based on studies carried out in international exchanges. Apart from this. The futures market is a zero sum game i. – Limit price: Price of the orders after triggering from stop–loss book.00. members are required to identify orders as being proprietary or client orders. the client account number should also be provided. Proprietary orders should be identified as ‘Pro’ and those of clients should be identified as ‘Cli’. the system determines the price.e. – Pro: Pro means that the orders are entered on the trading member’s own account.

two months and three –month’s expiry cycles which expire on the last Thursday of the month. Thus a January expiration contract ceases trading on the last Thursday of February. Expiry date :. On the Friday following the last Thursday. For instance.The price at which an asset trades in the spot market is called spot price Futures price: . Contract cycle: . The index futures contracts on the NSE have one-month.The period over which a contract trades. 35 . Contract size: . the contract size on NSE’s futures market is 200 Nifties.It is the date specified in the futures contract.The amount of asset that has to be delivered under one contract. at the end of which it will cease to exist.The price at which the futures contract trades in the futures market. This is the last day on which the contract will be traded.FUTURES AND OPTIONS Futures Terminology Spot price:. a new contract having a three-month expiry is introduced for trading.

This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset. basis will be positive. 36 . Contract Specifications Counter-party risk Differ from trade to trade. This reflects that futures prices normally exceed spot prices. In a normal market. Differences between Forward and Futures Contracts FEATURE FORWARD CONTRACT FUTURE CONTRACT Operational Mechanism Traded directly between two parties (not traded on the exchanges).. which becomes the counter party to all the trades or unconditionally guarantees their settlement. Traded on the exchanges. Exists. as contracts are standardized exchange traded contracts. Contracts are standardized contracts.in the context of financial futures. assumed by the clearing corp.FUTURES AND OPTIONS Basis: . Liquidation Profile Low. as contracts are tailor made contracts catering to the needs of the High.the relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. However. basis can be defined as the futures price minus the spot price. There will be a different basis for each delivery month for each contract. Cost of carry: . Exists.

FUTURES AND OPTIONS

Price discovery

needs of the parties. Not efficient, as markets are scattered.

Efficient, as markets are centralized and all buyers and sellers come to a common platform to discover the price.

Examples

Currency market in India.

Commodities, futures, Index Futures and Individual stock Futures in India.

OPTIONS
“ An option is a contractual agreement that gives the option buyer the right, but not the obligation, to purchase (in the case of a call option) or to sell( in case of put option) a specified instrument at a specified price at any time of the option buyer’s choosing by or before a fixed date in the future. Upon exercise of the right by the option holder, an option seller is obliged to deliver the specified instrument at the specified price.” Options are fundamentally different from forward and futures contracts. An option gives the holder of the option the right to do something. The holder does not have to exercise this right. In contrast, in a forward or futures contract, the two parties have committed themselves in doing something. Whereas it costs nothing (except margin requirements) to enter into a futures contract, the purchase of an option requires an up-front payment.

There are two basic types of options, call options and put options.

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FUTURES AND OPTIONS

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

HISTORY OF OPTIONS CONTRACT
Although options have existed for a long time, they were traded OTC, without much technology of valuation. The first trading in options began in Europe and US as early as the seventeenth century. It was only in the early 1990s that a group of firm’s setup what was known as the put and call Brokers and Dealers Association with the aim of providing a mechanism for bringing buyers and sellers together. If someone wanted to buy an option, he or she would contact one of the member firms. The firm would then attempt to find a seller or writer of the option either from its own clients or those of the other member firms. If no seller could be found, the firm would undertake o write the option itself in return for a price. This market however suffered from two deficiencies. First, there was a secondary market and second, there was no mechanism to guarantee that the writer of the option would honor the contract. In 1973, Black, Merton and Scholes invented the framed Back-Scholes formula. In April 1973, CBOE was setup specifically for the purpose of trading options. The market for options
38

FUTURES AND OPTIONS

developed so rapidly that by early 80’s , the number of shares underline the option contract sold each day exceeded the daily volume of shares traded on the NYSE. Since then has been no looking back.

Option Terminology
Before going into the concepts and mechanics of options trading, we need to be familiar with the basic terminology as they are repeatedly used in case of options. Index options: - These options have the index as the underline. Some options are European while other is American. Like index futures contracts, index options are also cash settled.

Stock options: - Stock options are options on individual stocks. Options currently trade on over 500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the specific price.

Buyer of an option: The buyer of an option is the one who by paying the option premium buys right but not the obligation to exercise his option on the seller / writer.

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FUTURES AND OPTIONS

Writer of an option: The writer of a call/per option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him.

Option price/premium: Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium. - To acquire an option, the speculator must pay option money, the amount of which depends on the share being dealt in. the more volatile the share the higher the cost of the option. It may, however, normally be somewhere within the range of 5-10 percent. The premium of the option is a function of variables, such as: Current stock price, Strike price, Time to expiration, Volatility of stock, and Interest rates. The buyer pays the premium to the seller, which belongs to the seller whether the option is exercised, or not. If the owner of an option decided not to exercise the option, the option expires and becomes worthless. The premium becomes the profit of the option writer, while if the option is exercised; the premium gets adjusted against the loss that the writer incurs upon such exercise

Striking price: - The fixed price at which the option may be exercised, known as the ‘striking price’ is based on the current quoted prices. With a call option the striking price is the higher quoted price plus a further small sum called the contango to recompense the option dealer. With a put option the striking price is usually the current lower quoted price. There is no contango money.
40

Percentage wise the price movements of a traded option are of more than those of the underlying share.If the options dealing is introduced in the stock exchanges.At the end of the period the holder either abandons his/her option or claims right under it. The costs to be covered are the jobber’s turn. Double options: . 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. they will be publicly traded like any other quoted stocks. The option money is exactly twice that of the current quoted prices. Traded options: . The time for doing this is the ‘declaration day’ which is the second last day in the account before the final account day on which completion of the option may take place Limiting risk: . the option money. the broker’s commission. and in the case of a call option the contango in the striking price.e. The holder of an option is then exposed to a higher risk but on the other hand could reap greater rewards in relation to the amount of his/her investment.As well as call and put options it is also possible to obtain a double option which is a combination of both. spot price 41 . Gearing: . The holder has the right either to buy or sell the shares subject to the option at the striking price which in this case will probably be around the middle of the current quoted prices.Options are expensive and in order to be profitable requires a fairly sharp shortterm price movement. 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. substantially reduce the speculator’s risk of loss. Greater flexibility is available to the holder of traded options than with the options which are not traded in stock exchanges.FUTURES AND OPTIONS Declaration day: . They do however.

which is in-the-money. while it is zero if the option is other than in-the-money. the put is ITM if the index is below the strike price. the call is said to be deep ITM.FUTURES AND OPTIONS > strike price). Therefore. An option on the index is at-the-money when the current index equals the strike price (i. In the case of a put. 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. For an option. For a call option.e. namely. Symbolically.e. spot price = strike price). which is out-of-the-money or at-the-money. wherein S indicates the present value of the stock and E is the exercise price. Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to negative cash flow it were exercised immediately. has zero intrinsic value. Intrinsic value is termed as parity value. In the case of a put. If the index is much higher than the strike price. intrinsic value and time value. the put is OTM if the index is above the strike price. then. 42 . If the index is much lower than the strike price. the intrinsic value is the excess of stock price (S) over the exercise price (E). the intrinsic value refers to the amount by which it is in money if it is in-themoney. A call option on the index is out-of-the-money when the current index stands at a level which is less than the strike price (i. Condition S>E S<E S=E Call option In-the-Money Out-of-the-Money At-the-Money Put option Out-of-the-Money In-the-Money At-the-Money Intrinsic Value:-The premium or the price of an option is made up of two components. These concepts are tabulated below. an option. the call is said to be deep OTM. spot price < strike price).

S . C. other things being equal. S – E) In case.S) Time Value: . An in-the-money put option has a time value if its premium exceeds the intrinsic value. which are at-the-money or out-of-the-money. Time value of a call = C – [max (0. The time value of an option is the difference between the premium of the option and the intrinsic value of the option. In case. Thus. and zero otherwise. Intrinsic Value of a put option = max (0. Generally. E .Time value is also termed as premium over parity.FUTURES AND OPTIONS Intrinsic Value of a call option = max (0. is greater than the intrinsic value.E)] Time value of a put = C – [max (0. the time value exists if the call price. For an in-the-money option time value may or may not exist. S – E. have their entire premium as the time value. Option Exercise Price (Rs) Stocks Price (Rs) Call Option Price (Rs) Classification 43 . which is at-the-money or out-of-the-money. Accordingly.S)] Consider the following data calls on a hypothetical stock. Like for call options. E . of an in-the-money put option. the entire premium about is the time value. the intrinsic value is the amount by which the exercise price exceeds the stock price. the greater will be the time value. a call or a put option. however. of a call which is inthe-money. E – S. the longer the time of a call to maturity. put options. This is also true for the put options. For.

2. The put writer may have to buy the asset from the holder at a price that creates a loss. 80 85 83. 2. S-E) 1.50-0=2 Covered & Uncovered Options An option contract is considered covered if the writer owns the underlying asset or has another offsetting option position.50 In-the-money Out-the-money We may show how the market price of the two calls can be divided between intrinsic and time values.50=3. S-E) Time Value C-max (0. The call writer may have to purchase the underlying asset at a price that is higher than he strike price.75 2.50 6.50 83.75-3. the writer is exposed to the risk of having to fulfill the contractual obligations by buying the asset at the time of delivery at an unfavorable price. 44 .FUTURES AND OPTIONS 1.50 3.50 83. In the absence of one of these conditions. 83.50 0 6.50 80 85 6.75 2. Option S E C Intrinsic Value Max (0. When they face such a risk writers are said to be uncovered (or naked).25 2.

18. At what price will it break even for the buyer of the option Mr. Ramesh? For Mr. The put option to sell the stock sells at Rs.18.18. The time value of the option in this case will be????? 45 . A security that is convertible into requisite number of shares of the underlying security. the spot will have to rise to 176 + 18. So answer to this will be Rs 194/Suppose ACC stock currently sells at Rs.134 costs Rs. A long position in a call on the same security that has the same or the lower strike price and that expires at the same time or later than the option being written. They must own a put on the same underlying asset with the same or later expiration month and the higher strike price than the option being written. We will consider some of the following examples to understand the above discussed concepts better:Suppose there is a call option at a strike of Rs. Rajesh to recover the option premium of Rs. A warrant exercisable for requisite number of shares of the underlying security. An escrow-receipt from a bank.176 and is selling at a premium of Rs. Covered Put There is only one way for put writer to be covered.120/-.FUTURES AND OPTIONS Covered Call Options / Covered Calls Call writers are considering to be covered if they have any of the following positions: Along position in the underlying asset.

called the expiration date. the writer must comply. the buyer must pay the writer the option price which is known as premium. The quantity of the stock required to be delivered in the case of exercise of the option. Call option A call option give the buyer the right but not the obligation to buy a given quantity of a underlying asset. An investor Mr.FUTURES AND OPTIONS It will be Rs4/Suppose the spot value of Nifty is 2140. Murti buys a one month nifty 2157 call option for a premium of Rs. In this case what will such an option be called???? It will be called as Out of the money Essential Ingredients of an Option Contract An options contract has four essential ingredients: The name of the company on whose stock the option contract has been derived.7. The date when the contract expires. Unlike the buyer. the writer has no choice regarding the fulfillment of the obligations under the contract. If the buyer wants to exercise his rights. For this asymmetry of privilege. The price. A call option gives the buyer the rights to buy a fixed number of shares/commodities in particular securities at the exercised price up to the date of expiration the contract. or the exercise price or the strike price. The seller of an option is known as the ‘writer’. a given price known as ‘exercise price’ on or given future date called a ‘maturity date’ or expiry date’. The rights and obligations of the buyer and writer of a call option are explained below 46 . at which the stock would be delivered.

its value must be sold immediately prior to expiry to realize a similar profit because at expiry. If the asset price is below the exercise price. 47 . HE IS OBLIGATED TO SELL ON DEMAND.FUTURES AND OPTIONS CALL OPTION BUYER OR HOLDER GOING LONG PAYS TOTAL PREMIUM SELLER OR WRITER GOING LONG RECEIVES TOTAL PREMIUM HE HAS THE RIGHT BUT NOT THE OBLIGATION TO BUY 100 SHARES OF THE UNDERLYING STOCK AT STRIKE PRICE. the option may be sold immediately prior to expiry to realize a similar profit because at expiry. If at the expiry date of the option. the buyer will exercise the option. This may then be sold in the market at spot price and makes profit. the option will be abandoned by the buyer and his loss will be equal to the premium paid on the purchase of call option. Buying a call The buyer of a call option pays the premium in return for the right to buy the underlying asset at the exercise price. THE UNDERLYNG STOCK OF 100 SHARES AT SRIKE PRICE WHEN THE BUYER/HOLDER EXERCISES CALL OPTION. pay the exercise price and receives the asset. its value must be equal to the difference between the exercise price and market price of the underlying asset. Alternatively. the underlying asset price is above the exercise price.

the call option will not be exercised and the writer will make the profit equal to the option premium k } Premium b Stock Price 48 Intrinsic Value Lines . the asset price is above the exercise price. the writer will incur loss because he will have to buy the asset at market price in order to deliver it to the option buyer in exchange for the lower exercise price. If the asset price is below the exercise price.FUTURES AND OPTIONS Intrinsic Value Lines Premium { k Stock Price Writing a call The call option writer receives the premium as consideration for bearing the risk of having to deliver the underlying asset is return for being paid the exercise price. If at the expiry.

having short sold a stock. i. Rs. i. His investment was only to the extent of premium paid. Thus. Options can thus be used as a handy tool for hedging. 400 per share and buying 100 shares of the stock would involve an investment of Rs. The investor thus makes a profit of Rs. Had he bought the stock outright. Hedging Trading with the objective of reducing or controlling risk is called HEDGING. sold short. 2. whenever he is to effect delivery for the stock. 100 per share on an investment of Rs. In the event of an increase in the stock's price. An investor. 300. he would at least have the commitment of the option writer to deliver the stock at the exercise price.FUTURES AND OPTIONS Rationale of Buying Call Options There are broadly three reasons why an investor could buy a call option instead of buying the stock outright. However. can protect himself by buying a call option. 20.000.e. Let us assume that the stock's share actually goes up to Rs. 20 per share. 49 . The maximum loss the investor may be exposed to would be limited to the premium paid on the call option. These are as follows: 1. Return on Investment An investor anticipates that a stock is shortly going to appreciate from Rs. 300 to Rs. 30. 400 within the currency of the option. the investor would have made Rs. a call option on the stock is available at a premium of Rs. This should be sufficient motivation for the investor to go in f6r call options on the stock as against outright buying of the stock. 80 per share (400 (300+20)].e. 33%. the investor got an appreciation of 400% on his investment.

if it so exists.FUTURES AND OPTIONS 3. options arbitrage provides an opportunity to earn money by exploiting the pricing inefficiencies. but not the obligation. to sell a given quantity of the underlying asset at a given price on or before a given date. The seller of the put option is known as ‘writer’. For this asymmetry of privilege. the option price called as ‘premium’. the writer must purchase at exercise price. The put option gives the right to sell the underlying asset at exercise price up to date of the contract. Arbitrage Arbitrage involves buying at a lower price and selling. PUT OPTION The put option gives the buyer the right. If the buyer wants to exercise his put option. As in any other trade. which may exist within a market or between two markets or two products and as a result tends to bring perfection to the market. He has no choice regarding the fulfillment of the obligation under the contract. PUT OPTION 50 . the buyer of put option must take the writer. The rights and obligations of the buyer and writer of a put are explained in below figure.at a higher price.

Buying a Put The buyer of the put option pays the option premium for the right to sell underlying asset at the exercised price. If the asset is above the exercise price. gives the asset and receive the exercised price. HE IS OBLIGATED TO BUY ON DEMAND. the buyer will exercise the option. If at expiry the asset prices are below the exercised price. THE UNDERLYNG STOCK OF 100 SHARES AT SRIKE PRICE WHEN THE BUYER/HOLDER EXERCISES PUT OPTION. 51 .FUTURES AND OPTIONS BUYER OR HOLDER GOING LONG PAYS TOTAL PREMIUM SELLER OR WRITER GOING LONG RECEIVES TOTAL PREMIUM HE HAS THE RIGHT BUT NOT THE OBLIGATION TO SELL 100 SHARES OF THE UNDERLYING STOCK AT STRIKE PRICE. the put option will be abandoned and the buyer will incur loss equal to the option premium.

If the asset is above the exercise price at expiry. the writer will incur a loss because he will have to pay the exercise price but will only be able to resell the asset at the lower market price. Rationale of Buying a Put Option 52 . If the market price of the asset is below the exercise price at expiry. the buyer will abandon the put option and the writer will make a profit equal to the option premium received.FUTURES AND OPTIONS WRITING A PUT The put writer receives the premium for bearing the risk of having to take the underlying asset at the exercised price.

However. if he anticipates fall in the price of some stock. writing a naked call option. the only difference being that the loss in the event of appreciation in the stock price would be curtailed to the extent of the premium received on writing the call option. as in the case of a call option. enter a sales transaction without owning the stock. he can buy the stock at a lower price and can deliver the stock sold to the buyer.e. the investor would be exposed to unlimited loss.FUTURES AND OPTIONS An investor. The first reason is that the investment in buying a put option is restricted to the premium as against a larger sum required for going short. which may not be sufficient attraction. thus making profit equal to the fall in the price. • There are no margin calls for many strategies. Write a call option without owning the stock. 53 . i. has the following alternatives: Sell the stock short. Secondly. The trader can lose the entire premium. the return on investment on buying a put option is much higher as compared to going short on the stock. The purchase of a put option is the most desirable policy as compared to either going short or writing a naked call option. Thus. In the event of a fall in the stock price. the loss to the put option buyer is restricted to the premium paid. in the event of increase in the stock price. Writing such an option is similar to selling short. i. but that amount is known when the position is initiated. Advantages of options • There is limited risk for many options strategies. in case the stock price appreciates instead of declining.e. Purchase a put option.

options have become the fastest growing derivative in the currency markets. Thus. the option trader has more leverage. with an option. the investor is committed to a future transaction. It is quite obvious that there is a price which has to be paid for this one way but which is known as ‘option premium’. • Options offer a way to add to futures positions without spending any more money or premiums.FUTURES AND OPTIONS • Options offer a wide range of strategies for a variety of conditions. They limit the downside of risk without limiting the upside. he enjoys the right to go ahead but he walk away from the deal if he so desires. Disadvantages of options 54 . Those who sell options must charge a premium high enough to cover their losses when options are exercised at prices that are much better than the existing market price. • With a forward and futures contract. • The options have certain favorable characteristics.

When volatility is high.FUTURES AND OPTIONS • The trader pays a premium to enter a market when buying options. • Currently. • Option premiums don’t move tick for tick with the futures (unless they’re deep in the money). This can be an occasional often occurs close to the final trading day of futures. this should not be construed to mean that commercials cannot use the options to hedge. so premium becomes an eroding asset. there is more liquidity in future contracts than there are in most options contracts. options sellers can receive price premium. Thus can be frustrating to have the market move in your direction. Entry and exit from some markets can be difficult. existing can be a problem. then liquidate the futures. but they have margin requirements. 55 . On the other side. The trade is paying for time. yet lose premium value. premiums can be very expensive. However. the option buyer can exercise the option. receive a futures position. Even if the positions entered with a limit order. unless the option is in the money. Of course. volatility and time to expiration are more important than price movement. • Many options contracts expire weeks before the underlying futures. There are more complex factors affecting premium prices for options.

slump in the market. is. he need an investment of Rs 10000for purchase of 100 shares in X Ltd. 100 he have no option with no value and so he will lose Rs. say 100 shares for Rs 10000 and he is correct in his expectations his shares will be worth Rs 15000 within three months showing a profit of Rs 5000. The risk attached in this investment. if X Ltd’s share price remains at Rs. Vicky decide that shares in X Ltd. then he will loose his money. will rise over the next month or so. 56 . 10). This option would give him the right to buy a share in X Ltd for Rs 100 at any time over the next three months. When an option is traded.FUTURES AND OPTIONS In May beginning Mr. 10 premium. 2. say at Rs. 10 premium per share that he has paid and his total extent of Rs. there is a risk of price drop on different factors like collapse of X Ltd. When options are traded 1. 3.1000( 100 shares *Rs. When no options are traded If Mr. when his expectations go wrong.etc. he could buy an option on the share. fall of shares market index. The current price is Rs.150 by the end of July. 100 and he hopes that the shares will be at Rs. 50% of the amount invested less expenses. Vicky buys the shares. And if the amount is invested.

150 then his option has value worth exercising. then he would be required to part with his shares in X Ltd at Rs. 4000 on an investment of Rs. 5. The increase in share price from Rs. so he would locally be getting Rs. 1000 and he earns a profit 400% on his investment by purchasing an option instead of shares in X Ltd. So he would get Rs. 10 would limit the paper loss in his portfolio if the X Ltd share price falls. If the share price goes up to Rs. 100 on shares and this Rs. 100 per share or buy them for onward delivery at the prevailing market price.150 per share amounting to total increase in Rs. If the price rose to over Rs 100.100 to Rs.5000 on 100 shares and his net return is RS. he would gets Rs. 10 premium as well.FUTURES AND OPTIONS 4. 10 premium as well. 57 . And the option was exercised. However.

58 . At a price equal to Rs 130 a break-even point is reached. Only when the price exceeds Rs 120 per share will a call be made. The buyer would obviously not call upon the call writer to sell shares if the price happens to be lower than Rs 120 per share. 2001 Price of share on the date of contract = Rs 124. say ABC Suppose the contract is made between two investors X and Y. 1000 (= 10 x 100) Investor Y takes a long position and pays Rs 1000 for it. Having paid Rs 10 per share for buying an option. On the date of maturity. who take. Call Options Consider a call option on a certain share. the buyer can make a profit only in case the share price would be at a point higher than Rs 120 + Rs 10 = Rs 130.FUTURES AND OPTIONS RISK AND RETURN WITH EQUITY OPTIONS We will now see the risk and return associated with equity stock options. The other details are given below: Exercise price = Rs 120 Expiration month = March. The profit/loss made by each of the investors for some selected values of the share price of ABC is indicated below. respectively. the short and long positions.50 Price of option on the date of contract = Rs 10 At the time of entering in to the contract. Investor X writes a contract and receives Rs. 2001 Size of contract = 100 shares Date of entering into contract =January 5. the profit or loss to each investor would depend upon the price of the share ABC prevailing on that day.

(a) For Investor X 90 100 110 120 130 140 150 160 1000 – – 1500 – 59 2000 .Call Option Possible Price of ABC at Call Maturity (Rs.) 90 100 110 120 130 140 Profit 150 160 1500 – Investor X Investor Y 1000 1000 1000 1000 0 -1000 -2000 -3000 -1000 -1000 -1000 -1000 0 1000 2000 3000 1000 – 500 – 0 The profit profile for this contract is indicated below. the writer of the call. while Figure (b) Stock the same for the other investor Y. Figure (a) shows the profit/loss function for 500 the investor X. the gives Price buyer of the option.FUTURES AND OPTIONS Profit / Loss Profile for the Investors .

2500 – FUTURES AND OPTIONS Loss Profit 3000 – 2500 – 2000 – (b) For Investor Y 1500 – 1000 – 500 – Stock Price 0 – 90 100 110 120 130 140 150 160 It is 500 – evident that the call writer's profit is limited to the amount of call premium but. there is no limit to the losses if the stock price continues to increase and the writer does not make a closing transaction by purchasing an identical call. there is no limit on the amount of profit which can result for the buyer. The situation is exactly opposite for the call 1000 buyer for whom the loss is limited to the amount of premium paid. depending on the stock price. Being a 1500 – – 60 Loss . theoretically. However.

a loss (gain) to one party implies an equal amount of gain (loss) to the other party. 2001 Size of contract= I 00 shares Date of entering into contract =January 6. the option will not be exercised. two investors X and Y enter into a contract and take short and long positions respectively.50 Now.FUTURES AND OPTIONS 'zero-sum' game. Put Options In a put option. X will receive Rs 750 (=7. If the price of the share is Rs 110 or greater than that. the profit profile is different from the one in a call option where the rights and obligations are different. the gain/loss to each party depends on the ruling price of the share. so that the writer pockets the amount of put premium-the maximum profit which can 61 . Y At the time of maturity.50 x 100) from the buyer. the writer of the option. Consider a put option contract on a certain share. as the contract is entered into. Suppose. since the investor with a long position has a right to sell the stock and the writer is obliged to buy it at the will of the buyer. 2001 Share price on the date of contract = Rs 1 12 Price of put option on the date of contract = Rs 7. PQP. The other details are given below: Exercise price = Rs I 10 Expiration month = March.

a loss would result to the writer and a gain to the buyer.50 per share. The maximum loss that the writer may theoretically be exposed to is limited by the amount of the exercise price. 110 – Rs.FUTURES AND OPTIONS accrue to a seller. 7.50 (= Rs 110 Rs 7. If the price of the share falls below the exercise price. the writer would make a loss-and the buyer makes a gain.50).50 = Rs. the gain/loss for each of the investors may be calculated as shown below. At the same time. when the price of the share is Rs 100. If the price of the share happens to be lower than this. Possible Price of PQR at Investor X Investor Investor Y Put Maturity (Rs) 80 90 100 110 120 130 140 150 -2250 -1250 -250 750 750 750 750 750 X Investor Y 2250 1250 250 -750 -750 -750 -750 -750 The break-even share price would be Rs 102. For instance. The profit/loss for some selected values share are given below. 102. if the value of the underlying share falls to zero. Thus. it represents the maximum loss that the buyer is exposed to. Investor X 62 . the loss to the writer is equal to Rs.

FUTURES AND OPTIONS Option premium received = 7. 500 – Stock Price (a) For investor X 1000 – 90 100 110 120 130 140 150 160 1500 – 2000 – 63 2500 . 10000 Net Profit (Loss) = 750 . 11000 500 The profile of profit/loss for each of the investors is given in Figures below.5 x 100 = Rs. the profiles of the two – investors replicate each other. 750 Amount to be received for shares = 110 x 100 = Market value of the shares = 100 x 100 = Rs. 250 Rs.11000 + 10000 = (Rs. As indicated earlier.5 x 100 = Rs. Fig.10000 = Rs. (b) gives the same for 0 the other investor Y. the buyer of the option. 11000 Market value of the shares = 100 x 100 = Rs. (a) shows the profit/loss function for the investor X the writer of the put. 10000 1000 – Net profit (loss) = -750 + 11000 . 750 Amount to be paid for shares = 110 x 100 = Rs. while the Fig. 250) InvestorProfit Y 1500 – Option premium paid = 7.

It is important to note that an investor need not take positions in naked options only or in a single option alone. In fact. a number of trading strategies involving options may Loss be employed by the investors. or in a strategy using the underlying instrument (equity stock. in conjunction with the futures contracts. for 64 – .3000 – FUTURES AND OPTIONS Loss Profit 2500 – 2000 – (b) For Investor Y 1500 – 1000 – 500 – Stock Price 0 – 90 100 110 120 130 140 150 500 – Option Trading Strategies We have considered above the profit/loss resulting to the investors with long and short positions 1000 in the call and put options. Options may be used on their own.

The maximum loss to the writer of a put option on an equity hare could be equal to the exercise price (since the stock price cannot be negative). Typically. the more out-of-the money option should one buy. Hedging using Call & Put Options Hedging represents a strategy by which an attempt is made to limit the losses in one position by simultaneously taking a second offsetting position. Thus. We now discuss some of the commonly used strategies.FUTURES AND OPTIONS example). and a long or short put option has already been discussed. the loss is limited to the premium payable while the profit is potentially unlimited. For the option buyer in this strategy. One of the attractions of options is that they could be used for creating a very wide range of payoff functions. a long put would gain value as the underlying asset. The writer writes a call with the belief or expectation that the market would not show an upward trend. the writer of a call has a mirror image position along the break-even line. The offsetting position may be in the same or a different security. To begin with. Accordingly. In most cases. a hedge strategy strives to prevent large losses without significantly reducing the gains. while selling of options may be used as a legitimate means of generating premium income and bought in the expectation of making profit from the likely bullish / bearish market sentiments. which we describe in the next section. the equity share price or the market index. be combined in several Ways without taking positions in the underlying assets or they might be used in conjunction with the underlying assets for purposes of hedging. The writer of a put option would get the maximum profit equal to the premium amount but would be exposed to loss should the market collapse. The loss for a put buyer is limited to the amount paid for the option if the market ends above the option exercise price. The more bullish market sentiment or perception. declines. the hedges are not perfect because they cannot eliminate all losses. A long call is used when one expects that the market would rise. we may consider investment in a single stock option. On the other hand. 65 . They may. however. they may or may not be used alone. In case of the put option. a put is bought when a decline is expected in the market. The payoffs associated with a long or short call.

6. 16 for an exercise price of. 110 – Rs. 24. at a share price of Rs. Table below gives the profit/loss for some selected values of the share price on maturity of the option. there is a risk that the price may in fact fall. However. equal to Rs.. In such a case. a hedge could be formed by buying a put i. obviously. 70. 16. With a loss of Rs. For instance. 30 incurred for the reason of holding the share. 110. discussed earlier. buying the right to sell. Consider an investor who buys a share for Rs. the put will be exercised and the resulting profit would be Rs. 100.e. He would. exercise the option only if the price of the share were to be less than Rs. he buys a put for Rs. the net loss equals to Rs. options in equities are employed to hedge a long o short position in the underlying common stock. Rs. Profit / Loss for Selected Share Values: Long Stock Long Put Share Price 70 80 Exercise Price 110 110 Profit on Exercise (i) 24 14 Profit / Loss on Share Held (ii) -30 -20 Net Profit (i) + (ii) -6 -6 66 . say. 70. Such options are called covered options in contrast to the uncovered or naked options.FUTURES AND OPTIONS Very often. 110. Hedging a Long Position in Stock An investor buying a common stock expects that its price would increase. To guard against the risk of loss from a fall in its price. or Rs 40 minus the put premium of Rs.

FUTURES AND OPTIONS 90 100 110 120 130 140 110 110 110 110 110 110 4 -6 -16 -16 -16 -16 -10 0 10 20 30 40 -6 -6 -6 4 14 24 The profits resulting from the strategy of holding a long position in stock and long put are shown in the figure below. the investor intends to make a profit. 67 . Any price increase can bring losses because of an obligation to purchase at a later date. the investor can buy a call option with an exercise price equal to or close to the selling price of the stock. To minimize the risk involved. Hedging: Long Stock Long Put Profit 50 40 30 20 10 0 10 20 30 40 E Profit on Exercise of Put Profit / Loss on Hedging Stock Price Profit / Loss on Long Stock Hedging a Short Position in Stock Loss Unlike an investor with a long position in stock. a short seller of stock anticipates a decline in stock price. By shorting the stock now and buying it at a lower price in the future.

Profit / Loss for Selected Share Values: Short Stock Long Call Share Price 90 95 100 105 110 115 120 Exercise Price 105 105 105 105 105 105 105 Profit on Exercise (i) -4 -4 -4 -4 1 6 11 Profit / Loss on Share Held (ii) 15 10 5 0 -5 -10 -15 Net Profit (i) + (ii) 11 6 1 -4 -4 -4 -4 The payoff function associated with this policy is shown below Profit 50 - 40 30 20 10 0 10 20 30 40 - Profit / Loss on Profit Hedging: Short Stock Long Call / Loss on Short Stock Call Option E Stock Price Profit / Loss on Hedging 68 . an investor shorts a share at Rs. 4 with a strike price of Rs. 105. The conditional payoffs resulting from some selected prices of the share are shown in a table below. 100 and buys a call option for Rs.FUTURES AND OPTIONS Let us suppose.

The profit/loss occurring at some prices of the underlying share is indicated in table below.. 105. By writing covered call options. consider an investor who has bought a share for Rs 100. If the common stock is not expected to experience significant price variations in the short run.e. Of course. then the strategies of writing calls and puts may be usefully employed for the purpose. 3. Profit / Loss for Selected Share Values: Long Stock Short Call Share Exercise Profit on Profit / Loss on Net Profit Price 90 95 100 Price 105 105 105 Exercise (i) 3 3 3 Share Held (ii) -10 -5 0 (i) + (ii) -7 -2 3 69 . As an example. then you may write a call on these. The writing of covered calls. agreeing to sell the stock you have. you will not derive any benefit if large price changes occur because then the option will be exercised or. Options may also be used for enhancing returns from the positions in stock. you would have to make a reversing transaction. suppose that you hold shares of a stock which you expect will experience small changes in the short term. i. you tend to raise the short-term returns.FUTURES AND OPTIONS Hedging with Writing Call & Put Options Both the strategies discussed above aim at limiting the risk of an underlying position in an equity stock. is a very conservative strategy. and receives a premium of Rs. else. This is known as writing covered calls. and who writes a call with an exercise price of Rs. To illustrate the strategy of writing a covered call.

the investor hopes to reduce the magnitude of loss that would be occurring from an increase in the stock price. by limiting the profit that could be made when the stock price declines. the buyer of the put will exercise the option only if the share price does not exceed the exercise price. As an example. 70 . an investor who shorts stock can hedge by writing a put option. 100. suppose that you short a share at Rs. 100 and write a put option for Rs. By undertaking to ‘be the buyer’. having an exercise price of Rs. 3.FUTURES AND OPTIONS 105 110 115 120 105 105 105 105 3 -2 -7 -12 5 10 15 20 8 8 8 8 Figure depicts the payoff function for the strategy of writing covered calls Profit 50 40 30 20 10 0 10 20 30 40 Loss E Profit / Loss on Call Option Hedging: Long Stock Short Call Profit / Loss on Long Stock Profit / Loss on Hedging Stock Price In a similar way. Clearly.

FUTURES AND OPTIONS The conditional payoffs resulting from some selected values of the share price are contained in table below. Profit / Loss on Short Stock Hedging: Short Stock ShortPut Profit / Loss on Hedging Profit Put Option / Loss on Stock Price 50 40 30 20 10 0 10 20 30 40 Loss E 71 . Profit / Loss for Selected Share Values: Short Stock Short Put Share Price 90 95 100 105 110 115 120 Exercise Price 100 100 100 100 100 100 100 Profit on Exercise (i) -7 -2 3 3 3 3 3 Profit / Loss on Share Held (ii) 10 5 0 -5 -10 -15 -20 Net Profit (i) + (ii) 3 3 3 -2 -7 -12 -17 The figure below gives a general view of the profit function associated with the policy of Profit writing a protected put.

The margin paid by the investor is kept at the disposal of the clearing house through the brokerage firms.FUTURES AND OPTIONS MARGINS The concept of margin here is the same as that for any other trade. to ensure performance of the contract and to cover day to day adverse fluctuations in the prices of the securities bought. The clearing house gets the protection against possible business risks through the margins placed with it in this manner and by the 72 . to introduce a financial stake of the client. i.e.

The initial margin is deposited is deposited before the opening of the day of the futures transaction. Both buyer and seller have to deposit margins. Maintenance margin: This is somewhat lower than the initial margin. the following day. margins are sought or released). based on which. This is set to ensure that the balance in the margin account never becomes negative. based on the volatility of market indices in India. All daily losses must be met by depositing of further collateral-known as variation margin. Normally this margin is calculated on the basis of variance observed in daily price of underlying (say the index) over a specified historical period (say immediately preceding one year). If the balance in the margin account falls below the maintenance margin. Usually three sigma (standard deviation) is used for this measurement. The margin is kept in a way that it covers price movements more than 99% of the time. the initial margin is expected to be around 6 percent. the investor receives a margin call and is expected to top up 73 . There can be different types of margin Initial margin Maintenance margin Variation margin Additional margin Cross margin Initial margin: The basic aim of initial margin is to cover the larger potential loss in one day. Any profit on the contract is credited to the clients variation margin account. This technique is also called Value it Risk (or VAR).FUTURES AND OPTIONS process of ‘marking to market’ (it means. which is required by the close of business. debiting or crediting the clients’ equity accounts with the loss or gains of the day. Variation margin: It is also called as ‘mark to market margin’.

options. if Initial Margin is fixed at 100 and the maintenance margin is at 80. For e. Additional Margin: in case of sudden higher than expected volatility. NSE CNX NIFTY 74 . India . additional margin may be called for by the exchange. If it drops below 80. This is generally imposed when the exchange fears that the markets have become too volatile and may result in some crisis. It was followed two months later by the S&P 500 index futures contract introduced by Chicago Mercantile Exchange (CME). then a margin of 30 (and not 10) is to be paid to replenish the levels of initial margin. The following are the Stock Index Futures are the most actively traded financial derivative the world over. hence. S&P500 Index Futures is the most actively traded futures contract.FUTURES AND OPTIONS the margin account to the initial margin level before trading commences on the next day. the total margin requirement reduces. This concept is not expected to be used in INDIA. like payments crisis. Stock Index Futures Stock index futures are one of the varieties of futures contracts.g. The first stock index futures contract based on value line index was introduced by Kansas City Board of Trade (KCBT) on 24th February. due to cross-hedges. cash market etc. then the broker is permitted to trade till such time that the balance in this initial margin account is 80 or more. 1982. This is a preemptive move by exchange to prevent break-down. say it drops to 70.BSE SENSEX. Cross Margin: this is the method of calculating margin after taking into account combined positions in futures. etc. At present.

Sensex is a composition of 30 blue-chip securities being traded on BSE.g. Japan Germany France U.G. The market lot size for Nifty futures is 200. E. a stock index futures contract is simply a futures contract where the underlying variable is a stock index such as BSE SENSEX.FUTURES AND OPTIONS U.DAX .HANGSENG . S&P CNX. S& P 500. The SEBI has suggested phased introduction of derivatives starting with stock index futures to be followed by stock index futures Features of Stock Index Futures Multiple or Market Lot size.S. NYSE. Therefore.CAC 40 . It means that if on a day Nifty futures is 75 . NIFTY etc. Theoretically.PTSE 100 .IBEX 35 .Gupta Committee Report.SMI . The SEBI has taken a landmark decision permitting the use of derivatives based on L. RUSSELL 2000.The stock index futures can be bought or sold only in a specified lot size.KUALALUMPUR . an investor who buys a stock index futures contract agrees to buy the entire stock index and the seller agrees to sell the entire stock index. NASDAQ 100 . the value of stock index futures derives its value from a stock index value.K Switzerland Spain Canada Hong Kong Malaysia South Korea – DJIA.KOSPI 2000 A stock index is a composition of select securities traded on an exchange.NIKKEI .TSE 35 .

FUTURES AND OPTIONS quoting at a price of 1400 then the value of one Nifty futures contract shall be Rs. Margin Requirement and Mark to the Market. price bands or price range.the lifetime of each series is generally three months worldwide. (200*400). a margin call is made and the trader is required to deposit additional amount so as to restore the balance in margin account back to the level of initial margin.It is a margin amount initially required opening a margin account for trading Maintenance margin. price steps or tick size. If the balance in margin account falls below this level. For instance when NSE introduced trading in Nifty futures on 12th June .A stock index futures contract does not entitle physical delivery of stocks and the contract is settled in cash on the settlement date. At any point of time there are three series open for trading. Initial margin. 76 . we had three contracts open for trading viz. settlement basis and the settlement price. Contract lifetime. These specifications make a stock index as a tradable security that can be bought or sold. trading cycle. Two month July Nifty futures – maturing on 27th July. Variation margin. One month June Nifty futures – maturing on 29th June. 2000. 80.000 i. Specifications. 2.variation margin is the amount of “margin call” required to be deposited by the trader in case balance in margin account falls below maintenance margin level. 2000. Cash settlement.e.on the stock index futures contract indicate the underlying index. The traders in a stock index futures market are required to keep good faith deposits which are adjusted on a daily basis to account for the gains or losses.Like any other futures contract a stock index futures contract is also characterized by margin requirement.It is the minimum amount of margin that must be maintained in a margin account. 2000. contract size. This is because it is virtually imposible to deliver all the stocks comprising the stock index and that too in the same proportion in which they appear in the index at the time of settlement. expiry day. There are three types of margins in a futures market.

Trading in Stock Index Futures Trading in sensex or Nifty futures is just like trading in any other security. the feel of trading in stock index futures is the same as trading on stocks. a new series of three month September futures came into existence on 30th June. The order will have to be punched in the system and the confirmation will be immediate like the existing system. two month July contract automatically became one month July contract and three month August futures then became two month August futures. A trader can carry the stock index futures contract till maturity or square it off at any time before expiry. Since the tick size and the market lot size in futures is similar to individual stock. On the expiry of one month June futures on 29 th June. An investor is able to buy or sell futures on the BSE-Bolt terminal or the NSE-NEAT screen with the broker. 77 . Separate bid and ask quotations are available like shares. You simply have to punch in your order of the required quantity at a price you wish to buy. 2000.2000. sell or execute the same at the market price. Then. On execution of the order you would receive a confirmation of the same.FUTURES AND OPTIONS Two month August Nifty futures – maturing on 31st August.

Stock Index Futures price depends upon: Spot index value Cost of carry or interest rate Carry returns i.FUTURES AND OPTIONS Pricing of Stock Index Futures Theoretically or fair price of a Stock Index Futures contract is derived from the well celebrated cost of carry model.e. F S e r y t = Se(r-y) t = Future price = Spot value of index = Exponential constant with value 2. dividend income = Time to maturity in years 78 . F Where. Accordingly.718 = Cost of Carry or interest cost = Carry return e. dividends expected on securities comprising the index Mathematically.g.

) 35.500.400 Day 3 335 35. Suppose an investor can speculate by trading Stock Index Futures.500 3.000). 3.000 (i.e. Thirdly. 35000 which is derived by multiplying index value of 350 by 100 which is fixed. For instance if the BSE-200 rises from 350 to 400 over a contract period of 3 months then the 79 . The investor has to deposit a margin of say 10% of the contract value which is Rs.000 3’400 Day 5 335 33. For instance if BSE-200 is currently trading at 350 points then the contract value will be Rs. the stock index is difficult to be manipulated and the possibility of cornering is reduced. Fourthly. if the BSE-200 moves in the following manner over the next 6 days the margin requirement will be calculated accordingly. the investment to be made is low which is restricted to the margin amount.550 Day 4 340 34. forgery and bad deliveries can be avoided.600 Value of the contract(Rs.7000 3.00035. Secondly.350 Day 6 360 36.000 Margin 3. As the settlement is done on cash basis the risk of fake certificates. Particulars BSE-200 Day 0 350 Day 1 370 3.000 3. 1.700 Day 2 340 34.FUTURES AND OPTIONS Stock Index Futures are the most popular equity derivatives where the contract value is based on the stock index value. as the Stock Index Futures enjoy great popularity they are likely to be more liquid than all other types of equity derivatives.000 3.500 3. the margin requirements shall be calculated daily linked to the value of the stock index. 36. As the margin is mark to market. Speculation in Stock Index Futures Trading An investor can speculate by trading in stock index futures based on his expectations of market rise or market fall.500 In the above case the profit to the investor over a period of 6 days shall be Rs. Thus.

then he can sell futures contracts. On the other hand if the investor expects market to fall then he can sell stock index futures. Hence.000[(400350)*400*10].10 crores/ 350*10=2857.000. 50. In such a case if the market comes down then the losses incurred on individual securities shall be compensated by profits made in the futures contract. Supposing if the investor buys 10 BSE-200 at 350 points cash. However. without the backing of a commercial position an investor can make profits by speculation.14 contracts. then he makes a profit of Rs. then he loses in the case of speculation. the Mutual Fund can sell 2857 or 2858 futures contracts. 10 crores and the BSE-200 is currently trading at 350 then the number of futures contracts to be sold shall be Rs.FUTURES AND OPTIONS investor makes a profit of Rs 5000 [(400-350)*100] on a contract value of Rs. Thus. Hedging with Stock Index Futures Hedging technique is very useful in the case of high net worth entities such as Mutual Funds having a portfolio of securities. On the contrary if the market rises. Supposing if the value of a portfolio of a Mutual Fund is Rs. then the loss incurred in the futures contract shall be compensated by profit made on the individual securities. However it is the possible to have a perfect hedge as the contracts cannot be traded in fractions. For instance if the investor wants to reduce the loss on his holding of securities due to uncertain price movements in the market. 80 . 35. if the investor makes a wrong judgment regarding the movement of the market.

He has short position on the cash market Rs.) Right Limited Wrong Limited Fair Limited Net position on the Raise 50.000 1.000 22.75.25. The beta of the Fair Limited is 0.000 index future 81 .000 Stagnant 20. a complete hedge against the following transactions: The share of Right Limited is going to rise. The beta of the Right Limited is 1.00.000 25.90 0. He has a long position on the cash Market at Rs.00.50.) Beta Indge value Position (Rs. The beta of the Wrong Limited is 0.50. 20 lakhs on the Wrong Limited.000 Short Long Long Short Depreciate 25.90. He has a long position on the cash market of Rs. 50 lakhs on the Right Limited.00.75 62.FUTURES AND OPTIONS The position on the index future gives a speculator. 20 lakhs of the Fair Limited. The share of Fair Limited is going to stagnant.25 0. Company Name Trend Amount (Rs.00.000 15. The share of Wrong Limited is going to depreciate.00.

Today. two months and three months expiry. Currently. NSE is the largest derivatives exchange in India. The trading in index futures commenced on June 4. TM-CM may clear and settle his own proprietary trades and client’s trades as well as lear and settle for others TMs. both in terms of volume and turnover. Participants and Functions NSE admits members on its derivatives segment in accordance with the rules and regulations of the exchange and the norms specified by SEBI. • Trading Member Clearing Member: TM-CM is a CM who is also a TM. undertakes risk management and performs actual settlement. Single stock futures were launched on November 9. the derivatives contracts have maximum of 3-month expiration cycles. Trading and clearing members are admitted separately. with one month. Essentially. 2001. a clearing member (CM) does clearing for all his trading members (TMs). 82 . 2000. A new contract is introduced on the next trading day following the expiry of the near month contract. 2001. NSE follows 2-tier structure stipulated by SEBI to enable wider participation. 2001 and trading in options on individual securities commenced on July 2.FUTURES AND OPTIONS NSE’s derivative market The derivatives trading on the NSE commenced with S&P CNX Nifty Index future on June 12. There are three types of CMs: • Self Clearing Member: A SCM clears and settles trades executed by him only on his own account or on account of his clients. Three contracts are available for trading. WDM and F&O segment. Those interested in taking membership on F&O segment are required to take membership of CM and F&O segment or CM.

017 77.096 83 .942 8.799 Stock futures 16.133 Stock options 4.505 78.218 Index futures 195 389 1.123 9. Crore) Month June 2000 June 2001 June 2002 June 2003 June 2004 June 2005 Index futures 35 590 2.042 7.473 16.FUTURES AND OPTIONS • Professional Clearing Members: PCM is a CM who is not a TM.348 64. Typically.424 14.392 163. banks or custodians could become a PCM and clear and settle for TMs.642 15. trading members are required to have qualified users and sales persons.178 46. 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. who have passed a certification programme approved by SEBI Business growth of futures and options market: Turnover (Rs. Besides this.

Additionally. It supports an anonymous order driven market which provides complete transparency of trading operations and operates on strict price-time priority. and order and trade management. Various conditions like Immediate or Cancel. provides a fully automated screen-based trading for Nifty futures and options and stock futures & options on a nationwide basis and an online monitoring and surveillance mechanism. which a trading member can take. It provides tremendous flexibility to users in terms of kinds of orders that can be placed on the system. Limit/Market price. It is similar to that of trading of equities in the Cash Market (CM) segment. they can enter and set limits to positions.FUTURES AND OPTIONS Trading mechanism The futures and options trading system of NSE. can be built on order. The Clearing Member (CM) uses the trader workstation for the purpose of monitoring the trading member(s) for whom they clear the trades. Stop loss. The Trading Members (TM) have access to functions such as order entry. etc. called NEAT-F&O trading system. order matching. The NEAT-F&O trading system is accessed by two types of users. 84 .

The option buyers then have a further decision to make. This key variations cause important differences in the risk reward relationship involved in wasting in either future or options. Both futures and options are useful derivatives but have some fundamental differences between the two types of the derivatives they are 85 . While the option premium represents the purchase of exercisable rights. although there are differences prices of premium are a wasting asset and are much affected by the volatility of the underlying price. Buyers pay a premium for the rights to purchase (or sell in the case of put option) an agreed quantity of the same underlying asset by the future date. is confirmed when the initial margin or deposit changes hands. The contract terms are standardized by futures exchange. however. An option does not carry the same obligations. which is that of exercising his option if he chooses to buy an underlying asset. in the obligation from both buyer and seller. Futures are contractual obligation to buy and sell at an agreed price at future date. The future contract margin is therefore the basis of a contractual commitment. he will take all the profit there is available by selling his option back at a higher price (this is why they are known as traded option). Futures margin are not a wasting asset they are affected differently by volatility. In both the concepts of gearing is crucial. whereas the latter confer rights.FUTURES AND OPTIONS Differences between Futures and Options Contracts The key difference between futures and options is that the former involved obligations. In most cases.

but retains upward has potential for all the upside return indefinite potential 4 The parties of the contract must perform The buyer can exercise option any time prior at the settlement date. They are not to the expiry date obligated to perform before the date 86 .FUTURES AND OPTIONS Futures 1 Options Both the parties are obliged to perform the Only the seller(writer) is obligated to perform contract the contract The buyer pays the seller(writer) a premium 2 No premium is paid by the either parties 3 The holder of the contract is exposed to The buyer loss is restricted to downside risk the entire spectrum of downside risk and to the premium paid.

At their simplest. Their supporters say that it improves risk management and increase liquidity. So even if the average investor doesn't invest directly in F&O segment it’s important that he or she knows what they are!!!!!!! Trading in F&O require extra preparation and caution. options and futures are calculated best on the movements of the underlying asset. Their critics claim that they make markets less transparent and more prone to instability. So if you do invest in F&O market. If you guess right you could earn a multiple of your initial investment in days but if you guess wrong your investment can be wiped out equally quickly. volatility and speculation. 87 . One should understand precisely how changes in the price of the underlying would affect the value of your investment and also study the underlying market whether it's stocks or commodities. While they are as old as commerce itself.FUTURES AND OPTIONS CONCLUSION Futures & Options are among the most complex financial instruments and also one of the most controversial. they have become prominent only in the last few decades. make sure you are especially diligent in researching both the derivative and the underlying asset.

com www.optionbroker. 88 .com www.com www.Economic Times.Google… News Paper: .tradingfutures.com Search Engine: . Business Standard.FUTURES AND OPTIONS BIBLIOGRAPHY BOOKS REFFERED:Derivatives Market (dealers) Module Work Book www.bseindia.nseindia.