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An Introduction to Equity Markets

S. No. 1. Equity Market Origin, Definition 2. Exchanges


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Indian, International, Index trading /formation 3. Indian Stock Market Dynamism, FII flow, Growth 4. Screen Based Trading Online trading mechanism 5. Regulator SEBI, Market Surveillance, Depository, Demat 6. Research Approach Fundamental, Technical, Top down, Bottom up Analysis 7. 8. Terminologies Identify Your Clients Arbitrager, Hedger, Speculator, Trader, Investor 9. Derivatives 15 10 14 8 6 5 4

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Are markets in which shares are issued and traded either through exchanges or over-the-counter markets. Also known as the equity market, it is one of the most vital areas of a market economy as it provides companies with access to capital and investors with a slice of ownership in the company and the potential of gains based on the company's future performance. Stock? Plain and simple, stock is a share in the ownership of a company. Stock represents a claim on the company's assets and earnings. As you acquire more stock, your ownership stake in the company becomes greater. Whether you say shares, equity, or stock, it all means the same thing. The importance of being a shareholder is that you are entitled to a portion of the companys profits and have a claim on assets. Profits are sometimes paid out in the form of dividends. The more shares you own, the larger the portion of the profits you get. The securities market has two interdependent segments: the primary (new issues) market and the secondary market. Primary market is where new issues are first offered, with any subsequent trading going on in the secondary market. The primary market provides the channel for sale of new securities. Secondary market refers to a market where securities are traded after being initially offered to the public in the primary market and/or listed on the Stock Exchange. Majority of the trading is done in the secondary market. Secondary market comprises of equity markets and the debt markets.


Share market in Indian started functioning in 1875. The name of the first share trading association in India was Native Share and Stock Broker's Association, which later came to be known as Bombay Stock Exchange (BSE). This association kicked of with 318 members. Indian Share Market mainly consists of two stock exchanges namely Bombay Stock Exchange (BSE) & National Stock Exchange (NSE) Bombay Stock Exchange (BSE) Bombay Stock Exchange is the oldest stock exchange not only in India but in entire Asia. Its history is synonymous with that of the Indian Share Market history. BSE started functioning with the name, The Native Share and Stock Broker's Association in 1875. It got Government of India's recognition as a stock exchange in 1956 under Securities Contracts (Regulation) Act, 1956. At the time of its origin it was an Association of Persons but now it has been transformed to a corporate and demutualised entity. BSE is spread all over India and is present in 417 towns and cities. The total number of companies listed in BSE is around 3500. The main index of BSE is called BSE SENSEX or simply SENSEX. It is composed of 30 financially sound company stocks, which are liable to be reviewed and modified from time-to-time. Index calculation methodology SENSEX, first compiled in 1986 was calculated on a "Market Capitalization-Weighted" methodology of 30 component stocks representing a sample of large, well established and financially sound companies. The base year of SENSEX is 1978-79. From September 2003, the SENSEX is calculated on a free-float market capitalization methodology. The "free-float Market Capitalization-Weighted" methodology is a widely followed index construction methodology on which majority of global equity benchmarks are based.

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Launch of Other BSE Indices The launch of SENSEX in 1986 was later followed up in January 1989 by introduction of BSE National Index (Base: 1983-84 = 100). The BSE National Index was renamed as BSE-100 Index from October 14, 1996 and since then it is calculated taking into consideration only the prices of stocks listed at BSE. The Exchange launched dollar-linked version of BSE-100 index i.e. Dollex-100 on May 22, 2006. The Exchange constructed and launched on 27th May, 1994, two new index series viz., the 'BSE-200' and the 'DOLLEX-200' indices. The launch of BSE-200 Index in 1994 was followed by the launch of BSE-500 Index and 5 sectoral indices in 1999. In 2001, BSE launched the BSE-PSU Index, DOLLEX-30 and the country's first free-float based index - the BSE TECk Index. The Exchange shifted all its indices to a free-float methodology (except BSE PSU index) in a pahsed manner. National Stock Exchange (NSE) National Stock Exchange (NSE) founded although late than BSE, is currently the leading stock exchange in India in terms of total volume traded. It is also based in Mumbai but has its presence in over 1500 towns and cities. In terms of market capitalization, NSE is the second largest bourse in South Asia. National Stock Exchange got its recognition as a stock exchange in July 1993 under Securities Contracts (Regulation) Act, 1956. The products that can be traded in NSE are: Equity or Share Futures (both index and stock) Options (Call and Put) Wholesale Debt Market Retail Debt Market NSE's leading index is Nifty 50 or popularly Nifty and is composed of 50 diversified benchmark Indian company stocks. Nifty is constructed on the basis of weighted average market capitalization method. GLOBAL EXCHANGES The New York Stock Exchange The most prestigious exchange in the world is the New York Stock Exchange (NYSE). The "Big Board" was founded over 200 years ago in 1792 with the signing of the Buttonwood Agreement by 24 New York City stockbrokers and merchants. Currently the NYSE, with stocks like General Electric, McDonald's, Citigroup, Coca-Cola, Gillette and Wal-mart, is the market of choice for the largest companies in America. American Stock Exchange The third largest exchange in the U.S. is the American Stock Exchange (AMEX). The AMEX used to be an alternative to the NYSE, but that role has since been filled by the Nasdaq. In fact, the National Association of Securities Dealers (NASD), which is the parent of Nasdaq, bought the AMEX in 1998. Nasdaq (History) The NASDAQ (acronym of National Association of Securities Dealers Automated Quotations) is an American stock exchange. It is the largest electronic screen-based equity securities trading market in the United States. It was founded in 1971 by the National Association of Securities Dealers (NASD), who

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divested themselves of it in a series of sales in 2000 and 2001. It is owned and operated by the NASDAQ OMX Group. Its main index is the NASDAQ Composite, which has been published since its inception. However, its exchange-traded fund tracks the large-cap NASDAQ 100 index, which was introduced in 1985 alongside the NASDAQ 100 Financial Index. NASDAQ lists approximately 3,200 securities, of which 335 are non-U.S. companies from 35 countries representing all industry sectors. To qualify for listing on the exchange, a company must be registered with the SEC, have at least three market makers (financial firms that act as brokers or dealers for specific securities), and meet minimum requirements for assets, capital, public shares, and shareholders.NasdaqOMX now has a dual listing agreement with the Tel Aviv Stock Exchange.Nasdaq is traditionally home to many high-tech stocks, such as Microsoft, Intel, Dell and Cisco. Dow Jones Industrial Average (DJIA) "The Dow", the DJIA is the oldest and single most watched index in the world. The DJIA includes companies like General Electric, Disney, Exxon and Microsoft. Charles Dow invented the DJIA back in 1896. The Dow Jones Industrial Average is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq. European Market Index - London Stock Exchange (LSE) The primary stock exchange in the U.K. and the largest in Europe, originated in 1773, the regional exchanges were merged in 1973 to form the Stock Exchange of Great Britain and Ireland, later renamed the London Stock Exchange (LSE). The Financial Times Stock Exchange (FTSE) 100 Share Index, or "Footsie", is the dominant index, containing 100 of the top blue chips on the LSE. Asian Market Indices Tokyo Stock Exchange (TSE) Tokyo Stock Exchange was established on May 15, 1878, and trading began on June 1st. Japan Stock Exchange: Nikkei Japan's Nikkei 225 Stock Average, the leading and most-respected index of Japanese stocks. It is a priceweighted index comprised of Japan's top 225 blue-chip companies on the Tokyo Stock Exchange. The Nikkei is equivalent to the Dow Jones Industrial Average Index in the U.S. In fact, it was called the Nikkei Dow Jones Stock Average from 1975 to 1985. Hong Kong Exchange: Hang Seng Index (HSI) In Hang Seng index there is market capitalization-weighted index of 40 of the largest companies that trade on the Hong Kong Exchange. The Index is maintained by a subsidiary of Hang Seng Bank, and has been published since 1969. The index aims to capture the leadership of the Hong Kong exchange, and covers approximately 65% of its total market capitalization.


With over 25 million shareholders, India has the third largest investor base in the world after USA and Japan. Over 7500 companies are listed on the Indian stock exchanges (more than the number of companies listed in developed markets of Japan, UK, Germany, France, Australia, Switzerland, Canada and Hong Kong.). The Indian capital market is significant in terms of the degree of development, volume of trading, transparency and its tremendous growth potential. Indias market capitalisation was the highest among the emerging markets. Total market capitalisation of The Bombay Stock Exchange (BSE), which, as on July 31, 1997, was US$ 175 billion has grown by 37.5% per

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cent every twelve months and was over US$ 834 billion as of January, 2007. Bombay Stock Exchanges (BSE), one of the oldest in the world, accounts for the largest number of listed companies transacting their shares on a nation wide online trading system. The two major exchanges namely the National Stock Exchange (NSE) and the Bombay Stock Exchnage (BSE) ranked no. 3 & 5 in the world, calculated by the number of daily transactions done on the exchanges. The Total Turnover of Indian Financial Markets crossed US$ 2256 billion in 2006 An increase of 82% from US $ 1237 billion in 2004 in a short span of 2 years only. Turnover in the Spot and Derivatives segment both in NSE & BSE was higher by 45% into 2006 as compared to 2005. With daily average volume of US $ 9.4 billion, the Sensex has posted excellent returns in the recent years. The market cap of the sensex as on April 11th, 2008 was Rs 2,237,540 crore with a P/E of 20.23x. Sensex high 2002-3 2003-4 2004-5 2005-6 2006-7 2007-8 3758 6249 6954 11356 12671 13950 Sensex low 2828 2905 4227 6118 8800 8799 272 348 450 540 686 785 Eps P/E High 13.8 18.0 15.5 21.0 18.5 17.8 P/E Low 10.4 8.3 9.4 11.4 12.8 11.2

Index Nifty: Returns (%) 10.7 End year mcap (Rs crore) 9,02,831 End year P/E 15.32 Bse Sensex Returns (%) 13.1 End year mcap (Rs crore) 7,35,528 End year P/E 17.1

SIZE OF EQUITY MARKET, RETURNS (%),P/E CY04 CY05 36.3 13,50,394 17.07

CY06 39.8 19,75,603 21.26

CY07 54.7 35,22,527 27.62

42.3 12,13,867 18.6

46.7 17,58,865 22.8

47.2 28,61,341 27.7

BSE 500 Returns(%) 17.5 End year Mcap (Rs crore) 15,80,762 End year P/E 15.2

36.6 22,81,579 17.5

38.9 33,36,509 20.2

63 64,70,881 29.1

Trends in Primary Markets According to Sebi data, the average size of IPO has increased from Rs 197 crore in FY06 to Rs 270 crore in FY07 and in FY08 this figure has magnified to 403 crore. Corporates collected Rs.22,131 crore in 2003-04, Rs 25,526 crore in 2004-05, Rs 23,676 crore in 2005-06, Rs 24,993 in 2006-07 and a whopping Rs 51,408 crore in 2007-08 (till the end of January 2008).

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FII inflows in India Net FIIs inflow in India increased steadily through the last decade of the 1990s. The year 2003 was a watershed year for FIIs investments in Indian stock market which reached an annual peak of US$ 10 billion in 2004-2005. This buoyancy continued during 2005-06 and the cumulative FII inflow in 9 months period ending December, 2006 had reached around US$ 10 billion. The cumulative FII inflow till 6th March, 2007 had reached around $ 51.47 billion from $4 million in 1992, reflecting the strong economic fundamentals of the country, as well as confidence of the foreign investors in the growth and stability of the Indian market. International Corporations which have invested in India include GE, Dupont, Eli Lily, Monsato, Caterpillar, GM, Hewlett Packard, Motorola, Bell Labs, Daimler Chrysler, Intel, Texas Instruments, Cummins, Microsoft, IBM, Honda, Toyota, Mitsubishi, Samsung, LG, Novartis, Bayer, Nestle, Coca Cola and McDonalds To name a few. They have pumped in over US$ 23 billion in the past three years which strengthens Indias position in emerging as a major investment destination for the world investors. Many Japanese and European investors have also started eyeing India, aiming to cash in on the rising equity markets. Registrations from non-traditional countries like Denmark, Italy, Belgium, Canada, Sweden and Ireland are on the rise. Bill Gates, chairman of Microsoft Corporation, the worlds largest software company, said that the company will invest US$1.7 billion in India over the next four years to expand its operations. 4. INTRODUCTION OF SCREEN-BASED TRADING SYSTEM (SBTS) Before the NSE was set up, trading on the stock exchanges in India used to take place through open outcry without use of information technology for immediate matching or recording of trades. This was time consuming and inefficient. The practice of physical trading imposed limits on trading volumes as well as, the speed with which new information was incorporated into prices. To obviate this, the NSE introduced screen-based trading system (SBTS) where a member can punch into the computer the quantities of shares and the prices at which he wants to transact. The transaction is executed as soon as the quote punched by a trading member finds a matching sale or buys quote from counterparty. SBTS electronically matches the buyer and seller in an order-driven system or finds the customer the best price available in a quote-driven system, and hence cuts down on time, cost and risk of error as well as on the chances of fraud. SBTS enables distant participants to trade with each other, improving the liquidity of the markets. The high speed with which trades are executed and the large number of participants who can trade simultaneously allows faster incorporation of price-sensitive information into prevailing prices. This increases the informational efficiency of markets. With SBTS, it becomes possible for market participants to see the full market, which helps to make the market more transparent, leading to increased investor confidence. The NSE started nation-wide SBTS, which have provided a completely transparent trading mechanism. Regional exchanges lost a lot of business to NSE, forcing them to introduce SBTS.

Online Trading Mechanism: Bombay Stock Exchange's trading system is popularly known as BOLT (BSE's Online Trading System). The BSE has deployed an OnLine Trading system (BOLT) on March 14, 1995. BOLT has a two-tier architecture. The

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trader workstations are connected directly to the backend server, which acts as a communication server and a Central Trading Engine (CTE). Other services like information dissemination, index computation, and position monitoring are also provided by the system. Access to market related information through the trader workstations is essential for the market participants to act on real-time basis and take immediate decisions. BOLT has been interfaced with various information vendors like Bloomberg, Bridge, and Reuters. Market information is fed to news agencies in real time. It makes the trade efficient, transparent and time saving. NSE provides its customers with a fully automated screen based trading system known as NEAT system, in which a member can punch into the computer quantities of securities and the prices at which he likes to transact and the transaction is executed as soon as it finds a matching sale or buy order from a counter party. It electronically matches orders on a price/time priority and hence cuts down on time, cost and risk of error, as well as on fraud, resulting in improved operational efficiency. It allows faster incorporation of price sensitive information into prevailing prices, thus increasing the informational efficiency of markets. The stocks are hold in a demutualised format helping in fast, transparent and efficient preservation and transactions. 5. REGULATORS OF SECURITIES MARKET The responsibility for regulating the securities market is shared by Department of Economic Affairs (DEA), Department of Company Affairs (DCA), Reserve Bank of India (RBI) and Securities and Exchange Board of India (SEBI). Securities and Exchange Board of India (SEBI) SEBI or Securities and Exchange Board of India is entitled to protect the investors' interests, regulate and develop securities market in India. The Securities and Exchange Board of India (SEBI) is the regulatory authority in India established under Section 3 of SEBI Act, 1992. SEBI Act, 1992 provides for establishment of Securities and Exchange Board of India (SEBI) with statutory powers for (a) protecting the interests of investors insecurities (b) promoting the development of the securities market and (c) regulating the securities market. Its regulatory jurisdiction extends over corporates in the issuance of capital and transfer of securities, in addition to all intermediaries and persons associated with securities market. It passes laws for streamlining the Indian share market for efficient outcomes. Role of SEBI SEBI has been obligated to perform the aforesaid functions by such measures as it thinks fit. In particular, it has powers for: Regulating the business in stock exchanges and any other securities markets Registering and regulating the working of stock brokers, subbrokers etc. Promoting and regulating self-regulatory organizations Prohibiting fraudulent and unfair trade practices Calling for information from, undertaking inspection, conducting inquiries and audits of the stock exchanges, intermediaries, self regulatory organizations, mutual funds and other persons associated with the securities market. Market Surveillance Mechanism In order to ensure investor protection and to safeguard the integrity of the markets, it is imperative to have in place an effective market surveillance mechanism. The surveillance function is an extremely vital

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link in the chain of activities performed by the regulatory agency for fulfilling its avowed mission of protection of investor interest and development and regulation of capital markets. The surveillance system adopted by SEBI is two pronged viz.: (1) Surveillance Cell in the stock exchange and (2) The Integrated Surveillance Department in SEBI. (1) Surveillance Cell in the stock exchange The stock exchanges as said earlier, are the primary regulators for detection of market manipulation, price rigging and other regulatory breaches regarding capital market functioning. This is accomplished through Surveillance Cell in the stock exchanges. SEBI keeps constant vigil on the activities of the stock exchanges to ensure effectiveness of surveillance systems. The stock exchanges are charged with the primary responsibility of taking timely and effective surveillance measures in the interest of investors and market integrity. Proactive steps are to be taken by the exchanges themselves in the interest of investors and market integrity as they are in a position to obtain real time alerts and thus know about any abnormalities present in the market. Unusual deviations are informed to SEBI. Based on the feedback from the exchanges, the matter is thereafter taken up for a preliminary enquiry and subsequently, depending on the findings gathered from the exchanges, depositories and concerned entities, the matter is taken up for full-fledged investigation, if necessary. (2) Integrated Surveillance Department in SEBI SEBI on its own also initiates surveillance cases based on references received from other regulatory agencies, other stakeholders (investors, corporates, shareholders) and media reports. Being proactive is one of the necessary features for success in taking surveillance measures. Keeping the same in mind, the Integrated Surveillance Department of SEBI keeps tab on the news appearing in print and electronic media. News and rumours appearing in the media are discussed in the weekly surveillance meetings with the stock exchanges and necessary actions are initiated. Integrated Market Surveillance System: In order to enhance the efficacy of the surveillance function, SEBI has decided to put in place a world-class comprehensive Integrated Market Surveillance System (IMSS) across stock exchanges and across market segments (cash and derivative markets). Depository System The erstwhile settlement system on Indian stock exchanges was also inefficient and increased risk, due to the time that elapsed before trades were settled. The transfer was by physical movement of papers. There had to be a physical delivery of securities -a process fraught with delays and resultant risks. The second aspect of the settlement relates to transfer of shares in favour of the purchaser by the company. The system of transfer of ownership was grossly inefficient as every transfer involves physical movement of paper securities to the issuer for registration, with the change of ownership being evidenced by an endorsement on the security certificate. In many cases the process of transfer would take much longer than the two months stipulated in the Companies Act, and a significant proportion of transactions would end up as bad delivery due to faulty compliance of paper work. Theft, forgery, mutilation of certificates and other irregularities were rampant. In addition, the issuer has the right to refuse the transfer of a security. All this added to costs and delays in settlement, restricted liquidity and made investor grievance redressal time consuming and, at times, intractable.

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To obviate these problems, the Depositories Act, 1996 was passed. It provides for the establishment of depositories in securities with the objective of ensuring free transferability of securities with speed, accuracy and security. It does so by (a) making securities of public limited companies freely transferable, subject to certain exceptions; (b) dematerialising the securities in the depository mode; and (c) providing for maintenance of ownership records in a book entry form. In order to streamline both the stages of settlement process, the Act envisages transfer ownership of securities electronically by book entry without making the securities move from person to person. The Act has made the securities of all public limited companies freely transferable, restricting the company's right to use discretion in effecting the transfer of securities, and the transfer deed and other procedural requirements under the Companies Act have been dispensed with. Two depositories, viz., NSDL and CDSL, have come up to provide instantaneous electronic transfer of securities. In any stock exchange, trades or transactions have to be settled by either squaring up the carrying forward positions or settling by payment of net cash or net delivery of securities. This account settlement period, if it is long leads to several price distortions and allows for market manipulation. It increases the chances of speculation resulting in volatility, which hurts the small investors. With the application of IT in the securities market - screen-based trading and trading through the Internet - it has been possible to reduce this settlement period. Dematerialization Dematerialization or "Demat" is a process whereby your securities like shares, debentures etc, are converted into electronic data and stored in computers by a Depository. It is safe, secure and convenient buying, selling and transacting stocks without suffering endless paperwork and delays. You can convert your securities to electronic format with a Demat Account. There are many advantages of holding a demat account. A few important ones' are as below. Shorter settlements thereby enhancing liquidity No stamp duty on transfer of securities held in demat form. No concept of Market Lots. Change of name, address, dividend mandate, registration of power of attorney, transmission etc. can be effected across companies held in demat form by a single instruction to the DP. A few features of a Demat account are: Dematerialisation of Securities Settlement of Securities traded on the exchange as well as off market transactions Pledging and Hypothecation of Dematerialised Securities Electronic credit in public issue Receipt of non-cash benefits in electronic form 8. METHODS USED TO ANALYZE SECURITIES The methods used to analyze securities fall into two very broad categories: fundamental analysis and technical analysis. Fundamental analysis involves analyzing the characteristics of a company in order to estimate its value. Technical analysis takes a completely different approach; it doesn't care one bit about the "value" of a company or a commodity. Technical Analysis A method of evaluating securities by analyzing statistics generated charts by market activity, such as past prices and volume. Technical analysts do not attempt to measure a security's intrinsic value, but instead

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use charts and other tools to identify patterns that can suggest future activity. Technical analysts believe that the historical performance of stocks and markets are indications of future performance. Fundamental Analysis A method of evaluating a security by attempting to measure its intrinsic value by examining related economic, financial and other qualitative and quantitative factors. Fundamental analysts attempt to study everything that can affect the security's value, including macroeconomic factors (like the overall economy and industry conditions) and individually specific factors (like the financial condition and management of companies). The biggest part of fundamental analysis involves delving into the financial statements. Also known as quantitative analysis, this involves looking at revenue, expenses, assets, liabilities and all the other financial aspects of a company. Fundamental analysts look at this information to gain insight on a company's future performance. The various fundamental factors can be grouped into two categories: quantitative and qualitative. The financial meaning of these terms isnt all that different from their regular definitions. Quantitative capable of being measured or expressed in numerical terms. Qualitative related to or based on the quality or character of something, often as opposed to its size or quantity. Quantitative fundamentals are numeric, measurable characteristics about a business. Qualitative fundamentals, these are the less tangible factors surrounding a business - things such as the quality of a companys board members and key executives, its brand-name recognition, patents or proprietary technology. Research Approach Top Down Approach Understanding economy and tracking economic trends to forecast future Top down investors are generally growth investors As emphasis is on economic conditions and market movement, changes contrary to expectations may have a larger impact on the portfolio Bottom-up Approach Starts with micro analysis at company level Typically look at under-researched companies that have potential to unlock value in LT. Finds favor with value investors In the process of focusing on individual companies, industries and sectors with promising outlook may be left out

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Equity/Share Total equity capital of a company is divided into equal units of small denominations, each called a share. For example, in a company the total equity capital of Rs 2,00,00,000 is divided into 20,00,000 units of Rs 10 each. Each such unit of Rs 10 is called a Share. Thus, the company then is said to have 20,00,000 equity shares of Rs 10 each. The holders of such shares are members of the company and have voting rights. Warrants Certificate issued along with a bond or preferred stock Entitles holder to buy specific no. of securities at a specific price Convertible Debentures Can be converted in stock at specified date in future At the discretion of either the issuer/lender Issuer can borrow at lower cost if the lender has convertibility option Rights Issue/ Rights Shares: The issue of new securities to existing shareholders at a ratio to those already held, at a price. For e.g. a 2:3 rights issue at Rs. 125, would entitle a shareholder to receive 2 shares for every 3 shares held at a price of Rs. 125 per share. Bonus Shares: Shares issued by the companies to their shareholders free of cost based on the number of shares the shareholder owns. Preference shares: Owners of these kind of shares are entitled to a fixed dividend or dividend calculated at a fixed rate to be paid regularly before dividend can be paid in respect of equity share. They also enjoy priority over the equity shareholders in payment of surplus. But in the event of liquidation, their claims rank below the claims of the companys creditors, bondholders/debenture holders. Cumulative Preference Shares: A type of preference shares on which dividend accumulates if remained unpaid. All arrears of preference dividend have to be paid out before paying dividend on equity shares. Cumulative Convertible Preference Shares: A type of preference shares where the dividend payable on the same accumulates, if not paid. After a specified date, these shares will be converted into equity capital of the company. IPO (Initial Public Offer) The first issue by a company to public investors Public Issue Any issue by a company to public investors Bonus Issue of securities to existing investors in a specific ratio without any consideration being received by the issuer Rights Issue of securities to existing investors in a specific ratio for a consideration received by the issuer GDR / ADR (Global Depository Receipt/ American Depository Receipt) Issue of securities that are listed in an international stock exchange; each security representing a specified number of securities listed in the local stock exchange

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Buyback Acquisition of securities by the issuer from existing investors, through a public offer or purchases in the secondary market. Face Value The nominal or stated amount (in Rs.) assigned to a security by the issuer. For shares, it is the original cost of the stock shown on the certificate; for bonds, it is the amount paid to the holder at maturity. Also known as par value or simply par. For an equity share, the face value is usually a very small amount (Rs. 5, Rs. 10) and does not have much bearing on the price of the share, which may quote higher in the market, at Rs. 100 or Rs. 1000 or any other price. For a debt security, face value is the amount repaid to the investor when the bond matures (usually, Government securities and corporate bonds have a face value of Rs. 100). The price at which the security trades depends on the fluctuations in the interest rates in the economy. Dividend is a percentage of the face value of a share that a company returns to its shareholders from its annual profits. Compared to most other forms of investments, investing in equity shares offers the highest rate of return, if invested over a longer duration. Market Capitalization Number of equity shares outstanding x market value per equity share. Represents the market value of the entire company Enterprise Value Enterprise value is a figure that, in theory, represents the entire cost of a company if someone were to acquire it. Enterprise value is a more accurate estimate of takeover cost than market capitalization because it takes a number of important factors such as preference shares, debt and cash that are excluded from the latter matrix. Enterprise value = Mkt cap + preference shares + outstanding debt - cash and cash equivalent Market capitalization =Number of outstanding shares * CMP Intrinsic Value It is discounted value of cash that can be taken out of a business during its remaining life. It is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised. Two people looking at same set of facts will come up with different intrinsic value figures. Beta A measure of the volatility of a stock relative to the overall market. A beta of less than one indicates lower volatility than the market; a beta of more than one indicates higher volatility than the market. Generally Consumer and utility stocks have low beta compared to cyclicals and industrials. Book Value It shows the historic cost of the assets as reduced by the depreciation. It is significant for evaluating Banking company stocks. Stocks of companies holding large blocks of land and other hidden assets are evaluated on this basis. It does not make sense to look at book value for companies in high growth businesses. BV = Shareholders funds / No. Of Equity shares

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Cost of Capital This is the cost of borrowing funds from the market. The ROE and the ROCE should be more then the cost of capital or else it would make little sense for the company to borrow funds. For stocks in the emerging markets the cost of capital should be 300 to 400 basis points above the risk free rate of return. COC = Risk free rate of return + Equity risk premium. Debt Equity Ratio Long-term debt divided by shareholders' equity, showing relationship between long-term funds provided by creditors with respect to the Shareholders funds. A high Debt Equity ratio indicates high risk while a lower ratio may indicates lower risk. Short-term debt is not included as long as cash is greater then short-term debt. As equity increases relative to debt, the company becomes a more attractive investment. Finally, bond debt is preferred to bank debt because bank debt is due on demand. Companies that repay back debt experience PE expansion compared to companies that take on debt. DER = Long term loans / Shareholders Funds Dividend yield This is the current yield on a stock. Dividend paying companies have in built bottoms. When the stock prices fall too much their dividend yield becomes attractive enough for existing investors to hold on as well as for new investors to get in. This is a basic criterion for a value investor Stocks that pay dividends are obviously favored over stocks that don't . Dividend paying stocks are likely to fall less in an economic downturn As stock prices fall with no fall in dividends, the dividend yield rises attracting new investors. Finally, if you do buy a stock for dividend , you should make sure that the company has a history of paying the dividend in both good times and bad. DY = Dividend per share / Market Price Discounted cash flow statement Discounted Value of free cash flow that a business generates during a particular period of time. Companies embarking on a major Capital expenditure program will experience reduced free cash flow and lower valuations. A rise in interest rates increases the cost of capital and also reduces valuations Most of the analyst fraternity uses this concept. The risk free rate is used as the discount rate. This evaluation tool is helpful only for evaluating stable businesses rather then high growth businesses Earning per share (EPS): This is the net income divided by the number of shares outstanding however; both the numerator and denominator can change depending on how you define "earnings" and "shares outstanding. The E.PS as an absolute figure means nothing and is significant only when viewed in relation to the price of the stock. EPS = Net Profits / No. Of Equity Shares Enterprise Value EV = Market Capitalization + Debt. Enterprise value for cash rich companies is market cap as reduced by cash. During bear markets smart Investors are able to spot a number of companies that are available at zero or negative enterprise value. In 2002 Trent was available at Rs 60 when it had Rs 100 as cash on its balance sheet. The stock has been a multibagger since.

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EVA Economic Value added is the excess of ROCE over the cost of capital . Companies with higher EVA's are able to generate higher PE's and are generally wealth creators compared to companies that have a low or negative EVA. EVA = (ROCE Cost of capital) Capital employed Free Cash flows The amount of cash left in a company after all expenditure both revenue and capital has been accounted for. This is also known as net addition to cash. Free cash flow per share = Cash earnings - capital spending. Companies that generate substantial free cash flows make for very good investments. Growth in Stock Price vs. Growth in earnings A dangerous signal is generated when the stock price of a company increases faster than its earnings. Invariabily this wleads to a higher PE multiple and makes the stocks liable for decline. Generally it is better to ivest into businesses their earnings growing at an equal pace to their stock prices. Market Capitalization The market cap is the amount of money that the acquirer would need to buy back all the outstanding shares. In case of absurd valuations the market cap reaches stupid levels. During the 2000 tech boom Himachal Futuristic sold at a market cap of Rs 20,000 crores. Multibaggers (stocks that go up a number of times) generally have a very small market cap to start with. Companies with a market cap of more then US $ 1 billion are classified as large caps, between US $ 250 million to 1 $billion as mid caps and less then 250 million as small caps. Market price x No. Of Equity shares Market Cap to Sales It is the number of times the sales exceeds the market cap. For companies in growth businesses the market cap to sales could be about 3 times whereas for companies in low growth businesses it should be equal to 1. The sales number is the most difficult to fudge and therefore the market cap to sales is a more reliable indicator in corporate analysis. In the 2000 technology bubble Infosys traded at a market cap to sales of more then 100! Market Cap / Sales PEG This is known as the Price earnings to growth ratio. It should be less then equal to 1 Growth in Earnings vs. the P/E Ratio. The ratio will be lower for slow growers and higher for fast growers. PEG = PE / Sustainable Growth Price Earnings (PE) This is one of the most widely used tools in sizing up stocks. Simply put, it is how much investors are willing to pay for a rupee of the company's earnings. It is also termed as referred to as a "multiple." When you calculate a P/E based on the past year's earnings, the P/E is called "trailing." Another way to determine a P/E is to substitute future earnings projections. This is the "forward" P/E (also referred to as the

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"anticipated" P/E). Another way of looking at the PE This as the number of years it will take to earn back the initial investment. PE = Market price / EPS Price to BookValue This is used mainly for Banking (where the book value is adjusted for Non performing assets) and old economy stocks. It is defined as the number of times the market price equals the book value of the stocks. PBV = Market Price / Book Value Return on Equity (RoE) Return on Equity (RoE) is an indicator of how efficiently the shareholders funds (Equity) are being used . Companies having a higher RoE tend to be wealth creators and companies having an RoE of less then 15% tend to be wealth destroyers . Normally higher the RoE higher the PE . Companies that are engaged into commodity businesses have lower RoE's compared to the ones that are engaged into high growth businesses. As with the PE Companies that are in the initial stages of growth and are available at small market caps or the ones, which are yet to see the earnings hit a peak, can be bought in spite of having a low RoE. Commodity companies exhibiting very high RoE's are a sign of danger since that would encourage new entrants to rush in and push prices down. RoE = EPS / Book Value Return on Market Cap The percentage that profits that can be earned if an investor buys all the shares from the market. It is theoretically equal to the inverse of the PE (1/PE)


Hedgers Executing equal and opposite positions to manage the adversity of price movement in same or different assets is hedging. In equity hedgers use futures for protection against adverse future price movements in the underlying cash. The rationale of hedging is based upon the demonstrated tendency of cash prices and futures values moving in tandem. The hedgers are very often businesses or individuals who at one point or another deal in the underlying cash script. Speculators Speculators are the second major group of futures players. They benefit from price variations and serve as counter-parties to hedgers. In fact, they accept the risk offered by the hedgers in a bid to gain from favourable price changes. For speculators, futures have a number of advantages over other investments. o They need to invest less capital in futures than in the cash market since they are required to pay only a fraction of the value of the underlying contract (usually around 30 per cent) as margin. o Further, commission/brokerage charges on futures traders are small compared to what they are in case of cash trades and other investments.

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Arbitragers Arbitragers work at making profits by taking advantage of discrepancy between prices of the same script. If, for example, they see the futures price of an asset getting out of line with the cash price, they would take offsetting positions in the two markets to lock in the profit. Funds There are two types of funds operating in the matured and ideal market, Hedge funds and Trading funds. These funds help investors to make money irrespective of their domain knowledge. They take pool of funds from the investors and trade on informed decisions in the market betting on their experience team. Investor Investors are typically people with having long term prospective in mind. They take usually informed decisions. Once research is done fully they take positions and provides comfortable time for management, economy and industry before booking their profits. HNI High Networth Investors are people having huge wealth with them and are return chasing or speculative investors. They can some times surpass the trading volumes of the corporates. In general the individuals trading in his/her account with huge volumes and having significant Networth is brought under this category. The definition of HNI varies from broker to brokers depending on the entry-level margin requirement of the particular brokerage houses. Retails This segment comprises of all other small and marginal investors, which has not been covered in HNI category. Punters/ Jobbers Punter and Jobbers are those who operate in very thin margins and bank on their number or volume of trades to generate revenues. These set of people are suppose to bring high liquidity in the exchange-traded contracts.

Derivatives are assets, which derive their values from an underlying asset. These underlying assets are of various categories like Commodities including grains, coffee beans, etc. Precious metals like gold and silver. Foreign exchange rate. Bonds of different types, including medium to long-term negotiable debt securities issued by governments, companies, etc. Short-term debt securities such as T-bills. Over-The-Counter (OTC) money market products such as loans or deposits. Equities

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For example, a dollar forward is a derivative contract, which gives the buyer a right & an obligation to buy dollars at some future date. The prices of the derivatives are driven by the spot prices of these underlying assets. However, the most important use of derivatives is in transferring market risk, called Hedging, which is a protection against losses resulting from unforeseen price or volatility changes. Thus, derivatives are a very important tool of risk management. There are various derivative products traded. They are; 1. 2. 3. 4. Forwards Futures Options Swaps

To understand these products better lets take an example: A Forward Contract is a transaction in which the buyer and the seller agree upon a delivery of a specific quality and quantity of asset usually a commodity at a specified future date. The price may be agreed on in advance or in future. Forward A contract to buy / sell underlying on future date at price that is determined today Outside the framework of stock exchanges. Therefore Illiquid No transparent pricing Trades not guaranteed by any stock exchange Futures Like a forward, but traded in exchange on the basis of standard contracts Regulations permit upto 12 month futures. Now available for 1,2 and 3 months India: Index Futures (June 2000); Stock Futures (Nov 2001) Forward contracts are being used in India on large scale in the foreign exchange market to cover the currency risk. Forward contracts, being negotiated by the parties on one to one basis, offer the tremendous flexibility to the parties concerned to articulate the contract in terms of the price, quantity, quality (in case of commodities), delivery time and place. Forward contracts however have poor liquidity and default risk (credit risk). Let us understand it in detail: Liquidity risk: Liquidity is generally defined as the ability of the operator to buy or sell the asset whenever he/she wants to do so. Now, these forward contracts, being traded on one to one basis, are tailor made contracts catering to the specific needs of the parties involved and so are not listed and traded on the exchanges. In case of change of perception of either of the parties after entering into contract but before contracts maturity, if he/she wants to come out of the contract, he/she has the necessarily to go to the same party, who being in a monopoly situation can exploit a weak counter party. Therefore, liquidity of these contracts is poor.

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Default risk/credit risk/counter-party risk: Forward contracts, as defined above are traded on one to one basis and so each party is exposed to counter-partys credit risk i.e. the risk of default exists in case of forward contracts. FUTURE CONTRACT A Future contract is a firm contractual agreement between a buyer and seller for a specified as on a fixed date in future. The contract price will vary according to the market place but it is fixed when the trade is made. The contract also has a standard specification so both parties know exactly what is being done. These contracts are traded on the exchanges. Futures markets are the extension of the forward markets. These markets being organized/ standardized are very liquid by their own nature. Therefore, liquidity problem, which persists in the forward market, does not exist in the futures market. In these markets, clearing corporation/house becomes the counter-party to all the trades or provides unconditional guarantee for the settlement of trades i.e. assumes the financial integrity of the whole system. In other words, we may say that the credit risk of the system is eliminated by the exchange through the clearing corporation/ house. Major distinction between forward and future contract is summarized below


Forward Contract

Future Contract

Operational Mechanism Contract Specifications

Not traded on exchange Differs from trade to trade.

Traded on exchange Contracts contracts. are standardized

Counter party Risk






Clearing Corporation/ house.

Liquidation Profile

Poor Liquidity as contracts are tailor maid contracts.


high are



contracts contracts.


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Price Discovery









markets are brought to the common platform.

OPTIONS An Options contract confers the right but not the obligation to buy (call option) or sell (put option) a specified underlying instrument or asset at a specified price the Strike or Exercised price up until or an specified future date the Expiry date. The Price is called Premium and is paid by buyer of the option to the seller or writer of the option. Option Unlike a future, in an option, only one party is committed, the other has an option i.e. a right, but not an obligation The party that has the option is the option buyer The party that is committed is the option writer. Earns a premium for taking such a position Price at which the option buyer can exercise the right is the exercise price / strike price Date on which contract would lapse is the expiration date The option can be to buy (call option) or to sell (put option) India: Index Options (June 2001); Stock Options (July 2001)) Understand that option buyer has the right and option seller has the obligation i.e. option buyer may or may not exercise the option given, but, if option buyer decides to exercise the option, option seller has no choice but to honor the obligation. A call option gives the holder the right to buy an underlying asset by a certain date for a certain price. The seller is under an obligation to fulfill the contract and is paid a price of this, which is called "the call option premium or call option price". A put option, on the other hand gives the holder the right to sell an underlying asset by a certain date for a certain price. The buyer is under an obligation to fulfill the contract and is paid a price for this, which is called "the put option premium or put option price". For Instance, Suppose Mr. Dhiraj is bullish and feels that the share price of Reliance will rise in future. Therefore he buys Out of money Reliance capital call at 350. Spot price is 330 at a premium outflow of Rs. 20/-. Lot size of reliance capital is 1100. Eventually he lands out paying Rs.22000/- and leveraged his position. If the market goes up from Rs. 350, he makes profit. However if his expectation proves wrong and reliance capital slides down. His loss is limited to his premium amount. Thus premium is a sunk cost for option buyer.

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KEY TERMS IN OPTIONS Before diving deep in the option market lets understand the key term in option trading, which are repeatedly used and also the factors that influence the option price. Strike Price: - The stated price per share for which underlying stock may be purchased (for a call) or sold (for a put) by option holder upon exercise of the option contract. (Ex Reliance capital call at 350) Expiration Date: - The date on which option expires is expiration date, the Exercised date, the strike date or the maturity date. It is the last day on which option can be exercised. Option normally has a month and/or quarterly expiration cycle. Option Price: - Option price is the price, which the option buyer pays to the option seller. It is also referred to as option premium. The Premium depend on various factors like strike price, Stock price, Expiration date, Volatility, Interest rate. The buyer pays premium to seller. On receiving the premium seller has the obligation to exercised the option when assigned to him American option: - American options are option that can be exercised any time upon the expiration date. Most exchange-traded option is American. Options on individual stocks are American. Ex. Reliance. CA, Tisco .PA, SBI. CA European option: - European options are option that can be exercised only on the expiration date itself. Index based option are European option. Ex. NIFTY CE Where; CA: Call American PA: Put American CE: Call European PE: Put European In the money: An in the money (ITM) option is an option that would lead to positive cash flows to the holder if it was exercised immediately. A call option is ITM when spot price is greater than strike price. If the difference is huge it is called deep in the money At-the-money: An at the money (ATM) option will lead to zero cash flow if exercised immediately. Option is at the money if strike price is equal to spot price. Out-of-the-money: An out of money (OTM) option will lead negative cash flow if exercised immediately. In case of call option if strike price is greater than spot price than it is OTM. Whereas in case of put option if strike price is less than spot price it is OTM


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Stock: INFOSYS Spot Price (S): 2300 Strike Price(K): 2200 2300 2400

ITM CALL S>K 2300 > 2200 PUT S<K 2300 < 2400

ATM S=K 2300 = 2300 S=K 2300 = 2300

OTM S<K 2300 < 2400 S>K 2300 > 2200

Intrinsic Value of an option: Option premium has two parts in it, i.e. Intrinsic value and Time value. Intrinsic value means how much is option ITM. Deeper is the option in the money more is the intrinsic value of an option. If the option is Out of the money or at the money its intrinsic value is zero. For a call option intrinsic value is Max (0, (St K)) For a put option intrinsic value is Max (0, (K - St )) In other words Intrinsic value can only be positive or zero. and

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Time Value of an option: Time value of option is difference between Premium and Intrinsic value. Both call and put have time value. ATM and OTM option only have time value and no Intrinsic value.

The portion of the option premium that is attributable to the amount of time remaining until the expiration of the option contract. ATM option has the highest time value. It is probability of option going ITM. Generally as there is more time to expiration greater is the Time Value. As the time remaining to maturity reduces time value decreases and becomes zero on maturity .

Example; ONGC Spot ( S ): ONGC Strike ( K ): 960 940 960 980

CALL STRIKE 940 960 980

PREMIUM 35 12 4

EXPIRY : 28th July 2005




INTRINSIC PREMIUM VALUE 35 (960-940) = 20 (960-960) =








12 0 (960-980) =








4 (-20) so 0

Fundamental Understanding of Derivatives Derivatives provide platform to investor to make huge profit by leveraging their position. However it is double edge sword if not handled properly may result in huge losses too. So as a prudent and smart investor one must look at the signal that markets continuously provides to make a right decision by taking calculative risk.

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The most important parameter to judge the performance of stock in Future and Option market is OPEN INTEREST OPEN INTEREST: Open interest and volumes are very close to each other. However Volumes considered total trade carried out whereas open interest is number of outstanding contracts at a particular time. It is more relevant as it considers number of contract which are outstanding and not squared off by the investor. Further Open interest increases only when new contract is traded i.e when existing parties (Buyer or seller) enters in fresh position and not square of or when new parties enter into a contract whereas Open interest decreases when existing parties i.e. Buyer as well as seller square off their position. Buyer of the contract sells it Seller of the contract buys it Example: Suppose trade is taking place in Infy Futures on 1st July 2005 Time 10.55 A.M.s Trader Mr. Subhash Mr. Ankit Mr. Ankit Ms. Seema Ms. Dhiraj Mr. Sunil Mr. Subhash Ms. Seema Trade Buy 2 Futures Sells 2 Future Buy 2 Futures = 2:30 P.M. Sells 2 Futures Sells 4 Futures Buys 4 Futures Sells 2 Futures Buys 2 Futures 6 Change Net open Interest 2

12.00 Noon

3:25 P.M

Open Interest along with Price movement is consider a good indicator of market trend OPEN INTEREST PRICE OUTLOOK POSITIVE NEGATIVE POSITIVE NEGATIVE

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PUT-CALL RATIO While most options traders are familiar with the leverage and flexibility that options offer, not everybody is aware of their value as predictive tools. Yet one of the most reliable indicators of future market direction is a contrarian sentiment measure known as the Put/Call options volume ratio. Put option gives the right to sell the option at a predetermined price whereas call option gives right to sell. While too many put buyer usually signals that market bottom is nearby while too many call buyer indicates market top is making. Put call ratio is simply number of put contracts divided by number of call contracts traded during the particular day. Higher put call ratio signifies market player are bearish and feel stock may fall whereas lower put call ratio tells the opposite story. However signals thrown by market player contradicts the real outcome. Higher PCR portrays that the stock is oversold and reversal is on the way .Its right time to get in. whereas Lower PCR portrays that the stock is over bought and downward trend is soon expected. The Put/call ratio is yet another solid weapon within a speculator's arsenal to trade and give clear picture many time that when to exit or when to enter the market but then also one cannot rely only on Put/call ratio to survive in the market and earn money. This fact also cannot be ignored that it is a very powerful tool, which help speculator up to a great extent to prejudge the market movement and invest accordingly.

Volatility Volatility is a statistical measure of the amount of fluctuation in a stocks price within a period of time. A stock with high volatility would have rapid up and down movements in its stock price. A stock with very little movement in its price would constitute low volatility. There are two main measures of Volatility: Historical Volatility & Implied Volatility. Historical volatility will be discussed in this report whereas implied volatility will be explained in the subsequent report. Historical Volatility is a statistical measure of the volatility of a futures contract, security, or other instrument over a specified number of past trading days Historical volatility is the measure of a stocks price movement based on historical prices. It measures how active a stock price typically is over a certain period of time. Usually, historical volatility is measured by taking the daily (close-to-close) percentage price changes in a stock and calculating the average over a given time period. The average is then expressed as an annualized percentage. Historical volatility is often referred to as actual volatility or realized volatility. Short-term or more active traders tend to use shorter time periods for measuring historical volatility, the most common being 5-day, 10-day, 20-day and 30-day. Intermediate-term and long-term investors tend to use longer time periods, most commonly 60-day, 180-day and 360-day.

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Implied Volatility can be defined as the volatility of an instrument as implied by the prices of an option on that instrument, calculated using an options pricing model. An options value consists of several components The strike price, expiration date, the current stock price, dividends paid by the stock (if any), the implied volatility of the stock and interest rates. Instead of substituting a volatility parameter into an option model (e.g. Black-Scholes) to determine an option's fair value, the calculation can be turned round, where the actual current option price is input and the volatility is output. Therefore implied volatility is that level of volatility that will calculate a fair value actually equal to the current trading option price. This calculation can be very useful when comparing different options on the same underlying & different strike prices. The implied volatility can be regarded as a measure of an option's "expensiveness" in the market, and is used by traders setting up combination strategies, where they have to identify relatively cheap and expensive option contracts. As there are many options on a stock, with different strike prices and expiration dates, each option can, and typically will, have a different implied volatility. Even within the same expiration, options with different strike prices will have different implied volatilities. FUTURES ARBITRAGE Arbitrage is the act of simultaneously buying and selling assets or commodities in an attempt to exploit a profitable opportunity. Arbitrage is done between two related instruments that are temporarily mis-priced. For example, the futures price and spot price are related by the interest rate, time to maturity and corporate benefit, if any, in the interregnum. If the two prices do not move in tandem, then it throws up arbitrage opportunity. An arbitrageur will buy what is cheap and sell what is costly and lock in profits without any risk. INDEX ARBITRAGE Index Arbitrage is the basis between the Index (Nifty) futures and its constituents (Basket). Nifty future is in discount to Nifty spot Buy Nifty Futures and Sell Basket. Nifty future is in premium to Nifty spot Buy Basket and Sell Nifty Futures. As we cant trade in Nifty spot, we have to create Basket of Nifty components either with underlying stock or stock futures. PROCESS If Nifty is in discount (as quite often), then you have to sell basket. As you cannot short sell in cash, we will be creating basket using stock futures. Advantage of using stock futures is only margin money will be deployed. We will be creating Basket based on the weight of the constituents in the Nifty.(Market Capitalization Method)

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We have to make portfolio - Perfect Hedge. HEDGING Protecting the value of an asset against risk arising out of fluctuations in price is known as hedging. Technically hedging means transfer of risk from the asset holder to another person who is willing to carry risk. When an investor is bearish on market, he can hedge his position by taking countervailing position against his portfolio, say, selling Nifty futures. If the market falls, the fall in portfolio value will be compensated by the gains on the Nifty futures. But if the market rises, the rise in the portfolio value would be offset against the futures loss. The same concept can be applied to any stocks which have a presence in futures market. The result of any Perfect Hedge contract is No Profit and No Loss PORTFOLIO HEDGING To hedge portfolio, we need to calculate the Beta of the Portfolio and then hedge the Portfolio against the price risk. Beta measures the sensitivity of the stock to the broad market index. So if the beta of the stocks Portfolio is 1.05, and if the markets rise by 1%, then the Portfolio is likely to go up 1.05% and same goes for negative movement too. Calculate the number of Nifty contracts needed for Hedging. We can use the formula (Portfolio Beta x Portfolio Value) / Futures Value. e.g.:- Portfolio value = Rs. 1,00,00,000, Nifty value = 4,50,000(4500*100) and Beta of Portfolio 1.05 No. of contracts = (1,00,00,000*1.05)/4,50,000 = 24 contracts So we need to sell 24 contracts of Nifty to hedge the Long Portfolio. =


The Greeks are various functions that show the sensitivity of Fair Value of an option to changes in market conditions. These functions are very helpful in assessing and comparing various option positions. They show what effect different variables will have on the fair value price of an option. There are ways of estimating the risks associated with options, such as the risk of the stock price moving up or down, implied volatility

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moving up or down, or how much money is made or lost as time passes. They are numbers generated by mathematical formulas. Collectively, they are known as the "Greeks", because most use Greek letters as names. Each greek estimates the risk for one variable: delta measures the change in the option price due to a change in the stock price, gamma measures the change in the option delta due to a change in the stock price, theta measures the change in the option price due to time passing, Vega measures the change in the option price due to volatility changing, and Rho measures the change in the option price due to a change in interest rates. Delta The first and most commonly used greek is "delta". For the record, and contrary to what is frequently written and said about it, delta is NOT the probability that the option will expire ITM. Simply, delta is a number that measures how much the theoretical value of an option will change if the underlying stock moves up or down Rs.1.00. Positive delta means that the option position will rise in value if the stock price rises, and drop in value if the stock price falls. Negative delta means that the option position will theoretically rise in value if the stock price falls, and theoretically drop in value if the stock price rises. The delta of a call can range from 0.00 to 1.00; the delta of a put can range from 0.00 to 1.00. Long calls have positive delta; short calls have negative delta. Long puts have negative delta; short puts have positive delta. Long stock has positive delta; short stock has negative delta. The closer an option's delta is to 1.00 or 1.00, the more the price of the option responds like actual long or short stock when the stock price moves. So, if the IFCI Mar 50 call has a value of Rs.2.00 and a delta of +.45 with the price of IFCI at Rs.48, if IFCI rises to Rs.49, the value of the IFCI Mar 50 call will theoretically rise to Rs.2.45. If IFCI falls to Rs.47, the value of the IFCI Mar 50 call will theoretically drop to Rs.1.55. If the IFCI Mar 50 put has a value of Rs.3.75 and a delta of -.55 with the price of IFCI at Rs.48, if IFCI rises to Rs.49, the value of the IFCI Mar 50 put will drop to Rs.3.20. If IFCI falls to Rs.47, the value of the IFCI Mar 50 put will rise to Rs.4.30. An ATM option has a delta close to .50. The more ITM an option is, the closer its delta is to 1.00 (for calls) or 1.00 (for puts). The more OTM and option is, the closer its delta is to 0.00. The delta of an option depends largely on the price of the stock relative to the strike price. Therefore, when the stock price changes, the delta of the option changes. Gamma Gamma is an estimate of how much the delta of an option changes when the price of the stock moves Rs.1.00. As a tool, gamma can tell you how "stable" your delta is. A big gamma means that your delta can start changing dramatically for even a small move in the stock price. Long calls and long puts both always have positive gamma. Short calls and short puts both always have negative gamma. Stock has zero gamma because its delta is always 1.00 it never changes. Positive gamma means that the delta of long calls will become more positive and move toward +1.00 when the stock prices rises, and less positive and move toward 0.00 when the stock price falls. It means that the delta of long puts will become more negative and move toward 1.00 when the stock price falls, and less negative and move toward 0.00 when the stock price rises. The reverse is true for short gamma.

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For example, the IFCI Mar 50 call has a delta of +.45, and the IFCI Mar 50 put has a delta of -.55, with the price of IFCI at Rs.48.00. The gamma for both the IFCI Mar 50 call and put is .07. If IFCI moves up Rs.1.00 to Rs.49.00, the delta of the IFCI Mar 50 call becomes +.52 (+.45 + (Rs.1 * .07), and the delta of the IFCI Mar 50 put becomes -.48 (-.55 + (Rs.1 * .07). If IFCI drops Rs.1.00 to Rs.47.00, the delta of the IFCI Mar 50 call becomes +.38 (+.45 + (-Rs.1 * .07), and the delta of the IFCI Mar 50 put becomes -.62 (-.55 + (-Rs.1 * .07). Gamma measures how much the delta of a position changes when the stock price moves Rs.1.00. At-themoney options have the highest Gammas. Gamma decreases as you go in-the-money or out-of-the-money. Gamma is sometimes used as a risk management tool to manage a large portfolio, because it tends to reflect the speed of an option. Options with high gamma are the most responsive to price movements, so they provide the most help in covering directional exposure Theta Theta, a.k.a. time decay, is an estimate of how much the theoretical value of an option decreases when 1 day passes and there is no move in either the stock price or volatility. Theta is used to estimate how much an option's extrinsic value is whittled away by the always-constant passage of time. Long calls and long puts always have negative theta. Short calls and short puts always have positive theta. Stock has zero theta its value is not eroded by time. All other things being equal, an option with more days to expiration will have more extrinsic value than an option with fewer days to expiration. The difference between the extrinsic value of the option with more days to expiration and the option with fewer days to expiration is due to theta. Therefore, it makes sense that long options have negative theta and short options have positive theta. If options are continuously losing their extrinsic value, a long option position will lose money because of theta, while a short option position will make money because of theta. But theta doesn't reduce an option's value in an even rate. Theta has much more impact on an option with fewer days to expiration than an option with more days to expiration. For example, the IFCI Oct 75 put is worth Rs.3.00, has 20 days until expiration and has a theta of -.15. The IFCI Dec 75 put is worth Rs.4.75, has 80 days until expiration and has a theta of -.03. If one day passes, and the price of IFCI stock doesn't change, and there is no change in the implied volatility of either option, the value of the IFCI Oct 75 put will drop by Rs.0.15 to Rs.2.85, and the value of the IFCI Dec 75 put will drop by Rs.0.03 to Rs.4.72. Theta is highest for ATM options, and is progressively lower as options are ITM and OTM. This makes sense because ATM options have the highest extrinsic value, so they have more extrinsic value to lose over time than an ITM or OTM option. The theta of options is higher when either volatility is lower or there are fewer days to expiration. The longer the stock price does not move big, the more theta will hurt your position. Vega Vega (the only greek that isn't represented by a real Greek letter) is an estimate of how much the theoretical value of an option changes when volatility changes 1.00%. Higher volatility means higher option prices. The reason for this is that higher volatility means a greater price swings in the stock price, which translates into a greater likelihood for an option to make money by expiration. Long calls and long puts both always have positive vega. Short calls and short puts both always have negative vega. Stock has zero vega it's value is not affected by volatility. Positive vega means that the value of an option position increases when volatility increases, and decreases when volatility decreases.

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Negative vega means that the value of an option position decreases when volatility increases, and increases when volatility decreases. Let's look at the IFCI Mar 50 call again. It has a value of Rs.2.00 and a vega of +.20 with the volatility of IFCI stock at 30.00%. If the volatility of IFCI rises to 31.00%, the value of the IFCI Mar 50 call will rise to Rs.2.20. If the volatility of IFCI falls to 29.00%, the value of the IFCI Mar 50 call will drop to Rs.1.80. Vega is highest for ATM options, and is progressively lower as options are ITM and OTM. This means that the value of ATM options changes the most when the volatility changes. The vega of ATM options is higher when either volatility is higher or there are more days to expiration. Rho Rho is an estimate of how much the theoretical value of an option changes when interest rates move 1.00%. The rho for a call and put at the same strike price and the same expiration month are not equal. Rho is one of the least used greeks. When interest rates in an economy are relatively stable, the chance that the value of an option position will change dramatically because of a drop or rise in interest rates is pretty low. Long calls and short puts have positive rho. Short calls and long puts have negative rho. How does this happen? The cost to hold a stock position is built into the value of an option. The more expensive it is to hold a stock position, the more expensive the call option. An increase in interest rates increases the value of calls and decreases the value of puts. A decrease in interest rates decreases the value of calls and increases the value of puts. Back to the IFCI Mar 50 calls. They have a value of Rs.2.00 and a rho of +.02 with IFCI at Rs.48.00 and interest rates at 5.00%. If interest rates increase to 6.00%, the value of the IFCI Mar 50 calls would increase to Rs.2.02. If interest rates decrease to 4.00%, the value of the IFCI Mar 50 calls would decrease to Rs.1.98. STRATEGY Option is used as a hedging tool HEDGING represents a strategy, which aims at limiting the loss in one position by taking a offsetting position in same securities or another security. Hedging does not completely eliminate the losses but it just minimizes it. Very often option is used for hedging in combination with having a long/ short position in underlying. Its done when volatility seems to be high and thus to minimize the downward risk. Strategies: Hedging by buying option Long position, buy put Short position, buy call

Hedging by selling option

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Long position, sell call (Covered Call) Short position, sell put (I) Long position, buy put Suppose there is a small retail investor Mr. Sharma who is holding the 1000 Essar Oil stock at a price of RS. 290. Having seen large movement in January month he still feels that the stock is good and its potential to rise further is intact. However a small sceptism arise as nifty is currently trailing at 5200 level and correction is possible at any time and so stock price may come down. Being a smart investor he limits his downward risk by buying 1000 OTM put at 280 at premium outflow of Rs. 14. His payoff at various spot prices would be Share Price 260 270 280 290 300 304 310 320 350 Exercise Price 280 280 280 280 280 280 280 280 280 PREMIUM Outflow 14 14 14 14 14 14 14 14 14 Profit on Exercise (i) 6 -4 -14 -14 -14 -14 -14 -14 -14 Profit / Loss on Share Held (ii) -30 -20 -10 0 10 14 20 30 60 Net Profit (i) + (ii) -24 -24 -24 -14 -4 0 6 16 46

Thus Mr. Sharma has hedged his downward risk to the extent of Rs. 2400/-(24*1000). But his profit potential is unlimited ones the stock price crosses 304 where it breaks even. Thus he has hedged his downward risk instead of just holding a naked position.

Summary: Profit: Unlimited above Breakeven Loss: Limited (X-S) + (P) = (280-290)+(-14) = -24 Break even: S+(S-X)+(P) =290+(290-280)+14 = 304

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Covered CALL

METHODOLOGY: Buying a stock, Writing a call One can hedge its long position in stock by writing a option. Writer of a option has a limited profit to the extent of premium received, however loss is unlimited. . As an example, suppose that Mr. Mehta hold shares of a stock, which he expect will experience small changes in the short term, then he may write a call on these. This is known as covered calls. By writing covered call options, you tend to raise the shortterm returns. Of course, you will not derive any benefit if large price changes occur because then the option will be exercised or, else, you would have to make a reversing transaction. Share Price 920 940 960 980 1000 1020 1040 Exercise price 1020 1020 1020 1020 1020 1020 1020 Premium P/L on exercise of call 0 0 0 0 0 0 -20 Profit on Exercise option (I) 20 20 20 20 20 20 0 P/L on shares held (II) -60 -40 -20 0 20 40 60 Net profit +(II) -40 -20 0 20 40 60 60

20 20 20 20 20 20 20

Suppose Mr. Mehta has 300 stocks of ONGC bought at 980. He feels that ONGC will rise in future. However in the worst scenario when market turns around and losses are huge Mehtaji writes a call at 1020 with the premium inflow of 20. When share price are expected to remain flat, the writing calls can be used to generate income, while also providing some protection against an unexpected fall in the market. In the above case Mr. Mehta has hedged its naked position by selling OTM call. However if the share price rises above 1040, call buyer will exercised and he should be ready to deliver the share. Summary: Profit: Loss: Breakeven: Limited to (X-S) + P i.e. (1020-980) +20 = 60 Unlimited if market moves downwards S-P = 980-20 =960

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Reverse of Covered Call: This strategy is reverse of writing a covered call. It is applied by taking a long position or buying a call option and selling the stocks. Example: Mr. Prashant enters into buying a call option on one lot of Rel. Petro. At a strike price of Rs.60 and a premium of Rs.6 per share. The maturity date is two months from now and along with this option he/she sells a share of Rel. Petrol. in the spot market at Rs. 58 per share. The payoff chart describes the payoff of buying the call option at the various spot rates and the profit from selling the share at Rs.58 per share at various spot prices. The thick line shows the net profit.

BUYING A Thus Mr. Prashant is safeguard from future losses if share price goes up by buying call option of ATM or REVERSE COVERED CALL OPTION S 46 48 50 52 54 56 58 60 62 Summary Profit: Breakeven: Loss: Unlimited profit if market moves below 52 X- net P Limited to net premium i.e. (X-S)+(P) unlimited 60-8= 58 60-58 +6 =8 Xt 60 60 60 60 60 60 60 60 60 c -6 -6 -6 -6 -6 -6 -6 -6 -6 Profit from Spot Price of Net Profit from Profit from Total Profit buying call Selling the Call Buying stock option stock 0 0 0 0 0 0 0 0 2 -6 -6 -6 -6 -6 -6 -6 -6 -4 58 58 58 58 58 58 58 58 58 12 10 8 6 4 2 0 -2 -4 6 4 2 0 -2 -4 -6 -8 -8

SPREADS In the above strategies only one option was traded. Spread involves taking a position in two or more option of the same type (i.e. Two or more call or two or more put) Bull Call Spread:

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When the investor is bullish that the stock price will rise further he goes for creating a spread. The spread has the advantage of being cheaper to establish than the purchase of a single call, as the premium received from the sold call reduces the overall cost. The spread offers a limited profit potential if the underlying rises and a limited loss if the underlying falls. Example: Ms. Kiran is very bullish on steel sector and feels that the prices of Tisco will move ahead therefore she buys one ATM call at350 with premium outgo of Rs. 11 and sells one OTM Call at 380 at Rs. 3 If the stock price rules between the strike prices of the two calls, the purchased call is In-the-money while the call sold expires unexercised. Thus, the payoff equals the difference between the stock price and the (lower) exercise price. If the stock price is greater than higher exercise price, both options are In-thePAYOFF FROM BULL SPREAD (CALL) Price of stock (S) Strike price of call bought (X1) 350 350 350 350 350 350 Strike price of call Sold (X2) 380 380 380 380 380 380 Premium For1st call (P1) Premium For1st call (P2) Net premium cost Profit from 1st call Profit from 2nd call Total Profit

340 350 358 360 370 380

11 11 11 11 11 11

3 3 3 3 3 3

8 8 8 8 8 8

0 0 8 10 20 30

0 0 0 0 0 0

-8 -8 0 2 12 22

money and the payoff equals the difference between the exercise prices of the two options.



Limited to the difference between the two strikes minus net premium cost. Maximum profit occurs where the underlying rises to the level of the higher strike (2) or above. Limited to any initial premium paid in establishing the position. Maximum the underlying falls to the level of the lower strike (1) or below. loss occurs where


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Break-even: Reached when the underlying is above strike (1) by the same amount as the establishing the position.

net cost of

Bull Spread by entering in a put option Suppose Ms. Kiran trade in two put option (Put option gives the right to sell the option at a determined price). She buys one OTM option of TISCO at 330 at 3.5 and sells one ITM option at 360 at 17. Total Premium inflow is 17-3.5 =13.5.


PRICE STOCK S1 > X2 X1 < S1 <= X2 S1 <= X1





NET PROFIT X2-X1 S-X2-P1+P2 X2-X1-p1+p2


PAYOFF FROM BULL SPREAD (PUT ) Price of stock (S) 320 330 340 346.5 350 360 370 380 Srike price of Put bought (X1) 330 330 330 330 330 330 330 330 Srike price of Put Sold (X2) 360 360 360 360 360 360 360 360 Premium For1st Put (P1) 17 17 17 17 17 17 17 17 Premium For1st Put (P2) 3.5 3.5 3.5 3.5 3.5 3.5 3.5 3.5 Net premium received 13.5 13.5 13.5 13.5 13.5 13.5 13.5 13.5 Profit from 1st Put 10 0 0 0 0 0 0 0 Profit from 2nd Put -40 -30 -20 -13.5 -10 0 0 0 Total Profit

-16.5 -16.5 -6.5 0 3.5 13.5 13.5 13.5

Summary Profit: Limited to the net premium credit. Maximum profit occurs where underlying rises to the level of the higher strike B or above. Loss: Maximum loss occurs where the underlying falls to the level of the lower strike A or below.

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Break-even: Reached when the underlying is below strike B by the same amount as the net credit of establishing the position BEAR SPREAD An investor who enters in bear spread is bearish and feels that stock price will decline. In a declining market too investor can make profit both by using call and put. However this strategy is opposite of that of Bull spread. Investor buys higher strike call and sells lower strike call. Thus there is a net premium inflow. For Instance Mr. Rakesh is bearish about nifty and feels that market will correct from here. He buys Nifty call at 2260 at premium of Rs.27 and sells lower strike call at 2230 at 40. Spot Nifty is trailing at 2226. Prudent investor Mr. Rakesh receives net premium of Rs. 13. Lot size of nifty is 100. Payoff Table PAYOFF FROM BEAR SPREAD (CALL )

Price of stock (S)

Srike price of call Sold(X1) 2230 2230 2230 2230 2230 2230 2230 2230 2230

Srike price of call Bought (X2) 2260 2260 2260 2260 2260 2260 2260 2260 2260

Premium For1st call (P1)

Premium For1st call (P2)

Net premium credit

Loss from 1st call

Profit from 2nd call

Total Profit

2200 2210 2220 2230 2240 2243 2250 2260 2270

40 40 40 40 40 40 40 40 40

-27 -27 -27 -27 -27 -27 -27 -27 -27

13 13 13 13 13 13 13 13 13

0 0 0 0 -10 -13 -20 -30 -40

0 0 0 0 0 0 0 0 10

13 13 13 13 3 0 -7 -17 -17

Summary: Profit: Limited to the net premium credit. Maximum profit occurs where underlying falls to the level of the lower strike or below X1. i.e. = 13 Loss: Limited to the difference between the two strikes minus the net credit received in establishing the position. Maximum loss occurs where the underlying rises to the level of the higher strike B or above. i.e. = (2260-2230) 13 = 17

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Break-even: Reached when the underlying is above strike price X1 by the same amount as the net credit of establishing the position. i.e. = 2230+ 13 = 2243 Combo Strategy: Option strategies not only include trading in same option. In fact we can have combo strategy i.e. trading both in call as well as put. The strategy to be used depends upon market outlook: Bearish outlook: Long Combo: Sell a higher strike call Buy a lower strike put Bullish outlook: Short Combo: Buy a higher strike call Sell a lower strike put A) Short Combo: Suppose Mr. Vinay is bullish on Information Technology sector and feels that Infosys will ride up. However to reduce its cost he buys one option and sells another. Currently spot Infy stands at 2400. He buys a OTM call at 2460 at Rs.50 and sells ITM put at 2370 at 75. Thus he has net premium credit of Rs. 25/-. Short Combo is used when investor is bullish, however when volatility is uncertain is advisable to go for Short Combo. In this strategy investor is taking advantage of both the option simultaneously. However Short combo is similar to long future with only difference that there is plateau created wherein there is no change in profit and loss. Payoff table: PAYOFF FROM SHORT COMBO

Price of stock (S) 2310 2340 2370 2400 2430 2460 2490 2520

Srike price of call bought(X1)

Srike price of put sold (X2) 2370 2370 2370 2370 2370 2370 2370 2370

Premium For call (P1)

Premium For Put (P2)

Net premium credit

Profit from call

Loss from put

Total Profit

2460 2460 2460 2460 2460 2460 2460 2460

50 50 50 50 50 50 50 50

75 75 75 75 75 75 75 75

25 25 25 25 25 25 25 25

0 0 0 0 0 0 30 60

-60 -30 0 0 0 0 0 0

-35 -5 25 25 25 25 55 85

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Summary: Profit: Unlimited in a rising market. Loss: Unlimited in a falling market. Break-even: Depending on the strikes chosen, establishing the position may yield a small premium cost or credit. If the position is created at a cost, break-even will occur where the market rises above point B by this amount. If the position is established at a credit, the break-even point will occur if the market falls below point A by the same amount. Long Straddle Stock market not always moves in similar fashion. Sometimes market player are not sure about their movement and feels volatility may rise in future. However they feel that there will be large movement but direction is not known. At this time straddle can be quite useful. Long straddle is worked by buying call and put at same strike price. Thus the loss is equal to total premium paid (both call & put). Ms. Seema is an active investor. She wants to trade in Reliance capital, However from past couple of days stock is highly volatile and direction in which it will move is uncertain. Therefore she buys call and put at strike price of 400. Current Stock price is 410. PAYOFF TABLE


Price of stock (S) 330 340 350 355 370 390 400 410 430 445 450 460 470

Srike price of call bought(X1)

Srike price of put bought(X2)

Premium For call (P1)

Premium For Put (P2)

Premium paid

Profi t / loss from call 0 0 0 0 0 0 0 10 30 45 50 60 70

Profit/L oss from put

Total Profit

400 400 400 400 400 400 400 400 400 400 400 400 400

400 400 400 400 400 400 400 400 400 400 400 400 400

20 25 20 25 20 25 20 25 20 25 20 25 20 25 20 25 20 25 20 W2W/ HRD/ 25 0809 20 25 20 25 20 25

45 45 45 45 45 45 45 45 45 45 45 45 45

70 25 60 15 50 5 45 0 30 -15 10 -35 0 -45 0 -35 0 -15 0page 37/37 0 0 5 0 15 0 25

Summary PROFIT LOSS Breakeven Unlimited at expiry. Above break-even point Limited to premium paid Strike price + Premium paid (X+P) and (X-P)

Thus Straddle should be used when large stock movement is expected. If stock price moves within premium range then it will result in losses. Gains will come when there is stock rises more than 445 or falls below 355. Profit can be taken early in the life of the straddle, but only if the expected movement occurs quickly. As the market moves strongly in one direction, the gain made on one leg exceeds the loss incurred and the other, and the straddle increases in value. Long Straddle consists of two long positions. As a result time decay works very strongly against the bought straddle. The longer the straddle is left in place, the greater the loss due to time decay. Position therefore needs to be closely monitored and closed out well before expiry. Short Straddle Payoff of Short straddle is completely opposite of that of long straddle. Short straddle is a high-risk strategy with the potential for damaging losses is share price moves sharply in either direction. The maximum profit that can be earned fro the short straddle is premium earned from the sale of the option. Maximum profit is earned if the share price is at the strike price at the expiry. If the share price moves sharply in either direction, the net premium received from selling the straddle provides limited protection, beyond which unlimited losses can occur. The stronger the move the greater this loss will be. Risk of dealing in this strategy is that unless the share price is exactly at a strike price of the option sold, one of the legs will be In-the-money; therefore there is always the risk of early exercise of one leg or another Taking the same example of Reliance, if we see it from option writer then profit from long straddle will turn out to be loss from short straddle. Thus max profit occurs when strike price will be equal to stock price i.e. of Rs45/- per share. Strangle

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Like straddle, strangle also involves taking position in both call and put. However in this strike price is different but expiry date is same. It is also called Bottom Vertical Combination. Its worked out by buying put option at say X1 and call option at X2 where X1 is less than X2. Thus investor benefits if stock price fall below Xi or rise above X2. In this strategy also investor is betting that there will be large price movement but uncertain whether it will be increase or decrease. Stock price have to move farther in strangle than in the straddle foe the investor to make a profit. Under strangle, as the volatility increases it improves its position as there can be major breakout in either of the direction Payoff from the strangle Price of Stock S1 <= E1 E1 < S1 < E2 S1 >= E2 Payoff from Put E1 S1 0 0 Payoff from Call 0 0 S1 E2 Total Payoff E1 S1 0 S1 E2

Suppose Mr. Mehta buys one put of 420 of Tata motor at 10 and one call of 450 of 18. He is uncertain above the direction in which stock price will move but expects high volatility. Maximum loss is equal to premium paid i.e. 28. Payoff of the strategy is as follow. PAYOFF FROM LONG STRANGLE Price of stock (S) Srike price of put bought(X 1) 420 420 420 420 420 420 420 420 420 420 420 420 Srike price of call bought(X2) Premium For put (P1) Premiu m For Call (P2) Premiu m paid Profit / loss from put Profit/ Loss from call Total Profit

380 390 400 410 420 430 440 450 460 470 480 490

450 450 450 450 450 450 450 450 450 450 450 450

10 10 10 10 10 10 10 10 10 10 10 10

18 18 18 18 18 18 18 18 18 18 18 18

28 28 28 28 28 28 28 28 28 28 28 28

40 30 20 10 0 0 0 0 0 0 0 0

0 0 0 0 0 0 0 0 10 20 30 40

12 2 -8 -18 -28 -28 -28 -28 -18 -8 2 12

Summary: Profit Unlimited

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Loss Break-even

Limited to Premium Low BEP X1- P High BEP X2+P

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