A STUDY ON INVESTMENT IN COMMODITY & DERRIVATIVE ON SHAREKHAN PVT LTD

In the partial fulfillment of the requirement for the degree of

POST GRADUATE PROGRAME IN MANGEMENT

Submitted By

DEEPAK KUMAR VATS
ENROLL NO. 12BSP1856

Under the guidance of

Dr. SOMBALA N.
Assistant Professor, IBS GUGAON

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CERTIFICATE OF ATTENDANCE
This is to certify that Mr. Deepak Kumar Vats, who was engaged in our organization as a Summer Trainee, has been regular & punctual. He has attended the training from 15th March to 4th of june 2012.

Signature MOHD. WAKEEL (Assistant Manager) Sharekhan Ltd.

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GUIDE’S CERTIFICATE
This is to certify that Mr. Deepak Kumar Vats, Enroll. No.12BSP1856, a student of Post Graduate Program In Management, Session 2011-2013, has completed Dissertation report on the topic “INVESTMENT IN COMMODITY & DERRIVATIVE ON SHAREKHAN PVT LTD” under my supervision. He has completed the project report in most systematic and regular way, his dedication and sincerity during project is highly commendable.

I wish him all the best for his endeavour.

Dr. SOMBALA N. FACULTY GUIDE IBS GURGAON

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submitted to the IBS GURGAON.DECLARATION I hereby declare that the project work entitled “A STUDY ON INVESTMENT IN COMMODITY & DERRIVATIVE ON SHAREKHAN PVT LTD”. Deepak kumar vats 4 . Faculty guide at IBS GURGAON. and this project work has not formed the basis for the award of any Degree/Diploma/Fellowship or similar title to any candidate of any university. Sombala N. in partial fulfillment of the requirement for the award of the degree of Post Graduate Program In Management is a record bonafide research carried out by me under the guidance of Dr.

SOMBALA N. New Delhi. I would like to express my deep sense of gratitude to my Industry guide. It cannot be completed without guidelines. Nirman Vihar Branch for providing information at various point of the project. The atmosphere of a learning organization that he has created along with his peers in Nirman Vihar Branch has not only helped me but all the other trainees. who spent his valuable time and guided me. MOHD WAKEEL. I am also sincerely thankful to all the faculty members of IBS GURGAON for providing their help and advice whenever it was needed. Finally I wish to extend my sincere acknowledgement to my parents for their moral and financial support. especially the discussions on the market. Assistant Manager– Sharekhan Ltd. IBS GURGAON) for giving me the opportunity to work on this project and make it a success.ACKNOWLEDGEMENT A project is never the work of an individual. suggestions. I have benefited a great deal from his incisive analysis and erudite suggestions. It is moreover a combination of ideas.. Acknowledgements are also due to all the other staff members and executives in Sharekhan Ltd. I would like to express my sincere indebtedness to Dr. It is my pleasure to acknowledge gratefully to all those honorable personalities who helped me lot into the creation of this project and shared their experiences. Nirman Vihar Branch.. contribution and work involving many folks. (Faculty Mentor. review. Deepak kumar vats 5 .

TABLE OF CONTENTS        Certificate Declaration Acknowledgement Executive Summary Objective of the Study Methodology Job Description Chapter 1. Introduction to Derivatives               Derivatives defined Emergence of Derivatives History of Derivatives Global Derivative Markets Derivatives Market in India Participants and Functions Types of Derivative Instruments Derivative Market at NSE Approval for Derivative Trading Clearing and Settlements Index Derivatives Trading Order type and Condition SEBI Advisory Committee on Derivative 6 . Introduction of Sharekhan Limited        About Sharekhan Limited Sharekhan Limited‟s Management Team Products and Services of Sharekhan Limited Types of account in Sharekhan Limited How to open an account with Sharekhan Limited? Research section in Sharekhan Limited Awards and Achievements Chapter 2.

Arbitrage and Speculation Strategies  Hedging Strategies with examples  Arbitrage Strategies with examples  Speculation Strategies with examples Chapter 5.Chapter 3. Introducion of Commodity       Introduction of Commodity Why Structured Commodity Market ? Characterstics Of Future Trading Economic benefit of future trading Commodity are suitable for future trading Need For Futures Trading In Commodities Chapter 7. Problem Face By Commodity Market In India 7 . Applicability of Derivative Instruments     Risk Management: Concept and Definition Risk Management with Future Contract Risk Management with Options Introduction to Option Strategies Chapter 6. Hedging. Hedging Strategies  Hedging  Regulatory body  Why Commodities Market? Chapter 8. Introduction to Futures and Options     Forward Contracts Future Contracts Options Payoffs for Derivative Contracts Chapter 4.

Suggestions and Recommendations 8 . Conclusion Chapter 12.Online commodity trading  SHAREKHAN COMMODITY ADVANTAGE  KEY BENEFITS OF COMMODITIES@ SHAREKHAN Chapter 10. Research  Research objective  Hypothesis  Source of data  Sampling process  Scope of study  Limitation of study  Analysis & Interpretation  Testing of Hypothesis Chapter 11. Problem Faced By Commodities Markets In India      Risks Associated With Commodities Market Key Factors For Success Of Commodities Market Key FActors For Success Of Commodities Exchange Future prospectis Regulatory approval for fit trading in commodity market Chapter 9.

The next few chapters are devoted to the study of the Derivative Market and Derivative Instruments in a very basic way. It also enlightens the readers about Sharekhan Limited’s strategies to acquire new customers. It also describe about the objective of this study. vision. It also makes the readers aware about the techniques and methodology used to bring this report alive. It provides knowledge to the readers regarding the company’s history. Further the project tells us about the profile of the company (Sharekhan Ltd. It also suggests some of the strategies that can be applied to earn more even when the market is too much volatile. People who are exposed to the same risk come together and agree that if anyone of the person suffers a loss the other will share the loss and make good to the person who lost. The next part of the project throws light upon my findings and analysis about the company and the suggestions for the company for better performance.Chapter 13. Also it gives special emphasis on the selling of products and management of the company. The Reference Material  Glossary  Bibliography EXECUTIVE SUMMARY Conceptually the mechanism of stock market is very simple.). 9 . customer base and the reasons to be associated with the company. The readers can also find the comparative analysis of the Derivative Market and the Cash Market in the Indian context. The initial part of the project focuses on the job and responsibilities I was allotted as a summer trainee. mission.

the objective of the Dissertation is to do in depth research on these derivative instruments. As a result one can have conviction in his portfolio in the hugely volatile stock market because a difficult and serious problem for all investors today is that there is entirely too much free information. relatives. entertaining cable TV market programs. So one need to confine himself to just a very few sources of relevant facts and data and a sound system that has proven to be accurate and profitable over time. the Internet. Realistically. contradictory. One get it from friends. there are not too many people one can listen to if he want to avoid confusing. Therefore. personal opinion. and other media. and faulty personal market opinions. It can be very risky and potentially dangerous.OBJECTIVE OF THE STUDY To find out whether the Derivative Instruments are applicable in the Indian Stock Market which can work both in good and bad times so that it can minimize our risk and maximize our returns. stock analysts. advisers. and advice about derivative instruments are there in stock market. people at work. brokers. 10 . promotion. hype.

for which I have introduced a separate chapter. I have also analyzed the top five most traded symbols in futures and options segment. I have given a brief introduction about the instruments. arbitrage and speculation strategies using both futures and options. which includes the comparison of derivative market with cash market. data regarding the traded volume and number of contracts traded from 2011. I have analyzed the Futures and Options.METHODOLOGY During this project. I have tried to identify various terms related to derivative trading. so that the reader is aware of basics of the subject. Then I have done a secondary data based study on growth of Indian Derivative Market. I have tried to analyze the instruments as per the Market Participant and the Market Trend. 11 . I identified hedging. Initially. and then segregated them into a chapter each. “Terms related to derivative market” Then I have tried to segregate the use of Instruments as per the Market Participants and Market Trend. Segregation involved a thorough study of the strategies and possible use.

canopies. Lawyers Travel agencies Transport business House wives Businessmen Corporate Employees etc. Ghaziabad. distributing pamphlets and etc. AREA ASSIGNED I covered areas like Delhi. I have been handling the Following responsibilities:  My job profile was to sale the products of the organization.  My job profile was to coordinate the team and also help them to sale the product and also help them in field. 12 .JOB DESCRIPTION The company placed me as a Summer Trainee.  My job profile was to generate the leads by cold calling. Gurgaon.  My job profile was to understand customers’ needs and advising them to make a portfolio as per their investment. TARGET ASSIGNED  To sell 6 accounts . Faridabad and NCR. making cold calling.  My job profile was to do sales promotion through e-mails. Charted accountants. TARGET MARKET         Different properties dealers.

Cold calling. Demonstrate the product on Internet to the client.DAY TO DAY JOB DESCRIPTION       Reporting time: 9. 13 . Completing the formalities like filling the application form and documentation. Visit clients place.00 AM Fixing appointment with clients.

ABOUT SHAREKHAN LIMITED 14 .Chapter 1 Introduction of Sharekhan ltd. INTRODUCTION OF SHAREKHAN LTD.

Oracle. The objective has been to let customers make informed decisions and to simplify the process of investing in stocks. HSBC. SSKI‟s institutional broking arm accounts for 7% of the market for Foreign Institutional portfolio investment and 5% of all Domestic 15 . Intel & Carlyle are the other investors. Spider Software Pvt Ltd.was launched on Feb 8. Known for its jargon-free. The site gives access to superior content and transaction facility to retail customers across the country. like Sun Microsystems. which has over eight decades of experience in the stock broking business. the SSKI group ventured into institutional broking and corporate finance 18 years ago. is one of the leading retail stock broking house of SSKI Group which is running successfully since 1922 in the country. the site has a registered base of over one lakh customers. The content-rich and research oriented portal has stood out among its contemporaries because of its steadfast dedication to offering customers best-of-breed technology and superior market information. Sharekhan has always believed in investing in technology to build its business. Verisign Financial Technologies India Ltd. Cambridge Technologies. NSE. On April 17.www. Vignette. Sharekhan offers its customers a wide range of equity related services including trade execution on BSE. 2002 Sharekhan launched Speed Trade. to build its trading engine and content. Sharekhan‟s ground network includes over 640 centers in 280 cities in India which provide a host of trading related services. online trading.com . This was for the first time that a netbased trading station of this caliber was offered to the traders. In the last six months Speed Trade has become a de facto standard for the Day Trading community over the net. depository services. 2000.Sharekhan Ltd. investor friendly language and high quality research. SSKI holds a sizeable portion of the market in each of these segments. Derivatives.sharekhan. a net-based executable application that emulates the broker terminals along with host of other information relevant to the Day Traders. It is the retail broking arm of the Mumbai-based SSKI Group. The firm‟s online trading and investment site . Microsoft. The Morakhiya family holds a majority stake in the company. Presently SSKI is one of the leading players in institutional broking and corporate finance activities. With a legacy of more than 80 years in the stock markets. Nexgenix. investment advice etc. The company has used some of the best-known names in the IT industry.

Institutional portfolio investment in the country. It has 60 institutional clients spread over India, Far East, UK and US. Foreign Institutional Investors generate about 65% of the organization‟s revenue, with a daily turnover of over US$ 2 million. The Corporate Finance section has a list of very prestigious clients and has many „firsts‟ to its credit, in terms of the size of deal, sector tapped etc. The group has placed over US$ 1 billion in private equity deals. Some of the clients include BPL Cellular Holding, Gujarat Pipavav, Essar, Hutchison, Planetasia, and Shopper‟s Stop.

PROFILE OF THE COMPANY
Name of the company: Year of Establishment: Headquarter : Sharekhan ltd. 1925 ShareKhan SSKI A-206 Phoenix House Phoenix Mills Compound Lower Parel Mumbai - Maharashtra, INDIA- 400013 Service Provider Depository Services, Online Services and Technical Research. Over 3500 Data Not Available www.sharekhan.com Your Guide to The Financial Jungle.

Nature of Business Services

: :

Number of Employees : Revenue Website Slogan : : :

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

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

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

REASON TO CHOOSE SHAREKHAN LIMITED

Experience SSKI has more than eight decades of trust and credibility in the Indian stock market. In the Asia Money broker's poll held recently, SSKI won the 'India's Best Broking House for 2004' award. Ever since it launched Sharekhan as its retail broking division in February 2000, it has been providing institutionallevel research and broking services to individual investors. Technology With its online trading account one can buy and sell shares in an instant from any PC with an internet connection. One can get access to its powerful online trading tools that will help him take complete control over his investment in shares. Accessibility Sharekhan provides ADVICE, EDUCATION, TOOLS AND EXECUTION services for investors. These services are accessible through its centers across the country over the internet (through the website www.sharekhan.com) as well as over the Voice Tool. Knowledge In a business where the right information at the right time can translate into direct profits, one can get access to a wide range of information on Sharekhan 17

limited‟s content-rich portal. One can also get a useful set of knowledge-based tools that will empower him to take informed decisions. Convenience One can call its Dial-N-Trade number to get investment advice and execute his transactions. Sharekhan ltd. have a dedicated call-centre to provide this service via a Toll Free Number 1800-22-7500 & 1800-22-7050 from anywhere in India. Customer Service Sharekhan limited‟s customer service team will assist one for any help that one may require relating to transactions, billing, demat and other queries. Its customer service can be contacted via a toll-free number, email or live chat on www.sharekhan.com. Investment Advice Sharekhan has dedicated research teams of more than 30 people for fundamental and technical researches. Its analysts constantly track the pulse of the market and provide timely investment advice to its clients in the form of daily research emails, online chat, printed reports and SMS on their mobile phone.

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

professional advice of Sharekhan limited‟s Tele Brokers V. After hours order placement facility between 8. Automatic funds transfer with phone banking facilities (for Citibank and HDFC bank customers) III.00 am and 9.TYPES OF ACCOUNT IN SHAREKHAN LIMITED Sharekhan offers two types of trading account for its clients  Classic Account (which include a feature known as Fast Trade Advanced Classic Account for the online users) and  Speed Trade Account CLASSIC ACCOUNT This is a User Friendly Product which allows the client to trade through website www. Online trading account for investing in Equities and Derivatives b. Single screen interface for cash and derivatives. f. Simple and Secure Interactive Voice Response based system for authentication IV.sharekhan. Real-time portfolio tracking with price alerts and Instant credit & transfer. This account comes with the following features: a. d. IPO investments. e.com and is suitable for the retail investor who is risk-averse and hence prefers to invest in stocks or who does not trade too frequently.30 am c. Instant order and trade confirmations by e-mail. Free trading through Phone (Dial-n-Trade) I. 20 . Integrated Banking. g. Two dedicated numbers(1800-22-7500 and 39707500) for placing the orders using cell phones or landline phones II. Integration of: Online Trading +Saving Bank + Demat Account. get the trusted. Demat and digital contracts. Instant cash transfer facility against purchase & sale of shares. This account allow investors to buy and sell stocks online along with the following features like multiple watch lists.

) Hot keys similar to broker‟s terminal. Alerts and reminders. highest value etc. NIL Rs.0.a. i. tic-by-tic charts. which enables one to buy and sell in an instant. NSE F&O & BSE. It is ideal for active traders and jobbers who transact frequently during day‟s session to capitalize on intra-day price movement. b. Back-up facility to place trades on Direct Phone lines. h. f.0. Single screen trading terminal for NSE Cash.10% 21 .0. Technical Studies. Market summary (Cost traded scrip. from second calendar year onward Delivery . Instant order Execution and Confirmation. j. c.50% Speed Trade Account Rs.SPEED TRADE ACCOUNT This is an internet-based software application. 1000/= Intra-day . Live market debts. Multiple Charting. 750/= Intra-day – 0. e. g. NIL first year Rs. Real-time streaming quotes.10 % Brokerage Delivery . 400/= p. d. This account comes with the following features: a.50 % Depository Charges: Account Opening Charges Annual Maintenance Charges Rs. CHARGE STRUCTURE Fee structure for General Individual: Charge Account Opening Classic Account Rs.

HOW TO OPEN AN ACCOUNT WITH SHARE KHAN LIMITED? Generally the process of opening an account follows the following steps: LEAD MANAGEMENT SYSTEM (LMS) / REFERENCES CONTACT THE PERSON OVER PHONE OR THROUGH EMAIL FIXING AN APPOINTMENT WITH THE PERSON GIVING DEMONSTRATION YES NO DOCUMENTATION FILLING UP THE FORM SUBMISSION OF THE FORM LOGIN OF THE FORM SENDING ACCOUNT OPENING KIT TO THE CLIENT TRADING 22 .

one needs to provide with the following documents in order to open an account with Sharekhan Limited. 5000). Saving Bank Statement** (should be latest) Two cheques drawn in favour of Sharkhan Limited. h. i.  Passport (valid) Voter‟s ID Card Ration Card Driving License (valid) Electricity Bill (should be latest and should be in the name of the client) Telephone Bill (should be latest and should be in the name of the client) Flat Maintenance Bill (should be latest and should be in the name of the client) Insurance Policy (should be latest and should be in the name of the client) Lease or Rent Agreement. ** A cancelled cheque should be given by the client if he provides Saving Bank Statement as a proof for correspondence address. 23 . NOTE: Only Saving Bank Account cheques are accepted for the purpose of Opening an account.:   Photocopy of the clients‟ PAN Card which should be duly attached Photo copy of any of the following documents duly attached which will serve as correspondence address proof: a.Apart from two passport size photographs. g. e. f. d. c. one for the Account Opening Fees and the other for the Margin Money (the minimum margin money is Rs. b. j.

It comprises a team of experts who constantly keep an eye on the share market and do research on the various aspects of the share market. one receives daily 5-6 Research Reports on their emails which they can use as tips for investing in the market. Generally the research is based on the Fundamentals and Technical analysis of different companies and also taking into account various factors relating to the economy. Daring Derivatives and Post-Market Report. Sharekhan's trading calls in the month of November 2007 has given 89% strike rate. 33 hit the profit target. High Noon. Investors Eye. Out of 37 trading calls given by Sharekhan in the month of November 2007. Apart from these.RESEARCH SECTION IN SHAREKHAN LIMITED Sharekhan Limited has its own in-house Research Organisation which is known as Valueline. These exclusive trading picks come only to Sharekhan Online Trading Customer and are based on in-depth technical analysis. Eagle Eye. As a customer of Sharekhan Limited. Sharekhan Limited‟s research on the volatile market has been found accurate most of the time. These reports are named as Pre-Market Report. Sharekhan Limited issues a monthly subscription by the name of Valueline which is easily available in the market. 24 .

twice by Euromoney Survey and four times by Asiamoney Survey.  Chapter 2 Introduction to Derivatives 25 . Sharekhan Limited won the CNBC AWARD for the year 2004.AWARDS AND ACHIEVEMENTS  SSKI has been voted as the Top Domestic Brokerage House in the research category.

in a contractual manner. to 26 . Such transaction is an example of a derivative. The underlying asset can be equity. wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. forex. DERIVATIVES DEFINED Derivative is a product whose value is derived from the value of one or more basic variables.INTRODUCTION TO DERIVATIVES The emergence of the market for derivative products. For example. futures and options. commodity or any other asset. can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. Through the use of derivative products. or reference rate). made on the trading screen of stock exchanges. most notably forwards. By their very nature. However. The price of this derivative is driven by the spot price of wheat which is the “underlying”. derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors. called bases (underlying asset. As instruments of risk management. the financial markets are marked by a very high degree of volatility. these generally do not influence the fluctuations in the underlying asset prices. by lockingin asset prices. In simple word it can be said that Derivatives are financial contracts whose value/price is dependent on the behavior of the price of one or more basic underlying assets (often simply known as underlying). index. These contracts are legally binding agreements. it is possible to partially or fully transfer price risks by locking–in asset prices.

1956 (SC(R) A) defines “derivative” to include – 1. of underlying securities. bond. A security derived from a debt instrument. who are major users of index-linked derivatives. a group of Chicago 27 . risk instrument or contract for differences or any other form of security. interest rate. or index of prices. To deal with this problem. The asset can be a share. share. A very simple example of derivatives is curd. HISTORY OF DERIVATIVES Early forward contracts in the US addressed merchants‟ concerns about ensuring that there were buyers and sellers for commodities. since their emergence. EMERGENCE OF DERIVATIVES Derivative products initially emerged as hedging devices against fluctuations in commodity prices. In the class of equity derivatives the world over. index. A contract which derives its value from the prices. futures and options on stock indices have gained more popularity than on individual stocks. However. Financial derivatives came into spotlight in the post-1970 period due to growing instability in the financial markets.buy or sell an asset in future. However “credit risk” remained a serious problem. etc. Even small investors find these useful due to high correlation of the popular indexes with various portfolios and ease of use. rupee dollar exchange rate. 2. The lower costs associated with index derivatives vis–a–vis derivative products based on individual securities is another reason for their growing use. which is derivative of milk. cotton. In the Indian context the Securities Contracts (Regulation) Act. coffee. The price of curd depends upon the price of milk which in turn depends upon the demand and supply of milk. these products have become very popular and by 1990s. and commodity-linked derivatives remained the sole form of such products for almost three hundred years. sugar. the market for financial derivatives has grown tremendously in terms of variety of instruments available. especially among institutional investors. crude oil. they accounted for about two-thirds of total transactions in derivative products. soybean. In recent years. their complexity and also turnover. loan whether secured or unsecured.

the turnover in exchange– 28 . Eurex etc.3 trillion as at end–December 2000. The total estimated notional amount of outstanding over–the–counter (OTC) contracts stood at US$ 95. the CBOT went one step further and listed the first “exchange traded” derivatives contract in the US. DTB in Germany.5 trillion as at end December 1999 to US$ 14. an increase of 7. In 1919. futures on T-bills and Euro-Dollar futures are the three most popular futures contracts traded today. these contracts were called “futures contracts”.. In 1865.businessmen formed the Chicago Board of Trade (CBOT) in 1848. According to BIS.9% over end–December 1999. The amount outstanding in organized exchange markets increased by 5. While interest rate futures and options accounted for nearly 90% of total turnover during 2000. Currently the most popular stock index futures contract in the world is based on S&P 500 index. was reorganized to allow futures trading. TIFFE in Japan. The turnover in derivative contracts traded on exchanges has increased by 9. indeed the two largest “financial” exchanges of any kind in the world today. SGX in Singapore. Its name was changed to Chicago Mercantile Exchange (CME). financial futures became the most active derivative instruments generating volumes many times more than the commodity futures.5 trillion as at end–December 2000. a spin-off of CBOT. the popularity of stock market index futures and options grew modestly during the year.2 trillion as at end–December 2000.8% during 2000 to US$ 384 trillion as compared to US$ 350 trillion in 1999(Table 1. During the mid eighties. The primary intention of the CBOT was to provide a centralized location known in advance for buyers and sellers to negotiate forward contracts. The turnover data are available only for exchange–traded derivatives contracts. According to the Bank for International Settlements (BIS). The CBOT and the CME remain the two largest organized futures exchanges. The first stock index futures contract was traded at Kansas City Board of Trade. Index futures. traded on Chicago Mercantile Exchange. Chicago Butter and Egg Board.8% from US$ 13. GLOBAL DERIVATIVE MARKETS The derivatives markets have grown manifold in the last two decades. the approximate size of global derivatives market was US$ 109. Growth in OTC derivatives market is mainly attributable to the continued rapid expansion of interest rate contracts. MATIF in France. Other popular international exchanges that trade derivatives are LIFFE in England.2). which reflected growing corporate bond markets and increased interest rate uncertainty at the end of 2000.

SEBI set up a 24–member committee under the Chairmanship of Dr. deposit requirement and real–time monitoring requirements. did not take off. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recognized stock exchange. however. 1998 prescribing necessary pre–conditions for introduction of derivatives trading in India. The government also rescinded in March 2000. To begin with. while there was some moderation in the OTC volumes. NSE and BSE. to recommend measures for risk containment in derivatives market in India. SEBI also set up a group in June 1998 under the Chairmanship of Prof.J.Varma.R.L. which prohibited forward trading in securities. which was submitted in October 1998. 1996 to develop appropriate regulatory framework for derivatives trading in India. The report. The trading in 29 . 1995.Gupta on November 18. broker net worth. which withdrew the prohibition on options in securities. DERIVATIVE MARKET IN INDIA The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance. as there was no regulatory framework to govern trading of derivatives.C. SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE–30 (Sensex) index. SEBI permitted the derivative segments of two stock exchanges. The SCRA was amended in December 1999 to include derivatives within the ambit of „securities‟ and the regulatory framework was developed for governing derivatives trading. and their clearing house/corporation to commence trading and settlement in approved derivatives contracts.traded derivative markets rose by a record amount in the first quarter of 2001. This was followed by approval for trading in options based on these two indexes and options on individual securities. Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2000. The market for derivatives. The committee submitted its report on March 17. The committee recommended that derivatives should be declared as „securities‟ so that regulatory framework applicable to trading of „securities‟ could also govern trading of securities. thus precluding OTC derivatives. the three–decade old notification. methodology for charging initial margins. worked out the operational details of margining system.

The most common variants are forwards. with 1 month.Speculators wish to bet on future movements in the price of an asset. Single stock futures were launched on November 9. The index futures and options contract on NSE are based on S&P CNX Nifty Index. Futures contracts on individual stocks were launched in November 2001. The following three broad categories of participants – Hedgers: . 2001.index options commenced in June 2001 and the trading in options on individual securities commenced in July 2001. 2001 and trading in options on individual securities commenced on July 2. If. futures. 30 . They use futures or options markets to reduce or eliminate this risk Speculators: . they can increase both the potential gains and potential losses in a speculative venture. and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and notified in the official gazette. 2 months and 3 months expiry. Futures and options contracts can give them an extra leverage. options and swaps. 2000. that is. Arbitrageurs: . for example. they see the futures price of an asset getting out of line with the cash price. The trading in index options commenced on June 4. they will take offsetting positions in the two markets to lock in a profit. 2001. The derivatives trading on the exchange commenced with S&P CNX Nifty Index futures on June 12. PARTICITANTS AND FUNCTIONS PARTICIPANTS Derivative contracts have several variants. Trading and settlement in derivative contracts is done in accordance with the rules. Three contracts are available for trading. Currently.Hedgers face risk associated with the price of an asset. A new contract is introduced on the next trading day following the expiry of the near month contract.Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. the futures contracts have a maximum of 3-month expiration cycles. byelaws.

They often energize others to create new businesses. monitoring and surveillance of the activities of various participants become extremely difficult in these kind of mixed markets. An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. the benefit of which are immense. TYPES OF DERIVATIVE INSTRUMENTS 31 . Derivatives. well-educated people with an entrepreneurial attitude. 1. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk. In the absence of an organized derivatives market. 6. 3.FUNCTIONS The derivatives market performs a number of economic functions. 2. Derivatives markets help increase savings and investment in the long run. 5. creative. Transfer of risk enables market participants to expand their volume of activity. new products and new employment opportunities. 4. due to their inherent nature. The derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them. The derivatives have a history of attracting many bright. speculators trade in the underlying cash markets. Margining. Prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. With the introduction of derivatives. are linked to the underlying cash markets. Speculative trades shift to a more controlled environment of derivatives market.

Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. DERIVATIVE MARKET AT NSE 32 . Currency swaps: These entail swapping both principal and interest between the parties. Puts give the buyer the right. Thus a swaption is an option on a forward swap. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts. The two commonly used swaps are: a. Options: Options are of two types . LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Rather than have calls and puts. They can be regarded as portfolios of forward contracts. The underlying asset is usually a moving average of a basket of assets. the swaptions market has receiver swaptions and payer swaptions. but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. with the cash flows in one direction being in a different currency than those in the opposite direction. Warrants: Options generally have lives of up to one year.Forwards: A forward contract is a customized contract between two entities. Longer-dated options are called warrants and are generally traded over-the-counter. where settlement takes place on a specific date in the future at today‟s preagreed price. These are options having a maturity of up to three years. b. A payer swaption is an option to pay fixed and receive floating. at a given price on or before a given future date. Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency.calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset. Equity index options are a form of basket options. Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. the majority of options traded on options exchanges having a maximum maturity of nine months. Baskets: Basket options are options on portfolios of underlying assets. A receiver swaption is an option to receive fixed and pay floating.

called NEAT-F&O trading system.Date. It supports an anonymous order driven market which provides complete transparency of trading operations and operates on strict price–time priority. with 1 month. 2 months and 3 months expiry. Currently. Three contracts are available for trading. A new contract is introduced on the next trading day following the expiry of the near month contract. they can enter and set limits to positions. Good-till-Cancelled. It is similar to that of trading of equities in the Cash Market (CM) segment. Those interested in taking membership on F&O segment are required to take 33 . The Trading Members(TM) have access to functions such as order entry. order matching. which a trading member can take. The index futures and options contract on NSE are based on S&P CNX Nifty Index. and order and trade management. MEMBERSHIP CRITERIA NSE admits members on its derivatives segment in accordance with the rules and regulations of the exchange and the norms specified by SEBI. 2000. 2001. NSE follows 2–tier membership structure stipulated by SEBI to enable wider participation. Various conditions like Good-till-Day. 2001 and trading in options on individual securities commenced on July 2. etc. Limit/Market price. Stop loss. APPROVAL FOR DERIVATIVE TRADING TRADING MECHANISM The futures and options trading system of NSE.The derivatives trading on the exchange commenced with S&P CNX Nifty Index futures on June 12. Immediate or Cancel. The Clearing Members (CM) uses the trader workstation for the purpose of monitoring the trading member(s) for whom they clear the trades. provides a fully automated screen–based trading for Nifty futures & options and stock futures & options on a nationwide basis and an online monitoring and surveillance mechanism. the futures contracts have a maximum of 3-month expiration cycles. Additionally. It provides tremendous flexibility to users in terms of kinds of orders that can be placed on the system. can be built into an order. The NEAT-F&O trading system is accessed by two types of users. 2001. The trading in index options commenced on June 4. Good till. Single stock futures were launched on November 9.

client open long position and client open short position. Trading and clearing members are admitted separately. trading members are required to have qualified users and sales persons. whether proprietary (if they are their own trades) or client (if entered on behalf of clients). TMs are required to identify the orders. 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. Typically. Besides this. Proprietary positions are calculated on net basis (buy-sell) for each contract. in the contracts in which they have traded.  Professional Clearing Member: PCM is a CM who is not a TM. banks or custodians could become a PCM and clear and settle for TMs. TM–CM may clear and settle his own proprietary trades and client‟s trades as well as clear and settle for other TMs. Clients‟ positions are arrived at by summing together net (buy-sell) positions of each individual client for each contract. A TM‟s open position is arrived at as the summation of his proprietary open position and clients open positions. Clearing: The first step in clearing process is working out open positions or obligations of members. A CM‟s open position is arrived at by aggregating the open position of all the TMs and all custodial participants clearing through him.membership of CM and F&O segment or CM. A TM‟s open position is the sum of proprietary open position. 34 . WDM and F&O segment. a clearing member (CM) does clearing for all his trading members (TMs). There are three types of CMs: Self Clearing Member: A SCM clears and settles trades executed by him only either on his own account or on account of his clients. Essentially.  Trading Member Clearing Member: TM–CM is a CM who is also a TM. It acts as legal counterparty to all deals on the F&O segment and guarantees settlement. in the contracts in which they have traded. who have passed a Certification programme approved by SEBI.  CLEARING AND SETTLEMENTS NSCCL undertakes clearing and settlement of all deals executed on the NSEs F&O segment. undertakes risk management and performs actual settlement.

Gupta attributes the popularity of index derivatives to the advantages they offer. For the purpose of settlement. Futures and options on individual securities can be delivered as in the spot market. i. forged/fake certificates. In his report. Index derivatives have become very popular worldwide. and the possibility of cornering is reduced. Pension funds in the US are known to use stock index futures for risk hedging purposes. Dr. The underlying for index futures/options of the Nifty index cannot be delivered. through exchange of cash. it has been currently mandated that stock options and futures would also be cash settled.C. premium and final exercise settlement. which can be cornered. These contracts. INDEX DERIVATIVES Index derivatives are derivative contracts which derive their value from an underlying index. Index derivatives offer ease of use for hedging any portfolio irrespective of its composition. have to be settled in cash. The two most popular index derivatives are index futures and index options. Index derivatives are cash settled. Index–derivatives are more suited to them and more cost–effective than derivatives based on individual stocks. all CMs are required to open a separate bank account with NSCCL designated clearing banks for F&O segment. Stock index is difficult to manipulate as compared to individual stock prices.  Institutional and large equity-holders need portfolio-hedging facility.     Requirements for an index derivatives market 35 . therefore. Stock index. is much less volatile than individual stock prices. more so in India. being an average.e. However.L. The settlement amount for a CM is netted across all their TMs/clients in respect of MTM.Settlement: All futures and options contracts are cash settled. This is partly because an individual stock has a limited supply. and hence do not suffer from settlement delays and problems related to bad delivery. This implies much lower capital adequacy and margin requirements.

Keeping in view the familiarity of trading members with the current capital market trading system. provides a fully automated screen-based trading for Nifty futures & options and stock futures & options on a nationwide basis as well as an online monitoring and surveillance mechanism. Clearing corporation settlement guarantee: The clearing corporation eliminates counterparty risk on futures markets. trading of index futures and index options commenced at NSE in June 2000 and June 2001 respectively. 2. A critical element of financial sector reforms is the development of a pool of human resources with strong skills and expertise to provide quality intermediation to market participants.1. I shall take a brief look at the trading system for NSE‟s futures and options market. Hence the need to have strong surveillance on the market both at the exchange level as well as at the regulator level. 4. With the entire above infrastructure in place. Index: The choice of an index is an important factor in determining the extent to which the index derivative can be used for hedging. The software for the F&O market has been developed to facilitate efficient and transparent trading in futures and options instruments. It supports an order driven market and provides complete transparency of trading operations. liquid index ensures that hedgers and speculators will not be vulnerable to individual or industry risk. called NEAT-F&O trading system. the best way to get a feel of the trading system is to actually watch the screen and observe how it operates. Strong surveillance mechanism: Derivatives trading brings a whole class of leveraged positions in the economy. A well diversified. TRADING Here. However. buying from the seller and selling to the buyer. It is similar to that of trading of equities in the cash market segment. speculation and arbitrage. Futures and options trading system The futures & options trading system of NSE. This insulates a participant from credit risk of another. 3. The clearing corporation interposes itself into every transaction. 36 . Education and certification: The need for education and certification in the derivatives market can never be overemphasized.

1. Professional clearing members: A professional clearing members is a clearing member who is not a trading member. Trading members: Trading members are members of NSE. banks and custodians become professional clearing members and clear and settle for their trading members. They can trade either on their own account or on behalf of their clients including participants. Trading members. Entities in the trading system There are four entities in the trading system. The unique trading member ID functions as a reference for all orders/trades of different users. time and quantity. BASIS OF TRADING The NEAT F&O system supports an order driven market. Order matching is essentially on the basis of security. The exchange notifies the regular lot size and tick size for each of the contracts traded on this segment from time to time. This ID is common for all users of a particular trading member. Each user of a trading member must be registered with the exchange and is assigned a unique user ID. Participants: A participant is a client of trading members like financial institutions. 2. All quantity fields are in units and price in rupees.modifications have been performed in the existing capital market trading system so as to make it suitable for trading futures and options. It tries 37 . Typically. The exchange assigns a Trading member ID to each trading member. The number of users allowed for each trading member is notified by the exchange from time to time. Each trading member can have more than one user. These clients may trade through multiple trading members but settle through a single clearing member. It is the responsibility of the trading member to maintain adequate control over persons having access to the firm‟s User IDs. it is an active order. its price. professional clearing members and participants. Clearing members: Clearing members are members of NSCCL. When any order enters the trading system. clearing members. wherein orders match automatically. The lot size on the futures market is for 200 Nifties. 3. 4. They carry out risk management activities and confirmation/inquiry of trades through the trading system.

Time conditions  Day order: A day order. If the order is not executed during the day. If it finds a match. Good till canceled (GTC): A GTC order remains in the system until the user cancels it. Good till days/date (GTD): A GTD order allows the user to specify the number of days/date till which the order should stay in the system if not executed. Consequently. The days counted are inclusive of the day on which the order is placed and the order is cancelled from the system at the end of the day of the expiry period. These conditions are broadly divided into the following categories:  Time conditions  Price conditions  Other conditions Several combinations of the above are allowed thereby providing enormous flexibility to the users. the order becomes passive and goes and sits in the respective outstanding order book in the system. The order types and conditions are summarized below. Each day/date counted are inclusive of the day/date on which   38 .to find a match on the other side of the book. If it does not find a match. the order is cancelled from the system. ORDER TYPES AND CONDITIONS The system allows the trading members to enter orders with various conditions attached to them as per their requirements. the system cancels the order automatically at the end of the day. a trade is generated. The maximum number of days an order can remain in the system is notified by the exchange from time to time after which the order is automatically cancelled by the system. Each day counted is a calendar day inclusive of holidays. if not traded on the day the order is entered. it spans trading days. The maximum days allowed by the system are the same as in GTC order. as the name suggests is an order which is valid for the day on which it is entered. At the end of this day/date.

This order is added to the regular lot book with time of triggering as the time stamp. the trigger is 1027. the system determines the price. after the market price of the security reaches or crosses a threshold price e.  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. price is market price).g. the limit price is 1030.00. and the unmatched portion of the order is cancelled immediately.00. Other conditions  Market price: Market orders are orders for which no price is specified at the time the order is entered (i. For the stop– loss sell order. 39 .the order is placed and the order is cancelled from the system at the end of the day/date of the expiry period.00.     Cli: Cli means that the trading member enters the orders on behalf of a client. if for stop–loss buy order. Price condition  Stop– loss: This facility allows the user to release an order into the system. Partial match is possible for the order. Pro: Pro means that the orders are entered on the trading member‟s own account. the trigger price has to be greater than the limit price. Limit price: Price of the orders after triggering from stop–loss book. then this order is released into the system once the market price reaches or exceeds 1027. For such orders. Trigger price: Price at which an order gets triggered from the stop–loss book.00.00 and the market (last traded) price is 1023.e. failing which the order is cancelled from the system. as a limit order of 1030.

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

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

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

Basket trading
In order to provide a facility for easy arbitrage between futures and cash markets, NSE introduced basket-trading facility. Figure 10.4 shows the basket 40

trading screen. This enables the generation of portfolio offline order files in the derivatives trading system and its execution in the cash segment. A trading member can buy or sell a portfolio through a single order, once he determines its size. The system automatically works out the quantity of each security to be bought or sold in proportion to their weights in the portfolio.

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

Contract specifications for index futures
NSE trades Nifty futures contracts having one-month, two-month and threemonth expiry cycles. All contracts expire on the last Thursday of every month. Thus a January expiration contract would expire on the last Thursday of January and a February expiry contract would cease trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three-month expiry would be introduced for trading. Depending on the time period for which you want to take an exposure in index futures contracts, you can place buy and sell orders in the respective contracts. The Instrument type refers to “Futures contract on index” and Contract symbol - NIFTY denotes a “Futures contract on Nifty index” and the Expiry date represents the last date on which the contract will be available for trading. Each futures contract has a separate limit order book. All passive orders are stacked in the system in terms of price-time priority and trades take place at the passive order price (similar to the existing capital market trading system). The best buy order for a given futures contract will be the order to buy the index at the highest index level whereas the best sell order will be the order to sell the index at the lowest index level. Trading is for a minimum lot size of 200 units. Thus if the index level is around 1000, then the appropriate value of a single index futures contract would be Rs.200,000. The minimum tick size for an index future contract is 0.05 units. Thus a single move in the index value would imply a resultant gain or loss of Rs.10.00 (i.e. 0.05*200 units) on an open position of 200 units. 41

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

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

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

SEBI ADVISORY COMMITTEE ON DERIVATIVES
The SEBI Board in its meeting on June 24, 2002 considered some important issues relating to the derivative markets which include:  Physical settlement of stock options and stock futures contracts.  Review of the eligibility criteria of stocks on which derivative products are permitted.  Use of sub-brokers in the derivative markets. 42

Norms for use of derivatives by mutual funds.

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

REGULATORY OBJECTIVES
The LCGC outlined the goals of regulation admirably well in Paragraph 3.1 of its report. We endorse these regulatory principles completely and base our recommendations also on these same principles. We therefore reproduce this paragraph of the LCGC Report: “The Committee believes that regulation should be designed to achieve specific, Well-defined goals. It is inclined towards positive regulation designed to encourage healthy activity and behavior. It has been guided by the following objectives: (a) Investor Protection: Attention needs to be given to the following four aspects: (i) Fairness and Transparency (ii) Safeguard for clients‟ moneys (iii) Competent and honest service (b) Quality of markets: The concept of “Quality of Markets” goes well beyond market integrity and aims at enhancing important market qualities, such as cost-efficiency, price-continuity, and price-discovery. This is a much broader objective than market integrity. (c) Innovation: While curbing any undesirable tendencies, the regulatory framework should not stifle innovation which is the source of all economic progress, more so because financial derivatives represent a new rapidly developing area, aided by advancements in information technology.”

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Chapter 3

Introduction to Futures and Options
44

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

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

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the exchange specifies certain standard features of the contract. High Leverage: The primary attraction. The standardized items in a futures contract are:  Quantity of the underlying asset  Quality of the underlying assets (not required in case of financial futures)  The date and the month of delivery  The units of price quotation (not the price)  Minimum fluctuation in price (tick size)  Location of settlement  Settlement style. 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. a standard quantity and quality of the underlying instrument that can be delivered. ADVANTAGES OF FUTURE TRADING IN INDIA 1. index.  Illiquidity. The reason that futures trading can be so profitable is the high leverage. rupee-dollar exchange rate. In simple words. cotton. crude oil. It is a standardized contract with standard underlying instrument. sugar. The asset can be share. the futures contracts are standardized and exchange traded. But unlike forward contracts. (or which can be used for reference purposes in settlement) and a standard timing of such settlement. interest rate. bond. Futures are exchange-traded contracts to buy or sell an asset in future at a price agreed upon today. soybean. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. To „own‟ a futures contract an investor only has 46 . To facilitate liquidity in the futures contracts. and Counterparty risk FUTURE CONTRACT Futures markets were designed to solve the problems that exist in forward markets. is the potential for large profits in a short period of time. More than 99% of futures transactions are offset this way. coffee etc. of course.

With the launch of futures on individual securities (herein referred to as stock futures) on the 9th of November.10-0. i. One can differentiate a forward contract from a future contract on the following lines: 47 . Profit in Both Bull & Bear Markets: In futures trading. Lower Transaction Cost: Another advantage of futures trading is much lower relative commissions. stock futures are particularly appealing due to familiarity and ease in understanding. trading stock futures is no different from trading the security itself. options on index were available for trading. A future contract is nothing but a form of forward contract. there are huge amounts of contracts traded every day. High Liquidity: Most futures markets are very liquid. Your commission for trading a futures contract is one tenth of a percent (0. 2. the basic range of equity derivative products in India seems complete. However futures are a significant improvement over the forward contracts.20%). Of the above mentioned products.to put up a small fraction of the value of the contract (usually around 10-20%) as „margin‟. stock futures can be effectively used for hedging and arbitrage reasons.e. The confusion is primarily because both serve essentially the same economic functions of allocating risk in the presence of future price uncertainty. By choosing correctly. 4. A purchase or sale of futures on a security gives the trader essentially the same price exposure as a purchase or sale of the security itself. This ensures that market orders can be placed very quickly as there are always buyers and sellers for most contracts. A year later. 2001. In this regard. USING FUTURES ON INDIVIDUAL SECURUTIES Index futures began trading in India in June 2000. you can make money whether prices go up or down. it is as easy to sell (also referred to as going short) as it is to buy (also referred to as going long). July 2001 saw the launch of options on individual securities (herein referred to as stock options) and the onset of rolling settlement. DIFFERENCES BETWEEN FORWARD AND FUTURE CONTRACT Forward contracts are often confused with futures contracts. Besides speculation. 3.

THEORETICAL WAY OF PRICING FUTURES The theoretical price of a futures contract is spot price of the underlying plus the cost of carry.  Counter Party Risk: In forward contracts there is a risk of counter party default. Futures Price = Spot Price + Cost of Carry The Cost of Carry is the sum of all costs incurred if a similar position is taken in cash market and carried to expiry of the futures contract less any revenue that may arise out of holding the asset. But this is not so in the case of forward contract. While the terms of future contracts are decided by the exchange on which these are traded.  Squaring off: A forward contract can be reversed with only the same counter party with whom it was entered into. A future contract can be reversed on the screen of the exchange as the latter is the counter party to all futures trades. the actual price may vary depending upon the demand and supply of the underlying asset. Customized vs Standardized: Forward contracts are customized while future contracts are standardized. In case of futures. The cost typically includes interest cost in case of financial futures (insurance and storage costs are also considered in case of commodity futures). Revenue may be in the form of dividend. Though one can calculate the theoretical price. In general. FUTURES TERMINOLOGIES  Spot price: The price at which an asset trades in the spot market. Terms of forward contracts are negotiated between the buyer and the seller. the exchange becomes counter party to each trade and guarantees settlement. 48 .  Liquidity: Futures are much more liquid and their price is transparent as their price and volume are reported in media. Please note that futures are not about predicting future prices of the underlying assets.

 Futures price: The price at which the futures contract trades in the futures market. Contract size: The amount of asset that has to be delivered less than one contract. This is the last day on which the contract will be traded. two-months and threemonth expiry cycles which expire on the last Thursday of the month. In a normal market. Expiry date: It is the date specified in the futures contract.        49 . This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset. the margin account is adjusted to reflect the investor‟s gain or loss depending upon the futures closing price. The index futures contracts on the NSE have one-month. There will be a different basis for each delivery month for each contract. This is called marking–to– market. Thus a January expiration contract expires on the last Thursday of January and a February expiration contract ceases trading on the last Thursday of February. Basis: In the context of financial futures. Contract cycle: The period over which a contract trades. basis can be defined as the futures price minus the spot price. basis will be positive. the contract size on NSE‟s futures market is 200 Nifties. at the end of each trading day. This reflects that futures prices normally exceed spot prices. Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin. On the Friday following the last Thursday. Marking-to-market: In the futures market. For instance. Cost of carry: The relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. at the end of which it will cease to exist. a new contract having a three-month expiry is introduced for trading.

Writer of an option: The writer of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him. Some options are European while others are American. in a forward or futures contract.     50 . 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. Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that the balance in the margin account never becomes negative. Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer. Options currently trade on over 500 stocks in the United States. An option gives the holder of the option the right to do something. OPTIONS TERMINOLOGIES  Index options: These options have the index as the underlying. the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day. the two parties have committed themselves to doing something. OPTIONS Options are fundamentally different from forward and futures contracts. the purchase of an option requires an up–front payment. There are two basic types of options. call options and put options. indexing options contracts are also cash settled. Whereas it costs nothing (except margin requirements) to enter into a futures contract. In contrast. If the balance in the margin account falls below the maintenance margin. A contract gives the holder the right to buy or sell shares at the specified price. The holder does not have to exercise this right. Stock options: Stock options are options on individual stocks. Like indexing futures contracts.

the strike date or the maturity. An option on the index is at-the-money when the current index equals the strike price (i. Option price: Option price is the price. the call is said to be deep ITM. Most exchange-traded options are American. Strike price: The price specified in the options contract is known as the strike price or the exercise price. European options: European options are options that can be exercised only on the expiration date itself. American options: American options are options that can be exercised at any time upto the expiration date. Expiration date: The date specified in the options contract is known as the expiration date. 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. 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. spot price > strike price). In the case of a put. 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. spot price = strike price).e. which the option buyer pays to the option seller. the exercise date. Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cash flow if it were exercised immediately. and properties of an American option are frequently deduced from those of its European counterpart. the put is ITM if the index is below the strike price.e.e. A call option on the index is out-of-the-money when the current index stands at a level. spot price < strike price). If the index is much higher than the strike 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. If the index is much lower than the strike         51 . It is also referred to as the option premium. which is less than the strike price (i. European options are easier to analyze than American options.

the greater is an option‟s time value. has the obligation to buy the underlying asset at the strike price if the buyer decides to exercise his option to sell. An option that is OTM or ATM has only time value. Both calls and puts have time value. the maximum time value exists when the option is ATM.A Put option gives the holder (buyer/ one who is long Put).Strike price) Premium}.A call option gives the holder (buyer/ one who is long call). Example: An investor buys One European call option on Infosys at the strike price of Rs. has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy. If the market price of Infosys on the day of expiry is more than Rs. 3500+100). if at the time of expiry stock price falls below Rs. the call is said to be deep OTM. 100. 52 . the option will be exercised and the investor will buy 1 share of Infosys from the seller of the option at Rs 3500 and sell it in the market at Rs 3800 making a profit of Rs. 3500 say suppose it touches Rs. In the case of a put. Usually. TYPES OF OPTIONS 1. 3500 at a premium of Rs. Put Options. 3000. all else equal. 3600 (Strike Price + Premium i. paid which should be the profit earned by the seller of the call option. In another scenario. 2. The longer the time to expiration. The seller (one who is short call) however. 200 {(Spot price . Suppose stock price is Rs. 3800. the right to buy specified quantity of the underlying asset at the strike price on or before expiration date. the right to sell specified quantity of the underlying asset at the strike price on or before an expiry date.e. the option will be exercised. the buyer of the call option will choose not to exercise his option.  Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. Call Options.price. In this case the investor loses the premium (Rs 100). At expiration. an option should have no time value. 3500. the put is OTM if the index is above the strike price. The seller of the put option (one who is short Put) however. The investor will earn profits once the share price crosses Rs.

The investor's Break-even point is Rs. the buyer of the Put option immediately buys Reliance share in the market @ Rs... investor will earn profits if the market falls below 275.& exercises his option selling the Reliance share at Rs 300 to the option writer thus making a net profit of Rs. 275/ (Strike Price . 25/-.Example: An investor buys one European Put option on Reliance at the strike price of Rs.e. the option can be exercised as it is 'in the money'. Suppose stock price is Rs.Option Buys the right to buyer or buy the underlying option holder asset at the specified price Buys the right to sell the underlying asset at the specified price 2. market price of Reliance is Rs 320/ -. 300.e. 260. Rs 25/-). which shall be the profit earned by the seller of the Put option. 260/. If the market price of Reliance. on the day of expiry is less than Rs. 300/.Premium paid}. the buyer of the Put option will choose not to exercise his option to sell as he can sell in the market at a higher rate.Spot Price) . In another scenario. In this case the investor loses the premium paid (i. at a premium of Rs. Option Has the obligation to Has the obligation to seller or sell the underlying buy the underlying option writer asset (to the option asset (from the holder) at the option holder) at the specified price specified price LEVERAGE AND RISK 53 . 15 {(Strike price .premium paid) i. (Please see table) THE OPTIONS GAME Call Option Put Option 1. if at the time of expiry.

this loss can be the entire amount of the premium paid for the option. the call option no longer has positive exercise value. no matter how much the spot market price has risen. In-the-money. This means an option buyer can pay a relatively small premium for market exposure in relation to the contract value (usually 100 shares of underlying stock). Out-of-the-money An option is said to be „at-the-money‟. Leverage also has downside implications. a profit can be made by selling Sensex at this higher price. The call holder will not exercise the option to buy Sensex at 3900 when the current price is at 3700. At-the-money. An investor can see large percentage gains from comparatively small. when the option's strike price is equal to the underlying asset price. Options offer their owners a predetermined. (Please see table) Striking the price 54 . leverage can magnify the investment's percentage loss. This is true for both puts and calls. Using the earlier example of Sensex call option. For example. a Sensex call option with strike of 3900 is „in-the-money‟. on the other hand. favorable percentage moves in the underlying index. if the owner's options expire with no value. The call holder has the right to buy a Sensex at 3900. if the Sensex falls to 3700. An uncovered option writer. may face unlimited risk. set risk. a call option is „out-of-the-money‟ when the strike price is greater than the underlying asset price. If the underlying stock price does not rise or fall as anticipated during the lifetime of the option. A call option is said to be „in-the-money‟ when the strike price of the option is less than the underlying asset price. And with the current price at 4100.Options can provide leverage. On the other hand. However. when the spot Sensex is at 4100 as the call option has value.

Out-of-themoney Strike Price greater than Spot Price of underlying asset Strike Price less than Spot Price of underlying asset  A put option is in-the-money when the strike price of the option is greater than the spot price of the underlying asset. The put no longer has positive exercise value. a Sensex put at strike of 4400 is in-the-money when the Sensex is at 4100. a put option is out-of-the-money when the strike price is less than the spot price of underlying asset. is in-the-money at any given moment is called its intrinsic value.  Options are said to be deep in-the-money (or deep out-of-the-money) if the exercise price is at significant variance with the underlying asset price. the time value is the total option premium. Thus. by definition. an at-the-money or out-of-the-money option has no intrinsic value. At-the-money Strike Price equal to Spot Price of underlying asset Strike Price equal to Spot Price of underlying asset 3. the put option has value because the put holder can sell the Sensex at 4400. In the above example. For example. Likewise. however. the buyer of Sensex put option won't exercise the option when the spot is at 4800. The amount by which an option. these options can be obtained 55 . When this is the case.In-the-money Strike Price less than Strike Price greater Spot Price of than Spot Price of underlying asset underlying asset 2.Call Option Put Option 1. This does not mean. call or put. an amount greater than the current Sensex of 4100.

Any amount by which an option's total premium exceeds intrinsic value is called the time value portion of the premium. Underlying stock price. 2. all of these factors determine time value. 4. There are other factors that give options value. The effect of supply & demand. Option Premium = Intrinsic Value + Time Value FACTORS THAT AFFECT THE VALUE OF AN OPTION PREMIUM There are two types of factors that affect the value of the option premium: Quantifiable Factors: 1. therefore affecting the premium at which they are traded. The "depth" of the market for that option . 56 .both in the options marketplace and in the market for the underlying asset 4. based on fundamental or technical analysis 3. The strike price of the option. 3. 5. The volatility of the underlying stock. Market participants' varying estimates of the underlying asset's future volatility 2. The time to expiration and. interest rates. Non-Quantifiable Factors: 1. Together.the number of transactions and the contract's trading volume on any given day. Individuals' varying estimates of future performance of the underlying asset.at no cost. It is the time value portion of an option's premium that is affected by fluctuations in volatility. dividend amounts and the passage of time. The risk free interest rate.

OPTIONS TRADING As described earlier. providing tremendous versatility and utility. An option pricing model assists the trader in keeping the prices of calls & puts in proper numerical relationship to each other & helping the trader make bids & offer quickly. short a call. to 57 . to hedge an existing position in an asset. b.  Pricing models include the binomial options model for American options and the Black-Scholes model for European options. expectations.DIFFERENT PRICING MODELS FOR OPTIONS The theoretical option pricing models are used by option traders for calculating the fair value of an option on the basis of the earlier mentioned influencing factors. short a put. and style. and d. The two most popular option pricing models are:  Black Scholes Model which assumes that percentage change in the price of underlying follows a normal distribution. whether it is bullish. Binomial Model which assumes that percentage change in price of the underlying follows a binomial distribution. long a put. choppy. bearish. Among their multiple applications are the following: to speculate on the movement of an asset. Options are unique trading instruments. This trading structure can be adapted to handle any type of market outlook. c. or in conjunction with other financial instruments to create a number of option-trading strategies. These four can be used independently. four possible option selections exist for a trader: a. together. long a call. and enables him or her to anticipate every conceivable situation in the market. or neutral. They can be used for a multitude of purposes. to hedge other option positions. These combinations enable a trader to develop an option-trading model which meets the trader's specific trading needs.

To succeed. and he have to be right about how much the price will change as well as the time frame it will take for all this to happen. So why do people speculate with options if the odds are so skewed? Aside from versatility. 58 . WHY TO USE OPTIONS? There are two main reasons why an investor would use options:  to Speculate and  to Hedge. Think of this as an insurance policy. The use of options in this manner is the reason options have the reputation of being risky.generate income by writing options against different quantities of options strategies that arise from these applications and the fact that the scope of this book is limited. we will devote coverage to a cursory explanation of two of the most popular strategies which are designed to take advantage of market movement: spreads and straddles. Hedging The other function of options is hedging. Speculation is the territory in which the big money is made . but also the magnitude and the timing of this movement. Just as one insures his house or car. On the other hand. especially for large institutions. Because of the versatility of options. he shouldn't make the investment. Critics of options say that if he is so unsure of his stock pick that he needs a hedge. When one is controlling 100 shares with one contract. it doesn't take much of a price movement to generate substantial profits. he must correctly predict whether a stock will go up or down.and lost. This is because when one buys an option. there is no doubt that hedging strategies can be useful. it's all about using leverage. The advantage of options is that one isn‟t limited to making a profit only when the market goes up. Speculation One can think of speculation as betting on the movement of a security. options can be used to insure your investments against a downturn. one can also make money when the market goes down or even sideways. he have to be correct in determining not only the direction of the stock's movement.

which indicates that the expiration is the third Friday of July and the strike price is $70. you'd also have to take commissions into account. To recap.15 for a July 70 Call. he would be able to restrict his downside while enjoying the full upside in a cost-effective way.15. Three weeks later the stock price is $78. that's why you must multiply the contract by 100 to get the total price. here is what happened to our option investment: Date Stock Price May 1 $67 59 May 21 $78 Expiry Date $62 . the option contract is worthless. The strike price of $70 means that the stock price must rise above $70 before the call option is worth anything. so you are currently down by this amount. a stock option contract is the option to buy 100 shares. but we'll ignore them for this example. because the contract is $3. which are called "closing your position. HOW OPTIONS WORKS? Let's say that on May 1. The options contract has increased along with the stock price and is now worth $8. Remember. We are now down to the original investment of $315. By the expiration date. But don't forget that you've paid $315 for the option. In reality.$3.unless. let's say we let it ride. When the stock price is $67." and take your profits . furthermore. the price drops to $62.25 x 100 = $825. For the sake of this example. Because this is less than our $70 strike price and there is no time left. The total price of the contract is $3. it's less than the $70 strike price. the stock price of L&T is $67 and the premium (cost) is $3. the break-even price would be $73. but say he also wanted to limit any losses. you think the stock price will continue to rise. and your profit is ($8. Subtract what you paid for the contract.15) x 100 = $510.25 .Even the individual investor can benefit. of course.15 x 100 = $315. so the option is worthless. One can imagine that he wanted to take advantage of technology stocks and their upside. You almost doubled our money in just three weeks! You could sell your options. By using options.15 per share.

the price of the option in our example can be thought of as the following: Premium = Intrinsic Value + Time Value $8. you could make money by exercising at $70 and then selling the stock back in the market at $78 for a profit of $8 a share. According to the CBOE. This is leverage in action. and 30% expire worthless. In our example. a majority of options are not actually exercised.25 In real life options almost always trade above intrinsic value. and writers buy their positions back to close. about 10% of options are exercised. You could also keep the stock. Basically. Intrinsic Value and Time Value At this point it is worth explaining more about the pricing of options. intrinsic value is the amount in-the-money.15 $8.15 to $8. Exercising Versus Trading-Out So far we've talked about options as the right to buy or sell (exercise) the underlying.25 $825 $510 worthless $0 -$315 Contract Value $315 $0 The price swing for the length of this contract from high to low was $825. This means that holders sell their options in the market.25. Remember. for a call option. an option's premium is its intrinsic value + time value. This is true. knowing you were able to buy it at a discount to the present value. which. If you are 60 . So. 60% are traded out. the majority of the time holders choose to take their profits by trading out (closing out) their position. which would have given us over double our original investment. In our example the premium (price) of the option went from $3. means that the price of the stock equals the strike price.25 = $8 + $0. but in reality. Time value represents the possibility of the option increasing in value. These fluctuations can be explained by intrinsic value and time value.Option Price Paper Gain/Loss $3. However.

usually after the close of trading on Fridays or over the weekend. Many option theoreticians recalculate their volatility. Avoid trading in an illiquid option market. WHEN NOT TO BUY AN OPTION? It is also important to consider the time or the date at which one should enter the option market. Avoid purchasing put options when the underlying security is down for the day versus the prior day's close. which may be acceptable when holding an option over an extended period of time but is detrimental when day trading. HOW TO READ AN OPTION TABLE? 61 . we just picked the numbers for this example out of the air to demonstrate how options work. delta. as any favorable price movement will have a negligible effect upon premium. Avoid purchasing options well after the market has established a defined trend . Avoid buying or selling options based upon anticipated news (buyouts in particular).  Avoid purchasing call options just prior to a stock going ex-dividend. Avoid purchasing call options when the underlying security is up for the day versus the prior day's close. unless one intends to take a trendfollowing stance. unless one intends to take a trendfollowing stance.wondering. Avoid purchasing way out-of-the-money options when day trading. Besides bordering on unethical trading.     Be careful when holding long option positions beyond Friday's trading day's close unless one is option position trading. the information received is more likely to be rumor than correct. The resulting adjustments in these values most often have a negative effect on the value of the long option.this is especially true when day trading. and time decay numbers once a week. as any option premium advantage will have dissipated.

-listed options expire on the third Friday of the expiry month.This is the stated price per share for which an underlying stock may be purchased (for a call) or sold (for a put) upon the exercise of the option contract. Column 7: Open Interest .S. Column 3: Call or Put .Column 1: Strike Price . these are contracts that have neither expired nor been exercised. Column 4: Volume . PAYOFF FOR DERIVATIVES CONTRACT 62 .This shows the termination date of an option contract. Column 6: Ask .This indicates the price someone is willing to pay for the options contract.This column refers to whether the option is a call (C) or put (P). Column 5: Bid . Option strike prices typically move by increments of $2.50 or $5 (even though in the above example it moves in $2 increments).This indicates the price at which someone is willing to sell an options contract.This indicates the total number of options contracts traded for the day. Remember that U. Column 2: Expiry Date .Open interest is the number of options contracts that are open. The total volume of all contracts is listed at the bottom of each table.

When the index moves up. it means that the losses as well as profits for the buyer and the seller of a futures contract are unlimited. PAYOFF FOR FUTURES Futures contracts have linear payoffs. The underlying asset in this case is the Nifty portfolio. it starts making losses. and when the index moves up. however his 63 .A payoff is the likely profit/loss that would accrue to a market participant with change in the price of the underlying asset. Payoff for seller of futures: Short futures The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Payoff for buyer of futures: Long futures The payoff for a person who buys a futures contract is similar to the payoff for a person who holds an asset. Take the case of a speculator who buys a twomonth Nifty index futures contract when the Nifty stands at 1220. His profits are limited to the option premium. He has a potentially unlimited upside as well as a potentially unlimited downside. These linear payoffs are fascinating as they can be combined with options and the underlying to generate various complex payoffs. the short futures position starts making profits. For a writer. In simple words. In simple words. Take the case of a speculator who sells a twomonth Nifty index futures contract when the Nifty stands at 1220. however the profits are potentially unlimited. OPTIONS PAYOFF The optionally characteristic of options results in a non-linear payoff for options. The underlying asset in this case is the Nifty portfolio. it means that the losses for the buyer of an option are limited. and when the index moves down it starts making losses. the long futures position starts making profits. When the index moves down. This is generally depicted in the form of payoff diagrams which show the price of the underlying asset on the X– axis and the profits/losses on the Y–axis. the payoff is exactly the opposite.

an investor shorts the underlying asset. If upon expiration. and sells it at a future date at an unknown price. Nifty for instance. an investor buys the underlying asset. Nifty for instance. Payoff profile for writer of call options: Short call A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. he lets his option expire un-exercised. His loss in this case is the premium he paid for buying the option. We look here at the six basic payoffs. For selling the option. 64 . If upon expiration the spot price of the underlying is less than the strike price. Hence as the spot price increases the writer of the option starts making losses.losses are potentially unlimited. the writer of the option charges a premium. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. the buyer will exercise the option on the writer. Higher the spot price more is the profit he makes. and buys it back at a future date at an unknown price. Whatever is the buyer‟s profit is the seller‟s loss. for 1220. the spot price exceeds the strike price. Higher the spot price more is the loss he makes. the investor is said to be “long” the asset. Payoff profile for seller of asset: Short asset In this basic position. for 1220. If upon expiration. These non-linear payoffs are fascinating as they lend themselves to be used to generate various payoffs by using combinations of options and the underlying. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. If the spot price of the underlying is less than the strike price. the buyer lets his option expire unexercised and the writer gets to keep the premium. Payoff profile le for buyer of call options: Long call A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. he makes a profit. Payoff profile of buyer of asset: Long asset In this basic position. the spot price exceeds the strike price. once it is purchased.

the writer of the option charges a premium. 65 . If upon expiration. If upon expiration the spot price of the underlying is more than the strike price. If the spot price of the underlying is higher than the strike price. the buyer lets his option expire un-exercised and the writer gets to keep the premium. Payoff profile for writer of put options: Short put A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. For selling the option. The profit/loss that the buyer makes on the option depends on the spot price of the underlying.Payoff profile for buyer of put options: Long put A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. the spot price happens to be below the strike price. If upon expiration. Lower the spot price more is the profit he makes. he lets his option expire un-exercised. he makes a profit. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. His loss in this case is the premium he paid for buying the option. the spot price is below the strike price. Whatever is the buyer‟s profit is the seller‟s loss. the buyer will exercise the option on the writer.

ARBITRAGE AND SPECULATION STRATEGIES 66 . Arbitrage and Speculation Strategies HEDGING.Chapter 4 Hedging.

you may be well advised to hedge your position. if the market falls sharply. There are many different risks against which one can hedge and many different methods of hedging.e. chances are that any particular stock will fall too. you've set up your futures position as a complete hedge.) If you're trying to hedge an entire portfolio. A hedge is just a way of insuring an investment against risk. you will not participate in the rally. When someone mentions hedging. you may need to advance more margin to cover your short position. (It's most expensive because you're buying insurance not only against market risk but against the risk of the specific security as well. The efficiency of the hedge is strongly dependent on your estimate of the correlation between your high-beta portfolio and the broad market index. There are many ways of hedging against market risk. think of insurance. Consider a simple (perhaps the simplest) case.HEDGING Hedging is a way of reducing some of the risk involved in holding an investment. i. So if you own a stock with good prospects but you think the stock market in general is overpriced.  If the market goes up. and will not be able to use your stocks to cover the margin calls. futures are probably the cheapest way to do so. Much of the risk in holding any particular stock is market risk. HEDGING STRATEGIES WITH EXAMPLES Hedging: Long security. is to buy a put option for the stock you own. But keep in mind the following points. because by intention. short Nifty futures 67 . but most expensive method.  If the market moves up. The simplest.

In this sense. Once this is done. His understanding can be wrong. There is a peculiar problem here. so he makes losses.e. the average impact of a 1% move in Nifty upon the security. it is 68 . he faces two kinds of risks: 1.e. or. The entire market moves against him and generates losses even though the underlying idea was correct. i. which is purely about the performance of the security. The stock picker may be thinking he wants to be LONG SBI. without any extra risk from fluctuations of the market index. the stock picker has “hedged away” his index exposure.Investors studying the market often come across a security which they believe is intrinsically undervalued. The basic point of this hedging strategy is that the stock picker proceeds with his core skill. but a long position on SBI effectively forces him to be LONG SBI + LONG NIFTY. i.670 thinking that it would announce good results and the security price would rise. as incidental baggage. A few days later. When doing so. Every time you adopt a long position on a security. This is because a LONG SBI position generally gains if Nifty rises and generally loses if Nifty drops. a LONG SBI position is not a focused play on the valuation of SBI. A person may buy SBI at Rs. Nifty drops. There is a simple way out. The second outcome happens all the time. When this is done. picking securities. It may be the case that the profits and the quality of the company make it seem worth a lot more than what the market thinks. This offsets the hidden Nifty exposure that is inside every long–security position. Every buy position on a security is simultaneously a buy position on Nifty. The position LONG SBI+ SHORT NIFTY is a pure play on the value of SBI. even if his understanding of SBI was correct. We need to know the “beta” of the security. at the cost of lower risk. Methodology 1. If betas are not known. you should sell some amount of Nifty futures. 2. It carries a LONG NIFTY position along with it. A stock picker carefully purchases securities based on a sense that they are worth more than the market price. you will have a position. and the company is really not worth more than the market price.

The union budget is a common and reliable source of such volatility: market volatility is always enhanced for one week before and two weeks after a budget. and the market lot on the futures market is 200. they may have a view that security prices will fall in the near future.000. This planning can go wrong if by the time you sell shares. Many investors simply do not want the fluctuations of these three weeks.000 3. and they do not have an appetite for this kind of volatility. Sometimes.000. To short Rs. in order to finance a purchase of a house. 2. 4. This is particularly a problem if you need to sell shares in the near future.  Do nothing. they may see that the market is in for a few days or weeks of massive volatility.00.00. This sentiment generates “panic selling” which is rarely optimal for the investor. This leads to political pressures for government to “do something” when security prices fall.2 *3. The profits/losses position will fully reflect price changes intrinsic to SBIN. i. At other times. i. for example. is 1. The size of the position that we need on the index futures market.000.33. When you have such anxieties. Nifty has dropped sharply. Hence each market lot of Nifty is Rs 4.00.000 SHORT NIFTY Rs. hence only successful forecasts about SBIN will benefit from this position.000 This position will be essentially immune to fluctuations of Nifty.33. and suppose we have a LONG SBIN position of Rs. short Nifty futures The only certainty about the capital market is that it fluctuates! A lot of investors who own portfolios experience the feeling of discomfort about overall market movements.4.33. Hedging: Have portfolio.00.4.000 of Nifty we need to sell one market lot. Returns on the position will be roughly neutral to movements of Nifty. Suppose we take SBIN. Suppose Nifty is at 2000. suffer the pain of the volatility. We sell one market lot of Nifty (200 nifties) to get the position: LONG SBIN Rs. where the beta is 1.e.2. Rs 4.e. to completely remove the hidden Nifty exposure. 69 .3. there are two alternatives:  Sell shares immediately.generally safe to assume the beta is 1.3.

000. The complete hedge is obtained by adopting a position on the index futures market. 2. This allows rapid response to market conditions.25. which has a beta of 0.8)/3 or 1.In addition.3 million on the Nifty futures.3.1 million which has a beta of 1.250. it is safe to assume that it is 1.000 SHORT NIFTY Rs. 2400 Nifties to get the position: LONG PORTFOLIO Rs. Suppose Nifty is 1250. If the beta of any securities is not known. instead of doing nothing and suffering the risk. It allows an investor to be in control of his risk. i. Suppose we have a portfolio composed of Rs. the portfolio is Rs. a third and remarkable alternative becomes available:  Remove your exposure to index fluctuations temporarily using index futures. and the market lot on the futures market is 200.000. Each market lot of Nifty costs Rs. Methodology 1.000.4 + 2 * 0.3.000.3 million with a beta of 1.e.4 and Rs. In the case of portfolios. which completely removes the hidden Nifty exposure. then the portfolio beta is (1 * 1. where only 30–60% of the securities risk is accounted for by index fluctuations). In the above case.2 million of Hindustan Lever.e. This statement is true for all portfolios. 70 .25 million of Nifty futures. Then a complete hedge is obtained by selling Rs.1. whether a portfolio is composed of index securities or not. We need to know the “beta” of the portfolio.8. the average impact of a 1% move in Nifty upon the portfolio. i. 3.1 million of Hindalco. with the index futures market. Hence we need to sell 12 market lots. It is easy to calculate the portfolio beta: it is the weighted average of securities betas. which has a beta of 1. hence we would need a position of Rs. Every portfolio contains a hidden index exposure. without “panic selling” of shares. most of the portfolio risk is accounted for by index fluctuations (unlike individual securities. The idea here is quite simple.Hence a position LONG PORTFOLIO + SHORT NIFTY can often become one–tenth as risky as the LONG PORTFOLIO position! Suppose we have a portfolio of Rs.

This position will be essentially immune to fluctuations of Nifty. In that case. Hedging: Have funds. the futures gain and the portfolio loses.2 million of the futures. Another important choice for the investor is the degree of hedging. has cash. The exact degree of hedging chosen depends upon the appetite for risk that the investor has. two–thirds of his portfolio is hedged and one– third of the portfolio is held unhedged.  An open-ended fund has just sold fresh units and has received funds.3 million of the futures. which is not yet invested. If Nifty goes down. Sometimes the investor may be willing to tolerate some risk of loss so as to hang on to some risk of gain. buy Nifty futures Have you ever been in a situation where you had funds. invest the proceeds. and buy back shares after two years. the investor has no risk from market fluctuations when he is completely hedged. which just finished its initial public offering. the portfolio gains and the futures lose. which needed to get invested in equity? Or of expecting to obtain funds in the future which will get invested in equity. Getting invested in equity ought to be easy but there are three problems: 71 . This strategy makes the most sense for rapid adjustments. or (b) when his financial planning involves selling shares at a future date and would be affected if Nifty drops. The investor should adopt this strategy for the short periods of time where (a) the market volatility that he anticipates makes him uncomfortable. it is better to sell the shares. In either case. partial hedging is appropriate. It does not make sense to use this strategy for long periods of time – if a two–year hedging is desired. If Nifty goes up. The complete hedge may require selling Rs. The land deal is slow and takes weeks to complete. Complete hedging eliminates all risk of gain or loss. Some common occurrences of this include: _  A closed-end fund. It takes several weeks from the date that it becomes sure that the funds will come to the date that the funds actually are in hand. but the investor may choose to only sell Rs.  Suppose a person plans to sell land and buy shares. In this case.

He is exposed to the risk of missing out if Nifty rises. so there is no risk of missing out on a broad rise in the securities market while this process is taking place. Hence. but going to the market and placing market orders would generate large „impact costs‟. such as the land sale above. 2. As and when shares are obtained. a closed-end fund. which has just finished its initial public offering and has cash. For that time. With Nifty futures. immediately. the investor is partly invested in cash and partly invested in securities. and during this time. So far. A person who expects to obtain Rs. can immediately enter into a LONG NIFTY to the extent it wants to be invested in equity. This takes time. In some cases. 3. a third alternative becomes available:  The investor would obtain the desired equity exposure by buying index futures. we have had exactly two alternative strategies. he is exposed to the risk of missing out if the Nifty goes up. The execution would be improved substantially if he could instead place limit orders and gradually accumulate the portfolio at favorable prices. A person may have made up his mind on what portfolio he seeks to buy. This process takes time. and carefully pick securities that are expected to do well.5 million by selling land would immediately enter into a position LONG NIFTY worth Rs. or to suffer the risk of staying in cash. the investor/closed-end fund can gradually acquire securities (either based on detailed research and/or based on aggressive limit orders). he is exposed to the risk of missing out if the overall market index goes up. which an investor can adopt: to buy liquid securities in a hurry.  Later. During this time. hence he is forced to wait even if he feels that Nifty is unusually cheap. one would scale down the LONG NIFTY position correspondingly.1. A person may need time to research securities. this strategy would fully capture a rise in Nifty. in India.5 million. which is not yet invested. The index futures market is likely to be more liquid than individual securities so it is possible to take extremely large positions at a low impact cost. this strategy allows the investor to take 72 . Similarly. No matter how slowly securities are purchased. the person may simply not have cash to immediately buy shares.

It is common for people to think that the owner of shares needs index futures to hedge against a drop in Nifty.4. i. He entered into a LONG NIFTY MARCH FUTURES position for 2400 Nifties.000. when you want to be invested in shares. 5.more care and spend more time in choosing securities and placing aggressive limit orders. From 14 March 2005 to 25 March 2005 he gradually acquired the securities. 4. ARBITRAGE Arbitrage is the practice of taking advantage of a state of imbalance between two (or possibly more) markets. at 13 March prices. totaling Rs. his long position was worth 4. A person obtained Rs.4.e. 2. On each day. On each day.80. By 25 Mar 2005 he had fully invested in all the shares that he wanted (as of 13 Mar) and had no futures position left. A combination of matching deals are struck that 73 . He made a list of 14 securities to buy. On each day.8 million on 13th March 2005. he purchased one securities and sold off a corresponding amount of futures. 3. Holding money in hand. the securities purchased were at a changed price (as compared to the price prevalent on 13 March). is a risk because Nifty may rise.8 million. Hedging is often thought of as a technique that is used in the context of equity exposure. At that time Nifty was at 2000. he obtained or paid the „mark–to–market margin‟ on his outstanding futures position. Hence it is equally important for the owner of money to use index futures to hedge against a rise in Nifty! Methodology 1. thus capturing the gains on the index.

It is an ideal lending vehicle for entities which are shy of price risk and credit risk. On the other hand. we can exploit the market condition and earn risk-free return. a strategist can make risk-less profits by making use of mispricing in the market. Arbitrage could also be between two segments of the market. bank and financial institution are very active in arbitrage activities. Borrowing and lending is a common practice in arbitrage transaction. 74 . and simultaneously sells them at a future date on the futures market. The below stated strategies cover all the types of arbitrage possibilities using equity derivatives. the profit being the difference between the market prices. There is no price risk since the position is perfectly hedged. Most people would like to lend funds into the security market. With the help of the arbitrage strategies discussed above. and without bearing any credit risk. such as traditional banks and the most conservative corporate treasuries. therefore. What is new about the index futures market is that it supplies a technology to lend money into the market without suffering any exposure to Nifty. The lender buys all 50 securities of Nifty on the cash market.exploit the imbalance. A participant with ample funds can easily earn risk-free returns. Arbitrage is the safest way to make money in the market. Arbitrage could be inter-exchange. without suffering the risk. It is like a repo. The basic idea is simple. the scope for making money is diminutive. However. lend them to the market. Arbitrage is game of strategy and also funds. ARBITRAGE STRATEGIES WITH EXAMPLES Arbitrage: Have funds. NSE and BSE. A person who engages in arbitrage is called an arbitrageur. Cash and F&O. There is no credit risk since the counter party on both legs is the NSCCL which supplies clearing services on NSE. Traditional methods of loaning money into the security market suffer from (a) price risk of shares and (b) credit risk of default of the counter-party.

This is the point at which you are “loaning money to the market”. 3. A few days later. A moment later. 9. 5. with two complications: the moneylender additionally earns any dividends that the 50 shares pay while he has held them. 7.Methodology 1. A moment later. Round off the number of shares in each security. 75 . if the Nifty spot is 2100. brokerage) in doing these trades. and the moneylender suffers transactions costs (impact cost. a single keystroke can fire off these 50 orders in rapid succession into the NSE or BSE trading system. and the Nifty March 2005 futures are at 2142 then the difference (2% for 30 days) is the return that the moneylender obtains. you will have to take delivery of the 50 securities and pay for them. i. Now you are completely hedged. 6. A person wants to earn this return (60/2400 for 27 days). where the money invested in each security is proportional to its market capitalization. In this case. sell Nifty futures of equal value. Example On 1 August. you will have to make delivery of the 50 securities and receive money for them. you will unwind the entire transaction. At this point. 2. 8. Calculate a portfolio which buys all the 50 securities in Nifty in correct proportion. the difference between the futures price and the cash Nifty is the return to the moneylender.e. A futures contract is trading with 27th August expiration for 2460. so fluctuations in Nifty do not affect you. This is the point at which “your money is repaid to you”. A few days later. What is the interest rate that you will receive? We will use one specific case. reverse the futures position. Using the NEAT or BOLT software. This gives you the buy position 4. Now your position is down to 0. Nifty is at 2400. use NEAT to send 50 sell orders in rapid succession to sell off all the 50 securities. On 1 March 2005. where you will unwind the transaction on the expiration date of the futures. Some days later (anytime you want).

11% for 27 days.25%) on the spot Nifty and Rs.1.14. It is like a repo. the return is roughly 2460/2400 or 2. He sells Rs.e.88% In addition. you would 76 . 6.5% for 27 days. In the above case. The futures position spontaneously expires on 27 August at 2420 (the value of the futures on the last day is always equal to the Nifty spot). It is easier to make a rough calculation of the return.3 million of the futures at 2460. stocklending schemes that are widely accessible do not exist in India.14000 or 0. The index futures market offers a riskless mechanism for (effectively) loaning out shares and earning a positive return for them. He buys Rs. While waiting. Nifty happens to have closed at 2420 and his sell orders (which suffer impact cost) goes through at 2413. he places 50 market orders and ends up paying slightly more.4%. and we subtract 0. lend them to the market Owners of a portfolio of shares often think in terms of juicing up their returns by earning revenues from stocklending.63%) on the futures for a return of near 1.23% owing to the dividends for a total return of 2. we ignore the gain from dividends and we assume that transactions costs account for 0.3 million of Nifty on the spot market. putting 50 market orders to sell off all the shares. risk free. To do this. On 27 August. He has gained Rs. at 3:15. 2.4% for transactions costs giving 2. 5. 4. he has gained Rs.6 (0. a few dividends come into his hands. Arbitrage: Have securities. 3.1% for 27 days.3% higher. he has obtained the Nifty spot for 2407. The dividends work out to Rs. However. His average cost of purchase is 0. He takes delivery of the shares and waits.40 (1. In doing this.3 million goes through at near–zero impact cost. i. The futures market is extremely liquid so the market order for Rs.000. he puts in market orders to sell off his Nifty portfolio.

Conversely. You would sell off all 50 securities in Nifty and buy them back at a future date using the index futures. 1. this stock lending could be profitable 77 . A few days later. On the date that the futures expire. you would buy back your shares. with each share being present in the portfolio with a weight that is proportional to its market capitalization).2% per month. 5. Methodology Suppose you have Rs. it is not profitable. Invest this money at the riskless interest rate. you will receive money and have to make delivery of the 50 shares. This can be done using a single keystroke using the NEAT software.5% per month and you are loaning out the money at 1. as you like until the futures expiration. 6. 2. Sell off all 50 shares on the cash market. You would soon receive money for the shares you have sold. you will need to pay in the money and get back your shares.5 million of the NSE-50 portfolio (in their correct proportion. Buy index futures of an equal value at a future date. When is this worthwhile? When the spot-futures basis (the difference between spot Nifty and the futures Nifty) is smaller than the riskless interest rate that you can find in the economy. 4. On this date. put in 50 orders (using NEAT again) to buy the entire NSE-50 portfolio. 3. The basic idea is quite simple. If the spot–futures basis is 2. You can deploy this money. at 3:15 PM.sell off your certificates and contract to buy them back in the future at a fixed price. A few days later.5% per month. if the spot-futures basis is 1% per month and you are loaning out money at 1. and pay for them. There is no price risk (since you are perfectly hedged) and there is no credit risk (since your counterparty on both legs of the transaction is the NSCCL).

9%. To do this. he is completely hedged.71% over the two–month period. Then the total return is (Y .0. At the end of two months. funds invested at 1% per month yield 2. he makes delivery of shares and receives Rs. Over two months. Suppose the spot–futures basis is X% and suppose the rate at which funds can be invested is Y %.It is easy to approximate the return obtained in stock lending. Hence the spot– futures basis (10/1100) is 0.4%.99 million (assuming an impact cost of 2/1100). Let us make this concrete using a specific sequence of trades.01-0. Assume that the transactions costs are 0. The seller always suffers impact cost. 2.70. A few days later. A moment later. 3.4 million of Nifty using the feature in NEAT to rapidly place 50 market orders in quick succession. Suppose Nifty has moved up to 1150 by this time. Example Suppose the Nifty spot is 1100 and the two–month futures are trading at 1110. this is 1098* or 1120. suppose he obtains an actual execution at 1098.4%) over the time that the position is held. we assume that transactions costs account for 0. He puts in sell orders for Rs. placing market orders to buy back his Nifty portfolio. This makes shares are costlier in 78 .3.40. using NEAT. he get back Rs. In this case. Hence the total return that can be obtained in stock lending is 2.199.01%. This can also be interpreted as a mechanism to obtain a cash loan using your portfolio of Nifty shares as collateral. The order executes at 1110. Suppose a person has Rs. At this point. 1. 5. it may be worth doing even if the spot–futures basis is somewhat wider. he puts in a market order to buy Rs.4 or 0. he puts in 50 orders. Translated in terms of Nifty. Suppose cash can be riskless invested at 1% per month. On the expiration date of the futures. which he would like to lend to the market.4 million of the Nifty portfolio. Suppose he lends this out at 1% per month for two months.4 million of the Nifty futures.9-0. 4.4%.X% .

10. 8. owing to impact cost.15 on the spot position and Rs. ABB trades at Rs. If you notice that futures on a security that you have been observing seem overpriced. On the futures expiration date. As an arbitrageur. of 1120 + 40 .1000. suppose he ends up paying 1153 and not 1150. how can you cash in on this opportunity to earn riskless profits? Say for instance.400. Take delivery of the security purchased and hold the security for a month. the spot and the futures price converge.1153 or 7.4 million. 7. the cost-of-carry ensures that the futures price stay in tune with the spot price. Now unwind the position. 1.10 on the futures position. Say the security closes at Rs. sell the futures on the security at 1025. 79 . One–month ABB futures trade at Rs. Simultaneously. Sell the security. buy the security on the cash/spot market at 1000. Arbitrage: Overpriced futures: buy spot. 2. borrow funds. Return the borrowed funds. On day one. On a base of Rs. 6.1015. and the futures contract pays 40 (1150-1110) so he ends up with a clean profit. 6. 5. on the entire transaction. He has funds in hand of 1120. this is Rs.buying back. 4. Whenever the futures price deviates substantially from its fair value. arbitrage opportunities arise.25. When the market order is placed. sell futures As we discussed earlier. Futures position expires with profit of Rs. you can make riskless profit by entering into the following set of transactions.1025 and seem overpriced. 3. but the difference is exactly offset by profits on the futures contract. The result is a riskless profit of Rs.

965 and seem underpriced. 5. One–month ABB futures trade at Rs. the spot and the futures price converge. Say the security closes at Rs. Remember however. SPECULATIONS 80 . It is this arbitrage activity that ensures that the spot and futures prices stay in line with the cost–of–carry. sell the security in the cash/spot market at 1000. This is termed as cash–and–carry arbitrage. that exploiting an arbitrage opportunity involves trading on the spot and futures market. 2. exploiting arbitrage involves trading on the spot market. It could be the case that you notice the futures on a security you hold seem underpriced. we will see increased volumes and lower spreads in both the cash as well as the derivatives market. you can make riskless profit by entering into the following set of transactions. This is termed as reverse–cash–and–carry arbitrage. How can you cash in on this opportunity to earn riskless profits? Say for instance.10 on the futures position. Simultaneously. it makes sense for you to arbitrage.975. ABB trades at Rs. it makes sense for you to arbitrage.10.25 on the spot position and Rs. 1. As we can see. If the returns you get by investing in riskless instruments is less than the return from the arbitrage trades. sell spot Whenever the futures price deviates substantially from its fair value. Make delivery of the security. one has to build in the transactions costs into the arbitrage strategy. As an arbitrageur.1000. The result is a riskless profit of Rs. In the real world. arbitrage opportunities arise. 3. On the futures expiration date. On day one. Buy back the security. 7.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. Now unwind the position. 6. buy the futures on the security at 965. The futures position expires with a profit of Rs. As more and more players in the market develop the knowledge and skills to do cash–and–carry and reverse cash–and–carry. 4. Arbitrage: Underpriced futures: buy futures.

Specially speculation in derivates is even more riskier as the derivatives are leveraged instruments. SPECULATION STRATEGIES WITH EXAMPLES Speculation: Bullish Index. and sell them at a later date: or. Buy the entire index portfolio and then sell it at a later date. which are very risky. 81 . index is less volatile and index movement is easy to analyze than the individual stock movements. Speculation in the market index is very common. are individual securities are more volatile than the market index. How does one implement a trading strategy to benefit from an upward movement in the index? Today. or good corporate results. Market participants to speculate extensively use Index futures and stock futures. Speculator is responsible for liquidity in the market. Buy selected liquid securities which move with the index. Index futures attract the maximum volumes in the derivatives segment. a person has two choices: 1. or the onset of a stable government. because buying an option is highly leveraged transaction. The above-discussed strategies are responsible for liquidity in the Derivatives segment hence leading to volumes in the cash segment also. Speculation in individual securities attracts highest risk. Speculation in option is not very common. After a good budget. 2.Speculation has a lot of risks involved. Major part of the market volumes come from speculation. be it cash market or the F&O segment. many people feel that the index would go up. long nifty futures Sometimes we think that the market index is going to rise and that we can make a profit by adopting a position on the index. Speculation in options is naked positions.

980. 3. The minimum market lot is 200 Nifties. the Nifty July contract costs Rs. Hence. The investor can choose any of them to implement this position. Using index futures.000. The Nifty July contract has risen to Rs. On 14 July 2001.960 so his position is worth Rs. Taking a position on the index is effortless using the index futures market. The second alternative is cumbersome and expensive in terms of transactions costs. by paying up Rs.20. 82 . by paying an initial margin of Rs. these positions run the risk of making losses owing to company–specific news.000. 4.240. Methodology When you think the index will go up.980.4 million. Shorter dated futures tend to be more liquid.192.20. He sells off his position at Rs.35. Hence. At this time. 4. When the trade takes place. the investor is only required to pay up the initial margin. Futures are available at several different expirations. if Nifty is at 1200. However. Longer dated futures go well with long–term forecasts about the movement of the index. Example 1.000.000. 2. the investor gets a claim on the index worth Rs.000. the investment is done in units of Rs. He buys 200 Nifties with expiration date on 31st July 2001. they are not purely focused upon the index. he gains if the index rises and loses if the index falls.200. an investor can “buy” or “sell” the entire index by trading on one single security. Similarly.2.The first alternative is widely used – a lot of the trading volume on liquid securities is based on using these liquid securities as an index proxy. buy the Nifty futures.240. the investor gets a claim on Nifty worth Rs. which is something like Rs. On 1 July 2001. 3. a person feels the index will rise. Nifty has risen to 967. Once a person is LONG NIFTY using the futures market. The choice is basically about the horizon of the investor.000.

Once a person is SHORT NIFTY using the futures market. or bad corporate results. Sell selected liquid securities which move with the index. When the trade takes place. and buy them at a later date: or. The investor can choose any of them to implement this position. the investment is done in units of Rs. Hence. 2. which is something like Rs. The choice is basically about the horizon of the investor. How does one implement a trading strategy to benefit from a downward movement in the index? Today a person has two choices: 1. 83 . he gains if the index falls and loses if the index rises.240. Taking a position on the index is effortless using the index futures market. Sell the entire index portfolio and then buy it at a later date.000. if Nifty is at 1200. Shorter dated futures tend to be more liquid.000. This strategy is also cumbersome and expensive in terms of transactions costs. Similarly. His profits from the position are Rs.000. The first alternative is widely used – a lot of the trading volume on liquid securities is based on using these securities as an index proxy. by paying an initial margin of Rs. The second alternative is hard to implement. many people feel that the index would go down. Methodology When you think the index will go down. The minimum market lot is 200 Nifties. short Nifty futures Sometimes we think that the market index is going to fall and that we can make profit by adopting a position on the index.2. Using index futures. Longer dated futures go well with long–term forecasts about the movement of the index.4 million. Futures are available at several different expirations. the investor is only required to pay up the initial margin. an investor can “buy” or “sell” the entire index by trading on one single security.5. After a bad budget. Hence.000. these positions run the risk of making losses owing to company–specific news. they are not purely focused upon the index.20. However. by paying up Rs.200.240.20. Speculation: Bearish index.000 the investor gets a claim on the index worth Rs. or the onset of a coalition government.4000. the investor gets a claim on Nifty worth Rs. sell the Nifty futures.

2. 3. he squares off his position. He sells 200 Nifties with a expiration date of 26th June 2001.000. 4.14. On 10 June 2001.060 so his position is worth Rs.000.1.212. On 1 June 2001.Example 1. 84 . The Nifty June contract has fallen to Rs. a person feels the index will fall. the Nifty June contract costs Rs. His profits from the position work out to be Rs. At this time. 5. Nifty has fallen to 962.90.990.

Chapter 5 Applicability of Derivative Instruments APPLICABILITY OF DERIVATIVE INSTRUMENTS 85 .

evaluation and handling of opportunities and risks. its assets and its financial and earning potential. WHAT IS RISK? Risks are defined as internal or external causes of and reasons for deviations in actual results and forecasts/budgets. Implementing proper mechanism for the identification. Identifying threats to the company. analysis and mitigation of potential risks. or factors that can lead to changes in the forecast. interest rates and commodity prices have destabilizing affects on performance and corporate strategy.RISK MANAGEMENT: CONCEPT AND DEFINATION In recent years mangers have become increasingly aware of how their organizations can be affected by risks beyond their control. In many cases fluctuations in economic and financial variables such as exchange rates. Clearly prioritizing risks to the company and their mitigation strategies: and Creating opportunities through improving risk mitigation capabilities. WHAT IS RISK MANAGEMENT? Risk management embraces the whole spectrum of activities and measures associated with the identification. They are possibilities not included in forecast/budget and represent an upside or downside to the forecast/ budget. Effective and systematic Risk Management yields the following key benefits: 86 . OBJECTIVES AND BENEFITS OF RISK MANAGEMENT The key objectives of Risk Management are:      Providing a basis for informed decision making as a consequence of creating transparency in the company‟s risk situation.

87 . responsible thinking. the risk management process must remain sufficiently flexible to accommodate new situations as they arise. and  The organization is encouraged to manage proactively rather than reactively. so the organization is prepared for what might happen and is better prepared for making decisions to improve the effectiveness and efficiency of performance. It embraces the whole spectrum of activities and measures concerned with systematic management of risks within the organization. The efficiency of the process is the responsibility of all managers within the organization and cannot be viewed as the sole responsibility of the Risk Manager. and what level of Risk Management it is prudent to apply. the benefits to be gained. Furthermore. It helps to speed up the decision making process. The process contains four main stages:     Risk Risk Risk Risk Identification Evaluation Handling.Forward.  RISK MANAGEMENT PROCESS The objective of risk management process is to identify and evaluate the key risks. All levels of management should manage risks. giving clear priorities to each type of activity or project requiring management attention and thus giving a clear cut advantage to the business. rigorous. and Controlling Controlling the Risk Management Process means monitoring whether the management process is actively and effectively lived throughout the organization. The risk management process must be established as a permanent and integral part of business process if it to be fully effective. and ensure ongoing reporting for informed decision making. since risks and risk structures change continuously. The overall objective of the risk management process is to optimize the risk return relationship and reject unacceptable risks.  Balance thinking – a trade – off must be struck between the cost of managing risk. treat and monitor these risks efficiently and effectively.

strategies.Risk Management Process Objectives. The general margining system that is followed in the futures market is as follows. This is determined by the exposure limit assigned to the investor. Depending on the position taken an initial margin is charged on the investor. For example. More than the initial margin collected. Opportunity/Risk Handling Measures and mechanisms for influencing risks. The MTM is made compulsory to remove any default on large losses if the position is accumulated for several days.33 is required. then it means that an initial margin of 3. the clearing corporation of the exchange by granting credit guarantee nullifies the counter party risk. organization of the company Risk Identification Identification of risks and of their sources Risk Evaluation Evaluation of risks concerning their impact & probability Risk Controlling Ongoing reporting and monitoring of risks and the handling mechanism. reduces the default risk associated with the futures. This can be interpreted as an advance payment made to take a larger position. 88 . Also the strict margining system followed in the futures market worldwide. RISK MANAGEMENT WITH FUTURES CONTRACT As the futures are exchange-traded. if the exposure limit is 33 times the base capital given by the investor. the net profit or loss on a position is paid out to or in by the investor on the very same day in the form of daily mark-to-market margins (MTM).

" 89 . the expectation for a Rs100 stock is to go up by Rs10. i. One way is to buy the stock in the cash segment by paying Rs100.Calculating the net loss associated with a position does the calculation of MTM margin. For example. you can even lose your full capital in case the price moves against your position. This is paid up each evening after trading ends. Conversely futures can be bought and position can be carried for a long time without taking delivery. futures position in the stock by paying about Rs30 toward initial and mark-to-market margin the same profit of Rs10 can be made on the investment of Rs30.e. unlike in the cash segment where it delivery has to be taken because of rolling settlement. The focus is on calculating the net loss on all contracts entered by the client. Further futures positions are leveraged positions. if any.   RISK MANAGEMENT WITH OPTIONS Risk is concerned with the unknown. This can enhance the return on capital deployed. Downside risk is the possibility of loss. meaning a position can be taken for Rs100 by paying Rs25 margin and daily mark-to-market loss. which is not possible in the cash segment because of rolling settlement. In this way the profit will be Rs10 on investment of Rs100. It is wrong to state that "options are risky. Certainty is exchanged with other players who assume the risk in hope of big gains. Alternatively. Please note that taking leveraged position is very risky. giving about 10% returns. about 33% returns. One half the reasons to use options (like other derivatives) is to reduce risk. Upside risk is the possibility of gain. ADVANTAGES AND RISKS OF TRADING IN FUTURES OVER CASH  The biggest advantage of futures is that short selling is allowed without having stock and position can be carried for a long time.

he can obtain a larger number of options than shares. In all cases. he will thus realize a larger gain than if he had purchased shares. Buyers/sellers of puts have upside/downside risk limited to the spot price of the asset (less the premium). Going forward. Reduce risk: The seller of a covered call exchanges his upside risk (gains above the strike price) for the certainty of cash in hand (the premium). If the stock price increases over the exercise price by more than the premium paid. Long Call A trader who believes that a stock's price will increase might buy the right to purchase the stock (a call option) rather than just buy the stock. but will only pay a small percentage of its current value. only the right to do so until the expiry date.  To understand risk. the premium was a certainty. The graph either flat lines or goes up on either side of the spot price. he will profit.  Buyers start out-of-pocket. Sellers start with a gain. he will let the call contract expire worthless.just like buying fire insurance for your house. look at the four standard graphs of options (put-call-buysell). The seller of a put accepts the downside risk of locking in his purchase price of an asset. but close enough. But going forward. in exchange for the premium. These graphs either flat line or go down on either side of the spot price. He would have no obligation to buy the stock. If the stock price decreases. 90 . they have no upside risk. The buyer of a covered put limits his downside risk for a price . The value of the options in the interim between purchase and expiration will not be exactly like these graphs. A trader might buy the option instead of shares. because for the same amount of money. Increase risk: The buyer of a call wants the upside risk of an asset. the option buyer has no downside risk. This is an example of the principle of leverage. Buyers/sellers of calls have unlimited upside/downside risk as the asset price increases. and only lose the amount of the premium. If the stock rises. so his returns are leveraged.  The extent of risk varies.

such a trader who sells a call option for those shares he already owns has sold a covered call. Both tactics are generally considered inappropriate for small investors. the short call position will make a profit in the amount of the premium. If the stock price decreases. If the stock price increases. but has the right to do so until the expiry date.Payoffs and profits from a long call. he will just let the put contract expire worthless and only lose his premium paid. the potential loss is unlimited. However. If the stock price increases over the exercise price by more than the amount of the premium. he will profit. the short will lose money. Payoffs and profits from a short call. Short Call (Naked short call) A trader who believes that a stock's price will decrease can short sell the stock or instead sell a call. The trader selling a call has an obligation to sell the stock to the call buyer at the buyer's option. 91 . He will be under no obligation to sell the stock. If the stock price decreases below the exercise price by more than the premium paid. Unless a trader already owns the shares which he may be required to provide. Long Put A trader who believes that a stock's price will decrease can buy the right to sell the stock at a fixed price.

the short put position will make a profit in the amount of the premium. the short position will lose money. The trader has sold insurance to the buyer of the put requiring the trader to insure the stockholder below the fixed price. Short Put (Naked put) A trader who believes that a stock's price will increase can sell the right to sell the stock at a fixed price. 92 . The trader now has the obligation to purchase the stock at a fixed price.Payoffs and profits from a long put. If the stock price increases. The most bullish of options trading strategies is the simple call buying strategy used by most novice options traders. Payoffs and profits from a short put. This trade is generally considered inappropriate for a small investor. If the stock price decreases below the exercise price by more than the premium. INTRODUCTION TO OPTIONS STRATEGIES Bullish Strategies Bullish options strategies are employed when the options trader expects the underlying stock price to move upwards. It is necessary to assess how high the stock price can go and the timeframe in which the rally will occur in order to select the optimum trading strategy.

they usually cost less to employ. Neutral or Non-Directional Strategies Neutral strategies in options trading are employed when the options trader does not know whether the underlying stock price will rise or fall. While maximum profit is capped for these strategies. stocks seldom go up by leaps and bounds. Mildly bearish trading strategies are options strategies that make money as long as the underlying stock prices do not go up on options expiration date. These strategies usually provide a small downside protection as well. they are so named because the potential to profit does not depend on whether the underlying stock price will go upwards or downwards. stock price seldom make steep downward moves. 93 . Rather. These strategies usually provide a small upside protection as well. The bull call spread and the bull put spread are common examples of moderately bullish strategies. The most bearish of options trading strategies is the simple put buying strategy utilized by most novice options traders.In most cases. In most cases. Moderately bullish options traders usually set a target price for the Bull Run and utilize bull spreads to reduce risk. Writing out-of-the-money covered calls is a good example of such a strategy. Bearish Strategies Bearish options strategies are employed when the options trader expects the underlying stock price to move downwards. they usually cost less to employ. It is necessary to assess how low the stock price can go and the timeframe in which the decline will happen in order to select the optimum trading strategy. Moderately bearish options traders usually set a target price for the expected decline and utilize bear spreads to reduce risk. the correct neutral strategy to employ depends on the expected volatility of the underlying stock price. The bear call spread and the bear put spread are common examples of moderately bearish strategies. Mildly bullish trading strategies are options strategies that make money as long as the underlying stock prices do not go down on options expiration date. While maximum profit is capped for these strategies. Also known as non-directional strategies.

with a strike price (pre-set. There are several basic variations. ratio spreads. They include the long straddle. But options are sold as well as bought. and easiest to understand. Bearish on Volatility Neutral trading strategies those are bearish on volatility profit when the underlying stock price experiences little or no movement. and takes on an obligation to fulfill the other side of the trade. 'if exercised. and short condor and short butterfly. MSFT (Microsoft). but not the obligation. Combining any of the four basic kinds of option trades (possibly with different exercise prices) and the two basic kinds of stock trades (long and short) allows a variety of options strategies. currently trading at $28. short strangle. Puts grant the buyer the right to sell at a pre-set price. long strangle. while more complicated strategies can combine several. to buy at a pre-set price. Simple strategies usually combine only a few trades. is the (long) call. Such strategies include the short straddle. must-be-bought-at-price') of $31. but in order to execute any of them successfully an investor new to options will need to know some elementary concepts.Bullish on Volatility Neutral trading strategies those are bullish on volatility profit when the underlying stock price experience big moves upwards or downwards. 94 . Buying a call confers the right. long condor and long butterfly. have June 31 options that expire on the third Friday of June. OPTIONS TRADING STRATEGIES There are several basic Options Trading Strategies. That seller grants the buyer the right. The most basic are the call and the put. Long Calls The most basic.

If. the short position incurs a loss. Long Put Traders who anticipate that the future market price of an asset.Short ('Naked') Calls When the option seller (the 'writer') doesn't own the underlying stock he's obligated to sell (if the option is exercised). such as commissions. These strategies are either pure profit plays . the trader lets the contract 'expire worthless'.) If the price falls below the strike price by more than the premium.speculating on coming out on the plus side of the equation . 95 . in fact. If the price increases. (Excluding any transaction costs. or doesn't fall enough to cover the premium. If the asset's market price rises. say a stock. Short Put Traders who speculate that the future market price will increase. he is said to be selling a 'naked' call. The price rises above the strike price by more than the premium. he profits. They profit less than pure speculation. will fall prior to expiration can buy the right to sell the stock at a fixed price. the 'writer' loses money. The put buyer has no obligation to sell the stock. can sell the right to sell an asset at a pre-determined price. but simply the right. If the market price of the underlying asset decreases. but make up for it by offloading some risk.or combinations of speculation and hedging. Since he's on the selling side of the contract. the short call position will profit by the amount of the premium. the short put position makes a profit equal to the amount of the premium. Hedging involves taking positions that tend to move in opposite directions. the market price does fall below the strike price (prior to expiration of the option) by more than the premium paid. Several basic trading strategies utilize the characteristics of these four basc positions. his position is said to be 'short'.

000 If the L&T shares do go up you can close your position either by selling the option back to the market or exercising your right to buy the underlying shares at the exercise price. Sell 1Jan contract (Expiry) 2. Options trading software can demonstrate several concrete examples of how any of these . 254 Rs. Before moving into more complex bullish and bearish strategies. volume. etc in combination with different expiration dates and strike prices . an investor should thoroughly understand the fundamentals about buying and holding call options. Net Gain 40 1-Nov 20-Jan 96 . An alternative method uses a short put with low strike price and a long put with a higher strike price.000 1. Share Price Rs. use a long call with a low strike price in combination with a short call at a higher strike price and a short put with a higher strike price. by contrast. involve a short call with a low strike price and a long call with a higher strike price.under different assumptions about future prices. Net outlay is Rs 14. You expect the share price to rise significantly and want to profit from the increase Action: Buy 1 L&T call at 14. 300 Option Market Buy 1 Jan 260 call at Rs 14. for example. L&T is quoting at Rs 254 and the January 260 (strike price) call costs Rs 14 (premium). Situation: On 1 November. Cost =14. LONG CALL Market View Bullish Potential Profit Unlimited Potential Loss Limited Purchasing calls has remained the most popular strategy with investors since listed options were first introduced. Current Strategies 1. 'Bear spreads'.can result in profit (or loss).'Bull spreads'.

LONG PUT Market View Bearish Potential Profit Unlimited Potential Loss Limited A long put can be an ideal tool for an investor who wishes to participate profitably from a downward price move in the underlying stock. an investor should thoroughly understand the fundamentals about buying and holding put options. 97 .000) Net profit= 26. The loss is Rs.000.260 x 1000 units = 40.000 (premium) Net profit = intrinsic value of (Break even = 260+14) option i.000 Return 186% Share Price 300 Share price < 260 Stock price > 274 Possible Outcomes at expiry Option worth 40. is overvalued and may fall substantially. currently trading at Rs 270. and such sale will result in the receipt of time value in addition to any intrinsic value.000.000 Premium paid = (14. 2.46 18% (300 . Closing the position now will produce a net profit of 26. Action: Buy 1 L&T October 260 Put at Rs 8 for a total consideration of Rs 8. 14. the investor is obviously able to sell his option at any time prior to expiry. by whatever amount the share price exceeds 274 Although the profit is on expiry day. Before moving into more complex bearish strategies.000) Your gain is: Option sale = 40.Analysis Rises by Return Rs.e.000 Option expires worthless. If the L&T shares do go down you can close your position either by selling the option back to the market or exercising your right to buy the underlying shares at the exercise price. Situation: An investor thinks L&T. He therefore decides to buy Puts to gain exposure to its anticipated fall.

if the position is closed out. and such sale will result in the receipt of time value in addition to any intrinsic value. and fully collateralizes. or "covers. 240 Analysis Fall of profit Rs 30 effective Option Market Buy 1 L&T Oct 260 put at Rs 8 Total Outlay = 8. it is commonly referred to an "overwrite.000 1.000 Net profit 12. Short Call Naked short call / Covered short call Market View Bullish Potential Profit Limited Potential Loss Unlimited The covered call is a strategy in which an investor writes a call option contract while at the same time owning an equivalent number of shares of the underlying stock. the strategy is commonly referred to as a "buy-write. if the position is closed out." the obligation conveyed by writing a call option contract. The 260 put will be trading at Rs 20 which gives a profit of Rs 12 (20-8).240 x 1000 = 20. Sell 1 Oct contract.000 or 150% Share Price 240 Share price 240260 Stock price > 240 Possible Outcomes at expiry The 260 put will be trading at Rs 20 which gives a profit of Rs 12 (20-8).000) Option sale 20. 3. Although the profit is on expiry day. Recover intrinsic value of premium.1-Aug 20-Oct Share Price Rs. 270 Rs. This strategy 98 . If this stock is purchased simultaneously with writing the call con-tract. the investor is obviously able to sell his option at any time prior to expiry. Net gain 20 (260 .000) Effective profits Option purchase (8." In either case. the stock is generally held in the same brokerage account from which the investor writes the call." If the shares are already held from a previous purchase. 2.

the investor as a writer will sell shares originally purchased for Rs 254 at 274 (260+14). Short Put Naked Short Put / Covered Short Put Market View Bearish Potential Profit Limited Potential Loss Unlimited According to the terms of a put contract. Share Price 1-Nov Rs. 254 Option Market Sell 10 Jan 260 calls @ Rs 14 Income 1. a return of 7.000 (option value of premium) Possible Outcomes at expiry The holder will exercise his position and if called.40.8% over 3 months. An investor holds 10000 shares but does not expects their price to move very much over the next few months so decides to write call option against this shareholding.000 shares).40.000 20-Jan Rs. Situation: It is 1 November and L&T share is trading at Rs 254. a put writer is obligated to purchase an equivalent number of underlying shares at the put's strike price if assigned an exercise notice on the written contract.is the most basic and most widely used strategy combining the flexibility of listed options with stock ownership. The option expires worthless Share Price > 260 Share price < 240 4. 254 Option expire worthless Analysis No change to Effective profits shareholding Profit =1. Action: The January 260 calls are trading at 14 and investor sells 10 contracts (one contract is 1.40. He receives an option premium equal to Rs 1.000 and takes on the obligation to deliver 10000 share at 260 each if the holder exercise the option. Many investors write puts because 99 .

Bull Call Spread Market View Bullish Potential Profit Limited Potential Loss Limited Establishing a bull call spread involves the purchase of a call option on a particular underlying stock.000. Initial income remains as profit. at a higher strike price. while simultaneously writing a call option on the same underlying stock with the same expiration month. Possible Outcomes at expiry The investor's expectation is correct and the put will expire without being exercised.00. effectively for 51. Situation: An investor owns 10. Thus he received premium of 4. and are always the same number of contracts.000.000).they are willing to be assigned and acquire shares of the underlying stock in exchange for the premium received from the put's sale. same expiration month. For this discussion. rise slightly. possibly. Action: The Investor decides to generate some additional income on his portfolio and writes 10 NIIT 550 puts at Rs 40.4.00.00.00.00. The net outflow in this situation is: Future Margin – Option Premium. Both the buy and the sell sides of this spread are opening transactions.000 (55.000 shares and also has a cash holding of around 60. In early March he feels that the share price of NIIT will either remain constant or. 100 . a put writer will be considered "covered" if he has on deposit with his brokerage firm a cash amount (or other approved collateral) sufficient to cover such a purchase. The put option will be exercised and the stock will have to be purchased. this strategy requires a substantial investment. Share Price =/ > 550 Share price < 550 In relation to the Indian markets. This spread is sometimes more broadly categorized as a "vertical spread": a family of spreads involving options of the same stock. 5.000.

but different strike prices.e Rs 8 Share price 200. Advantages Position established for less cost than a long call and breaks even more quickly. the share price of L&T is 204. Stock price > The position can be closed for a maximum profit 220 of Rs 12 above 220 i. Total outlay and maximum loss is 8. and be bullish or bearish. difference in intrinsic value of two calls less than net debit (20-8). 6. can be executed as a "unit" in one single transaction. Break even is Rs 208 (200+8). Bear Put Spread Market View Bullish Potential Profit Limited Potential Loss Limited Establishing a bear put spread involves the purchase of a put option on a particular underlying stock. Buy 1 L&T July 200 call option at Rs 16 and sell 1 July 220 call at Rs 8. Note: the long call position always covers the risk on the short call position. not as separate buy and sell transactions. while simultaneously writing a put option on the 101 . as any spread. if the short option is exercised against you. The bull call spread. Limited loss. Maximum profit is therefore realized at 220. They can be created with either all calls or all puts. the point just before which the 220 calls may be exercised. Eg. Maximum profit is 12 (220-200-8).e.The 200 call gains intrinsic value and profit is 220 equal to the intrinsic value of the 200 calls less the net debit of Rs 8. it is possible to exercise the long position and acquire stock in order to satisfy the short position. Possible Outcomes at expiry Share Price < 200 Both the 200 and 220 calls are worthless and the maximum loss is equal to the net cost of establishing the spread i. Situation: On 1 November.

This spread is sometimes more broadly categorized as a "vertical spread": a family of spreads involving options of the same stock. Situation: The share of Tata Tea is trading at 228. and are always the same number of contracts. as any spread. They can be created with either all calls or all puts. but with a lower strike price. The maximum potential profit of Rs 11 is realized just before the level at which the 220 put may be exercised by the holder The position can be closed for the difference in the intrinsic value of two puts. but different strike prices. 7.e Rs 9 The position can be closed out for the intrinsic value of the Rs. and be bullish or bearish. Expectation: This strategy is appropriate when anticipating a fall in the price of the underlying share. You buy 1 Tata Tea Oct 240 put at Rs 16 and sell 1 Tata 220 put at Rs 7.same underlying stock with the same expiration month. not as separate buy and sell transactions. Maximum profit is Rs 11 and maximum loss Rs 9. Limited loss. Both the buy and the sell sides of this spread are opening transactions. Long Straddle 102 . same expiration month. The bear put spread. 240 put. Possible Outcomes at expiry Both puts are worthless and the maximum loss is equal to the net cost of establishing the spread i. can be executed as a "package" in one single transaction. so the profit is 11 (240-220-9) Share Price > 240 Share price 240-220 Stock price 220 Stock price < 220 Advantages Position established for less cost than a long put and breaks even more quickly.

once the direction of the underlying becomes clear the other 'leg' is closed which effectively reduces the break even. the underlying share. Normally. The potential profit is unlimited as the stock moves up or down.Market View Mixed Potential Profit Unlimited Potential Loss Limited For aggressive investors who expect short-term volatility yet have no bias up or down (i. This position involves buying both a put and a call with the same strike price. maximum loss Rs 30. in this example. 8. Possible Outcomes at expiry Share Price < The call expires worthless and profit is equal to 260 the intrinsic valued of the 260 put less the premium paid Share price > Profit is equal to the intrinsic value of the 260 260 Premium less the paid Although profit opportunities are unlimited below Rs 230 and above Rs 290.. however. has to move 11% before the strategy breaks even. a neutral bias). loss potential is limited. and underlying.e.30 net debit) Profit is unlimited. The potential loss is limited to the initial investment. Short Straddle 103 . expiration. Upside breakeven = 290 (Exercise price 260 + net debit 30) Downside breakeven = 230 (260 . Advantages Profit potential open ended in either direction. Situation: Buy 1 L&T Apr 260 call at Rs 21 and Buy 1 L&T Apr 260 Put at Rs 9. Expectation: Purchasing a straddle is appropriate when anticipating significant volatility in the underlying but when uncertain about direction. the long straddle is an excellent strategy. Maximum Loss limited to the premium paid.

Conversely a sharp upward movement could be protected by buying the 280 calls. Normally a stop loss would only be implemented on one side leaving the other exposed. the short straddle is particularly appropriate when taking the view that the underlying will trade in the range between the breakeven points and when prepared to deliver stock. Alternatively. In this case. and underlying. to prevent such exposures a stop loss facility could be implemented. Action: Sell 1 L&T April 260 call at Rs21. Advantages Generation of earnings from premium received. the profit is limited to the initial credit received by selling options. if the investor felt that there was a possibility of a sharp downward movement the 240 puts could be purchased to protect downside. that if the underlying does prove to be volatile.Market View Mixed Potential Profit Unlimited Potential Loss Unlimited For aggressive investors who don't expect much short-term volatility. 104 . of course. sell 1 L&T April 260 put at Rs 9. Share Price 260 The risk is. Upside breakeven = 290 (Exercise price 260 + net credit 30) Downside breakeven = 230 (260 . the short straddle position exposes an investor in both direction it is important that the stock and cash should be in place to cover the call and put legs respectively. at Rs 290 or alternatively take delivery of stock at Rs 230. Nevertheless. In the example above. in this example. The potential loss is unlimited as the market moves up or down. the short straddle can be a risky. expiration. This strategy involves selling a put and a call with the same strike price. Possible Outcomes at expiry Maximum profit potential is realized as both calls and put are worthless. maximum loss unlimited. Expectation: Generally undertaken with a view that the underlying share price will trade between break even points.30 net credit) Maximum profit is 30. but profitable strategy.

Short Strangle Market View Potential Profit 105 Potential Loss . Profit potential unlimited. Maximum loss of 22 premium paid. Situation: The share of L&T is currently standing at 247.Secure known purchase and sale price. Buy 1 L&T Oct 260 call at Rs 12. Share Price > 260 Share price 240-260 Stock price < 240 Advantages Profit potential open ended in either direction. buy 1 Oct 240 put at Rs10.. a neutral bias). 10.e.22 net debit) Possible Outcomes at expiry Profit from the call is equal to its intrinsic value less the premium paid Both call and put are out of money. The potential loss is limited to the initial investment while the potential profit is unlimited as the market moves up or down. This strategy typically involves buying out-of-the-money calls and puts with the same expiration and underlying. Upside breakeven = 282 (Exercise price 260 + net debit 22) Downside breakeven = 218 (240 .Long Strangle Market View Mixed Potential Profit Unlimited Potential Loss Limited For aggressive investors who expect short-term volatility yet have no bias up or down (i. Loss limited to total premium paid. 9. the long strangle is another excellent strategy.

Disadvantages Loss is unlimited In the Indian Markets. The profit is limited to the credit received by selling options. The potential loss is unlimited as the market moves up or down. The 22 credit is retained The put is exercised. 11. Situation: L&T shares are currently standing at Rs 247 and you sell 1 October 260 call at Rs 12 and sell 1 October 240 put at Rs 10. The seller takes delivery of the stock at 218. Share Price > 260 Share price 240-260 Stock price < 240 Advantages Generation of earnings from premium received. Secure know sale and purchase prices.Mixed Limited Unlimited For aggressive investors who don't expect much short-term volatility. Upside breakeven = 282 (Exercise price 260 + net debit 22) Downside breakeven = 218 (240 . but profitable strategy. the investment required for such a strategy is very high and should only be attempted by people with huge funds and an appetite for large losses.Butterfly 106 . (260+22). Both the call and put would expire worthless. the short strangle can be a risky. This strategy typically involves selling out-of the-money puts and calls with the same expiration and underlying. Possible Outcomes at expiry The call is exercisec by the holder and the seller delivers stock at 282.22 net debit) Your maximum profit is Rs 22 and loss is unlimited.

The net profit would be 240-220-5 = Rs. net debit Can be difficult to execute such strategies quickly.5 i. Both the buy and the sell sides of this combination are opening transactions. 30. The option portions of this strategy are referred to as a combination. In other words.e.e. Situation: L&T shares are currently trading at 240. Upside breakeven = 255 Downside breakeven = 225 The maximum profit is 240-220-5 = Rs. Generally.15 Disadvantages Stock price < The loss is Rs. the put and the call are both out of-the-money when this combination is established.15 Possible Outcomes at expiry Share Price > 260 Stock price 240 The maximum profit would be at this level. The loss is Rs. 12. 220 Requires big margin to execute this strategy. one collar equals one long put and one written call along with owning 100 shares of the underlying stock. This is called "buying a butterfly. net debit Advant ages Potential loss is limited 107 . When investors expect stable prices.Collar A collar can be established by holding shares of an underlying stock." The opposite would be to sell the butterfly. and are always the same number of contracts.Market View Mixed Potential Profit Limited Potential Loss Unlimited Ideal for investors who prefer limited risk. The options.5 i. and buy one Jan 260 call at 25. You buy one Jan 220 call at Rs. 40. limited reward strategies. and have the same expiration month. which must be all calls or all puts. sell two Jan 240 calls at Rs. they can buy the butterfly by selling two options at the middle strike and buying one option at the higher and lower strikes. must also have the same expiration and underlying. purchasing a protective put and writing a covered call on that stock.

limited reward strategy that profits in stagnant markets.240 in may and would like a way to protect your downside with little or no cost.e.Expectation: An investor will employ this strategy after accruing unrealized profits from the underlying shares. 108 . A profit is made if the stock remains above the lower break even point or below the upper break even point. You would create a collar by buying one May 220 put at 10 and selling one May 260 call at 15. Since there are two spreads involved in the strategy (four options). Share Price @220 Stock price @240 Stock price @260 Advantages The collar strategy is best used for investors looking for a conservative strategy that can offer a reasonable rate of return with managed risk and potential tax advantages. Possible Outcomes at expiry The profit from the put offsets the loss from the stock. Expectation: The long condor can be a great strategy to use when your feeling on a stock is generally neutral because it's been trading in a narrow range. The profit would be equal to the net inflow i. Net credit is Rs. At the same time. Maximum loss: When the share is at or below 220. an investor will combine a Bear-Call Credit Spread and a Bull-Put Credit Spread on the same underlying security. at Rs. Disadvantages The primary concern in employing a collar is protection of profits accrued from underlying shares rather than increasing returns on the upside.5 Maximum profit: When share is at 260. and wants to protect these gains with the purchase of a protective put. the condor is a limited risk. Like the butterfly. In the Iron Condor. By doing this.5 The profit on the stock is exactly offset by the loss on the call option that was sold. the investor is willing to sell his stock at a price higher than the current market price so an out-of-the-money call contract is written. Rs. covered in this case by the underlying stock Situation: Suppose you purchased 100 shares of L&T ltd. Condor Spread The Condor Spread strategy is a neutral strategy similar to the Butterfly. there is an upper break even and a lower break even. an investor will potentially be able to double the credit obtained over a single spread position. 13.

Situation: Imagine that L&T ltd. is trading at Rs. Losses are limited if the stock goes against you one way or the other. Expectation: A calendar spread involves the sale of a near dated call (put) and the purchase of a longer dated call (put) at the same exercise price. If you are facing a large gain or drop in the underlying you could only close one leg of the four legs in the position. Calls are 109 . 5 (initial debit) Share Price <220 Stock price 240-260 Stock price>260 Advantages: The double credit achieved helps lower the potential risk. 5 (initial debit) The profit would be equal to 20-5= Rs. Maximum profit: When the stock price is between 240 & 260 Maximum loss: When the stock price is above 280 or below 220 Possible Outcomes at expiry The loss would be of Rs. 14. 240 and has been relatively flat for some time. The more rapid erosion in the near month series works to the advantage of the writer and the strategy is therefore particularly appropriate when the near month series is overpriced. Action Sell 1 240 call @ 20 Sell 1 260 call @ 15 Buy 1 220 call @ 30& buy 1 280 @ 10 call as a hedge in case the market moved against you. a spread opens up between the two. Since the time value element of an option‟s premium erodes faster in the near month series than the far month series. Disadvantages: Commission costs to open the position are higher since there are four trades.15 The loss would be Rs. might be cost prohibitive to trade iron condors that are low net credits. Calendar Spread Calendar spreads take advantage of the different rates at which time value erodes. If you think the situation is unlikely to change.

Disadvantages Limited profit.288 and the May 280 Call is available @ Rs. 6 Possible Outcomes at expiry The May 280 call expires worthless leaving the position long 1 Jun 280 call at a reduced cost of 6. Share Price <280 Stock price @280 Stock price >280 A calendar spread using puts could be established in the same way to suit a neutral to moderately bearish strategy. Situation: On 1 May the shares of L&T ltd. This is generally known as a reverse calendar spread. but the true value of the Jun 280 call is likely to be lower. i. are trading at Rs. Net debit is Rs. Buy 1 L&T Ltd. initial debit. 30 Action: Sell 1 L&T Ltd.24 and the Jun Call is available @ Rs.e.30. Position may be disrupted by early exercise. Maximum profit potential is realized. Advantages Limited loss. Alternatively.used when market view is moderately bullish and puts are used when market view is moderately bearish. if the May calls were purchased and the Jun calls sold then the risks and rewards would be reversed. Jun 280 call @ Rs. The May 280 call expires worthless but the Jun 280 call will have 1 month time value remaining. 110 . Both calls will have intrinsic value. May 280 call @ Rs.24.

111 .

Chapter 6 Introduction of commodity 112 .

Futures trading in oilseeds was organized in India for the first time with the setting up of Gujarati Vyapari Mandali in 1900. The securities market was a poor cousin of this market as there were not many papers to be traded at that time. following widespread discontent amongst leading cotton mill owners and merchants over the functioning of the Bombay Cotton Trade Association. This coupled with the regulatory constraints in 1960s. 113 . resulted in virtual dismantling of the commodities future markets. There were booming activities in this market and at one time as many as 110 exchanges were conducting forward trade in various commodities in the country." in 1875. In 1893. which carried on futures trading in groundnut . in which the role of market forces for resource allocation got diminished. castor seed and cotton. saw the decline of this market since the mid-1960s. a separate association by the name "Bombay Cotton Exchange Ltd." was constituted. The era of widespread shortages in many essential commodities resulting in inflationary pressures and the tilt towards socialist policy. Before the Second World War broke out in 1939 several futures markets in oilseeds were functioning in Gujarat and Punjab. It is only in the last decade that commodity future exchanges have been actively encouraged.INTRODUCTION Commodities Market In India Organized futures market evolved in India by the setting up of "Bombay Cotton Trade Association Ltd. the markets have been thin with poor liquidity and have not grown to any significant level. However.

Indore (NBOT). which itself cannot be ignored. mustard seed. Forward trading was permitted in cotton and jute goods in 1998. The year 2003 marked the real turning point in the policy framework for commodity market when the government issued notifications for withdrawing all prohibitions and opening up forward trading in all the commodities. 2000 by the government that futures trading will be encouraged in increasing number of agricultural commodities was indicative of welcome change in the government policy towards forward trading. But with the strong emergence of: National Multi-commodity Exchange Ltd. commodities related (and dependent) industries constitute about roughly 50-60 %. sesame. Secondly. National Commodities and Derivatives Exchange. run mainly by entities which trade on them resulting in substantial conflict of interests.. Most of the existing Indian commodity exchanges are single commodity platforms. and National Board of Trade. This period also witnessed other reforms. Mumbai (NCDEX). new promoters with resources and professional approach were being attracted with a clear mandate to set up demutualized. cottonseed etc.. Thirdly. Ahmedabad (NMCE). which have reduced bottlenecks in the development and growth of commodity markets. These exchanges are expected to be role model to other 114 . strengthening of infrastructure and institutional capabilities of the regulator and the existing exchanges received priority. technology driven exchanges with nationwide reach and adopting best international practices. all these shortcomings will be addressed rapidly. opaque in their functioning and have not used technology to scale up their operations and reach to bring down their costs. in 1999. A statement in the first ever National Agriculture Policy.A three-pronged approach has been adopted to revive and revitalize the market. amendments to the Essential Commodities Act. Securities (Contract) Rules. Firstly. Of the country's total GDP. on policy front many legal and administrative hurdles in the functioning of the market have been removed. as the existing exchanges are slow to adopt reforms due to legacy or lack of resources. Multi Commodity Exchange Ltd. issued in July. are regional in nature. followed by some oilseeds and their derivatives. such as groundnut. such as. Mumbai (MCX).

In this way the total area of market will become broad. Total turnover of commodity of market is nearly Rs. crude.  In our country agricultural products form 25% of GDP. 10. In which 60. Promissory contracts have been started science 1875. demand is comparatively high prices of the product will go up. Here against one seller there will be more then one buyer. The current mindset of the people in India is that the Commodity exchanges are speculative (due to non delivery) and are not meant for actual users. In this market buyers will come across the country for transactions. Where the production is less but. One major reason being that the awareness is lacking amongst actual users. Presently nearly in 122 commodities tread is being done  Transaction in the organized market: 115 . But due to some restriction it was not properly worked. In India. exchange rate risks are WHY STRUCTURED COMMODITY MARKET? Today the business is not limited to our area only.1. On the contrary where the production is high but demand is comparatively low the prices will go down. speculator.exchanges and are likely to compete for trade not only among themselves but also with the existing exchanges. Interest rate risks. and hedger can tread.000 corer.  If sellers and buyers come together at a place then it will create a market. etc…  Today in our country most of the trade is done in unorganized market.000 corer comes from agriculture and left is coming from coal. In the market current and future contracts are done.  In this market not only producer and seller are included but arbitrageur.

Day by day number of commodity items is incising. MCX To begin with contacts in gold. In this commodity market classified as agriculture products. soyabean. crude palm oil and RBD Palmolive are being offered. mustered seed. the National Commodity and Derivative Exchange Ltd (NCDEX) launched futures trading in nine major commodities.Organized markets have structured forms of transactions. precious metal. 1952 for regulating forward\future contracts. soya oil. other metal and energy which we discuss above. silver. Now more then 40 commodity items are included. rapeseed oil. The various commodities that tread on the NCDEX and look at some commodity specific issues. The commodity exchanges are regulated as per rules and regulations define in The Forward Contracts (Regulation) Act. cotton. COMMODITIES 116 . In December 2003.

117 .

It is invariably entered into for a standard variety known as the "basis variety" with permission to deliver other identified varieties known as "tender able varieties". he can do so not only at the location of the Association through which trading is organized but also at a number of other pre-specified delivery centers. The units of price quotation and trading are fixed in these contracts. In case he decides to deliver goods. b. Futures’ trading is necessarily organized under the auspices of a market association so that such trading is confined to or conducted through members of the association in accordance with the procedure laid down in the Rules & Byelaws of the association. The delivery periods are specified. d.CHARACTERISTICS OF FUTURES TRADING A "Futures Contract" is a highly standardized contract with certain distinct features. c. In futures market actual delivery of goods takes place only in a very few cases. e. f. The seller in a futures market has the choice to decide whether to deliver goods against outstanding sale contracts. Transactions are mostly squared up before the due date of the contract and contracts are settled by payment of differences without any physical delivery of goods taking place. Some of the important features are as under: a. parties to the contracts not being capable of altering these units. 118 .

production and manufacturing 119 . Having entered into an export contract. The futures trading is very useful to the exporters as it provides an advance indication of the price likely to prevail and thereby help the exporter in quoting a realistic price and thereby secure export contract in a competitive market.this mechanism dampens the peaks and lifts up the valleys i.     Leads to integrated price structure throughout the country. It is useful to producer because he can get an idea of the price likely to prevail at a future point of time and therefore can decide between various competing commodities. Other benefits of futures trading are:  Price stabilization-in times of violent price fluctuations . Encourages competition and acts as a price barometer to farmers and other trade functionaries. it enables him to hedge his risk by operating in futures market. Helps balance in supply and demand position throughout the year. ECONOMIC BENEFITS OF THE FUTURES TRADING Futures contracts perform two important functions of price discovery and price risk management with reference to the given commodity. It is useful to all segments of economy. He can do proper costing and also cover his purchases by making forward contracts.e. the best that suits him. Facilitates activities. It enables the consumer get an idea of the price at which the commodity would be available at a future point of time. lengthy and complex. the amplititude of price variation is reduced.

Soy Seeds. Yellow Peas. Copper.e. Tur Fibre: Kapas.  THE FOLLOWING ITEMS ARE TRADED IN THE MULTI COMMODITY EXCHANGE Bullion: Gold. there should be large demand for and supply of the commodity . which decide the suitability of the commodities for future trading:  The commodity should be competitive. i. Mustard Seed Oil. Gold M. Tin Long Staple Cotton.  The commodity should have long shelf life and be capable of standardization and gradation. Soymeal. Refined RBD Palmolein. Jeera. Basmati Rice. Groundnut Oil.. Turmeric Long. Mustard Seed. Oil & Oil Seeds : Soy Oil.no individual or group of persons acting in concert should be in a position to influence the demand or supply. Crude Palm Oil.   There should be fluctuations in price. Silver M. Nickel. Medium Staple Cotton Urad. Cottonseed Spices: Pepper. The market for the commodity should be free from substantial government control. COMMODITIES ARE SUITABLE FOR FUTURE TRADING The following are some of the key factors. Silver. Steel Flat. Pulses: Chana. Gold HNI. Castor Oil. Maize. Cottonseed Oilcake. Wheat. Cereals: Rice. Silver HNI Castor Seeds. and consequently the price substantially. Red Metal: Steel Chilli. Sarbati Rice 120 .

can be broadly classified into precious metals. It acts as a smart investment choice by providing hedging. Guargum Bandhani. Guarseed Bandhani  NEED FOR FUTURES TRADING IN COMMODITIES Commodity Futures. traders and processors to exporters/importers and end-users of a commodity. thus minimizing the losses to the farmers. trading 121 . Guar Seed. Futures trading in commodities results in transparent and fair price discovery on account of large-scale participations of entities associated with different value chains. which forms an essential component of Commodity Exchange. agriculture. energy and other metals. Gur.Energy: Crude Others: Oil Rubber. Current futures volumes are miniscule compared to underlying spot market volumes and thus have a tremendous potential in the near future. It reflects views and expectations of a wider section of people related to a particular commodity. It also provides effective platform for price risk management for all segments of players ranging from producers. Cashew Kernel. It also helps in improving the cropping pattern for the farmers. Guargum.

pricing in commodities futures has been less volatile compared with equity and bonds. Historically. In other words "Share prices mimic the commodity price movements".and arbitrage opportunities to market players. 122 . hence going forward the industry can hedge this risk by trading in the commodities market. Industry in India today runs the raw material price risk. The significance of raw materials can further be strengthened by the fact that the "increase in raw material cost means reduction in share prices". Raw materials form the most key element of most of the industries. thus providing an efficient portfolio diversification option.

Chapter 7 HEDGING STRATEGESIES 123 .

a purchase in the ready market is off-set by an opposite sale in the futures market and a sale in the ready market is off-set by purchase in the futures market. The ready and futures prices of a commodity ordinarily do move together in sympathy with each other because both ready and futures prices are basically determined by the demand and supply factors of that particular commodity. 124 . which provides the necessary immunity to the above interests in the marketing of commodities from the risk of adverse price fluctuations. The practice of hedging is based on the assumption that the ready and futures prices of the commodity move more or less parallel to each other. In each of these two cases. HEDGING Hedging is a sophisticated mechanism. A Hedge is a countervailing contract transacted in a futures market through which those who have bought in the ready market will sell in the futures market and those who have sold in the ready market would buy in the futures market. the sale or purchase hedge contract is closed out by an offsetting reverse purchase or sale contract in the futures market. When the purchase or sale commitment in the ready market is fulfilled.

its price in the futures market would normally have also declined so that the loss incurred in the ready market would be recovered by the profit made in the futures market. the ready and futures prices may not move together or the spread between the two may increase or decrease sharply. in the case of a speculative transaction. the form or nature of transactions entered into by both in the futures market is similar. Similarly. manufacturer or exporter is not. in certain circumstance. hedging in a futures market does afford such a protection to the various functionaries. They. there is no corresponding transaction in the ready market. His only interest is to ensure that he gets the necessary insurance against unforeseen fluctuation in prices. 125 . if the price rises in the ready market after the hedge sale had been entered into the futures market. be made up with the profit made in the ready market. which would. To the extent that they do not move together by the same extent. A speculator operating in a futures market is the one who buys or sells futures contracts without any countervailing commitments or transactions in the actual commodity with a view to making profit from the fluctuations in the prices. thus provide the much needed breadth and liquidity to the futures markets which in their absence would remain narrow and unstable. But. By and large.When the price of a commodity has declined in the ready market. per se. When a transaction takes place in a futures market. These operators are called speculators. however. there would be a loss in the futures market. Hedging on futures markets cannot be practiced unless there are operators willing to assume the risk of adverse price fluctuations which the hedgers desire to transfer. hedging itself may be a source of minor gains or losses. interested in such speculative losses or gains. While the motives of the speculator in entering into futures trans actions are different from a hedger. The basic distinction between a hedge and speculative transaction on a futures market is that while in the case of a hedge transaction there is a corresponding opposite transaction in the ready market. But a dealer.

The commission was set up under the Forward Contracts (Regulation) Act of 1952. 126 . the only variable being the price at which the contracts helps the members of associations in entering into uniform types of contracts in which the quantity and quality of goods. are pre-determined so that they can be entered into primarily for the purpose of exchange of money differences. such contracts are generally entered under the auspices of commercial bodies known as commodity exchanges or associations. While it is possible for the individual parties to enter into futures contracts. It is responsible for regulating and promoting futures/forward trade in commodities. The FMC is headquartered in Mumbai while its regional office is located in Kolkata. Futures trading in these commodity exchanges/associations are confined to or conducted through its members in accordance with the procedure laid down in its rules members in accordance with the procedure laid down in its rules and bye-laws. Curbing the illegal activities of the diehard traders who continued to trade illegally is the major role of the Forward Markets Commission. The need for organizing futures trading under the auspices of such commodity exchanges or associations arises mainly in order to ensure that payment of differences arising from settlement of purchase and sale contracts entered into by the members of such exchanges or aassociations take place in a smooth and orderly manner and thus defaults on account of non-payment of such differences are avoided. these exchanges/associations also help in evolving standard terms of contracts in which the quantity and quality of the goods traded.the transaction may well be between two hedgers or two speculators or between a hedger and a speculator. period of delivery and all other terms are pre-determined. period of delivery etc. Further.  REGULATORY BODY The Forward Markets Commission (FMC) is the regulatory body for commodity futures/forward trade in India.

with plethora of mandis. certification and warehousing are bound to occur. players hedge their risks by using futures Euro-Dollar fluctuations and the international prices affecting it. which needs use of futures and derivatives as price-risk management system. By using effectively futures and derivatives.g. For an agricultural country like India. trading in over 100 crops. the issues in price dissemination. standards. thus lowering cost of doing business. Fundamentally price you pay for goods and services depend greatly on how well business handle risk. businesses can minimize risks. For e. in the bullion markets. Commodity Market will serve as a suitable alternative to tackle all these problems efficiently 127 . WHY COMMODITIES MARKET? India has very large agriculture production in number of agri-commodities. Commodity players use it as a hedge mechanism as well as a means of making money.

Chapter 8 PROBLEM FACE BY COMMODITY MARKET IN INDIA 128 .

Currently. logistics. Exchanges are used only to hedge price risk on spot transactions carried out in the local markets. there are a lot of hassles such as octroi duty.. octroi duty. Also multiple restrictions exist on inter-state movement and warehousing of commodities.  PROBLEMS FACED BY COMMODITIES MARKETS IN INDIA Institutional issues have resulted in very few deliveries so far. transportation costs. If there is a broker in Mumbai and a broker in Kolkata. logistical problems prevent trading to take place. 129 .

namely: the price risk. the quantity risk. client. Commodity enterprises primarily face the following classes of risks. RISKS ASSOCIATED WITH COMMODITIES MARKETS No risk can be eliminated. but the same can be transferred to someone who can handle it better or to someone who has the appetite for risk. vendors etc) not fulfilling his obligations on due date or at any time thereafter is the most common risk. This risk is mitigated by collection of the following margins:      Initial Margins Exposure margins Market to market of positions on a daily basis Position Limits and Intra day price limits Surveillance Commodity price risks include:    Increase in purchase cost vis-à-vis commitment on sales price Change in value of inventory Counter party risk translating into commodity price risk  KEY FACTORS FOR SUCCESS OF COMMODITIES MARKET The following are some of the key factors for the success of the commodities markets:    How one can make the business grow? How many products are covered? How many people participate on the platform? 130 . the yield/output risk and the political risk. the risk of the counter party (trading member. Talking about the nationwide commodity exchanges.

Self-Regulation to ensure: Overview of Trading and Surveillance. The interests of Indian consumers. Effective Management of Counter party Credit Risk. reach of the organization and adding value on the ground. wider participation of Hedgers. Robust Trading & Settlement systems.  KEY EXPECTATIONS OF COMMODITIES EXCHANGES The following are some of the key expectations of the investor's w. financial soundness and capability. In addition to this. robustness of settlement structures. credibility of the institution. covering a wide range of commodities. if the Indian Commodity Exchange needs to be competitive in the Global Market.t. background of promoters. method of execution. households and producers are most important. size of the trade guarantee fund. then it should be backed with proper "Capital Account Convertibility".      Proper Product Conceptualization and Design. Audit and review of Members. any commodity exchange:  To get in place the right regulatory structure to even out the differences that may exist in various fields. scaleable technology. as these are the people who are exposed to risk and price fluctuations. Enforcement of Exchange rules. Speculators and Arbitrageurs. Fair and Transparent Price Discovery & Dissemination. acceptable clearing mechanism. transparency of platforms. KEY FACTORS FOR SUCCESS OF COMMODITIES EXCHANGES The following are some of the key factors for the success of the commodities exchanges: Strategy. 131 .r.

the need has been felt that various operators in the commodities market be provided with a mechanism to hedge and transfer their risks. commodities are the best option. Indian markets have recently thrown open a new avenue for retail investors and traders to participate: commodity derivatives. As. bonds and real estate. corporate will feel the pressure to hedge their price risk once the frontiers open up for free trade. The MSP programme will not be sustainable in such a scenario. Following are some of the applications. they will add depth to the commodities markets. 132 . Government subsidy may go down as a result of WTO. For those who want to diversify their portfolios beyond shares. India's obligation under WTO to open agriculture sector to world trade would require futures trade in a wide variety of primary commodities and their products to enable diverse market functionaries to cope with the price volatility prevailing in the world markets. FUTUREPROSPECTS With the gradual withdrawal of the government from various sectors in the postliberalization era. they have added depth to the equity markets. which can utilize the power of the commodity markets and create a win-win situation for all the involved parties: -  REGULATORY APPROVAL / PERMISSION TO FII'S FOR TRADING IN THE COMMODITY MARKETS FII's are currently not allowed nor disallowed under any law. Also. The farmer will have to look at ways of being in a position to trade on commodity exchanges in future. since they globally know the commodities.

without favoritism or control by a chosen few. where any user can 133 . many-to-many system. where every user has equal access to price quotes and trading functionality.Chapter 9 Online commodity trading  ONLINE COMMODITY TRADING Online commodity trading offers a way for an open. It provides a level playing field for all.

With most online commodity trading systems. Liquidity. is perhaps the best measure of success of an online trading commodity trading system. The Internet charges are becoming minimal and the Internet is soon becoming a way of life in India. 24 hours a day. and easily pass the trading objectives to others in companies in different times zones. Precious Metals. The Online trading system operates almost continuously around the clock. traders can be sure of finding an interesting market development or trading opportunity almost every time they log on. This allows any user to extend the trading day. The online commodity trading system in India is only an emerging segment yet. Options. It provides for various media ranging from Physical Delivery and Financial Cash Settlement. Differentials. It is in this scenario that online trading is becoming more the way of trading in India. and settlement terms ranging from Oil. act or trade on quotes posted by others. There are further derivative options available ranging from Forwards. or trade activity. Electric Power. They can be acted on with full assurance of a completed transaction. The greatest advantage of an online system for trading is that just a click can be used to hit a bid or lift an offer. structures. 134 . post their own prices and quantities for others to trade The Online commodity trading site usually lists a large number of unique products covering a variety of commodities. Swaps. Spreads. This is because the Internet boom in Indian is on the rise only now.view all quotes posted by other users in real time. Emissions and Weather. All quotes posted by users on any online commodity trading systems are live and firm. seven days a week. Natural Gas. Complex Derivatives.

 SHAREKHAN COMMODITY ADVANTAGE  KEY BENEFITS OF COMMODITIES@ SHAREKHAN: You are getting 20time exposer in MCX &10 time in NCDEX depends on commodity to open an account We have sms facility where u getting market information as well as buy/sell call You are also getting yahoo chat.Where our dealer/RM are always help for market information as well as buy/sell call 135 .

Secondary objectives are: 136 .Chapter 10 Research RESEARCH  Research Objective The main objective of the study is to analysis the awareness of derivatives and commodities segment and their potential market among the people of Delhi.

 To find out the best medium to educate the masses about Derivatives and Commodity. To know the awareness of Derivatives and Commodity.  To know the scope for the Derivatives and Commodity.  To know the investment habit and purpose of investing.  To know the influencing force behind the decision making while trading in Derivatives and Commodity. HYPOTHESIS: H0: There is no significant difference in level of awareness of Commodity. of the people of Delhi. Derivatives and Derivatives and 137 . Hα: There is significant difference in level of awareness of Commodity.

The most preferred way is to interview the individuals to get a sense of how they feel  Secondary Data When the data is collected and compiled from the published nature or any other’s primary data is called secondary data. So far as our research is concerned. we have not used secondary data for our research. SOURCES OF DATA There are two main sources of data 1. Primary Data 2. we have not collected any information from any sources. Secondary Data  Primary Data The data. So. 138 . is called primary data. which is collected directly from the respondent to the base of knowledge and belief of the research.

We have selected the selected the samples as per per convenience. Sample Universe Sampling Technique Sample Size Sampling Unit: Delhi City Stratified and Random 45 Respondents Bussiness Random Service Random Student Random Housewife Random = = = = 139 . SAMPLING PROCESS It is very true that to do the research with the whole universe. As we know that it is feasible to go to population survey because of the n number of customers and their scattered location. we have taken sample size of 45 respondents. All the respondents are stratified on the basis of their profession and savings. So far as our research is concerned. So for this purpose sample size has to be determined well in advance and selection of sample also must be scientific so that it represents the whole universe. We have selected Income Earners with saving to invest in Rajkot city.

 This will help the company to frame effective Marketing Strategy as well as select the right media for advertising to create brand awareness as well as to give knowledge of the product. SCOPE OF STUDY The research would be useful in the following respect. LIMITATION OF THE STUDY The limitations of the study are as follow: Personal Bias: 140 .  This will help the company to know the taste of masses and turn it towards Derivatives and Commodities. how to make people aware about Derivatives and Commodities by imparting best education.  This will help the company.  This will also help to select right medium for trading in Derivatives and Commodities segment.  Mind share of Sharekhan can be known.

Time Limit: The time duration given for the research is less. 141 .Individuals may have personal bias towards particular investment option so they may not give correct information and due to which the conclusion may be derived.

Gender Ratio: Male 40 Female 5 Gender Female 11% Male Female Male 89% In survey 89% people are male & 11% are female. so we cannot know the degree of the literacy outside the city. ANALYSIS & INTERPRETATION 1. 2.Area: The area was limited to Delhi only. which is of 45 only. due to which we may not get the proper results.Age: 25-35 42 36-50 3 ABOVE 50 0 142 . Sample Size: The last limitation is Sample Size.

D GRADUATE 67% It can be seen from pie charts 67% people are graduate & 33% people are post graduate.Occupation: Bussiness Services 1 33 Student 11 Housewife 0 143 .Education Qualification: Under Graduate 0 Graduate 30 Post Graduate 15 Ph.D 0% UNDER GRADUATE GRADUATE POST GRADUATE PH. 3.D 0 POST GRADUATE 33% UNDER GRADUATE 0% Education PH. 4.35-5050ABOVE 0% 7% Age 21-35 35-50 50ABOVE 21-35 93% It can be seen from pie charts 93% people are 21-35 age & rest are 35-50.

BUSINESS 2% STUDENT 25% HOUSEWIFE 0% Occupation BUSINESS SERVICES STUDENT HOUSEWIFE SERVICES 73% There are 73% people who are servicemen & 25% are student & 2% are businessmen. 5. 6. Do you invest surplus money in saving instrument: Yes No 21 24 Do you invest surplus in saving investment YES 44% NO 56% YES NO There are 44% people say they are invest surplus in saving instrument & 56% people say no.Investment Pattern: Securities No. of peopel 144 .

Bank FD. Preference for investment Derivatives & Commodity: Instruments Bullion Oil & Oil Seeds Spices Metal No.Bank F. 7.D. Gold Post Scheme Equity Insurance Derrivatives Mutual Fund Commodities 3 4 11 17 3 5 1 Where you invest your saving MUTUAL FUND 11% DERIVATIVES 7% COMOODITIES 4% BANK FD 7% GOLD POST SCHEMES 9% BANK FD GOLD POST SCHEMES EQUITY INSURANCE DERIVATIVES MUTUAL FUND COMOODITIES INSURANCE 38% EQUITY 24% It can be seen from the graph that the respondents have given first preference for investment to Insurance and Second preference Equity. 7 17 10 7 145 . Derivatives and Commodity having almost equal share. Mutual fund.

Fiber F&O 0 4 If you invest in Derrivative & Commodity Which you give first prefrence FIBER 0% METAL 16% F&O 9% BULLION 15% BULLION OIL & OIL SEED SPICES METAL SPICES 22% OIL & OIL SEED FIBER 38% F&O When asked to the respondents that out of the given options which one would they prefer? So they prefer Oil & Oil Seeds first. 19 23 1 2 0 146 . So the preference for commodity (Oil & Oil Seeds) is Equal to Derivatives. Factors that are to be consider by Individual at the time of investment Obstacles Risk Reduction Leverage Benefit Arbitrage Benefit Speculative Motive Liquidity preference No. 8.

Each and every investor are not risk taker though they want more return from the investment. Medium prefer by individual at the time of investment Factor Broker Internet Magazine News channel No.SPECULATIVE MOTIV ARBITRAGE BENEFIT 5% 2% Which factor play crucial role in decision to invest in derrivative & commodity LIQUIDITY PREFERENCE 0% RISK REDUCTION 42% RISK REDUCTION LEVERAGE BENEFIT LEVERAGE BENEFIT 51% ARBITRAGE BENEFIT SPECULATIVE MOTIV So. 9. 2 28 2 13 Which medium do you use to invest in Derrivative & Commodity BROKER NEWS CHANNELS 29% 5% BROKER INTERNET MAGZINE 4% MAGZINE NEWS CHANNELS INTERNET 62% 147 .

3 17 148 .LOW VERY LOW Mostly people say the return from derivative & commodity are neither high nor low as compare to other investment. 2 18 25 0 0 Do you think return from Derrivative & Commodity higher than other investment VERY LOW. mostly invester are use internet to trade in derrivative & commodity as compare to other medium. 10.Risk in Derrivative & Commodity Option Very high High No. Do you think return from Derrivative & Commodity higher than other investment:Option Very high High Neither high nor low Low Very low No.LOWVERY HIGH 0% 0% 4% VERY HIGH NEITHER HIGH NOR LOW 56% HIGH 40% HIGH NEITHER HIGH NOR LOW . 11.So.

LOW VERY LOW It can be seen from charts 55% people say risk in derivative & commodity are neither high nor low from other investment. 3 17 23 1 1 149 .LOW 0% VERY HIGH 7% VERY HIGH HIGH NEITHER HIGH NOR LOW 55% HIGH 38% NEITHER HIGH NOR LOW .Neither high nor low Low Very low 25 0 0 VERY LOW 0% Risk in Derrivative & Commodity . 12. Do you think risk & return compensation in this market:- Option Very high High Neither high nor low Low Very low No.

Do you think risk & return compensation in this market . 13.LOW VERY LOW There are 51% people say the risk & return compensation in this market.LOW 2% VERY LOW VERY HIGH 2% 7% VERY HIGH HIGH HIGH 38% NEITHER HIGH NOR LOW 51% NEITHER HIGH NOR LOW .& 38% people say hig risk & return compensation in this market. 9 13 17 6 150 .Which period of return from derivatives and commodities compensate the accepted risk:Option Daily Weekly Monthly Annually No.

14 .Which period of return from Derrivative & Commodity compensate accepted risk ANNUALLY 13% MONTHLY 16% DAILY 20% DAILY WEEKLY MONTHLY ANNUALLY WEEKLY 51% In derivative & commodity mostly people satisfied with return from derivative & commodity compensate the risk on weekly basis.What is your perception about risk & return relationship in derrivative & commodity Option Very high High Neither high nor low Low Very low No. 151 .LOW VERY HIGH 0% 0% 9% NEITHER HIGH NOR LOW 47% HIGH 44% VERY HIGH HIGH NEITHER HIGH NOR LOW .LOW VERY LOW There are 47% people say risk & return relation ship in derivative & commodity are neither high nor low but 44% people say high. 4 20 21 0 0 What is your perception about risk & return relationship in derrivative & commodity VERY LOW .

What are the reason of lose at this market No. 16.15. HOW do you take decision to trade in derrivative & commodity No. 15 2 5 2 21 0 Independently Broker/Agent News Channels News Papers Internet Tax consultant 152 . 23 1 15 6 Lack of knowledge Lack of Guidance Lack of Fund Availability Lack of Risk taking Ability What are the reason of lose at this market LACK OF RISK TAHING ABILITY 13% LACK OF KNOWLEDGE LACK OF GUIDENCE FROM BROKER LACK OF FUND AVAILABILTY 34% LACK OF GUIDENCE FROM BROKER 2% LACK OF KNOWLEDGE 51% LACK OF FUND AVAILABILTY LACK OF RISK TAHING ABILITY The reason for lose in this market is to lack of knowledge.

153 . you will take time to able to devote for learning derrivative & commodity Option ½ Hour 1 Hour 2 Hour No. 27 23 5 How much you will take time to able to devote for learning derrivative & commodity 2 HOUR 11% 1/2 HOUR 1 HOUR 29% 1/2 HOUR 60% 1 HOUR 2 HOUR So it can be say that it is easy to learn derivative & commodity because 60% people say they take ½ hour to learn this market. 17.HOW do you take decision to trade in derrivative & commodity TAX CONSULTANT 0% INTERNET 47% INDEPENDENTLY 33% INDEPENDENTLY BROKER/AGENT NEWS CHANNEL NEWS PAPER BROKER/AGENT 5% NEWS CHANNEL 11% INTERNET TAX CONSULTANT NEWS PAPER 4% Mostly people take decision in derivative & commodity independently or through internet.

Chapter 11 Conclusion 154 .18. Medium reliable for individual for trading Stock Broking Companies Franchisees Online 18 4 23 Which medium is most reliable for trading in derrivative & commodity STOCK BROKING COMPANY 40% ONLINE 51% STOCK BROKING COMPANY FRANCHISES ONLINE FRANCHISES 9% It can be seen that mostly people use online way to trade in derivative & commodity.

as it is very much applicable in the Indian Stock Market. Derivatives Instruments are the tools to be with.The Indian stock market witnesses both the good as well as the bad time. 155 . the objective of the study is accomplished and I recommend that one should use the Derivative & Commodity Instruments. Derivative & Commodity Instruments are a very good tool that will help us to minimize our risk and maximize our returns so that one can have conviction in his portfolio in the hugely volatile stock market Finally. Most of the people keep them away from bad times that lead to low liquidity in the markets. But for the rest who want to remain in the markets without loosing much of their capital and take leverage of the market movements in both north and south directions. to earn profits in any market direction.e. Therefore. I came to a conclusion that these instruments are the best ones to turn the bad time into a good one i. By studying and applying various Derivative & Commodity Instruments like Futures. Forwards and Option strategies .

Chapter 8 Suggestions and Recommendations SUGGESTIONS AND RECOMMENDATIONS 156 .

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Chapter 9

The Reference Materials

THE REFERENCE MATERIALS
GLOSSARY

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

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

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

On the ex-dividend date. the previous day's closing price is reduced by the amount of the dividend because purchasers of the stock on the ex-dividend date will not receive the dividend payment. The demand of the owner of a call option that the number of units of the underlying specified in the contract be delivered to him at the specified price. FLEXIBLE EXCHANGE OPTIONS (FLEX): Customized equity and equity index options. The user can specify. FILL: When an order has been completely executed.EQUITY OPTION: An option on shares of an individual common stock. except it is "killed" immediately if it cannot be completely executed as soon as it is announced. The demand by the owner of a put option contract that the number of units of the underlying asset specified be bought from him at the specified price. Examples include Bermuda options (somewhere between American and European type. and sometimes unique. Similar to an all-or-none (AON) order. and settlement 162 . Unlike an AON order. EXCHANGE TRADED: The generic term used to describe futures. EXOTIC OPTIONS: Various over-the-counter options whose terms are very specific. FILL OR KILL (FOK) ORDER: This means do it now if the option (or stock) is available in the crowd or from the specialist. EX-DIVIDEND DATE: The day before which an investor must have purchased the stock in order to receive the dividend. Also known as a stock option. the terms of the options. it is described as filled. the FOK order cannot be used as part of a GTC order. otherwise kill the order altogether. options and other derivative instruments that are traded on an organized exchange. such as exrcise price. EUROPEAN STYLE OPTION: An option that can only be exercised on the expiration date of the contract. this option can be exercised only on certain dates) and look-back options (whose strike price is set at the option's expiration date and varies depending on the level reached by the underlying security). within certain limits. exercise type. expiration date. EXERCISE: The act by which the holder of an option takes up his rights to buy or sell the underlying at the strike price.

calculation. Can only be traded in a minimum size. See box spread and strangle. To differentiate between these two strangles. HAIRCUT: Similar to margin required of public customers this term refers to the equity required of floor traders on equity option exchanges. FOLLOW-UP ACTION: Term used to describe the trades an investor makes subsequent to implementing a strategy. FRONT MONTH: The first month of those listed by an exchange . A box spread can be viewed as the combination of an in-the-money strangle and an out-of-the-money strangle. FRONTRUNNING: An illegal securities transaction based on prior nonpublic knowledge of a forthcoming transaction that will affect the price of a stock. Example: an owner of common stock buys a put option to hedge against a possible stock price decline. Generally. GUTS: The purchase (or sale) of both an in-the-money call and in-the-money put. the term guts refer to the in-the-money strangle. ILLIQUID: An illiquid market is one that cannot be easily traded without even relatively small orders tending to have a disproportionate impact on prices. but liquidity will move from this to the second month contract as the front month nears expiration. IMMEDIATE-OR-CANCEL (IOC) ORDER: An option order that gives the trading floor an opportunity to partially or totally execute an order with any remaining balance immediately cancelled. which makes FLEX an institutional product. Through these adjustments. one of the advantages of being a floor trader is that the haircut is less than margin requirements for public customers.this is usually the most actively traded contract. This is usually due to a low volume of transactions and/or a small number of participants. 163 . HEDGE: A position established with the specific intent of protecting an existing position. the investor transforms one strategy into a different one in response to price changes in the underlying. Also known as the NEAR MONTH.

Instead of utilizing a "spread order" to insure that both the written and the purchased options are filled simultaneously. To buy on margin refers to borrowing part of the purchase price of a security from a brokerage firm. LEVERAGE: A means of increasing return or worth without increasing investment.INDEX: The compilation of stocks and their prices into a single number. always with January expirations. the amount by which it is in-the-money). also known as long-dated options. INDEX OPTION: An option that has an index as the underlying. These are usually cash-settled. LEGGING: Term used to describe a risky method of implementing or closing out a spread strategy one side ("leg") at a time. The BSE SENSEX / S&P CNX NSE NIFTY. INTRINSIC VALUE: Amount of any favorable difference between the strike price of an option and the current price of the underlying (i. or greater than the price of the underlying for a put option. MARKET BASKET: A group of common stocks whose price movement is expected to closely correlate with an index. Currently. Using borrowed funds to increase one's investment return. 164 . In other words.g. Some indexes also have LEAPs. Only about 10% of equities have LEAPs.e. E. Calls and puts with expiration as long as 2-5 years. MARGIN: The minimum equity required to support an investment position. equity LEAPS have two series at any time. an investor gambles a better deal can be obtained on the price of the spread by implementing it as two separate orders. The intrinsic value of an out-of-the-money option is zero.. the option has an intrinsic value greater than zero. MARK TO MARKET: The revaluation of a position at its current market price. for example buying stocks on margin. LEAPS: Long-term Equity Anticipation Securities. Option contracts are leveraged as they provide the prospect of a high return with little investment. IN-THE-MONEY (ITM): Term used when the strike price of an option is less than the price of the underlying for a call option.

It must be remembered that this is a subjective evaluation. OCC issues and guarantees all option contracts. Can be placed as a day or GTC order.or constantly in the case of some screen based markets . This means when the strike price of a call is greater than the price of the underlying. OPTION CHAIN: A list of the options available for a given underlying. or the strike price of a put is less than the price of the underlying. OVERVALUED: An adjective used to describe an option that is trading at a price higher that its theoretical value. OCC is an intermediary between option buyers and sellers. The loss potential of naked strategies can be virtually unlimited. only time value. ONE-CANCELS-THE-OTHER (OCO) ORDER: Type of order which treats two or more option orders as a package. An out-of-the-money option has no intrinsic value. whereby the execution of any one of the orders causes all the orders to be reduced by the same amount.during normal market hours. NET MARGIN REQUIREMENT: The equity required in a margin account to support an option position after deducting the premium received from sold options.MARKET MAKER: A trader or institution that plays a leading role in a market by being prepared to quote a two way price (Bid and Ask) on request . because theoretical value depends on one subjective input . 165 . OPTIONS CLEARING CORPORATION (OCC): A corporation owned by the exchanges that trade listed stock options. OUT-OF-THE-MONEY (OTM): An out-of-the-money option is one whose strike price is unfavorable in comparison to the current price of the underlying. NAKED: An investment in which options sold short are not matched with a long position in either the underlying or another option of the same type that expires at the same time or later than the options sold. NEUTRAL: An adjective describing the belief that a stock or the market in general will neither rise nor decline significantly.the volatility estimate.

SETTLEMENT PRICE: The official price at the end of a trading session. This is a fixed price per unit and is specified in the option contract.PARITY: An adjective used to describe the difference between the stock price and the strike price of an in-the-money option. See mark-to-market. PUT/CALL RATIO: This ratio is used by many as a leading indicator. REALIZED GAINS AND LOSSES: The profit or losses received or paid when a closing transaction is made and matched together with an opening transaction. and profit from moment to moment price movements. ROLLOVER: Moving a position from one expiration date to another further into the future. such as biotechnology or small capitalization stocks. traders wishing to maintain their positions will often move them to the next contract month. It is computed by dividing the 4-day average of total put VOLUME by the 4-day average of total call VOLUME. it is said to be trading at parity. RATIO CALENDAR COMBINATION: A term used loosely to describe any variation on an investment strategy that involves both puts and calls in unequal quantities and at least two different strike prices and two different expirations. SCALPER: A trader on the floor of an exchange who hopes to buy on the bid price. SECTOR INDICES: Indices that measure the performance of a narrow market segment. and for other purposes. Risk is limited by the very short time duration (usually 10 seconds to 3 minutes) of maintaining any one position. As the front month approaches expiration. STRIKE PRICE: The price at which the holder of an option has the right to buy or sell the underlying. The SEC is the United States federal government agency that regulates the securities industry. This is accomplished by a simultaneous sale of one and purchase of the other. This price is established by The Options Clearing Corporation and is used to determine changes in account equity. 166 . When an option is trading at its intrinsic value. SEC: The Securities and Exchange Commission. margin requirements. sell on the ask price. Also known as striking price or exercise price.

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

. the value of which decreases over time if there is no price fluctuation in the underlying asset. Published by Printice Hall of India. Miller. Dubofsky and Thomas W. The Internal Revenue Service prohibits wash sales since no change in ownership takes place. JR.WASH SALE: When an investor repurchases an asset within 30 days of the sale date and reports the original sale as a tax loss.  168 . Marshall and Vipul K. Financial Engineering: A Complete Guide to Financial Innovation By John F. BIBLIOGRAPHY Books:  Derivatives: Valuation and Risk Management By David A. WASTING ASSET: An investment with a finite life. Bansal. Published by Oxford University Press.

com 169 .sebi.gov.com www.investors.economictimes.com www.com www.com www.com www.in www.nseindia.investopedia.moneycontrol.bseindia.Newspapers:  The Times of India The Economic Times Internet:        www.

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