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J WINGS MANIFEST WEALTH

A PROJECT REPORT
ON

FUNDAMENTALS AND TECHNICAL ANALYSIS OF


EQUITY DERIVATIVES

BY
SREELEKHA BABYSANKAR
17BSPHH01C1100

AT
J WINGS MANIFEST WEALTH

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J WINGS MANIFEST WEALTH

A PROJECT REPORT
ON

FUNDAMENTALS AND TECHNICAL ANALYSIS OF


EQUITY DERIVATIVES

BY
SREELEKHA BABYSANKAR
17BSPHH01C1100
IBS HYDERABAD
AT
J WINGS MANIFEST WEALTH
A REPORT SUBMITTED IN PARTIAL FULFILLMENT OF THE
REQUIREMENTS OF MBA PROGRAM OF
IBS HYDERABAD

DISTRIBUTION LIST:
FACULTY GUIDE COMPANY GUIDE
PROF. DR D SREENIVASACHARY MR GOPALA KRISHNA

DATE OF SUBMISSION
9th MAY 2018

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TABLE OF CONTENTS
SL NO. TITLE PAGE NO.

1 Authorization 6
2 Acknowledgement 7
3 Abstract 8
4 1.Introduction 10
5 1.1 About The Company 10
6 2 About The Project 10
7 2.1 Objectives 10
8 2.2 Methodology 11
9 2.3 Limitations 11
10 3. Forex Market 12
11 4 Indian Derivatives 12
12 4.1 History 13
13 4.2 Exchange Traded Markets 14
14 4.3 Over The Counter Markets 15
15 4.4 Financial Derivatives 15
16 4.5 Equity Derivatives 16
17 4.6 Commodity Derivatives 16
18 4.7 Participants In Derivative Market 17
19 4.8 Derivative Instruments 18
20 5. Forwards Contract 19
21 5.1 Pay Offs From Forward Contracts 21
22 5.2 Limitation Of Forward Contracts 21
23 6. Options Contract 22
24 6.1 Options Terminology 23
25 7. Futures Contract 26
26 7.1 Features Of Futures Contract 26
27 7.2 Futures Terminology 27
28 7.3 Kinds Of Transactions In Futures Contract 28
29 7.4 Currency Futures 29
30 7.5 Speculation Using Futures 30

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SL NO TOPIC PAGE NO.
31 7.6 Operation Of Margin Account 31
32 7.7 Leverage 33
33 7.8 Pay Off Structure 35
34 7.9 Hedging With Futures 37
35 7.10 Open Interest 40
36 7.11 Delivery 41
37 7.12 Cash Settlement 42
38 8. Technical Analysis 43
39 8.1 Japanese Candle Sticks 44
40 8.2 Single Candle Stick Patterns 44
41 8.2.1 Marubozu 45
42 8.2.2 Spinning Top 45
43 8.2.3 Doji 46
44 8.2.4 Hammer 47
45 8.2.5 Hanging Man 48
46 8.2.6 Inverted Hammer 49
47 8.2.7 Shooting Star 50
48 8.3 Multiple Candle Stick Patterns 51
49 8.3.1 Engulfing Pattern 51
50 8.3.2 Piercing Pattern 51
51 8.3.3 Dark Cloud Cover Pattern 52
52 8.3.4 Harami Pattern 53
53 8.4 Triple Candle Stick Patterns 54
54 8.4.1 The Evening Star 54
55 8.4.2 The Morning Star 55
56 9. Technical Indicators 56
57 9.1 Relative Strength Index 57
58 9.2 Moving Averages 60
59 9.3 Fibonacci Retracement 61
60 9.4 Stochastic Oscillator 62
61 9.5 Bollinger Bands 65
62 10 Limitations 69
63 11 Conclusion 70
64 12. Reference 71

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LIST OF FIGURES

SL. NO TOPIC PAGE


NO.
Fig 1 Market Participants 17
Fig 2 Pay Off From Forwards 21
Fig 3 Option Chain 23
Fig 4 Stock Options 25
Fig 5 Stock Futures 29
Fig 6 Long Futures 36
Fig7 Short Futures 37
Fig 8 Hedging With Futures 38
Fig 9 Open Interest 40
Fig 10 Technical Analysis 43
Fig 11 Marubozu 45
Fig 12 Spinning Top 45
Fig 13 Doji 46
Fig 14 Paper Umbrella 47
Fig 15 Hammer 48
Fig 16 Hanging Man 48
Fig 17 Inverted Hammer 49
Fig 18 Shooting Star 50
Fig 19 Engulfing Pattern 51
Fig 20 Piercing Pattern 52
Fig 21 Dark Cloud Cover Pattern 52
Fig 22 Harami Pattern 53
Fig 23 Evening Star 54
Fig 24 Morning Star 55
Fig 25 Triple Candle Stick Pattern 56
Fig 26 Technical Indicators 57
Fig 27 Relative Strength Index 58
Fig 28 Relative Strength Index 59
Fig 29 Moving Averages 61
Fig 30 Fibonacci Retracement 62
Fig 31 Stochastic Oscillator 63
Fig 32 Bollinger Bands 65
Fig 33 W Bottoms 66
Fig 34 M Tops 67
Fig 35 Walking The Band Signal 68

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AUTHORIZATION

I, Sreelekha B hereby declare that the project entitled “STUDY ON THE FUNDAMENTALS
AND TECHNICAL ANALYSIS OF EQUITY DERIVATIVES” has been prepared under the
guidance of Dr D Sreenivasachary, Professor , ICFAI Business School, Hyderabad in partial
fulfillment of the requirement for the fulfillment of MBA Program (2017-19) of IBS Hyderabad.

I also declare that this is a bona fide record of research work done by me during the course of our
study and no part of it has been submitted for any other degree, fellowship or other similar title of
recognition.

SREELEKHA B
17BSPHH01C1100
MBA(2017-2019)

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ACKNOWLEDGEMENT

The journey of Summer Internship On a rare topic which is “A Study on the Fundamentals of
Indian Derivatives market with special focus on Equity derivatives” for the last one and half
Months sounds very interesting. This of course would not have been possible without the support
and guidance of certain people.

To start with, I would like to thank J wings Manifest Wealth for providing me the chance to
undertake this internship study and allowing me to explore the areas of derivative market and
forex market which will greatly add to my experience in the field of finance.

I express my gratitude to my college guide, Dr. D Sreenivasachary Professor, ICFAI Business


School, Hyderabad, for helping me in each and every stage of this project.

I would also like to thank Rev. Mr. Megesh M, Managing Director of J wings Manifest Wealth
for his valuable guidance throughout the completion of this work. His continuous support and
encouragement was highly instrumental in making this report in its present form.

I would like to express my deep sense of gratitude to Mr Gopala Krishna, Business Head, J
wings Manifest Wealth for his valuable guidance throughout the work. His advice, support and
feedback has helped a lot.

I also appreciate the encouragement and constructive criticism that I have received from my
Friends and family which went long way to make this project a satisfying experience to me.

Above all I thank God Almighty for providing me the right atmosphere and mental strength to
Work and for showering all blessings for the successful execution of this project.

SREELEKHA B
17BSPHH01C1100
MBA (2017-2019)

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ABSTRACT

Briefly speaking the project started on a positive note with a discussion with company mentor on
selection of the topic. After considering various factors like growing fields of financial
instruments, growing demand of various financial options ,global and international investment and
trading trends, future relevance and scope to research and explore more ,I have selected the topic
“A study on the fundamentals and technical analysis of equity derivatives” with special focus on
futures.

An equity derivative is a derivative instrument whose value is derived from underlying assets
based on equity securities. An equity derivative's value will fluctuate with changes in its underlying
asset's equity, which is usually measured by share price. The major types of equity derivatives are
futures and options. A future contract is an agreement between two parties to buy or sell an asset
at a certain time in the future at a certain price. Options are contracts that grant the right, but not
the obligation to buy or sell an underlying asset at a set price on or before a certain date. The right
to buy is call option and the right to sell is put option. Derivatives like futures, options, etc were
introduced for Hedging and Price discovery, instead retail investors are investing in futures
contracts for Speculative purposes mainly because of the fact that these instruments yield high
returns but of course in trade off with high risk.

The research started with the basics of Indian derivatives market, read and learnt about various
derivative instruments, functions, participants and more about equity derivatives. My focus was
mainly on futures and about its operations. Further the research gave more importance on the actual
operation of futures in derivatives market including the formation of the agreement till settlement.
The research also gave focus on forwards and about their working and operations. Understanding
and learning about the fundamentals of options. The main motive was to understand about the
futures market including the operations of currency futures and to predict their price trend by
analyzing the respective underlying asset with the help of technical indicators.

The study also gave large importance to the technical analysis undertaken to predict the market
trend. The technical analysis helps to identify the trading opportunities using actions of market
participants through charts, indicators and patterns. The concept of technical analysis can be used
to analyze any asset class – equities, foreign exchange, commodities etc. The few key assumptions
of technical analysis are market discounts everything, price moves in trends and history tends to
repeat itself. The types of charts used to analyze trade patterns are bar charts, line charts and
Japanese candle stick charts. The Japanese candle stick charts are the most popular and the widely
used charts to analyze any market. In a Japanese candle stick chart, strength is represented by a
bullish candle and weakness by a bearish candle. Some of the widely used indicators are Relative
strength index, Fibonacci retracement, moving averages, stochastic oscillator, Bollinger bands and
pivot point.

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As the company’s focus was more onto forex and stock market trade, they gave training on various
widely used technical indicators namely Relative strength index, moving averages ,Pivot points
and Fibonacci retracement. The study stretched to a different perspective when I started analyzing
the charts of various underlying assets with the help of technical indicators. The research gave
importance to the study of candle stick charts as well. Some great market traders always says,
candle stick charts itself are sufficient enough to predict the market trend.
The project started focusing more on the technical analysis part including learning more about
Japanese candle stick charts and various technical indicators. The study also involved comparing
the various strategies of technical indicators .However no one indicator is completely reliable in
market, every indicator has its own pros and cons. Till now the fundamental research on equity
derivatives have been completed along with the understanding of technical analysis and Japanese
candle stick charts. Presently the research is happening on the role of leverage in futures market
and regarding various strategies of technical indicators. Finally the focus would be to understand
the various risks and rewards related to trading on equity derivatives mostly on futures.
Trading in futures market and forex market are highly risky and thus highly profitable as well. The
traders must keep stop losses for every trade in order to limit their losses .It’s always better to
develop a trading plan and make sure it’s followed. Only trade when you feel it’s the right moment
to execute a trade and never trade to compensate for your losses that may end up in a huge failure.
If one is not ready to take small losses, he/she will have to bear mother of losses. There are various
demo accounts available for forex and futures trading .People can try out their new strategies in
these demo accounts and track the effectiveness of their trades.

The whole idea of the project is to learn and understand about futures market and forex market in
detail along with technical analysis, with the help of candle stick charts and indicators. The project
explains about forwards, futures, currency futures and about the various technical indicators used
to predict the trend in the market. Futures are highly leveraged and risky products that can
create lots of wealth if used properly or else it can be a weapon of mass destruction as well.
Forex Derivatives were introduced to eliminate Cross Currency risk or Translational Risk.
Institutions having currency risk can hedge their positions by entering into forex futures.
The research has also focused on the relevance of margin account, role of leverage and hedging
with futures. The research has made use of only secondary data, from various websites, books and
journals.

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INTRODUCTION

1. ABOUT THE COMPANY

J wings manifest wealth is a financial services and trading company which is mainly into stock
market and forex trading. They provide training services and various financial advisory services
as well. J wings is also into health Insurance and investment planning services .The company has
vast experience and comprehensive understanding in the field of forex trade and technical analysis.
The company offers trading through an online trading platform, under this online trading platform
investors are able to trade through various platforms such as web based terminal, mobile based
trading as well as app based trading. These online platforms enable the investors to trade in forex
market. They update the investors with the market trends and notify them on various fundamental
news regarding various currency pairs. Their office is situated at Horamavu, Bangalore, Karnataka.

2. ABOUT THE PROJECT

2.1 OBJECTIVES

o Understanding the concept of Indian Derivatives market


o To learn more about different derivative instruments and it’s functioning from
formation of the agreement till settlement with special focus on futures.
o To understand and examine the role of leverage and importance of margin account in
futures market
o To learn about the pay off structure and about the various risks and rewards related to
equity derivatives
o To study the technical analysis and critically examine the working of futures in
derivatives market.
o To learn more about the candle stick charts and various technical indicators to analyse
the underlying assets

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2.2 METHODOLOGY:

The present study is purely an exploratory study, dependent on the secondary sources of
data. Secondary data will be the formal and official references of the researcher which
includes annual reports of various institutions and other publications about derivatives
market and equity derivatives, online portals, relevant literature and facts, statistics and data
available on various books, newspapers, websites etc. This project used descriptive and
explanatory research and secondary research based on secondary data.

Descriptive And Explanatory Research


Descriptive study is a fact finding investigation with an adequate interpretation. It is the simplest
type of research and is more specific. In the given project, complete descriptive research has
been adopted where detailed study of the concept was implemented.

Secondary Data
Secondary research was done to know more about the history and working of equity derivatives
including futures and options. Information from various published sources like reports by
National Stock Exchange (NSE) ,books, research papers , online publication etc was taken

2.3 LIMITATIONS

o Limited time period of three months


o Indian Derivatives is a very wide topic thus its unable to concentrate on all the derivative
instruments in this limited time period
o Many are not willing to invest in futures as they are highly leveraged products that
carries high risk
o Mostly investors are not willing/unable to invest large amounts and are risk averse
o Technical indicators may not be completely reliable all the time.
o People have less knowledge regarding derivatives market

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3. FOREX MARKET
Forex market is also known as currency market , where 36 cross pair currencies are traded .The
major and mostly traded six currency pairs are AUS/USD,EUR/USD, GBP/USD,JPY/USD,
USD/CHF and XAU/USD(GOLD).The mostly traded currencies are dollar 84.9 % , Euro 39.1%
and Yen 19 %. One pip movement in currency is equivalent to 10 dollars , in gold one pip
movement is equivalent to 100 dollars and for silver its 50 dollars. Trading in forex is between
various currency pairs. The first currency in any currency pair is called base currency and the
second currency is called the quote currency. The difference in the ask and bid price gives the
spread amount , which goes to the broker as commission.

The bid price is actually the price at which the market is prepared to buy a specific currency pair
in the forex market .This is the price at which the trader sells the base currency. The ask price is
the price at which the market is prepared to sell a currency pair in the forex market .At this price
the trader buys the base currency.
For example ,if the quote for eur/usd has been given as bid 1.2815 and ask price as 1.2820 usd.
Here the trader can buy a euro for 1.2820 and can go for a short at 1.2815.
A standard lot is 100,000 units of the base currency, a mini lot represents 10,000 units ,a micro lot
represents 1000 units and a nano lot represents 100 units of the base currency. A pending order
allows the trader to set orders that will be activated once the price reaches a level chosen by the
trader. The most important four types of pending orders are buy limit,sell limit, sell stop and buy
stop. A buy limit order is executed when a buy order is placed below the current market price. A
buy stop order is entered at a stop price above the current market price. A sell limit order is a sell
pending order that is placed above the market price. A sell stop order is an order to sell a stock if
its price falls to a certain predetermined amount .

4. INDIAN DERIVATIVES
Derivatives are financial products whose value is determined from one or more underlying assets
in a contractual manner. The underlying asset can be commodities or financial assets. Derivative
markets are working on the basis of spot price and future price. Derivative market functions
according to the agreements between parties to the contract. Major function of Derivative contracts
is risk management. The common underlying assets for derivatives are equity shares, equity
indices, debt market securities, interest rates, foreign exchange and commodities. The major
derivative exchanges in India include the following:

• Bombay stock exchange(BSE)


• National Commodity and Derivatives Exchange (NCDEX)
• National stock exchange(NSE)
• Multi Commodity Exchange(MCX)

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Derivative is a contract or a product whose value is derived from value of some other asset known
as underlying. Derivatives are based on wide range of underlying assets. These include:
• Metals such as Gold, Silver, Aluminum, Copper, Zinc, Nickel, Tin, Lead
• Energy resources such as Oil and Gas, Coal, Electricity
• Agri commodities such as wheat, Sugar, Coffee, Cotton, Pulses and
• Financial assets such as Shares, Bonds and Foreign Exchange.

The factors driving the growth of equity derivatives are:


• Increased volatility in asset prices in financial markets
• Increased integration of national financial markets with the international markets
• Development of more sophisticated risk management tools, providing economic agents
a wider choice of risk management strategies
• Innovations in the derivatives markets

DERIVATIVES: FINANCIAL WEAPON OF MASS DESTRUCTION


4.1 HISTORY

The origin of derivatives can be linked to the need of the farmers to protect their crops against
the fluctuations in the price of their crop. Earlier, from the time of sowing to the time of crop
harvest, farmers always faces uncertainties regarding the price of the commodity, but with the
introduction of derivative products farmers are in a position to hedge their price risk by locking
in asset prices. These happens on the basis of certain simple contracts between two parties one
can be a farmer and other can be a merchant or any other interested person to the contract. With
the help of these agreements the supplier is in a position to earn more when the prices fall down
because of high supply during harvest period.

The merchant or the second party to the contract also benefits from the derivative contracts. The
merchant is assured with the supply of certain commodities on a pre determined date for a
predetermined price. This helps him to secure himself from paying more amounts of cash for a
certain commodity in case of scarcity or low supply. In this way both the parties to the contract
will be benefitted from derivative contracts.

The concept of derivatives can be tied to the formation of Chicago Board of Trade (CBOT) in
1845 by a group of farmers and merchants with an aim to safeguard the interest of participants of
the board by predetermining the price of commodities with the help of lock in price. They setup
the world’s first commodity exchange under the name of CBOT in the year 1848.

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The concept became very successful for hedging and speculating the price changes of various
commodities traded and in 1925, the first future clearing house came into existence.

Derivatives have been associated with a number of high-profile corporate events that shocked the
global financial markets over the past two decades. To some critics, derivatives have played an
important role in the near collapses or bankruptcies of Barings Bank in 1995, Long-term Capital
Management in 1998, Enron in 2001, Lehman Brothers in and American International
Group (AIG) in 2008 sub-prime crisis etc. Warren Buffet even viewed derivatives as time bombs
for the economic system and called them financial weapons of mass destruction. But derivatives,
if properly handled, can bring substantial economic benefits. These instruments help economic
agents to improve their management of market and credit risks. They also foster financial
innovation and market developments, increasing the market resilience to shocks.
Derivatives can be of two types mainly;

➢ Financial Derivatives
➢ Commodity Derivatives

4.2 EXCHANGE TRADED MARKETS

This is the market where individuals trade with standardized contracts that has been approved by
the exchange. People have been trading in derivatives exchanges since a long time. In 1848
Chicago Board of Trade (CBOT) was established to bring farmers and merchants together. Initially
their main duty was to standardize the quantities and qualities of the grains that were traded. Within
a very few years the first futures contract was developed and came to be known as the to arrive
contract. The speculators found trading in contracts as more attractive than trading in grain itself.
In 1919 Chicago Mercantile Exchange(CME) was established followed by various exchanges all
over the world. The CBE and CBOT were later emerged to form the CME group, which also
includes the Newyork mercantile exchange ,the commodity exchange (COMEX) , and the Kansas
city Board of Trade (KCBT).

The Chicago Board of Options Exchange started trading on call option contracts on 16 stocks in
1973 .Options were even traded prior to 1973 but CBOE could create an orderly market with well
defined contracts. Put options started trading on the exchange in 1977. The CBOE now trades
options on over 2500 stocks and many different stock indices. Traditionally derivative exchanges
have been using the open outcry system, wherein the traders physically meeting on the floor of the
exchange, shouting and by using various hand signals to indicate the trades that they would like to
place .This open outcry system has been largely replaced by the electronic trading .Wherein the
user enters the trade with the help of a computer terminal and places their trade online. Electronic
markets makes use of computer programs to initiate trades and has led to a growth in high
frequency and algorithm trading.

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4.3 OVER -THE COUNTER MARKETS

This is not a physical market place but a collection of brokers and dealers, scattered across the
country. The main participants in OTC derivative markets are large financial institutions, banks,
fund managers and corporations. Once an OTC trade has been agreed, the two parties can either
present it to a central counterparty (ccp) or clear the trade bilaterally. A CCP takes up the role of
an exchange clearing house, it stands between two parties to the transaction so that one party do
not have to bear the risk of default from another party. Usually participants in the OTC market
have contacted each other through phone and email or finds a counter party through an interdealer
broker . OTC market is less regulated as the trades take place between qualified and capable
counterparties , who are supposed to take care of their trades. At the same time exchange traded
contracts are highly standardized contracts ,whose prices are determined by the interaction of
buyers and sellers on an anonymous auction platform. The clearing house guarantees settlement
of transactions. The number of derivatives transactions per year in OTC market is smaller
compared to that in exchange traded markets. But the average size of the transactions in OTC
market is much greater.

4.5 FINANCIAL DERIVATIVES

Section 2(ac) of securities contract Regulation Act (SCRA) 1956 defines Derivative as “a contract
which derives its value from the prices, or index of prices of underlying securities. Financial
Derivatives can be defined as financial instruments whose value is based on the performance of
assets such as stocks, bonds, currency exchange rates etc. The growing instability in the financial
markets helped the financial derivatives in gaining prominence after1970. The growing instability
includes the collapse of the Bretton Woods system of fixed exchange rates in 1971 which increased
the demand for hedging against exchange rate risk. The Chicago Mercantile Exchange allowed
trading in currency futures in the following year. Advancements in options pricing research, most
notably the Nobel-prize winning Black-Scholes options pricing model introduced in the year 1997,
provided a new framework for portfolio managers to manage risks. In recent years, the market for
financial derivatives has grown in terms of the variety of instruments available, as well as their
complexity and turnover. Financial derivatives have changed the world of finance through the
creation of innovative ways to understand , measure, and manage risk.

Applications Of Financial Derivatives

a. Management of risk: Risk management is not the elimination of risk but the
management of risk. Financial derivatives provide a powerful tool for limiting risks that
individuals and organizations face in the ordinary conduct of their business. It requires a
thorough understanding of the basic principles that regulate the pricing of financial
derivatives. Proper and effective use of financial derivatives can save cost and can also
increase returns.

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b. Efficiency in trading : Financial derivatives allow for free trading of risk components
and that leads to improving market efficiency. Traders can use a position in one or more
financial derivatives as a substitute for a position in the underlying instruments.

c. The underlying instruments: In many instances, traders find financial derivatives to be a


more attractive instrument than the underlying security. This is mainly because of the
greater amount of liquidity in the market offered by derivatives as well as the lower
transaction costs associated with trading a financial derivative as compared to the costs of
trading the underlying instrument in cash market.

d. Speculation : Financial derivatives are considered to be highly risky .If not used properly
these can lead to huge financial destruction. But these are powerful instruments for
knowledgeable traders to expose themselves to calculated and well understood risks for
high returns.

e. Price Stabilization function : Derivative market helps to keep a stabilizing influence on


spot prices by reducing the short-term fluctuations.

4.6 EQUITY DERIVATIVES

An equity derivative is a derivative instrument whose value is derived from underlying assets
based on equity securities. An equity derivative's value will fluctuate with changes in its underlying
asset's equity, which is usually measured by share prices in the spot market. The major types of
equity derivatives are forwards, futures and options. A forward contract is a contractual agreement
between two parties to buy and sell asset at a certain time in future , at a price decided on the date
of the contract .A future contract is an agreement between two parties to buy or sell an asset at a
certain time in the future at a certain price. Options are contracts that grant the right, but not the
obligation to buy or sell an underlying asset at a set price on or before a certain date. The right to
buy is call option and the right to sell is put option.

4.7 COMMODITY DERIVATIVES

Derivative contracts where underlying assets are commodities are called as commodity
derivatives. These underlying assets can include precious metals (gold, silver, platinum), agro
products (coffee, wheat, pepper, cotton), energy products ( crude oil, heating oil, natural gas) etc.
They help in future price discovery of underlying commodities. Here the trade is routed through
certain organized mechanisms. The major focus is that presently farmers are deciding the
commodity to be cultivated for next year is based on the price of the commodity in current year.
Ideally this decision should be based on next year’s expected price. This can be obtained with the
help of the price discovery mechanism of commodity market.

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4.8 PARTICIPANTS IN A DERIVATIVE MARKET

The following are the participants in a derivative market;

Fig 1

PARTICIPANTS

HEDGERS SPECULATORS ARBITRAGERS

▪ Hedgers

Hedgers face the risk associated with price of an asset. They use the futures or
options market to reduce or eliminate the risk. Derivative market with the help of
various instruments will transfer risk from person who have them but may not like
them to those who are ready to take it.

▪ Speculators
Speculators are people who bet on the future movement of the price of an asset.
Instruments like futures and options give them more leverage because by keeping a
small amount of money upfront, they can take large positions in the market. Because
of this leverage they increase the potential for large profits and large gains.

▪ Arbitragers
Arbitragers works on the principle of taking the advantage of variations or
discrepancy in prices across markets. They usually take offsetting positions in two
different markets to lock in the profits. It happens when a trader purchases an asset
cheaply in one location and simultaneously arranges to sell it at a higher price in
another location.

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4.9 DERIVATIVE INSTRUMENTS

▪ Forwards
Forward contracts are agreement between two parties who are agreed to buy/sell the
underlying at a future date at today’s predetermined price. Forward contracts are not
regulated by exchange and because of that they take place over the counter. There
are no formal rules for market stability, integrity and for safeguarding the interest of
market participants in these instruments.

▪ Futures
Future contracts are agreements between two parties to buy or sell some underlying
assets at a future date at today’s future price. They are exchange regulated and hence
over the counter transaction is not allowed. Futures are standardized exchange
traded contracts.

▪ Options
There are mainly two types of options;
❖ Call option: A call option gives the buyer the right not the obligation to buy
a given quantity of underlying asset at a given price on or before the due
date.

❖ Put option: A put option gives the seller the right not the obligation to sell a
given quantity of underlying asset at a given price on or before the due date.

▪ Warrants
Option contracts generally have a life time of maximum twelve months. Most of
the option agreements are for nine months. Option contracts which are traded for
more than nine months are called warrants.

▪ Baskets:
Baskets options are options on portfolio of underlying assets. The underlying asset
will be the weighted average of the assets in the basket. Equity index options are a
form of basket options.

▪ Swaps:
Swaps are agreements between two parties to exchange cash flows in the future
according to some prearranged formula. There are mainly two types of swaps
namely interest rate swaps and currency swaps.
• Interest rate swaps : These entail swapping only the interest related cash
flows between the parties in the same currency.

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• Currency swaps: These entail swapping both principal and interest


between the parties, with the cash flows in one direction being in a
different currency than those in the opposite direction

SIGNIFICANCE OF DERIVATIVES

Like other segments of Financial Market, Derivatives Market serves following specific
functions:
• Derivatives market helps in improving price discovery based on actual valuations and
expectations.
• Derivatives market transfers different risks from those who are exposed to risk but have low
risk appetite to participants with high risk appetite. Like hedgers want to give away the risk
where as traders are willing to take risk.
• Derivatives market helps shift of speculative trades from unorganized market to organized
market. Risk management mechanism provides stability to the financial system.

Various risks faced by the participants in derivatives

Market Participants must understand that derivatives, being leveraged instruments, have risks
like
➢ Counterparty risk (default by counterparty)
➢ Price risk (loss on position because of price move)
➢ Liquidity risk (inability to exit from a position)
➢ Legal or regulatory risk (enforceability of contracts)
➢ Operational risk (fraud, inadequate documentation, improper execution, etc.)

5. FORWARD CONTRACTS

It is an agreement made between two parties to buy / sell an asset on a specific date in the future,
at the conditions decided today. Forwards are widely used in equity, interest rate markets,
commodities & foreign exchange. The exchange happens at a specific price on a specific future
date and the price is fixed by both the parties on the day they enter into contract. All the terms of
the contract like price, quantity and quality of underlying, delivery terms like place, settlement
procedure etc. are decided on the day of entering in contract.

To understand better let’s take an example to understand basic difference between spot market and
forwards?

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Assume on April 9, 2018 you wanted to purchase gold from a goldsmith. The market price for
Gold on April 9, 2018 was Rs. 14,425 for 20 gram and goldsmith agrees to sell you gold at market
price. You paid him Rs.14,425 for 20 gram of gold and took gold. This is a cash market transaction
at a price (in this case Rs.14,425) referred to as spot price. Now suppose you do not want to buy
gold on April 9, 2018, but only after 1 month. Goldsmith quotes you Rs.14,450 for 20 grams of
gold. You agree to the forward price for 20 grams of gold and go away. Here, in this example, you
have bought forward or you are long forward, whereas the goldsmith has sold forwards or short
forwards.

There is no exchange of money or gold at this point of time. After 30 days, you come back to the
goldsmith pay him Rs. 14,450 and collect your gold.

This is a forward contract, where both the parties are obliged to go with the contract irrespective
of the value of the underlying asset (in this case gold) at the point of delivery.

Essential features of a forward are:


• It is a bilateral contract.
• All terms of the contract like price, quantity and quality of underlying, delivery terms like
place, settlement procedure etc. are decided on the day of entering in contract.

In other words, Forwards are bilateral over-the-counter (OTC) transactions where the terms of the
contract, such as price, quantity, quality, time and place are negotiated between two parties to the
contract. Any changes in the terms of the contract are possible only if both the parties agree to it.
Corporations, traders and investing institutions extensively use OTC transactions to meet their
specific requirements. The main objective of entering into a forward is to cap the price and
subsequently avoid the price risk. Thus, by entering into forwards, one is assured of the price at
which one can buy/sell an underlying asset. In the above-mentioned example, if on May 9, 2018
the gold trades at Rs. 16,500 in the cash market, the forward contract becomes favourable to you
because you can then purchase gold at Rs. 14,450 under the contract and sell in cash market at
Rs. 16,500 i.e. net profit of Rs.2050. Similarly, if the spot price is 13,390 then you incur loss of
Rs. 60 (buy price – sell price).

Forward contracts on foreign exchange are also very popular. Most large banks employ both spot
and forward foreign exchange traders. Forward contracts are highly used to hedge foreign currency
risk .Let’s say, if you are planning to place a trade between GBP( great Britain pound) and USD.
Here GBP is the base currency and USD is the quote currency .Lets consider the spot and forward
quotes for the USD/GBP exchange rate on May 6 2018 as follows. On spot market ,the bid price
was 1.5541 and offer price was 1.5545. For three months forward the bid price is 1.5533 and offer
price is 1.5538. Suppose on May 6 2018 ,the US corporation is liable to pay Euro 10 million in 3
months (august 6) .The corporation will agree to buy euro 10 million 3 months forward at an
exchange rate of 1.5538. The corporation now has a long forward contract on GBP and it has
agreed to buy the sum from the bank for 1.5538 million. Thus the bank now has a short forward
contract on GBP.

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5.1 PAYOFFS FROM FORWARD CONTRACTS

The payoffs can be positive or negative. This gives a better idea about the trader’s total loss and
gain. The payoff from a long position in a forward contract on one unit of an asset is denoted as
Pt-K . Where as the payoff from a short position in a forward contract on one unit is denoted as
K-Pt. where K is the delivery price and Pt denotes the price of asset at contract maturity.

In the above example , the contract obligates the corporation to buy euro 10 million for 1553800
dollars. If the spot exchange rate rose to 1.6000 , the corporation earns a profit of 46200 dollars.
At the same time if the spot exchange rate fell to 1.5000 at the end of 3 months , the forward
contract would give a loss of 53800.This would lead to the corporation paying 53800 more than
the market price.

Fig 2

5.2 MAJOR LIMITATIONS OF FORWARD CONTRACT

Liquidity risk:
As forwards are highly customized contracts i.e. the terms of the contract are according to the
specific requirements of the parties, other market participants may not be interested in these
contracts. The investment bank has to find a person who has an opposite view. The investment
bank does this for a fee.

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Counterparty risk:
Counterparty risk is the risk of an economic loss from the failure of counterparty to fulfil its
contractual obligation.This happens when the counterparty defaults. This is also called as default
risk or counterparty risk.

Regulatory Risk :
The forwards contract agreement is executed by a mutual consent of the parties involved and there
is no regulatory authority governing the agreement .This may increase the incentive to default.

Rigidity:
The rigidity of forward agreement is that they cannot foreclose the agreement halfway through.
Future contracts were then designed to reduce the risk of forward agreements.

6. OPTIONS CONTRACT
Options are traded in the Indian markets for over 15 years, but the real liquidity was available only
since 2006.An option is a tool for protecting your position and reducing risk. An option is a
contract that gives the right but not an obligation, to trade the underlying asset on or before a stated
date/day , at a stated price ,for a price. The party taking a long position i.e entering the option is
called buyer/holder of the option and the party taking a short position i.e selling the option is called
the seller/writer of the option.

A buyer of the call option has the right and the seller has an obligation to make delivery .The
option buyer has the right but not the obligation with regards to buying or selling the underlying
asset, while the option writer has the obligation in the contract.Therefore, option buyer/ holder will
exercise his option only when the situation is favourable to him, but, when he decides to exercise,
option writer would be legally bound to honour the contract. Options may be categorized into two
main types:-

Call Options: Options, which gives buyer a right to buy the underlying asset
Put Options: Options which gives buyer a right to sell the underlying asset

At the time of agreement the option buyer pays a certain amount to the option seller ,this is called
the premium amount. The agreement happens at a pre specified price called the strike price.The
option buyer benefits only if the price of the asset increases higher than the strike price. If the asset
price stays at or below the strike price ,the buyer does not benefit and thus its always advisable to
buy options when you really expect the prices would increase. Options are cash settled in India.
Similar to futures contract, options contract also have an expiry. They expire on the last Thursday
of every month. Option contracts have different expires- the current month, mid month and far
month contracts.

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Buy a put option when you are bearish about the prospects of the underlying and when you are
bullish on the underlying one can either buy a call option or sell a put option. The maximum loss
the buyer of a call option experiences is to the extend of the premium paid. The loss is experienced
as long as the spot price is below the strike price. The call option buyer has the potential to make
unlimited profits provided the spot price moves higher than the strike price.The point at which the
call option buyer completely recovers the premium he has paid that is called the breakeven point.
The call option buyer truly starts making a profit only beyond the break even point. Selling a put
option required you to deposit a margin. When you sell a put option your profit is limited to the
extend of the premium you receive and your loss can potentially be unlimited.

Fig 3

6.1 OPTIONS TERMINOLOGY

a) Index option: Options having index such as Nifty, Sensex, etc. as an underlying asset.

b) Stock option: These options have individual stocks as the underlying asset. For example,
option on ONGC, NTPC etc.

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c) Buyer: Option Buyer is the one who has a right but not the obligation in the contract. For
owning this right, he pays a price to the seller of this right called ‘option premium’.

d) Writer: Option writer is one who receives the option’s premium and is thereby obliged to
sell/buy the asset if the buyer of option exercises his right.

e) Option price/Premium: It is the price which the option buyer pays to the option seller. In
the above screenshot of nifty option, the premium amount is 1207.95.

f) Lot size: Lot size is the number of units of underlying asset in a contract. Lot size of Nifty
option contracts is 50.

g) Expiry Day: It is the day on which a derivative contract expires. It is the last trading
date/day of the contract. In our example, the expiration day of contracts is the last Thursday
of every month i.e. for current month options will expire on 26 April, 2018.

h) Spot price (S): 10404.50 is the spot price for nifty here in the above example. It is the
price at which the underlying asset is traded at the spot market.

i) Strike price or Exercise price (X): strike price for 9200 Call option is 9200. It is the price
per share for which the underlying security may be purchased or sold by the option holder.

j) In the money (ITM) option: This option would give holder a positive cash flow, if it
were exercised immediately. A call option is said to be ITM, when spot price is higher than
strike price. And, a put option is said to be ITM when spot price is lower than strike price.

k) At the money (ATM) option: At the money option would lead to zero cash flow, if it were
exercised immediately. Therefore, for both call and put ATM options, strike price is equal
to spot price.

l) Out of the money (OTM) option: In other words, this option would give the holder a
negative cash flow if it were exercised immediately. A call option is said to be OTM, when
spot price is lower than strike price. And a put option is said to be OTM when spot price is
higher than strike price.

m) Intrinsic value: Option premium, defined above, consists of two components - intrinsic
value and time value. For an option, intrinsic value refers to the amount by which option
is in the money i.e. the amount an option buyer will realize, before adjusting for premium
paid, if he exercises the option instantly.

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n) Time value: It is the difference between premium and intrinsic value, if any, of an option.
ATM and OTM options will have only time value because the intrinsic value of such
options is zero.

o) Open Interest: As discussed in futures section, open interest is the total number of option
contracts outstanding for an underlying asset. For example 9200 CE has an open interest
of 68475.

The table below shows the list of stock options registered under national stock exchange. The table
also contains the respective underlying asset, expiry date , strike price and also data on open, high,
low, prev close and last price.

Fig 4

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7. FUTURES CONTRACT
Futures markets were innovated to overcome the limitations of forwards. A futures contract is an
agreement made through an organized exchange to buy or sell a fixed amount of a commodity or
a financial asset on a future date at an agreed price. Simply, futures are standardized forward
contracts that are traded on an exchange. The clearinghouse associated with the exchange
guarantees settlement of these trades. A trader, who buys futures contract, takes a long position
and the one, who sells futures, takes a short position. The words buy and sell are figurative only
because no money or underlying asset changes hand, between buyer and seller, when the deal is
signed. Mostly future contracts are cash settled thus there is no worry of moving the asset from
one place to another and there is total transparency in the cash settlement.

The futures agreement inherits the transactional structure of the forwards contract. A futures
agreement derives its value from its corresponding underlying asset in the spot market. For
example TCS futures derives its value from the underlying in the TCS share market. These are
highly standardized contracts whose variables are predetermined- lot size and expiry date.
a) To enter into a futures agreement one has to deposit a margin amount ,which is a certain
percent of the contract value. Margin allows us to deposit a small amount and take exposure
to a large value transaction and hence leveraging on the transaction.
b) When we transact in a futures contract ,we digitally sign the agreement with the counter
party and thus becomes obliged to honor the contract upon expiry.
c) The futures agreement is then tradable, the trader can hold it till the expiry or trade it in
between. The trader can take a long position if he expects the price to go up and can go for
a short if the prices will go down.
d) Equity futures are always cash settled. Future agreements are called zero sum game
because it allows one to transfer money from one pocket to another.

In the futures market ,all the trades are regulated by the exchange .The exchange in return takes
the burden of guaranteeing the settlement of all the trades. The exchange makes sure that the people
who are entitled to profits receive the same and also they ensure that they collect the money from
the party who is supposed to pay up. They do this by collecting the margins and by marking the
daily profits or losses to the market. The futures market in India is regulated by SEBI securities
and exchange board of India.

7.1 FEATURES OF FUTURES CONTRACT

In futures market, exchange decides all the contract terms of the contract other than price.
Accordingly, futures contracts have following features:
• Contract between two parties through Exchange
• Centralised trading platform i.e. exchange
• Price discovery through free interaction of buyers and sellers

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• Margins are payable by both the parties


• Quality decided today (standardized )
• Quantity decided today (standardized)

7.2 FUTURES TERMINOLOGY

a) Underlying asset: An underlying asset is a financial instrument from which a derivative


derives its value.Underlying assets can be metals ,agricultural commodities ,stock, index
etc. The futures price completely mimics the underlying as when the price of underlying
goes up the price of futures also rises. Likewise when the price of underlying goes down
the future price also comes down.

b) Spot price: This is the price at which the asset trades in the regular market or spot market.It
is the current market price.For example if we are talking about gold as an underlying then
the price of gold in spot market is spot price and gold in futures market is called gold
futures.

c) Future Price: The price at which the asset is traded at futures market.

d) Lot Size : Futures is a standardized contract where everything related to the agreement is
predetermined. Lot size is one such parameter. Lot size specifies the minimum quantity
that you will have to transact in a futures contract. Lot size varies from one asset to another.

e) Contract Value : Futures contracts are traded in lots and to arrive at the contract value we
have to multiply the price with contract multiplier or lot size or contract size. Contract
value = Futures price *Lot size.

f) Margin: Margin amount is a percent of contract value that is paid as a token advance in
the beginning. It is paid for entering into the contract. Margin allows investors to deposit a
small amount of money and take exposure to a large value transaction. This initial margin
includes span margin and exposure margin.

a. At the time of initiating the futures position , margins are blocked in one’s trading
account.
b. The margins that get blocked are called the initial margin.
c. The initial margin is made up of span margin and exposure margin
d. Initial margin will be blocked in your trading account for how many ever days the
trader choose to hold the trade.

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g) Expiry :Future contracts are time bound .The expiry date of the futures contract is the date
upto which the agreement is valid. It is the date till which the one can hold the future
agreement. All derivative contracts in India expire on the last Thursday of the month.

h) Open Interest: Open interest is the total number of open or outstanding (not closed or
delivered) options and/or futures contracts that exist on a given day, delivered on a
particular day. It gives an idea of how many contracts are open and live in the market.

i) Hedging: This is a technique to ensure that your position in the market is not affected by
any adverse movements. When a position is hedged it becomes neutral to the overall
market position and thus this will neither make money nor lose money.

j) Bid and Ask prices :Bid prices are those provided by buyers who want to buy shares or
futures .Ask prices are those quoted by sellers who want to sell shares or futures or other
products at these prices, The difference between the ask and bid price is called as the
spread.

k) Mark To Market (M2M) :Marking to market or mark or market is a simple accounting


procedure which involves adjusting the profit or loss you have made for the day.

7.3 KINDS OF TRANSACTIONS IN FUTURES

• Opening buy means creating a long or buy position ,this happens when the investor believes
that the stock prices would rise
• Opening Sell means creating a Short Position .When we believe that the price of stock is
going to decline ,we opt for a short position.
• Closing Buy means offsetting (fully or partly) an earlier Short Position
• Closing Sell means offsetting (fully or partly) an earlier Long Position
Square off is closing an existing futures position. The square off for a buy open position
would be to sell and the square off for for a sell is to go for a long position.

The table below shows the list of stock futures registered under National Stock Exchange. The
table also contains the respective underlying asset, expiry date , strike price and also data on open,
high, low ,previous close and last price.

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Fig 5

7.4 CURRENCY FUTURES

The future contracts on various currency pairs are knows as currency futures. Currently the future
contracts that are available are : USD/INR, EURO/INR, GBP/INR and JPY/INR. These contracts
are allowed to be traded on NSE and MCX. The contracts are very similar in nature and have to
be cash settled .Some of the contract details are as follows :
The symbols are USDINR ,EURINR, GBPINR and JPYINR , respectively. The underlying asset
here is actually the exchange rate of the respective currencies in Indian rupees; It is the exchange
rate for USD 1 in INR , EURO 1 in INR ,GBP 1 in INR and JPY 100 in INR.One unit of trading
in currency futures denotes USD 1000 and the tick size is INR 0.0025(i.e 0.25 paisa ). The contract
can be traded between 9am and 5:00 pm Monday to Friday .The contract trading cycle is a 12
month trading cycle with the last trading day being two working days prior to the last business
day of the expiry month of the contract at 12:00 noon .

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The final settlement day is the last working day (excluding Saturday ) of the expiry month.The
base price is the theoretical price on the first day of the contract ; for all other days it is the daily
settlement price , which is calculated based on the last half an hour weighted average price.The
final settlement price is the Reserve Bank of India reference rate .Also the contract follows a
“T+2” cycle for the final settlement.

The position limits for trading members are as follows :


➢ For USD/INR contracts , the limit is 15% of the toal open position or USD 50 million
whichever is higher
➢ For EUR/INR contracts ,the limit is 15% of the total open position or Euro 25
million,whichever is higher
➢ For GBP/INR contracts ,the limit is 15% of the total open position or GBP 25 million ,
whichever is higher
➢ For JPY/INR contracts , the limit is 15% of the total open position or JPY 1000 million ,
whichever is higher.

The minimum initial margin is based on SPAN and the extreme loss margin is
• 1% of the mark to market value of all open positions for USD/INR
• 0.3% of the mark to market value of all open positions for EUR/INR
• 0.5% of the mark to market value of all open positions for GBP/INR
• 0.7% of the mark to market value of all open positions for JPY/INR

7.5 SPECULATION USING FUTURES

Speculation is basically the act of trading in an asset that has a significant risk of losing money
with the expectation of making a gain. The speculators wishes to take a position in the market. So
speculators will either bet that the price of the asset will go up or they will bet that the price of the
asset will go down.
Lets consider a US speculator who in march thinks that the British pound will strengthen relative
to the US dollar over the next two months and is planning to invest to the extend of 250000 pounds.
One thing the speculator can do is to purchase 250000 pounds in spot market in the hope that the
sterling can be sold at higher prices in the future market. Another alternative is to take a long
position in four CME May futures contracts on sterling. Each futures contract is worth 62500
pounds.

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Buy 250000 pounds Buy 4 futures contracts


Spot price=1.5470 Future price=1.5410
Investment $386750 $20000
Profit if May spot =1.6000 $13250 $14750
Profit if May spot=1.5000 -$11750 -$10250

The above table gives a picture about the profits and losses made on both the alternatives. If the
rate increases to 1.6000 dollars per pound in May, the futures contract alternative enables the
speculator to realize a profit of (1.6000-1.5410) *250000 = $14750.

The spot market alternative leads to 250000 units of an asset being purchased for $ 1.5470 in
March and sold for $1.6000 in April , so that a profit of ( 1.6000-1.5470 )*250000=$13250 would
be made. At the same time consider a situation where the exchange rate falls to 1.5000 dollars per
pound. The futures contract gives rise to a loss of ( 1.5410-1.5000)*250000= $10250 and the spot
market alternative gives rise to a loss of (1.5470-1.5000) =$11750 .Thus it becomes very evident
from the example that the futures alternative is favourable.The initial investment that was made in
the spot market for buying sterlings were 250000*1.5470=$ 386750 .Whereas the investor just had
to deposit a small sum of amount in the margin account. It was $5000 for one contract and thus
$20000 for four futures contract.

7.6 OPERATION OF MARGIN ACCOUNTS

One of the most important role of exchange is to organize trades , so that contract defaults are
avoided .This is where margin accounts comes into picture. Margin allows us to deposit a small
amount of money and takes exposure to a large value of transaction , thereby helping the trader to
leverage on the transaction. The exchanges set the margin levels and are constantly required to
review the rates as per the market volatility. The margin amounts can go up and down as well. The
forwards market doesn’t have a regulator, but all the trades in futures market are routed through
the exchange. The exchange here in return takes the burden of guaranteeing the settlement of all
the trades. The exchange makes sure that the deserving party receives the amount . They ensure
that they collect the money from the right party who is supposed to pay up.

At the time of initiating a futures position, the margins are blocked in the trading account .The
margins that get blocked is called the initial margin .The initial margin is actually a combination
of the Span margin and exposure margin. Initial margin would be blocked in the trading account
for how many ever days you choose to hold the futures trade .Span margin or maintenance margin
is the minimum requisite margins blocked as per the exchange’s mandate .

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Exposure margin is blocked over and above the span to cushion for any mark to market losses.It
is collected as per the broker’s requirement .Both span and exposure are specified by the exchange.
Span margin is more important as not having this in your account may lead to a penalty in the
exchange .As the volatility rises , the span margin also rises. The moment the cash balance falls
below the maintenance margin , they will call you asking you to pump in more money .In the
absence of which they will force close the positions themselves .This call the broker makes
requesting to pump in money is called the margin call. The margins vary from one underlying to
the another.
To illustrate how margin accounts work , we can consider an investor who contacts his broker to
buy two December gold futures contracts.We can take current future price as 1450 per ounce . As
the contract size is 100 ounces, the investor is required to buy a total of 200 ounces at this price.
The broker will require the investor to deposit funds in a margin account .This fund deposited at
the time of entering into the contract is known as initial margin .Let’s suppose thus us 6000 per
contract and 12000 in total here .At the end of each trading day , the margin account is adjusted to
reflect the investor’s gain or loss .This is known as the daily settlement or marking to market .

Suppose at the end of first day the futures price has dropped by $9 from $1450 to $1441. The
investor here will have a loss of $ 1800 (200*9) , because the gold can now only be sold at $1441.
The balance in the margin account will reduce to 10200 from 12000.A trade is first settled at the
close of the day on which it takes place .It is then settled at the close of trading on each subsequent
day.The investor has the full right to withdraw any balance in the margin account in excess of the
initial margin.

The daily settlement is not just an arrangement between broker and client. Whenever there is a
decrease in futures price , the margin account of an investor with long position would be reduced
by that specific amount. In the example given here $1800 would be reduced from the investor’s
account. The investor’s broker has to pay the exchange clearing house $1800 and this money is
passed on to the broker of an investor with a short position. Similarly when there is an increase in
the futures price ,brokers for parties with short positions pay money to the exchange clearing house
and brokers for parties with long positions receive money from the exchange clearing house.

The exchange ensures that the balance in the margin account never becomes negative with the help
of maintenance margin, which would be somewhat lower than the initial margin. At this point
when the balance in the margin account falls below the maintenance margin , the investor receives
a margin call and is expected to top up the margin account to the initial margin level by the end of
the next day.The extra funds deposited are known as a variation margin .If the investor does not
provide variation margin ,the broker closes out the position. Here in the example , closing out the
position involves selling off 200 ounces of gold for delivery in December.

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The table given below illustrates the operation of margin account for one possible sequence of
futures prices.The maintenance margin is assumed to be $4500 per contract or $9000 in total .On
day 7 the balance in the margin account falls $1020 below the maintenance margin level.This
leads to a margin call and the investor is supposed to add up $4020 to bring the account balance
upto the initial margin level of $12000.The investor here provides this margin by the close of
day 8. The contract is entered into on day 1 at $1450 and closed out on Day 16 at $1426.90.The
margin is the only factor that provides confidence to market participants that others will meet the
obligations on time.

Table 1
Day Trade Settlement Daily Cumulative Margin Margin
Price Price Gain Gain Account Call
Balance
1 1450 12000
1 1441.00 -1800 -1800 10200
2 1438.30 -540 -2340 9660
3 1444.60 1260 -1080 10920
4 1441.30 -660 -1740 10260
5 1440.10 -240 -1980 10020
6 1436.20 -780 -2760 9240
7 1429.90 -1260 -4020 7980 4020
8 1430.80 180 -3840 12180
9 1425.40 -1080 -4920 11100
10 1428.10 540 -4380 11640
11 1411.00 -3420 -7800 8220 3780
12 1411.00 0 -7800 12000
13 1414.30 660 -7140 12660
14 1416.10 360 -6780 13020
15 1423.00 1380 -5400 14400
16 1426.90 780 -4620 15180

7.7 LEVERAGE

Futures are highly leveraged products , this one factor makes futures more appealing and also a
risky venture. Leverage here in futures trading means that the traders here have to pay only a
small amount to the exchange to control a lot of product. The margin amount is only a small
percentage of the contract value .This small amount facilitate the investors to take exposure for a
large value transaction. The higher the leverage, the higher is the risk and the higher is the profit
potential.

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The higher the leverage the higher is the risk .When leverage is high ,only a small movement in
the underlying is required to wipe out the margin deposit
Let’s understand the role of leverage in a better way with the help of an example considering two
situations. Take for example , Mr M plans to buy shares of Infosys in spot market to the extend of
100000 . On 30th April 2018 , the Infosys share is traded at a price of 1168. Thus Mr M can afford
to buy 86 shares of Infosys.
100000/1168 = 86
Now on May 7th , when Infosys is trading at 1300 .Mr M can square off the position for a profit
of 11800 on investing 100000.
86*1300 =111800 ,
The return percentage would be 11800/100000=.1180 or 11.80 %

A return of 11.80 % on a 7 days time is a great thing. Now lets look at another alternative when
Mr M decides to buy Infosys futures of 100000 worth in futures market .The minimum number of
shares that needs to be bought in Infosys is 125 or in multiples of 12 .Thus the contract value is
the lot size multiplies by the futures price .In this case the futures price is 1168 per share , hence
the contract value becomes
125 *1168=146000. Here he doesn’t have to pay the entire contract value instead he only pays the
margin amount and can enter the trade .The margin amount is a certain percent of contract value
and here when we take a 14% , it happens to be 146000 *14%=20440. Thus Mr M can easily take
4 lots of the contract instead of 1 lot .Thus with 4 lots of Infosys futures the number of shares
would be 500 (125*4)- at the cost of 81760.

Futures contract value at the time of buying =Lot size * number of lots *Futures Buy price
=125*4* Rs 1168
=Rs 584000/-
Margin amount – Rs 81760
Futures Sell price = 1300
Futures contract Value at the time of selling = 125 *4*1300 =Rs 650000
Thus a profit of Rs 66000
Hence the return percent becomes [66000/81760] *100 =80.72%

That’s becomes a large amount of profit from Infosys futures .Thus the investor can earn a return
of 80.72% from investing in futures market . The same person could only earn an approx. 12%
return from investing in the spot market of the same security. Thus by virtue of margins,the
investors can take positions much bigger than the actual capital available , this is called
“Leverage”. Its like a double edged sword, if used in the right spirit and knowledge , it can lead to
the creation of wealth or else can even wipe out your account. The higher the leverage ,the higher
is the risk associated with the trade. When you are trading with a high leverage ,only a small move
in the underlying is required to wipe out the margin deposit.

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LEVERAGE CALCULATION

The leverage calculated as follows :

Leverage =Contract value / Margin


Hence for the above Infosys trade the leverage one lot is

146000/20440 =7.14

This means every Re 1 in the trading account can buy upto Rs7.14 worth of Infosys. This is a very
manageable ratio.However if the leverage increases then the risk also increases. At 7.14 times
leverage , Infosys has to fall by 14% for one to lose all the margin amount ,this is calculated as
follows –
=1/7.14
=14%
Now for a moment assume the margin requirement was just Rs 5000 ,instead of 20440 .In this
case the leverage would be
=146000/5000
=29.2 times
This is clearly a very high leverage ratio ,the investor would lose all his capital if Infosys falls by
1/29.2
=3.4%
Here is this case , a 3.4% move in the underlying is enough to wipe out all your margin
deposit.Alternatively , at 29.2 times leverage one just need a 2.4% move in the underlying to
double your money.Thus the higher the leverage ,the higher is the risk. From the above calculations
its evident that , the more the margin the less would be the leverage associated with it .Whereas
when the margin amount is less , the leverage would be high and thus more risky.

7.8 PAY OFF STRUCTURE

The payoff structure plots a graph of the possible price on the day you bought the share versus the
buyer’s profit and loss. In case of a long position -Any price above the buy price results in a profit
an any price below the buy price results in a loss.If the trader has initiated a short position – then
any price below the short price will result in a profit and any price above the short price lead to a
loss.Since the traders here takes place trades in lots , just one point price movement results in a
gain of (1* lot size ) and the same with a one point negative movement. The proportionality comes
from the basic fact that the money made by the buyer is the loss suffered by the seller. The profit
and loss is a smooth straight line thus its called as a linear pay off instrument.

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The pay off for buyers of futures contract is similar to the pay off for a person who holds an asset.
He has a potentially unlimited upside and downside as well. Consider for example the case of a
speculator who buys a two month Nifty Index futures contrtact when the nifty stands at 1220 .The
underlying asset in this case is the nifty portfolio .When the index moves up , the long futures
position starts giving profits and when the index moves down it starts making losses.
The graph below represents the pay off structure for futures during a long position. If SPm is the
spot price on maturity and PP is the purchase price ,then the pay off on a long position per one
unit of the asset is “SPM-PP”.

Fig 6

The payoff for a person who sells a future contract is similar to the payoff for a person who shorts
an asset .For example take the case of a speculator ,who sells a two month Nifty index futures
contract when the nifty stands at 1290 .The underlying asset in this case is the nifty index. When
the index moves down ,the short futures position start making profits and when the index moves
up , it starts making losses.

If SPm is the spot price on maturity and PP is the purchase price ,Then the pay off on a short
position per one unit of the asset is “PP-SPm “ .

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Fig 7

7.9 HEDGING WITH FUTURES

A majority of the investors in futures market are hedgers . Their main motive is to use futures
markets to reduce a particular risk that they face. Hedging position is undertaken by the investors
inorder to eliminate the risk. When an individual or company chooses to use futures market to
hedge a risk , the objective is to take a position that neutralizes the risk as far as possible .

Lets consider an example where an investor takes an hedging position against a single stock.
Imagine if we bought 250 shares of Infosys at 2300 per share .This works out to be an investment
of 575000. Here the investor is long on Infosys shares in the spot market.

After initiating this position , the investor realize that the quarterly results are expected soon.The
investor is worried that Infosys may announce a not so favorable set of numbers , as a result of
which the stock price may decline considerably .To avoid making a loss in the spot market , the
investor decides to hedge the position.

Thus , in order to hedge the position in spot market , the investor here took a short position in the
futures market for 250 shares at a price of 2301 per share.Thus the contract value becomes 575250
and the lot size is 250 . Now on one hand the investor is long on Infosys in spot market and on the
other hand he is short on Infosys on futures market.Thus the investor could create a neutral position
here.

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Arbitrary price Long on spot Short on Futures Net P & L


P&L P&L
2200 2200-2300= -100 2301-2200= 101 -100+101= 1
2400 2400-2300= 100 2301-2400= -99 100-99= 1
2550 2550-2300= 250 2301-2550 = -249 250-249 =1

Fig 8

In the above figure , the investor has taken a long position in the spot market and a short position
in the futures market. The above example neither make money nor lose money , the overall position
is frozen here. In fact the position becomes indifferent to the market , this is why we say when a
position is hedged it stays neutral to the overall market conditions . Hedging can be undertaken by
buying in the spot market and selling in the futures market or else by taking a long position in the
futures market and shorting in the spot market.

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Short hedge

A short hedge is a hedge , which involves a short position in future contracts .A short hedge is
appropriate when the hedger already owns an asset and expects to sell it at some time in the future.
Consider an example , assume that it is May 15 today and that an oil producer has has just
negotiated a contract to sell 1 million barrels of crude oil .It has been agreed that the price that will
apply in the contract is the market price on August 15.The oil producer is therefore in the position
where it will gain $10000 for each 1 cent increase in the price of the oil over the next three months
and lose $ 10000 for each 1 cent decrease in the price during this period . Suppose that on May 15
the spot price is $80 per barrel and the crude oil futures price for august delivery is $79 per barrel,
Because each futures contract is for the delivery of 1000 barrels, the company can hedge its
exposure by shorting 1000 futures contract .If the oil producer closes out its position on August
15, the effect of the strategy should be to lock in a price close to $79 per barrel.
Suppose if the spot price on August 15 proves to be $75 per barrel .The company realizes $75
million for the oil under its sales contract .Because August is the delivery month for the futures
contract , the futures price on August 15 should be very close to the spot price of $75 on that date.
The company therefore gains approximately

$79-$75 = $4 per barrel or $4 million in total from the short futures position. The total amount
realized from both the futures position and the sales contract is therefore approx. $79 per barrel or
$79 million in total. Suppose the price of oil on August 15 proves to be $85 per barrel .The
company realizes $85 per barrel for the oil and loses approximately $85-$79=$6 per barrel. Again
the total amount realized is approximately $79 million .

Long Hedges
Hedges that involve taking a long position in a futures contract are known as long hedges. A long
hedge is appropriate when a company knows it will have to purchase a certain asset in the future
and wants to lock in a price now. Lets consider an example ,assume that it is January 15 now.A
copper fabricator knows it will require 100000 pounds of copper on May 15 to meet a certain
contract .The spot price of copper is 340 cents per pound , and the futures price for may delivery
is 320 cents per pound .The fabricator can hedge its position by taking a long position in four
futures contracts offered by the COMEX division of the CME group and closing its position on
May 15.Each contract is for the delivery of 25000 pounds of copper .The strategy has the effect of
locking in the price of the required copper at close to 320 cents per pound.

Suppose that the spot price of copper on May 15 proves to be 325 cents per pound. Because May
is the delivery month for the futures contract , thus should be very close to the futures price .The
fabricator therefore gains approximately 100000 *( $3.25 -$3.20)= $5000 on the futures contract.

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It pays 100000 *$ 3.25= $ 325000 for the copper ,making the netcost aprroximately $325000-
$5000 = $ 320000. For an alternative outcome , suppose that the spot price is 305 cents per pound
on May 15. The fabricator then loses approximately 100000 *($3.20- $3.05) =$15000.

On the futures contract and pays 100000 * $3.05 = $305000 for the copper .Again , the net cost is
approximately $320000 or 320 cents per pound.

7.10 OPEN INTEREST

The open interest is the total number of open or outstanding contracts on a particular day. It gives
the investors an idea about all the open and live positions in the market.When a buyer is said to be
long on a position and the seller is said to be short on the same contract , then the open interest
becomes one.The open interest helps the investors in knowing about the liquidity in the market.
The more the open interest the more would be the liquidity .Thus it helps the traders to enter and
exit trades at competitive bid/ask rates.

Fig 9

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Just have a look at the above snapshot . As of May 7 2018 , the open interest on nifty futures is
2.38 crores . The change is open interest gives data on the number contracts added on a particular
day .Here a total 244125 contracts have been added or that make up a 1.03% on 2.38 crores.People
gets confused with volumes and open interests . Volumes starts from zero every day whereas open
interest is not discrete like volumes. It gets on increasing and decreasing based on the entry and
exit orders of traders.
When there is an increase in both the price and volume , the market is tend to be bullish.When
both the price and volume are decreasing the traders will will think that the bearish trend could
probably end can expect a reversal. Another situation can be when the price decreases along with
an increase in the volume ,this leads to a bearish trend. The status of open interest can give a sense
of strength between bullish and bearish positions. If there is an abnormally high open interest
backed by a rapid increase or decrease in prices , then the investor has to be cautious as a very
small trigger can lead to a lot of panic in the market. Now lets look at the trader’s perception when
there is a change in the price of the stock and the open interest

Price Open Interest Trader’s Perception


Increase Increase More trades on the long side
Decrease Decrease Longs are covering up their positions ,long unwinding
Decrease Increase More trades on the short side ,bearish
Increase Decrease Shorts are covering their position , short covering

7.11 DELIVERY

A very few futures contracts that are entered into lead to delivery of the underlying asset. Most are
closed out early The period during which delivery can be made is defined by the exchange and
varies from contract to contract .The decision on when to deliver is made by the party with the
short position,whom we can refer here as investor A .When this investor A decided to deliver ,
investor A’s broker issues a notice of intention to deliver to the exchange clearing house. This
notice states how many contracts will be delivered and in the case of commodities ,it also specifies
where delivery will be made and what grade will be delivered. The exchange then chooses a party
with a long position to accept delivery .

Suppose that the party on the other side of investor A’s futures contract when it was entered into
was investor B. It is very important to know that , its not necessary to expect investor B to take the
delivery .Investor B may have closed out his or her position by trading with investor C. Same with
investor C as well , investor C must have closed his or her position by trading with investor D and
so on. The usual rule of the exchange is to pass the notice of intention to deliver on to the party
with the oldest outstanding long position. Parties with long positions must accept delivery

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notices. However, if the notices are transferable ,the long investors have a short period of time ,
usually half an hour , to find another party with a long position that is prepared to take delivery in
place of them.

In case of commodities ,taking delivery usually means accepting a warehouse receipt in return for
immediate payment .The party taking delivery is then responsible for all warehousing costs.In the
case of livestock futures , there may be costs associated with feeding and looking after the animals.
In the case of financial futures, delivery is usually made by wire transfer .For all contracts ,the
price paid is usually the most recent settlement price. If specified by the exchange , this price is
adjusted for grade , location of delivery and so on .The whole delivery procedure from the issuance
of the notice of intention to deliver to the delivery itself generally takes about two to three days.

There are three critical days for a contract .These are the first notice day , the last notice day and
the last trading day.The first notice day is the first day on which a notice of intention to make
delivery can be submitted to the exchange .The lase notice day is the last such day .The last trading
day is generally a few days before the last notice day .To avoid the risk of having to take delivery,
an investor with a long position should close out his or her contracts prior to the first notice day.
A futures contract is referred to by its delivery month .The exchange must specify the precise
period during the month when delivery can be made. For many futures contracts , the delivery
period is the whole month .The delivery months vary from contract to contract and are chosen by
the exchange to meet the needs of market participants. At any given time, contracts trade for the
closest delivery month and a number of subsequent delivery months.

7.12 CASH SETTLEMENT

Mostly all the financial futures are cash settled , such as those on stock indices are settled in cash
because it is inconvenient or impossible to deliver the underlying asset .In the case of futures
contract on the S&P 500 , for example delivering the underlying asset would involve delivering a
portfolio of 500 stocks. When a contract is settled in cash, all outstanding contracts are declared
closed on a predetermined day.The final settlement price is set equal to the spot price of the
underlying asset at either the open or close of trading on that day.

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8. TECHNICAL ANALYSIS
The technical analysis helps to identify the trading opportunities using actions of market
participants through charts, indicators and patterns. The concept of technical analysis can be used
to analyse any asset class – equities, foreign exchange, commodities etc. The few key assumptions
of technical analysis are market discounts everything, price moves in trends and history tends to
repeat itself. The types of charts used to analyse trade patterns are bar charts, line charts and
Japanese candle stick charts. The Japanese candle stick charts are the most popular and the widely
used charts to analyse any market. In a Japanese candle stick chart, strength is represented by a
bullish candle and weakness by a bearish candle. Some of the widely used indicators are Relative
strength index , Fibonacci retracement , moving averages and pivot point. Technical analysis can
be used to analyse various underlying assets to decide on a derivative trade with the help of various
technical indicators. Because the prices of the derivatives and their underlying assets moves in
tandem. Technical analysis facilitates the study and understanding of candle sticks and various
technical indicators.
Fig 10

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8.1 JAPANESE CANDLE STICK CHARTS


The earliest use of candlesticks dates back to the 18th century by a Japanese rice merchant named
Homma Munehisa. Though the candlesticks have been in existence for a long time in Japan, the
western world traders were clueless about it. In 1980’s a trader named Steve Nison accidentally
discovered candle sticks and he introduced this to the rest of the world. He published the book
named “Japanese candlestick charting Techniques” and the candle stick techniques began to gain
popularity in the 90’s. The Japanese candle stick charts are widely used around the world to
conduct technical analysis.
Japanese candle sticks can be used for any time frame including one day , one hour ,30 minutes
etc. The candle sticks are classified into bullish candle and bearish candle. The bullish candle is
mostly represented by green/blue/white and bearish as red/black. They are formed using the high,
low, open and close of the chosen time period. If the close is above the open ,then a hollow/green
candlestick is formed called a bullish candle. If the close is below the open , then a red/ black
candlestick is formed called a bearish candle. Bullish candle indicates strength and thus it gives
buy signals , whereas a bearish candle indicates weakness and thus go for a short.
Every candlestick consists of three components namely the
• Central real body: The rectangular shaped real body that connects the opening and
closing price
• Upper shadow: connects the high to the close in case of bullish candle and connects the
high to the open for a bearish candle
• Lower Shadow: It connects the low to the open in case of a bullish candle and connects
the low to the close for a bearish candle.

8.2 SINGLE CANDLESTICK PATTERNS


8.2.1 MARUBOZU:
The marubozu is a candle with no upper and lower shadow. It will just have a real body. This can
be classified into bullish marubozu and bearish marubozu. When the open is equal to the low and
high is equal to the close, a bullish marubozu is formed. It shows that there is so much buying
interest in the market and the market participants are willing to buy the stock at every price point
during the day. In a bearish marubozu the open is equal to the high and the close is equal to the
low. It shows that there is so much selling pressure in the market and the participants sold at every
price point during the day.

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Fig 11

8.2.2 THE SPINNING TOP:


These candles have a small real body with equal upper and lower shadows.It conveys indecision
and uncertainity as both bulls and bears were not able to influence the market. If the bulls were
successful then the real body would have been a long green candle.If the bears were successful
then the real body would be a long red candle.The presence of upper and lower shadow tells us
that the bulls and bears have tried their best. Whenever the spinning top pattern forms , the traders
will have to wait for the next price movement.In an uptrend if a bullish candle is formed soon
after the spinning top pattern at a support level ,the investor can go for a long position .
Fig 12

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8.2.3 THE DOJI


In doji candles the open price and the close price will be equal.The upper and lower shadow can
be of any size.Doji candles conveys indecisions and uncertainity , in this case the market can swing
in both ways. Prices move either above and below the open price during the session ,but close at
or very near the open price.There are four types of Doji candles namely long legged doji, dragonfly
doji, gravestone doji and four price doji.

Fig 13

8.2.4 PAPER UMBRELLA


In a paper umbrella the length of the lower shadow should be at least twice the length of real body.
It appears with a small real body and a long lower shadow. A paper umbrella consists of two trend
reversal patterns namely the hanging man and the hammer .The hammer is a bullish trend reversal
pattern that forms during downtrend and the hanging man is a bearish trend reversal pattern that
appears in an uptrend. The chart below shows both the hanging man and the hammer along with
their respective trends.

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Fig 14

THE HAMMER
This candle stick appears at the bottom end of a downward trend and is relatively bullish. The
length of the lower shadow be atleast twice the length of the real body.The low of the hammer is
taken as the stop loss.The true confirmation of a hammer candle can only be made when the next
proceeding candle closes with a higher low than the hammer candle. The price action on the
hammer formation day indicates that the bulls were reasonably successful in taking the price
higher. Thus traders can look for buying opportunities. The hammer is a bullish reversal pattern
and it’s named so as it acts like hammering out a bottom. The main points to be considered include

➢ The long shadow has to be two or three times of the real body
➢ There would be little or no upper shadow
➢ The real body is at the upper end of the trading range
➢ The color of the real body doesn’t matter, but a bullish candle is mostly preferred.

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Fig 15

8.2.5 THE HANGING MAN


This candlestick appears at the top end of a upward trend and is relatively bearish.The length of
the lower shadow should be atleast twice the length of the real body.The day the hanging man
candle appears , it shows that the bears have managed to make an entry.The hanging man formation
does not mean that the bulls have definitely lost control ,but it may be an early sign that the
momentum is decreasing and the direction of the asset may be getting ready to change. It is more
easily identified in intraday charts than daily charts.Thus it’s highly used by intraday traders. Thus
it suggests a short trade and the stop loss would be the high of the hanging man.
Fig 16

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The main features to be noted while looking for an hanging man are as follows :
➢ A long lower shadow which is two to three times of the real body.
➢ Little or no upper shadow
➢ The real body has to be in the upper end of the trading range
➢ The colour of the body doesn’t matter , anyhow a bearish candle is more preferable.

8.2.6 INVERTED HAMMER


An inverted hammer is a bullish reversal candlestick .The inverted hammer is formed in the
downward trend. It appears with a longer upper shadow , which is atleast twice the body’s
length.The trader can think about taking a long position and the stop loss could be kept at the low
of the inverted hammer.It indicates that the bulls have made an entry and the buyers have tried to
take the price higher.

Fig 17

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8.2.7 THE SHOOTING STAR


This candlestick has a longer upper shadow and the length of the upper shadow is atleast twice the
length of the real body.It’s a bearish pattern and thus the prior trend has to be bullish. On the day
the shooting star pattern forms, the market would make a new high. But at the high point ,there is
a selling pressure which lead the price to close near the low point .Thus it indicates that the bears
have made an entry and they could push the prices down.Thus it gives the trader selling
opportunities and the stop loss to be kept at the high of the pattern.

Fig 18

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8.3 MULTIPLE CANDLESTICK PATTERNS


8.3.1 Bullish Engulfing Pattern :
It appears at the bottom of a downtrend and is considered to be bullish. Bullish engulfing pattern
evolves over two days , the first day of the pattern should be a red candle and the second day
candle would be a green candle.Its not necessary for the green candle to engulf the shadows but
the real body of the red candle would be completely engulfed.The traders can initiate a long
position and the stop loss has to be the lowest of the pattern.

8.3.2 Bearish Engulfing Pattern


This bearish pattern appears at the top end of an uptrend and thus the prior trend has to be
bullish.This is also evolved over two days , on the first day a bullish candle is formed followed
by a long bearish candle that completely engulfs it.This means that the sellers are more powerful
than the buyers and that the prices can come down.The traders can look for selling oppurtunities
and the stop loss has to be at the highest of the pattern.

Fig 19

8.3.3 THE PIERCING PATTERN


This is very similar to the bullish engulfing pattern with a small variation. In a piercing pattern
the green candle formed on the second day partially engulfs the red candle formed on the first
day. The engulfing happens between 50% and less than 100 %. The traders can look for buying
opportunities and the stop loss to be kept at the low of the pattern.

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Fig 20

8.3.4 THE DARK CLOUD COVER


This is very similar to bearish engulfing pattern with a slight variation. In a dark cloud cover pattern
the red candle formed on the second day engulfs the green candle partially about 50%-100% . The
traders can look for selling opportunities and the stop loss would be the high of the pattern.

Fig 21

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8.3.5 THE HARAMI PATTERN


Harami is the old Japanese word for pregnant. Its a two candle pattern with the first candle being
usually long and the second candle has a small body. There are two types of harami patterns –the
bullish harami and the bearish harami.

a) THE BULLISH HARAMI


This candle is formed in a downtrend pushing the prices lower ,therefore giving the bears more
control over the market.But on the second day the market gains strength and thus manages to close
on a positive note , thus forming a green candle. The small green candle formed on the second day
appears pregnant within the long red candle.Traders can initiate a long position and can keep the
stop loss at the lowest low of the pattern.Risk takers can initiate a long trade around the close of
the green candle on second day.

b) THE BEARISH HARAMI


This candle is formed at the top end of an uptrend. A bullish candle is formed on the first day
and a red candle on the second day. The small red candle formed on the second day appears
pregnant within the long blue candle. The opening price of the red candle should be lower than
the closing price of the green candle. Traders can look for selling opportunities and the stop loss
to be kept as the highest high of the pattern. This picture shows the bullish and the bearish
harami respectively.
Fig 22

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8.4 TRIPLE CANDLE STICK PATTERNS


8.4.1 THE EVENING STAR
This is a bearish candle stick pattern that evolves over a three day period and it appears at the top
of an uptrend. The first candle would be a bullish candle followed by a doji or spinning top with a
gap up opening. The third candle would be a bearish candle with a gap down opening and the
current market price should be lower than the opening price of first candle. The traders can initiate
a short position and the stop loss has to be the highest high of the pattern.

In an evening star pattern , the trader has to look for the following :
➢ The first candlestick is a bullish candle ,which is a part of a recent uptrend.
➢ The second candle must have a small body , this candle can either be bullish or bearish.
This candle shows perfect indecision in the market.
➢ The third candlestick is an absolute bearish one and it closes beyond the midpoint of the
first candle.

Fig 23

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8.4.2 THE MORNING STAR


This is a bullish candle stick pattern that evolves over a three day period and it appears at the
bottom of a downtrend. The first candle would be a bearish candle followed with a gap down
opening ,the second candle would either be a doji or a spinning top.The third candle would be a
bullish candle and the current market price being higher than the opening of the first candle.The
traders can look for buying opportunities and the stop loss has to be the lowest low of the pattern.
A trader can look for the following signals in order to confirm regarding this pattern .
➢ The first candle is a bearish candle that is formed at the top of an uptrend
➢ The second candle is a small and indecisive candle stick. This can be a bearish or bullish
candlestick .
➢ The third candle is any long or bullish candle.

Fig 24

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Fig 25

9. TECHNICAL INDICATORS
Technical indicators helps the investors to analyse the price movements of securities and hence
leads to more accurate trading decisions. Indicators are of two kinds mainly leading indicator and
lagging indicator. The leading indicator leads the price and thus it signals the occurrence of a
reversal or a new trend in advance. Lagging indicators lags the price and thus it usually signals the
occurrence of a reversal or a new trend after it has occurred. The trader has to be highly alert while
using technical indicators because no indicator can give complete true signals. The efficiency of
technical indicators also increases along with the trade experience. Some of the most widely used
indicators are Pivot points ,Fibonacci Retracement, Moving averages, Bollinger Bands ,Relative
strength Index and stochastic Oscillator.

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Fig 26

9.1 RELATIVE STRENGTH INDEX :


The relative strength index or RSI is a very popular indicator developed by J.Welles Wilder. RSI
is a leading momentum indicator which helps in identifying a trend reversal .RSI indicator
oscillates on a scale of 0 and 100, and based on the latest indicator reading , trade positions are
decided.
The formula to calculate the RSI is as follows
RSI = 100- 100/1+RS
RS= Average Gain /Average Loss
Wilder’s formula normalizes relative strength and turns it into an oscillator that fluctuates between
0 and 100 .The Relative strength index indicator can be broken down into relative strength ,
average gain and average loss. The RSI calculation is based on 14 periods ,which is the default
time frame suggested by Wilder .Losses are expressed as positive values , not negative values.

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The very first calculations for average gain and average loss are simple 14 period averages.First
average gain is the sum of gains over the past 14 periods divided by 14. And the first average loss
is the sum of losses over the past 14 periods divided by 14. The second set of calculations are
based on the prior averages and the current gain or loss. Here the
Average gain =[(previous average gain)*13+ current gain] /14.
Average loss=[(previous average loss )*13 +current Loss ] /14
Taking the prior value with the current value is part of smoothing technique similar to that used in
calculating the exponential moving average. The RSI values become more accurate as the
calculation period extends.The RSI is normally zero when the Average gain equals zero .Assuming
a 14 period RSI , a zero RSI value means price moved lower all 14 periods .There wasn’t any gains
to measure .The RSI is 100 when the average loss equals zero .This indicates that the prices moved
higher on all 14 periods and there were no losses to measure.
A value between 0 and 30 is considered oversold and thus the trader should start looking for buying
opportunities. Any value between 70 and 100 is considered to be overbought and the trader can
look for selling opportunities. If the RSI value is fixed in the overbought region for a long period
that shows an excess of positive momentum and the trader can go for a long position .If the RSI
value stays in the oversold region for a long time that shows the excess of negative momentum
and can thus go for a short.The below graph is the candle stick chart of nifty futures along with
RSI indicator.
Fig 27

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Wilder says divergences signal a potential reversal point , thus RSI considers the bullish
divergence and bearish divergence as well. A bullish divergence occurs when the underlying
security makes a lower low and the RSI forms a higher low.The RSI indicator here is not
confirming the lower low and this shows strengthening momentum. A bearish divergence is
formed when the security records a higher high and the RSI forms a lower high .Here the RSI is
not accepting the newer high and thus shows the weakening momentum. The chart below shows a
bearish divergence during august –october and a bullish divergence during January –March.
Fig 28

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9.2 MOVING AVERAGES


The moving averages are one of the widely used technical indicators ,used to identify the buying
and selling oppurtunities. When the stock price trades above its average price ,it means the traders
are willing to buy the stock at a higher price than its average price. Therfore the trader can look
for buying oppurtunities. We use exponential moving averages to analyse the market. For example
take 50days EMA.The trader has to go for a long position ,when the current market price turns
greater than the 50day ema and can exit the long position when the price is less than the 50 day
EMA.Moving averages can be calculated on any time frame.

Simple moving averages (SMA), exponential moving average(EMA) and weighted moving
average (WMA) are the three types of moving averages. For stocks ,common time periods for
moving averages are 10 days ,21 days, 50 days, 100 days and 200 days. The most commonly and
widely used moving average is the simple moving average. Single simple moving average can be
used to identify a trend , but dual or triple moving averages combined together is more powerful
and effective.

Traders makes use of moving average cross over system ,by combining two moving averages of
different time frames. Thus is usually referred to as smoothing. The shorter moving average
(50day MA) takes lesser number of data points to calculate the average and hence it always sticks
closer to the current price. Whereas the longer moving average (100 day MA) takes more data
points to calculate the average and thus it tends to stay away from the current price. When the short
term moving average turns greater than the long term moving average, the trader can take a long
position. When the short term moving average turns lesser than the longer term moving average,
the trader goes for a short position. The entire outlook turns bullish, when the faster EMA is above
the slower EMA and it looks bearish when the faster EMA is going below the slower EMA. The
below graph is the candle stick chart of Nifty futures. The green line on picture below indicates a
50 day moving average and the red line denotes a 100 day moving average.

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Fig 29

9.3 FIBONACCI RETRACEMENT


Under this indicator technical analysis is carried out with the help of certain ratios i.e 61.8% ,38.2%
and 23.6%.These retracement level provide a good opportunity for the traders to enter into new
positions. This analysis is used by traders when there is a noticeable up- move or down-move in
prices. We should first identify the 100% Fibonacci move. This move can be an upward or a
downward rally. Traders need to pick the most recent peaks and trough on the chart. Once these
points are identified, these are connected using a Fibonacci Retracement tool. These ratios act as
a potential level upto which a stock can correct. This indicator enable the traders to identify the
retracement levels and therefore helps to position accordingly. This indicator can help the investor
to decide on stop loss and take profit as well.

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Fig 30

9.4 STOCHASTIC OSCILLATOR


This momentum Oscillator was created by George Lane in the late 1950s. The stochastic oscillator
presents the location of the closing price of a stock in relation to the high and low range of the
price of a stock over a period of time ,typically a 14 day period. He originally designed the
oscillator to follow the momentum of price but now its more popularly used to identify the
overbought and oversold conditions. The stochastic is scaled from 0 to 100.When the stochastic
lines are above 80 usually denoted by a red line ,then the market is said to be overbought. When
the lines are below 20 usually denoted by a blue line ,then the market is said to be oversold. The
overbought readings are not necessarily bearish , because this can remain overbought during a
strong uptrend. In a similar way, oversold readings are not always bullish , this can remain oversold
and remain oversold during a strong downtrend.

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Closing levels that are consistently near the top of the range indicate accumulation of buying
pressure and those near the bottom of the range indicate distribution or selling pressure. The key
concept behind this indicator is that in an upward trending market , prices tend to close near their
high and during a downward trending market, prices tend to close near their low.The stochastic
oscillator is set at 14 periods by default ,which can be days ,weeks ,months or an intraday
timeframe. A 14%K would use the most recent close ,the highest high over the last 14 periods and
the lowest low over the last 14 periods .The %D is the 3 day moving averages of %K. This line is
plotted alongside %K to denote as a signal or trigger line. The below graph is the candle stick chart
of Nifty futures along with stochastic oscillator indicator.

Fig 31

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9.5 PIVOT POINTS


The pivot point is a technical analysis indicator used to determine the overall trend of the market
over different time frames.We calculate the pivot point of a stock by taking the average of the
opening ,closing , high and low of the previous candle. On the subsequent day ,trading above the
pivot point is considered to indicate bullish sentiments and trading below the pivot point indicates
bearish sentiments. It helps the trader to find out the support and resistance levels and also to plan
for the stop loss and take profit points. The other types of pivot points include the Woodie’s pivot
point , classical or standard pivot point , Fibonacci pivot point and camarilla pivot point.
The pivot points and the associated support and resistance levels are calculated by using the last
trading session’s open ,high, low and close.

The calculation for a pivot point are as follows:


Pivot point (PP) = (High +Low +Close )/3
The support and resistance levels are then calculated .
First level support and resistance:
First resistance (R1) =(2*PP)- Low
First support (S1)=(2* PP)-High

Second level of support and resistance:


Second resistance (R2) =PP +(High –Low)
Second Support (S2) =PP-(High –Low)

Third level of support and resistance:


Third resistance(R3)= High +2(PP-Low)
Third Support (S3) =Low -2(High-PP)

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9.6 BOLLINGER BANDS


Bollinger Bands , a technical indicator developed by John Bollinger is used to measure the
volatility of the market. When the market is quiet ,the bands contract and when the market is loud,
the bands expand. These are mostly used to determine the overbought and oversold levels, where
a trader will short when the price reaches the top of the band and will execute a long position when
the price reaches the bottom of the band. The band automatically widens with the increase in the
volatility and it narrows as the volatility decreases. The investors use the Bollinger bands to
identify various signals including the W bottoms , M bottoms and to determine the strength of the
trend.

The Bollinger bands has three components : the middle line is the 20 day moving average of the
closing prices, an upper band is the +2 standard deviation of the middle line and the lower band is
the -2 standard deviation of the middle line. The middle band is a measure of the intermediate term
trend ,usually a simple moving average that serves as the base for the upper band and lower band.
The interval between the upper and lower bands and the middle band is determined by volatility.
The middle band is a simple moving average that is usually set at 20 periods. A simple moving
average is used because the standard deviation formula also uses a simple moving average.The
outer bands are usually set 2 standard deviations above and below the middle band.The below
graph is the candle stick chart of Nifty futures along with Bollinger bands indicator.
Fig 32

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The formula can be simplified as follows :


Middle band =n- period moving average
Upper band =Middle band + (y *n-period standard deviation)
Lower band =Middle band- (y*n-period standard deviation )
Where: n= number of periods
Y=factor to apply to the standard deviation value (y=2)

W bottom signal

This was developed by Arthur Merril ,who identified 16 patterns with a basic W shape .A W-
Bottom forms in a downtrend and involves two reaction lows. The second low must be lower than
the first bottom ,but it has to be above the lower band. Second there has to be a bounce towards
the middle band .The next low formed must be lower than the initial one and it should be above
the lower band. Finally the the pattern shows a strong upward trend. Bolinger bands are calculated
on closing prices so signals should also be based on closing prices .

Fig 33

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M tops signal
This signal was also part of Arthur Merril’s work that identified 16 patterns with a basic M shape.
M top pattern is similar to a double top. The highs of the pattern may not be always equal .The
first high can be higher or lower than the second high .This is the exact opposite of W bottoms. At
first a security creates a reaction high above the upper band , followed by a pullback towards the
middle band.Third ,the prices move above the prior high but fails to reach the upper band.This is
a warning sign for the investor .The inability of the second high to reach the upper band shows the
declining momentum and may lead to a trend reversal. The final confirmation comes up with a
support break or a bearish indicator signal.

Fig 34

Walking the bands signal


When the pattern touches the upper band after the Bollinger band confirms a W –Bottom would
signal the start of an uptrend. The 20 day simple moving average line acts as a support . The dip
below the 20 days SMA provides buying opportunities to the investor. There would be instances
where pattern goes in a downtrend after an M top formation. The stock would not be closing above
the upper band rather would close below the lower band .Here he support break and the initial
close below the lower band signals a downtrend.

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Fig 35

10. LIMITATIONS

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• Futures are expensive and highly leveraged products that carries high risks , thus
investors/traders are not always active like stock market traders.

• Futures contracts carry definite expiration dates , thus whatever the established fixed price
be , it may appear less attractive when the expiry dates are near.

• Futures were mainly introduced for hedging purpose in the market , but it has been used
for speculation by retail investors ,thus leading to unnecessary volatility and price
movements in the market .

• Forex market provide the maximum leverage and are thus highly risky products. Thus an
highly leveraged bet in forex can lead to a huge loss.

• The Japanese candle sticks look different on every time frame. Thus it’s difficult to trust
them completely on different time frames.

• The candle sticks are a lagging indicator.

• Technical indicators may give mixed signals , if they are used in isolation. Thus its always
better to use a combination of indicators and patterns .

• Technical indicators are mostly based on probability, thus it’s not always necessary to be
correct even after a thorough analysis.

• A single trading strategy may not be work out in all situations in the market .The strategies
needs to be updated and revised as per the market.

• Investors can neither be completely reliable on candle sticks nor on technical indicators.

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11. CONCLUSION

Derivatives are often called “Weapons of Mass Destruction” as they are financial instruments
which provide high degree of leverage and in turn possess humongous risk associated with the
movement of their underlying. Derivatives like futures, options, etc were introduced for Hedging
and Price discovery, instead retail investors are investing in futures contracts for Speculative
purposes mainly because of the fact that these instruments yield high returns but of course in trade
off with high risk.

The most important distinctive characteristic of futures contracts is the daily settlement of gains
and losses and the associated credit guarantee provided by the exchange through its clearing house.
When a party buys a futures contract, it commits to purchase the underlying asset at a later date
and at a price agreed upon when the contract is initiated. The counterparty (the seller) makes the
opposite commitment, an agreement to sell the underlying asset at a later date and at a price agreed
upon when the contract is initiated. The agreed upon price is called the futures price. Identical
contracts trade on an ongoing basis at different prices, reflecting the passage of time and the arrival
of new information to the market. Thus, as the futures price changes, the parties make and lose
money. Rising (falling) prices, of course, benefit (hurt) the long and hurt (benefit) the short. At
the end of each day, the clearinghouse engages in a practice called Mark to market, also known
as the daily settlement. The clearinghouse determines an average of the final futures trades of the
day and designates that price as the Settlement price. All contracts are then said to be marked to
the settlement price

Forex Derivatives were introduced to eliminate Cross Currency risk or Translational Risk.
Institutions having currency risk can hedge their positions by entering into forex futures and hence
can safe guard there investments against potential downside. Indian Forex market allows trade in
7 Cross Currency pairs & 4 INR Currency pairs.

There are two kinds of analysis for any stock, they are Fundamental analysis and Technical
analysis. The fundamental analysis is a way of looking at the forex market by analyzing economic,
social and political forces that may affect the supply and demand of an asset. In technical analysis,
the investors study the price movements by the use of candle stick charts and various technical
indicators. A combination of these indicators and patterns will lead to various reliable and
profitable strategies. Some of the widely used technical indicators include relative strength index,
Fibonacci retracement, stochastic oscillator, Bollinger bands and the moving averages .It’s always
advisable to take calculated risks in the market in order to avoid severe failures.

Trading in futures and forex market has got high scope and career opportunities in today’s
world, therefore it’s the need of the hour to be a smart and active trader.

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12. REFERENCES

• https://www.nseindia.com/
• https://www.forexfactory.com/
• Investopedia
• Varsity By Zerodha
• Options, Futures And Other Derivatives by John C Hull and Sankarshan Basu

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