Dokumen - Pub Options Trading in Bear Mkts 0070152721 9780070152724

OPTION TRADING
BEAR MARKET STRATEGIES

OPTION TRADING
BEAR MARKET STRATEGIES
Sasidharan K
Director
Derivative Research Forum
Centre for Resource
Development and Research
Kochi, Kerala
Alex K Mathews
HeadResearch
Geojit PNB Paribas Financial Services Ltd.
Kochi, Kerala
Tata McGraw Hill Education Private Limited

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RZZCRRBFRQBLA
To
Late Smt. Sreedevi
and
Late Smt. Anse K. Mathews
PREFACE
Capital market in India has been witnessing high volatility since the last
quarter of 2007. The global financial market meltdown has adversely affected
the Indian capital market with the two stock market indices BSE Sensex and
NSE Nifty touching multi-year lows. Though the fall in the market was sharp,
many investors hoped for recovery and hence held on to their stocks.
Unfortunately, adding fuel to fire, the US sub-prime crisis and the consequent
fall in the American stock indices played a significant role in bringing down
almost all the major stock indices across the world and India could not escape
from this tragedy. For over six months bears have ruled the Indian capital
market smashing the hopes of many investors.
We hear losses of investors in bear markets, but seldom have we heard
stories of gains, whereas investors are buoyant when the markets are bullish
and gains are lucrative. Hence, people are afraid of and hesitant to venture
into a bear market. This prompted us to think of strategies which would enable
an investor to make reasonable profit even in weak bear markets. From our
market experience, we identified options as the best hedging tools in weak
bear market conditions and certain strategies that would help the investors to
reap gains even in weak bear market conditions. This book on option trading
specifically spells out these strategies.
Before writing this book, we extensively researched the availability of books
on this theme. Although books like Trade Options Like a Professional by James
Bittmann (Powell’s Books), Bear Market Investing Strategies by Harry D. Shultz
(Wiley Trading, Wiley), etc., are available in the international market we did
not come across any book dealing exclusively with the weak bear market
strategies suitable for all Indian market conditions. The books available in
India on derivatives are specifically on futures and options and even those are
more generic in nature and not market trend-specific. Hence, we felt the need
for a reference book that can be used by traders, stock market professionals,
FIIs arbitrageurs, hedgers and investors to protect their investments from the
vagaries of a falling market.
Since the book is structured around market conditions in India, all the
data and trading information have been collected from the option trading
platform of NSE which has the highest volume in the F&O segment in the
viii Preface
Indian stock market. Even the example of pricing has been worked out using
data from the F&O segment of Indian stock market. Similarly, the examples of
market quotations have been culled out from Indian newspapers.
The book is divided into 14 chapters. The first chapter, presents the history
of derivative trading in India and the structure of Indian derivative market.
The second chapter provides the basic understanding of options and option
terminology. Basics of option trading, contract structure, trading mechanism,
etc., prevalent in the Indian market are covered in the third chapter. The fourth
chapter deals with price indices, construction of indices and components of
stock indices in the Indian stock market. The fifth chapter covers the Black
Scholes and Binomial Models of option pricing based on prices in the Indian
derivative market.
The sixth chapter on strategic option trading tools extensively deals with
put/call relationship, put/call ratio and its use in option trading, open
interest and volume analysis, impact cost, rollover, etc. The seventh chapter is
exclusively devoted to volatility, covers both historical and implied volatility
and explains the use of volatility in option trading. Another important factor
in option trading is the use of Greeks which have been explained in the eighth
chapter. The most important chapter is the ninth one in which 21 option
trading strategies are explained with diagrammatic presentation and two real-
life examples of losses in derivative trading, viz., Barings Bank and the Fall of
Amaranth Advisors LLC. Besides, this chapter explains the concepts of
backwardation, contango and spread, citing the Ranbaxy–Daiichi deal as
example of backwardation. It also throws light on the use of probability in
framing option trading strategies.
The tenth chapter details the sources from which market information can be
drawn. Though derivatives are risk management tools, they themselves bring
in various risks. The potential risks in derivative transactions and the method
of hedging them are covered in the eleventh chapter. The twelfth chapter deals
with the accounting and taxation of derivative transactions and answers some
of the commonly raised questions about option trading in the FAQ section—
questions raised in course of various seminars conducted by us at different
centres on trading in futures and options. The book concludes with a glossary
of derivative terms.
The book is unique in its complete coverage of all aspects of option trading
specific to the Indian stock market. The book will be immensely useful for
traders, investors and option dealers. The students pursuing advanced
courses in behavioral finance, capital markets and derivatives will also find
this book as an excellent reference material. That the book is written from the
real experiences of option trader gives it another edge. We hope the readers
will find this book highly useful. We encourage suggestions for further
improvement.
SASIDHARAN K.
ALEX K. MATHEWS
ACKNOWLEDGEMENTS
We have cherished the desire to write a book on derivative strategies

specific to bear markets for the past 12 years. The prolonged and prevailing
bearish conditions in the Indian capital market since January 2008
encouraged us to complete this task as fast as possible. We could write this
book in a short time span only due to the immense support, guidance and
encouragement received from various quarterstraders, dealers,
professionals and academicians. First of all, we are thankful to Mr. C. J.
George, Managing Director of Geojit BNP Paribas Financial Services Ltd.,
who greatly encouraged us to complete this task. Since the book covers real
market practices, we needed the assistance of National Stock Exchange
Ltd. for using market information. Hence, we thank NSE for permitting us
to reproduce the data available on their website in this book. We also
express our sincere gratitude to the management of The Economic Times for
giving us permission to reproduce the articles from the ET in this book. We
are thankful to the editorial team of Tata McGraw Hill Education (India)
R Chandra Sekhar, Dipankar Das, Sindhu Ullas and their colleaguesfor
the efforts they have put in bringing out our book in an excellent shape. We
owe a special thanks to Mr. Tapas Maji of Tata McGrawHill who persuaded
us to complete this task and referred us to their professional publication
team. We are thankful to the top management team of Geojit BNP Paribas
Financial Services Ltd.Mr. Satish Menon, Mrs. Jaya Jacob Alexander and
Mr. Balakrishnanfor their immense support and encouragement. We also
thank Mr. Johny Varghese, Mr. Sudheer Kumar, Mr. K.K. Alexander, Mr.
Saju Varghese, Mr. Tency Kurien, Mr. Ashon Mathew, Mr. Ganesh, Mr.
Vishnu Das and Mr. Franklin for their support and assistance. We are
grateful to Mr Sanil Abraham of MM news channel who was literally a
helping hand in proof reading the book. We are extremely thankful to our
family members who spared us from many of our commitments to them and
helped us go on with this task. Finally, we thank the Almighty for giving us
health, intelligence and power to complete this task witshin the scheduled
time.
SASIDHARAN K.
ALEX K. MATHEWS
x Contents
CONTENTS
Preface vii
Acknowledgements ix
1 INTRODUCTION 1
1.1 Objectives 1
1.2 Indian Derivatives Market: An Overview 1
1.3 What are Derivatives? 3
1.4 Evolution of Derivative Trading in India 3
1.5 Participants in Derivatives Market 4
1.6 Types of Derivatives 5
Summary 8
Keywords 8
2. UNDERSTANDING OPTIONS 9
2.1 Objectives 9
2.2 Introduction 9
2.3 Options: An Overview 9
2.4 Types of Options 10
2.5 Advantages of Options 11
2.6 Terminologies in Options 12
2.7 Trading System 16
2.8 Procedure for Margin Collection 18
2.9 Types of Orders 21
2.10 Settlement Schedule for Option Contracts 22
2.11 Settlement Mechanism 22
2.12 Writing of Options 23
Summary 23
Keywords 23
3. OPTION TRADING 25
3.1 Objectives 25
3.2 Introduction 25
3.3 Market-wide Limits 25
Summary 39
Keywords 39
xii Contents
4. PRICE INDEX 41
4.1 Objectives 41
4.2 Introduction 41
4.3 What is an Index? 41
4.4 Eligibility Criteria of Indices 42
4.5 Construction of Index 42
4.6 Desirable Attributes of an Index 43
Summary 87
Keywords 88
5. PRICING OF OPTIONS 89
5.1 Objectives 89
5.2 Introduction 89
5.3 Black–Scholes Option Pricing Model 89
5.4 Pricing of Equity Options 94
5.5 Pricing of Options on Dividend Paying Scrips 95
5.6 Binomial Model of Option Pricing 96
5.7 Pricing of Binomial Put Option 98
5.8 Binomial Multiple Period Model 99
Summary 101
Keywords 101
Appendix 101
6. STRATEGIC DERIVATIVE TOOLS 103
6.1 Objectives 103
6.2 Introduction 103
6.3 Put–call Parity 103
6.4 PC Ratio 109
6.5 Weighted PC Ratio 110
6.6 Volume PC Ratio 111
6.7 Tools to Measure Market Sentiment 112
Summary 120
Keywords 121
7. VOLATILITY 123
7.1 Objectives 123
7.3 Types of Volatility 124
7.4 Estimating Volatility 125
7.5 Estimating Historical Volatility 125
7.6 Factors Affecting the Computation of Historical Volatility 128
7.7 Implied Volatility 130
7.8 Volatility Smile 130
Contents xiii
7.9 GARCH 133

7.10 Impacts of Implied Volatility and Underlying Asset Price on
Purchase of Options 136
7.11 Volatility Trading 137
7.12 NSE Volatility Index 138
7.13 Behavioral Study of Nifty Options during Distress 139
7.14 Impacts of Events on Volatility—A Case Study 141
7.15 Comparative Study of the Behaviour of Nifty and IT Stocks During
an Event 145
7.16 Impact of Quarterly Results on Stock Futures 150
7.17 Volatility Skew 151
7.18 Stochastic Volatility 152
7.19 Volatility Arbitrage 153
7.20 Volatility Change 153
Summary 154
Keywords 154
8. OPTION GREEKS 155
8.1 Objectives 155
8.3 Delta 155
8.4 Gamma 159
8.5 Vega 161
8.6 Theta 164
8.7 Rho 167
Summary 169
Keywords 169
Appendix 170
9. OPTION TRADING STRATEGIES 171
9.1 Objectives 171
9.3 Advantages of Strategies 171
9.4 Buying Put Option 172
9.5 Bear Spread with Puts 175
9.6 Long Put Ratio Spread 177
9.7 Bear Spread with Call 178
9.8 Synthetic Short 179
9.9 Short Put Ladder 181
9.10 Long Combo 182
9.11 Long Call Christmas Trees 183
9.12 Short Put Albatross 185
9.13 Short Straddle versus Put 187
xiv Contents
9.14 Short Strip with Calls 188

9.15 Long Guts 189
9.16 Long Call Ladder 191
9.17 Long Iron Butterfly 191
9.18 Long Put Spread versus Short Call 193
9.19 Basic Option Strategies 195
9.20 Trading Strategy Adopted by Nick Leeson 197
9.21 Short Straddle 210
9.22 Long Straddle 212
9.23 Covered Call Writing 213
9.24 Probability 214
9.25 Spread Trading 217
9.26 Contango and Backwardation 220
9.27 Trading Strategies with Long-Term Options 221
9.28 Portfolio Hedging by Call Writing 226
9.29 Portfolio Hedging Through Delta Hedge 226
9.30 Diagonal Spread 227
9.31 Scalping 227
Summary 227
Keywords 228
10. MARKET INFORMATION 229
10.1 Objectives 229
Summary 240
Keywords 240
11. RISK IN DERIVATIVES 241
11.1 Objectives 241
11.3 Risk in Options 241
11.4 Is Writing Options a High Risky Strategy? 241
11.5 Classification of Risks 242
11.6 Elimination of Market Risk through Hedging 243
Summary 246
Keywords 247
12 ACCOUNTING AND TAXATION OF OPTION TRADING 249
12.1 Objectives 249
12.3 Accounting Norms for Equity and Index Options 249
12.4 Charges in F&O Segment 251
12.5 Taxation of Derivatives 251
Contents xv
12.6 Income Tax 251

Summary 252
Keywords 252
13 FAQs ON OPTIONS 253
13.1 Objectives 253
Summary 261
Keywords 262
14. DERIVATIVE GLOSSARY 263
14.1 Objectives 263
Summary 275
Keywords 276
Index 279
xvi Contents
CHAPTER 01
INTRODUCTION
1.1 OBJECTIVES
The objective of this chapter is to familiarize the readers with the concept of
derivatives, Indian derivative market and the different types of derivatives
available in the market.
1.2 INDIAN DERIVATIVES MARKET: AN OVERVIEW

Though derivative trading has been in existence in India in commodity
markets since ancient times, the financial derivatives came into existence in
the late 1990s. The first step was the promulgation of the Securities Laws
(Amendment) Ordinance, 1995, which withdrew the prohibition on option
trading in securities. The L.C. Gupta panel, appointed by Securities and
Exchange Board of India (SEBI) to develop appropriate regulatory
framework for derivatives trading played a crucial role in the introduction
of equity derivative in the Indian capital market. Later, the J.R. Verma
Committee brought out extensive risk containment measures which
facilitated the launching of stock derivatives and index derivatives in India.
The trading on index futures was commenced on 12 June 2000, followed by
index options on 4 June 2001, options on individual securities on 2 July 2001,
and individual stock futures on 2 November 2001. The two major indices
traded in the Indian capital market are Sensex of Bombay Stock Exchange
(BSE) with 30 scrips in its basket and Nifty of National Stock Exchange
Limited (NSE) with 50 stocks in its fold. Simultaneously, the derivatives were
introduced in foreign currencies (USD/INR).
Although Reserve Bank of India permitted banks to use credit derivatives
for managing their credit risk and interest rate derivatives (IRDs) for managing
the interest rate risks, these instruments did not pick up as expected. The
derivative trading in commodity market also became active with the initiative
of three major exchanges, viz. National Multi Commodity Exchange of India,
Multi Commodity Exchange of India, and National Commodity and Derivative
Exchange. The picture shows the growth in derivative segment as a whole
(NSE) which includes stock futures, index futures, index options and stock
options. The growth in number of contracts in 2007 was partly due to reduction
2 Option Trading
in options’ lot size; for example the Nifty lot size has been reduced from 200 to
100. Later, in 2007 it was again reduced to 50 (Fig. 1.1).
450000000
400000000
350000000
300000000
250000000 No. of companies

200000000 Turnover
150000000
100000000
50000000
0
1
9
–0
–0
–0
–0
–0
–0
–0
–0
–0
00
01
02
03
04
05
06
07
08
20
20
20
20
20
20
20
20
Fig. 1.1 Derivative growth in India 20
Over a period of time, the growth in Nifty options has increased

spontaneously due to higher participation from foreign financial institutions,
domestic investors including arbitrage funds and portfolio hedgers. In the
beginning of 2008, we had seen a drastic drop in individual stock option
segment due to extreme market volatility (Fig. 1.2).
1400000
1200000
1000000
Now options or
800000 Stock options or
600000
400000
200000
0
20 01
20 02
20 03
20 –04
20 –05
20 –06
20 –07
20 –08
9
–0
–
–
00
01
04
06
02
03
05
07
08
20
Fig. 1.2 Options growth in India

Introduction 3
1.3 WHAT ARE DERIVATIVES?

Derivatives are financial contracts structured on an underlying asset, which
could be shares, bonds, loans, commodities, indices etc. These contracts help
the investor to mitigate the price risk arising out of movements in prices of
the underlying assets. Derivatives have helped corporations to maximize
their profits by reducing their risk in respect of financial transactions. A
derivative contract helps a firm or an individual to fix the price of the
underlying asset for delivery on a future date. Some derivative contracts
such as options have only the right but not the obligation to deliver the
underlying asset. As a result a buyer of a derivative contract can opt for not
taking giving delivery of the underlying asset if the price moves against the
buyer of the contract by paying a price known as premium while entering
into the contract. However, the derivatives have turn out to be too risky
when the dealers resort to speculation. They have also caused substantial
loss to the corporations and financial institutions, ultimately leading to
closure of some of them. The latest among these is the story of Northern Rock
Bank in USA.
1.4 EVOLUTION OF DERIVATIVE TRADING IN INDIA

The derivative markets developed as a result of the consciousness that
derivatives could be used to manage the risk involved in capital markets.
Derivatives have been in existence in India in some form or the other for a
long time. If we speak about commodities, the Bombay Cotton Trade
Association started futures trading in 1875, and by the early 1900s India had
one of the largest futures industry. These derivative instruments protect the
investors against adverse market conditions and can also be used to hedge
investors’ position thereby helping in reducing cost. As the government in
1952 imposed a ban on cash settlement, option trading and derivative
trading shifted to informal forward contracts.
The RBI in June 2000 allowed the trading in security derivatives on stock
exchanges. The major contributory factors for downfall/success of
derivative markets include the underlying market and of course the market
culture. The Securities Contracts Regulation Act of 1956 was implemented to
prevent gambling in contracts by prescribing appropriate regulations to
restrict such activity. Before the inception of derivatives in India, there was
‘forward trading’ in securities using the instruments like ‘Teji’, ‘Mandi’ and
‘Fatak’. A series of reforms of the stock market between 1993 and 1996 paved
the way for the development of exchange-traded equity derivatives market
in India. Further, the improvements brought to NSE unleashed of new
avenues. In 1996, the NSE had sent a proposal to SEBI for listing exchange-
traded derivatives. The liberalization policy of the Congress government in
the 1990s helped the introduction of derivatives based on interest rates and
foreign exchange.
4 Option Trading
The NSE had launched interest rate futures in 2003, but there has been little
trading in these interest rate futures when compared to the equity derivatives.
The main reason for less interest in these instruments was faults in the
contracts’ specifications, leading to deviation of the underlying interest rate
from the reference rate used by the investor.
One another less active derivative counter was foreign exchange derivatives
which were less active than IRDs when introduced. But, the whole scenario
changed with the foreign exchange derivatives becoming the active derivative
instrument rather than interest rate derivative. In foreign exchange derivatives,
the most popular ones are currency forwards and swaps. In a currency swap,
banks and corporations may swap its rupee-denominated debt into another
currency or vice versa.
Exchange-traded commodity derivatives have been traded only since 2000,
and we have seen a significant growth in this market. The number of
commodities eligible for futures trading increased from 8 in 2000 to 80 in 2004
with the trading value clocking almost four times.
The users of derivatives in India include many financial institutions such
as banks that have assets and liabilities of different maturities and that too in
different currencies which are exposed to different risks. The IRDs and the
foreign exchange derivatives help them in managing their credit risk.
Transactions between banks dominate the market for IRDs but the state-owned
banks contribute only a small part. The corporations on the other hand are
active in the currency forwards and swaps markets, buying these instruments
from banks.
1.5 PARTICIPANTS IN DERIVATIVES MARKET

Participants in derivative trading include dealers, hedgers, speculators, and
arbitrageurs according to the nature of investment.
Dealers are those who put orders to buy or sell on behalf of clients, institutions
such as banks, mutual funds, securities houses etc., and they are the end-users
of the trading channel.
Hedgers consist of corporations, investment institutions, banks, governments
and individual clients who want to reduce exposure to market variables such
as interest rates, share values, bond prices, currency exchange rates and
commodity prices. Their aim is to mitigate the risks associated with the
underlying price of an asset, whether in equities or in commodities. Consider
an institutional investor holding 3000 Reliance shares bought at a price of Rs.
2000. They can hedge their open position in Reliance by entering into an
opposite position in the futures. Here, they can sell 40 lots of Reliance futures
(1 lot = 75 shares) for the same price. If the price moves down drastically, they
can cover their shorts in the futures at a profit.
Speculators are people who expect higher returns than average profits. They
will take high risks in the expectation of making quick bucks. A speculator is
interested in capital gains rather than the income from the investment.
Introduction 5
Arbitrageurs constitute another group of participants who takes the

advantage of a price differential between two or more markets. If futures of a
commodity or a stock trades substantially above the cost of carry, arbitrageurs
sell the expensive futures and they will buy the spot. Thereby, they will make
a riskless profit.
1.6 TYPES OF DERIVATIVES

The derivatives can be classified into commodity derivatives, financial
derivatives, weather derivatives etc. The innovations in the market may give
rise to new class of derivatives based upon the customer demand.
Commodity derivatives Commodity derivatives are those contracts where
the underlying assets are commodities. The best example for commodity
derivatives in India is pepper futures, oil futures, jute futures, hessian futures
etc. Rubber derivatives were introduced to hedge the risk arising out of the
price movement in the rubber market. This mechanism will enable the growers
to get a fair return on their investments.
Financial derivatives As mentioned, a financial derivative is a contract based
on a financial asset. The asset can be a loan or a deposit. Financial derivatives
are traded in the financial market. The major financial markets where the
derivatives are traded are Mumbai and Chennai.
Financial derivatives can further be classified into:
Equity derivatives where the underlying assets are shares.
Interest rate derivatives are hedging tools to manage the risk arising out of
interest rate movement. The IRDs can be based on debentures or bonds or
simple plain vanilla derivative like bond futures, treasury bill futures, interest
rate options, interest rate swaps etc.
Credit derivatives are structured based on credit instruments or loans where
the Pay off is decided based on a credit event. These contracts are linked to a
third party reference asset. Credit default swaps, credit default options,
collateralized bond obligations etc. are examples of credit derivatives.
Index derivatives are contracts structured based on indices. The pay off is
determined based o n the movement of indices. The indices can be that of stock,
commodities etc. Examples of index derivatives are CNX Nifty futures, CNX
Nifty options etc.
Currency derivatives represent contracts covering foreign currency
obligations or claims. The payoff is decided based on the price of the currency.
The important types of currency derivatives are currency futures, currency
options, currency swaps etc.
Weather derivatives Weather derivatives are financial products that enable
an organization to offset the financial risk due to a weather variable. They
allow companies to control the effects of weather on demand for their
6 Option Trading
products. This hedging reduces the volatility of future revenue to a more

predictable cash flow. A common measure of temperature that arose from the
market is a degree-day. A degree-day is the deviation of a day’s average
temperature from the reference temperature. This was found to be a useful
measure that the energy suppliers could use to hedge their supply in adverse
temperature conditions. The common forms of weather derivatives are call
options, put options, caps, floors, collars and swaps. Some of the exotic
varieties like one-touch, digitals, barrier and basket options are also
structured to meet the specific needs.
Forwards Forwards contracts are the traditional form of hedging tools
extensively used in India. They are OTC derivatives and are not traded on
exchange floors. Forward contracts are not standardized; hence, full hedging
is possible. Another important aspect of forward contracts is that the
underlying assets are to be delivered upon receipt of payment from the
counterparty. Cancellation of forward contracts before the expiry date
involves cost. Similarly, the parties have to pay the charges for early delivery
and extension of contracts, if the price moves against the bank.
Futures Futures are contracts structured for the delivery of the underlying
assets on an agreed future date; the delivery may or may not take place. Where
the cash settlement happens, the counterparty will take delivery or give
delivery. Otherwise, the contract will be wound up by settling the difference
between the contract value and the spot price at the time of maturity. The
futures can be equity futures, index futures, interest rate futures, currency
futures, commodity futures or weather futures. Futures are generally
exchange-traded. Therefore, they are less risky and highly liquid. The
advantage of futures contract is that the investor can liquidate his position at
any time since the exchange is the counterparty. The exchange ensures the
settlement under the contract. For this purpose, they collect margin from the
contracting parties.
Options Options are financial contracts entered between two parties where
one party has the right to give or take delivery of an underlying asset but has
no obligation to do so, whereas the other party has the obligation to give or
take delivery. Options can be a call option where a person having short
position in the asset buys the option. In the case of put option, a person
holding long position sells the option to hedge against the downward
movement of price. The seller of the option is otherwise known as writer and
the counterparty is known as the option buyer. The process is known as
writing of option.
Options can be American or European. In the case of American option, the
buyer can exercise the contract at any point of time before the maturity. In
the case of European option, the contact can be exercised only on the expiry
date. All equity options are American options whereas all index options are
European options.
The options can be plain vanilla options, compound options or complex
options such as futures with option, swaption, exotic options, etc.
Introduction 7
Swaps A swap is a contract entered between two parties for exchange of cash
flows with identical maturities for the purpose of taking advantage of
comparative advantage enjoyed by either one or both. The swap can be an
interest rate swap or a currency swap. In the case of an interest rate swap, the
contracting parties exchange a floating rate with a fixed rate, a fixed rate with
a fixed one or a floating rate with floating. The currency swaps enables the
contracting parties to exchange the cash flows in two different currencies for
taking advantage of the interest rate differentials as well as the exchange rate
differentials. The principal under swap contracts are notional and only the
interest rate differentials are exchanged by the contracting parties. Unlike
options or futures, the swaps can be liquidated only on maturity. Therefore,
swaps are illiquid. The swaps can be equity swaps, commodity swaps,
currency swaps or compound swaps like swaptions.
Forward rate agreements A forward rate agreement (FRA) is a derivative
contract, which protects the buyer of FRA from changes in interest rate.
Normally, FRAs are long-term contracts, say for 3 years, 5 years etc., with
intermittent reset dates. For example, an FRA with maturity of 3 years can have
interest rate reset dates at the end of every 6 months. An FRA by a company,
which has decided to avail a loan from a bank for a period of 6 months on a
date 3 months from then, ensures an interest rate which is mutually agreed
upon by the FRA buyer and the seller. In this contract, the FRA seller, normally
a bank, agrees to pay the interest rate differential in case the interest rate
prevailing at the time of availing the loan as well as on the reset dates are more
than the agreed rate. If the interest rate happens to be less than the agreed rate,
the buyer has to pay the differential to the seller. A typical FRA transaction is
given in Fig. 1.3.
6 Months
3 Months 3 Months 3 Months
Current Date Sanction Date Reset Date Maturity Date
Fig. 1.3 A typical FRA transaction

In this diagram, the contract is entered on date CD for a loan to be availed on
date SD, 3 months after CD. The loan period is 6 months. During the period of
6 months, the interest will be reset on RD. If the rate of interest agreed upon at
the time of signing the contract is 9% and the actual rate of interest at the time
of availing the loan is 10%, the FRA seller will pay 1% to the buyer. If on the
reset date the interest rate falls to 8.5%, the FRA buyer has to pay 0.5% to the
FRA seller. FRAs can be used effectively for hedging the risks in respect of
investments as well as borrowings.
8 Option Trading
Caps, floors and collars Caps and floors are set of option contracts entered
into to hedge the risk arising out of movement of interest rates. When there is
more than one cap or floor, it is known as caplets or floorlets. The caps protect
the cap buyer from an upward movement of interest rate. The cap differs from
FRA because in the case of cap the buyer can abandon the contract if the rate
moves downwards, in which case his maximum loss is the upfront premium
paid by him. However in the case of FRA, the FRA buyer cannot abandon the
contract, but has to pay the difference.
A floor is an option contract, which protects the floor buyer from
downward movement of interest rate. In the event of a fall in the interest
rate, the FRA seller will pay the difference to the FRA buyer, whereas if the
rate moves upwards the buyer need not pay anything to the seller. His
maximum loss is the upfront premium paid by him to the seller at the time of
writing the option.
A collar is a combination of caps and floors. The collar helps the investor
to hedge against both upward and downward movement of interest rates.
In India, the major transactions take place in futures and options segment
of the capital market, commodity market and currency market . In this book,
we will focus on option especially on option strategies which are meant for a
bearish stock market. The options and their features, various strategies in a
bear market, accounting and taxation will be discussed in detail in the
subsequent chapters.
Summary
In this chapter we have broadly discussed the concept of derivatives, evolution
and structure of derivative markets in India, market participants and different
types of derivatives. This will remain as a basic platform on which we have
built up the remaining chapters.
Keywords
Derivatives National Stock Exchange Bombay Stock Exchange
Dealers Hedgers Commodity exchanges
Speculators Arbitrageurs Forwards
Options Futures Swaps
FRA Caps Collars
CHAPTER 02
UNDERSTANDING
OPTIONS
2.1 OBJECTIVES
Having understood the concept of derivatives and their varieties, we shall
now move on to the specific area of derivative products. One of the most
common derivative products is options. In this chapter, we will discuss the
basic concepts of options and the option terminologies.
2.2 INTRODUCTION
Options are generally classified into call options and put options. These are
traded based on their premiums. American options can be exercised during
the lifetime of the contract whereas the European options can be exercised on
the day of expiry. The risk of option buyers is limited to the extent of the
premium that they have paid for while purchasing the same. But option writers
undertake high risk and, therefore, high margins are required for writing
options.
2.3 OPTIONS: AN OVERVIEW

The basic parameter for a professional investor to choose a financial product is
its risk–return profile. This paved the way for the origin of derivatives in the
financial market worldwide. In the previous chapter, we have discussed
various types of derivative products. Derivative markets around the world act
as a price protection mechanism for the investors. The values of these products
are derived from their underlying value whether it is an asset, an index or
reference rate. These derivative products are gaining day-to-day importance
in the rising volatile conditions of the financial market and on increased
participation of investors. In the initial days of derivative market, they were
meant simply for hedging, but later on they began to be used for speculation
and arbitrage opportunities.
Of the several variants in derivatives, options are preferred by investors for
investing, hedging and speculative purposes. To recapitulate what we have
10 Option Trading
discussed in the previous chapter: ‘An option buyer has the right to buy/
sell an underlying at a fixed price (strike) on a future date. The seller
has the obligation to deliver/buy the underlying if the buyer desires to
exercise the option. Purchasing an option requires an upfront payment,
while it costs nothing to enter into a futures and forwards contract (Tables
2.1 and 2.2).
Table 2.1 Distinction between Futures and Forwards
Futures Forwards
Futures contracts are traded on an Forward contracts are OTC
organized exchange. (over-the-counter) in nature.
Futures contracts are standardized Forward contracts are customized.
contracts.
Futures contracts are more liquid. Forward contract is less liquid.
Futures require margin payment. No margin payment is needed
for Forward contracts.
Futures contracts are settled on Forward contracts are settled
a daily basis. only at the end of a period.
No counterparty risk. Counterparty risk may happen.
Table 2.2 Distinction between Options and Forwards
Options Forwards
Options are traded on an organized Forward contracts are OTC (over-
exchange or OTC. the-counter) only in nature.
Option contracts are standardized Forward contracts are customized.
contracts.
Option contracts are more liquid. Forward contract is less liquid.
Exchange traded options require No margin payment needed for
margin payment. forward contracts.
Option contracts are settled on a Forward contract settlement is only
daily basis (American options). at the end of a period.
No counterparty risk. Counterparty risk may happen.
2.4 TYPES OF OPTIONS

Options are broadly classified into two categories: (1) call option and (2) put
option (Fig. 2.1). Call option may be defined as an instrument that gives the
option buyer the right but not the obligation to buy an agreed quantity of a
financial instrument from the option seller on a certain date at a previously
agreed-upon price. The put option gives the put buyer the right but not the
Understanding Options 11
obligation to sell a financial instrument on a certain date at a previously

agreed-upon price. Further, the options are classified into American and
European options. The American options give the investor the choice to
exercise his right at any time during the lifetime of the contract, while the
holder of the European option can only exercise his option at the end of the life
of the contract.
CALL OPTION
STOCK OPTIONS AMERICAN OPTIONS
PUT OPTION
OPTIONS
CALL OPTION
INDEX OPTIONS EUROPEAN OPTIONS
PUT OPTION
Fig. 2.1 Types of options
2.5 ADVANTAGES OF OPTIONS

The options offer the advantages as discussed further.
Cost effectiveness. The cost incurred by an investor in options is just the
premium amount multiplied by the market lot of an index or stock option,
instead of investing a huge amount to purchase a stock. For example, if you
want to buy 200 Infosys shares from the cash market when it is trading at
around Rs. 1300, then you have to pay an amount equal to Rs. 2,60,000, but if
you are buying Infosys option at the strike price of 1300, you will have to pay
the premium, for example, Rs. 40 multiplied by the lot size which is 200. So the
amount that you must pay will be just Rs. 8000.
Low risk and high returns In options, the maximum amount of money lost
in the case of buying call and put is the premium amount only. The loss of the
option buyer is limited and the profit is unlimited, while the option seller’s
profit is limited to the option premium and the loss, on the other hand, is
unlimited. Suppose you are holding 75 shares of Reliance Industries at a
purchase price of Rs. 2000, but you are afraid that there can be a fall in price
due to political uncertainties. So, you thought of buying put options of
Reliance Industries. The price of Reliance 2000 put option is Rs. 50 when the
spot is trading at Rs. 2100. You can buy one lot of Reliance 2000 put option by
paying Rs. 3750 (75 ´ 50). The put option will expire on 30 December, 2008.
Points to remember:
1. The expiry of Reliance Industries’ put option is on 30 December, 2008.
So, you can hold on the position till 30 December.
12 Option Trading
2. You bought the Rs. 2000 put option at a premium of Rs. 50. The
maximum loss is limited to Rs. 50 ´ 75 = Rs. 3750.
3. The investor will get a protection below Rs. 1950 (2000 – 50).
4. If the stock does not fall below Rs. 2000, then your investments are safe,
but you will lose the premium of Rs. 3750.
An investor who is bearish on the market will buy put options. Investors
with bearish view on Nifty (market) will buy Nifty put options. Assume that
Nifty is trading at 5000 and you are expecting Nifty to test 4500 in the month of
October. So you buy 100 Nifty put October options at Rs. 100. Premium can be
the maximum loss. If Nifty falls below 5000, then you start making profits
(5000 –100), and if it is assumed to close at 4000 then you may earn
Rs. 99,900 ((1000 ´ 100) –100). Here, the premium is the maximum loss.
Low margin requirement: Another distinct advantage of options is the low
margin requirement. The purchase of call and put option attracts only the
premium for the options. In other words, the margin is limited to the premium
of the options. The seller of the call option and put options has the obligation
to pay higher margin because of the unlimited risk exposure. The margins are
calculated using VaR model (value at risk) by the National Stock Exchange.
2.6 TERMINOLOGIES IN OPTIONS

The following are some of the major terms used in option trading.
Long: One is long in a stock when he is having a purchase position in it. In the
same way, buying positions in call or put options can be termed as long
positions.
Short: The term ‘short’ is used when one has selling positions in call or put
options.
Opening buy (buy open): Opening buy refers to the purchase of an option
contract either call or put.
Opening sell (sell open): Opening sell means a sale position in either the
call or put options to create fresh short positions.
Close out: Close out is the opposite transaction of buy open and sell open
which closes the open positions fully or partly. For example, a short position
in an option contract can be offset by the purchase of a contract having same
characteristics while a purchase position in an option contract can be offset by
the sale of a contract having the same characteristics.
Closing buy (buy close): Closing buy refers to a purchase transaction that
offsets a short position either wholly or partly (sale position). For example, a
call option seller can close his short position through the purchase of the same
contract.
In order to cover a short position in call having some special features such
as underlying asset, strike price, exercise date, etc., one should select a call
option having the same characteristics. For example, one sold Nifty 2500 call
option expiring on March 2009, if s/he wants to close out the short, s/he has
to buy 2500 call option expiring on March 2009. Note that a call option cannot
be closed out by a put option or vice versa.
Though both the options should fundamentally be the same, the premium
on which they are bought and sold may be different since this is determined by
the market forces from time to time. It gives an opportunity to the trader to make
gains from buying and selling of option contracts.
Closing sell (sell close): Closing sell means a sale transaction, which offsets
a long position either wholly or partly. For example, the buyer of a put or call
can eliminate his long position by effecting a sale in the same type of contract,
and this is similar to squaring up of long positions in the equity market.
As stated earlier, the difference in premium, if any, is the profit/loss of the
trader.
Option class: A set of options that are identical with respect to type and
underlying asset.
Option series: An option series consists of all the listed option contracts of a
given class that have the same strike price and expiry date.
Open interest: Open interest on a contract refers to the total number of such
contracts outstanding at any point of time. Open interest increases when a
fresh contract of the same variety is bought or sold in the market and decreases
as an existing contract is extinguished by squaring up/settlement by the
buyers and sellers.
Strike price: It is the price at which an underlying stock can be purchased or
sold. Alternatively, it is the price at which a specific derivative contract can be
exercised. Strike prices are mostly used to describe stock and index options, in
which strike prices are fixed in the contract. For call options, the strike price is
the price at which the security can be bought (up to the expiration date), while
for put options the strike price is the price at which shares can be sold.
Expiration date: It is the date on which the contract expires and the holder of
an option can opt to exercise the option or can allow it to expire worthless. In
India, expiration date for option contract is fixed as the last Thursday of the
month. In case of holiday on Thursday, expiration will happen on the previous
trading session. Let us assume that we had taken a long position in August
2008 put option at Rs. 35. The August 2008 series will expire on the last
14 Option Trading
Thursday of August 2008, which is 28th. If you want to carry over the purchase
put option to September 2008 on or before 28 August, you should sell August
put option and you have to buy a new contract expiring on 25 September (last
Thursday of September). Purchase or sale position of put option or call option
can be kept till the expiry of that particular series or one can trade on
premium. Say, for example, you bought a call option for Rs. 105
September 2008 series and you can sell call position when the call
premium increased to Rs. 120. Therefore, you will make a profit of Rs.
15 per share.
Premium: It is the price that the option buyer pays to the option seller. The
option buyer and seller determine option premium. Option premium consists
of intrinsic value and time value. The premium will change according to the
demand and supply of the option. If the market is bearish, there will be more
demand for the put option thereby causing an increase in premium. If the
market is bullish, then the call buyer will pay more premium for the call
options. Many investors are calculating option premium using various
methods like Black Scholes formula, binomial trees and trinomial trees. In
India, investors normally track Black Scholes formula for finding out the
theoretical option prices. The Black Scholes formula is commonly used by
investors to find out the theoretical price of the Nifty options. Pricing of options
using Black Scholes formula is discussed in Chapter 5.
Intrinsic value: In options, intrinsic value is the amount of in the money
portion in the premium value. This means the real value for both call and put
option, with respect to their different strike prices against respective spot
prices. For a call option, intrinsic value is the difference between the
underlying asset’s spot price and strike price. But, for a put option, intrinsic
value is the difference between strike price and the underlying asset’s spot
price. For example, a 170 call option of RPL trading at a premium of Rs. 17,
with spot price of Rs. 180; will have an intrinsic value of Rs. 10 (180 - 170). And
a put option of 200 RPL put trading at a premium of Rs. 25 will have an
intrinsic value of Rs. 20 (200-180).
Time value: It is the difference between the premium and intrinsic value of an
option. It is the real demand for the stock by investors on their expectation
towards stock price. It is also referred to as the value that an option has in
addition to its intrinsic value. In the above example of call option of RPL, Rs. 7
(17-10) is the time value of RPL 170 call, whereas, for put option, it has a time
value of Rs. 5 (25-20). An option is said to have time value, if it is at the money or
out of the money. At the money option has the maximum time value as the
intrinsic value will be zero when both the strike and spot prices are same.
At-the-money: An option is said to be at the money when the current spot

price equals the strike price in the case of both call and put options.
In the money: An option is said to be in the money if the exercise of the option
leads to cash inflow to the holder of the option. A call option is said to be in the
money if the option’s strike price is below the market price of the underlying.
And, if the spot price is much higher than strike price, that call option is said to
be deep in the money. But, for a put option, it is the inverse,that is a put option is
said to be in the money only if market price of the underlying is below the strike
price. If the spot price lies far below the strike price, that put option is said to be
deep in the money.
Out of the money: An option is said to be out of the money, if the option
becomes worthless on expiry. A call option is said to be out of the money if the
spot price of the option is below the strike price. If the spot price is far lower
than the strike price, that call option is said to be deep out of the money. In the
case of a put option, an option is said to be out of the money if the strike price
lies lower than the spot price and is said to be deep out of the money, if the strike
price is much lower then the spot price.
A brief view on different option types are given in Tables 2.3 and 2.4.
Table 2.3
Strike Price Spot Price Call Premium Option Type

1500 1600 150 Deep ITM
1550 1600 100 ITM
1600 1600 60 ATM
1650 1600 35 OTM
1700 1600 15 Deep OTM
Table 2.4
Strike Price Spot Price Put Premium Option Type

1500 1600 15 Deep OTM
1550 1600 30 OTM
1600 1600 90 ATM
1650 1600 120 ITM
1700 1600 160 Deep ITM
Source: www.nseindia.com
16 Option Trading
Price Bands: To prevent erroneous order entry, operating ranges or

daily minimum and maximum ranges are fixed for derivatives segment.
· For Index Futures: 10% of the base price
· For Index and Stock Options: Upper Operating range + 99 % of base
price or Rs. 20, whichever is higher,
· For Stock Ffutures: 20 % of the base price
Volatility: Volatility represents the changes in the prices of underlying asset.
Volatility is one of the factors considered for calculating option price. Volatility
can be historical volatility or implied volatility. While historical volatility is
computed from past data relating to the prices of the underlying asset, implied
volatility is embedded in the option price (premium) and varies according to
the market conditions. Volatility is dealt with in a more detailed manner in
another chapter.
American and European options: In the European model of options,
contract buyers are allowed to exercise their right to buy or sell (the asset) on
the settlement day alone and the settlement day may probably be the expiry
day of the contract. However, buying and selling positions could be squared
up at any time in the market by entering into a reverse transaction. In the
American model of options, call or put option holders can settle their claims by
exercising the right to buy or sell on any day that falls between the date of entry
and the expiry date. In India, both call and put options are settled in cash
whereas in US, it is settled in stock.
2.7 TRADING SYSTEM*

The futures and options trading system provides a fully automated trading
environment for screen-based, floor-less trading on a nation-wide basis and
an online monitoring and surveillance mecha-nism. The system supports an
order-driven market and provides complete trans-parency of trading
operations. Orders, as and when they are received, are first stamped and then
immediately processed for potential match. If a match is not found, then the
orders are stored in different ‘books’. Orders are stored in price–time priority
in various books in the following sequence:
· Best price
· Within price, by time priority.
2.7.1 Margin Requirements for Investors
2.7.1.1 Margin on Purchases of Options
An investor who has taken long position in an option (call or put) will have to
pay a margin equal to the premium of the option. In this case, the risk of the
investor is limited. For example, if an investor goes long on Infosys by buying
a 1300 call option when the premium is at Rs. 64 and the lot size being 200, she
has to pay a margin amount equal to Rs. 12,800 (64 ´ 200).
*
2.7.1.2 Margin on Selling of Options

An investor who has taken short position in an option will have to pay not
only the initial margin but also the mark–to-market margin. This is because of
the risk factor involved with a short position on an option. For example, if an
investor goes short on Infosys by selling a call option of 1300 when the
premium is at Rs. 64 and the lot size being 200, he will receive an amount equal
to Rs. 12,800 but has to pay the initial margin prescribed by the NSE span
margin (e.g. if the initial margin fixed by NSE is 15%, then the investor has to
pay Rs. 40920 as the initial margin amount [(1300 + 64) ´ (200 ´ 15/100)]) and
also the mark-to-market margin at the end of every day as the difference
between the sale price and the closing price multiplied by the lot size which
will be debited to the client account (e.g. if the premium increased from Rs. 64
to Rs. 70 at the close of the day, then the sellers have to pay Rs. 1200 at the end
of the day as mark-to-market margin apart from the initial margin).
2.7.2 Margins for Trading Members

Online position monitoring and margining system is the most critical
component of risk containment mechanism for futures and options segment
introduced by NSE. Actual margining and position monitoring is done on an
intra-day basis. A portfolio-based system called Standard Portfolio Analysis
of Risk (SPAN) is used by National Securities and Clearing Corporation Ltd.
(NSCCL) for the purpose of margining.
The overall risk in a portfolio of futures and options are identified using
SPAN for each member. F&O contracts are treated in the same way by the
system, identifying unique exposures associated with options portfolios like
extremely deep out of the money short positions, inter-month risk and
commodity risk. The main objective of SPAN is to identify the largest loss,
which may incur by a portfolio from one day to the next day. SPAN then sets
margin requirement at a level sufficient to cover the day’s loss.
The factors affecting value of an option for Standard Pricing Models are:
· Underlying market price
· Volatility of underlying instrument
· Time to expiration
SPAN uses delta information to form spreads between futures and options
contracts. Futures and option’s value change in relation to the changes in the
value of the underlying is measured as Delta. It is 1.0 for Futures and -1.0 to
+1.0 for Options. Option deltas are dynamic, by which a change in the
underlying will cause change in both option’s price and delta.
2.7.3 Margins for Option Trading

The loss incurred for the buyer of a call/put option is the premium amount
which is paid on the initial, while that for writer of an option, the loss is equal
18 Option Trading
to the difference between strike price and spot price multiplied by the number
of options. Often, the buyer of an option, in the case of both call and put options
need to pay only the premium amount as margin, whereas the seller of an
option (call or put) has to pay short option minimum charge towards the
exchange. The seller of an option has the obligation to buy or sell the
underlying on the discretion of the buyer and so the loss for the seller of the
option is unlimited. Hence, the seller has to pay an initial margin to the
exchange, because of probability of unlimited losses that can occur for a day,
as default from the seller may cause settlement issues in option contract. This
initial margin will be refunded to the seller upon the expiry of the contract after
netting the losses and gains on each day, which is same as that in futures
contracts, as it is mark-to-market on a daily basis. That means any loss at the
end of a day’s trade is netted against the initial margin from seller’s account
according to the positions taken in call and put options in both index and
stock options.
2.7.4 Short Option Minimum Charge

Short positions in extreme deep out of the money strikes may change wildly
and may start generating losses and may change into in-the money. Hence,
NSCCL has set up a minimum margin for every short option position in a
portfolio called Short Option Minimum charge. The Short Option Minimum
charge serves as a minimum charge towards margin requirements for each
short position in an option contract.
If the short option minimum charge is Rs. 50 per short position, a portfolio
containing 20 short options will have a margin requirement of at least Rs.
1000, even if the scanning risk charge plus the inter month spread charge on
the position is only Rs. 500.
Premium margin is the client-wise margin amount payable for the day and
has to be paid by the buyer till the premium settlement is complete.
2.8 PROCEDURE FOR MARGIN COLLECTION

SEBI has prescribed two types of margins in derivatives market—initial
margin and mark to market margin.
· Initial Margin is adjusted from the available liquid net worth of the
clearing member on an online real time basis. Initial margin is based on
99% VaR and worst case loss over a specified horizon, depending on the
time in which mark to market margin is collected. NSCCL collects initial
margin up-front for all the open positions of a clearing member based on
the margins computed by NSCCL-SPAN. A CM (clearing member) is in
turn required to collect the initial margin from the TMs and his
respective clients. Similarly, a TM should collect upfront margins from
his/her clients.
Futures contracts. The open positions (gross against clients and net of
proprietary/self trading) in the futures contracts for each member are marked
to market to the daily settlement price of the futures contracts at the end of each
trading day. The daily settlement price at the end of each day is the weighted
average price of the last half an hour of the futures contract. The profits/losses
arising from the difference between the trading price and the settlement price are
collected by/given to all the clearing members.
Option contracts. The marked to market for option contracts is computed
and collected as part of the SPAN margin in the form of net option value. The
SPAN margin is collected on an online real time basis based on the data feeds
given to the system at discrete time intervals.
The Initial Margin is the higher of (Worst Scenario Loss + Calendar Spread
Charges)
Or
short option minimum charge.
2.8.1 Short Option Minimum Charge

The worst scenario loss are required to be computed for a portfolio of a client and
is calculated by valuing the portfolio under 16 scenarios of probable changes
in the value and the volatility of the index/individual stocks. The options and
futures positions in a client’s portfolio are required to be valued by predicting
the price and the volatility of the underlying over a specified horizon so that
99% of times the price and volatility so predicted does not exceed the maximum
and minimum price or volatility scenario. In this manner, initial margin of
99% VaR is achieved. The specified horizon is dependent on the time of
collection of mark to market margin by the exchange.
The probable change in the price of the underlying over the specified
horizon, i.e., ‘price scan range’, in the case of Index futures and Index option
contracts are based on three standard deviation (3s ) where ‘s ’ is the volatility
estimate of the Index. The volatility estimate ‘s ’ is computed as per the
exponentially weighted moving average methodology. This methodology has
been prescribed by SEBI. In case of option and futures on individual stocks, the
price scan range is based on three and a half standard deviation (3.5s) where
‘s’ is the daily volatility estimate of individual stock.
If the mean value (taking order book snapshots for past 6 months) of the
impact cost for an order size of Rs. 0.5 million exceeds 1%, the price scan range
would be scaled up by square root three times to cover the close out risk. This
means that stocks with impact cost greater than 1% would now have a price
scan range of - Sqrt (3) ´ 3.5s, or approx. 6.06s. For stocks with impact cost of
1% or less, the price scan range would remain at 3.5s.
For index futures and stock futures, it is specified that a minimum margin of
5% and 7.5% would be charged. This means, if for stock futures the 3.5s value
20 Option Trading
falls below 7.5%, then a minimum of 7.5% should be charged. This could be
achieved by adjusting the price scan range.
The probable change in the volatility of the underlying, i.e., ‘volatility scan
range’ is fixed at 4% for Index options and is fixed at 10% for options on
individual stocks. The volatility scan range is applicable only for option
products.
Calendar spreads are offsetting positions in two contracts in the same
underlying across different expiry. In a portfolio-based margining approach,
all calendar-spread positions automatically get a margin offset. However, risk
arising due to difference in cost of carry or the ‘basis risk’ needs to be
addressed. It is, therefore, specified that a calendar spread charge would be
added to the worst scenario loss for arriving at the initial margin. For
computing calendar spread charge, the system first identifies spread positions
and then the spread charge, which is 0.5% per month on the far leg of the
spread with a minimum of 1% and maximum of 3%. Presently, calendar spread
position on exchange-traded equity derivatives has been granted calendar
spread treatment till the expiry of the near month contract.
In a portfolio of futures and options, the non-linear nature of options makes
short option positions most risky. Especially, short deep out of the money
options, which are highly susceptible to, changes in prices of the underlying.
Therefore, a short option minimum charge has been specified. The short option
minimum charge is 3% and 7.5% of the notional value of all short Index option
and stock option contracts, respectively. The short option minimum charge is
the initial margin if the sum of the worst-scenario loss and calendar spread
charge is lower than the short option minimum charge.
To calculate volatility estimates, the exchanges are required to use the
methodology specified in the Prof. J.R. Varma Committee Report on Risk
Containment Measures for Index Futures. Further, to calculate the option value
the exchanges can use standard option pricing models—Black-Scholes,
binomial, Merton, Adesi-Whaley.
The initial margin is required to be computed on a real-time basis and has
two components:
· The first is the creation of risk arrays taking prices at discreet times
taking latest prices and volatility estimates at the discreet times, which
have been specified.
· The second is the application of the risk arrays on the actual portfolio
positions to compute the portfolio values and the initial margin on a
real-time basis.
The initial margin so computed is deducted from the available liquid net
worth on a real time basis.
2.8.2 Calendar Spread Charge

The margin on calendar spread shall be calculated on the basis of delta of the
portfolio consisting of futures and options contracts in each month. A calendar
spread positions will be treated as non-spread (naked) positions in the far
month contract, three trading days prior to expiration of the near month
contract.
2.9 TYPES OF ORDERS

Orders in the F&O segment are entered by the trading members (TMs) as per
their requirements based on time, price and other conditions.
2.9.1 Time Condition

Orders can be entered into the system based on a timeframe basis by the TMs.
There are two types of orders based on time condition: day order and
immediate or cancel (IOC) order.
A day order is an order valid only for the day on which it is entered into the
system. The system will cancel the order automatically at the end of the day, if
the order is not executed by the end of the day.
An immediate or cancel order allows user to place an order, either to buy or sell
a contract in an immediate manner into the trading system. If the order does
not match with that in the system, then that order is cancelled at once from the
system. If the order satisfies partial match with the system, the remaining
unmatched portion of the order is cancelled instantly.
2.9.2 Price Condition

The stop loss price condition allows a user to release order into the system in the
case of buying and selling with a stop loss price, beyond which the client
cannot bear a loss on the particular stock or index. For a stop loss buy order,
with a trigger price1 of Rs. 120 and limit price of Rs. 130, the order will be
executed once the market price reaches Rs. 120. For a stop loss sell order, the
trigger price will be higher than the limit price.2
2.9.3 Other Conditions

Besides time and price conditions, there is another type of order known as
market order by which orders are placed, based on the current market price,
which is determined by the system itself and clients cannot buy or sell their
orders according to their choice of price.
1
Trigger price is the price at which an order gets triggered from the stop loss book.
2
Limit price is the price of the orders after triggering from the stop loss book.
22 Option Trading
2.10 SETTLEMENT SCHEDULE FOR OPTION CONTRACTS

· The premium settlement of index and securities option contracts works on T+1
working day settlement at or after 11.30 am for pay-in, whereas pay-out
works on T+1 working day at or after 12.00 pm. (T is the trade day.)
· Exercise and final settlement for index options is in the order of T+1 working
day at or after 11:30 am for pay-in and T+1 working day at or after 12.00
pm for pay-out. (T is the expiration day of the contract.)
· Interim exercise settlement for option contracts on individual securities is in
the order of T+1 working day at or after 11.30 am for pay-in and T+1
working day at or after 12.00 pm for pay-out. (T is the exercise day.)
· Exercise and final settlement for option contract on individual securities is in
the order of T+1 working day at or after 11.30 am for pay-in and T+1
working day at or after 12.00 pm for pay-out. (T is the expiration day of
the contract.)
2.11 SETTLEMENT MECHANISM
2.11.1 Premium Settlement
Premium settlement in the case of option contracts on index or individual
securities is cash settled, and the settlement style is premium. Net premium
payable or receivable at the end of each day for each CM is calculated by
netting across all the premium payable and premium receivable positions of
the client level. Those CMs having premium payable positions are required to
pay the premium amount to NSCCL that is passed on to the members with
premium receivable position, which is known as daily premium settlement.
Premium amounts from TMs and clients are collected and settled by CMs.
Premium settlement for pay-in and pay-out is done on T+1 days and the
premium payable amount and premium receivable amount is directly debited
or credited to the clearing bank account of CM.
2.11.2 Interim Exercise Settlement

Interim exercise settlement for option contracts on individual securities is
allowed only for valid exercised option positions at in-the-money strike prices
on the closing of trading hours on the exercise day. These valid option
positions of in-the-money contracts are matched to short positions in the same
series on a random basis. The interim exercise settlement value is computed as
the difference between strike price and settlement price of the relevant option
contract. The exercise settlement value is debited or credited on the T +1 day on
the clearing bank account of the CMs.
2.11.3 Final Exercise Settlement

Final exercise settlement for option positions of in-the-money strike prices at
the closing hours of trading hours on the expiration day of an option contract
are eligible for settlement. The long positions of in-the-money strike prices are
assigned automatically to short positions in option contracts with the same
series. Exercise style is European for index option contracts and is American
style for individual securities. The CMs will assign and allocate those
option contracts, which have been exercised at the client level. Exercise
settlement is cash settled and is debited or credited to the relevant
CM’s clearing accounts with the respective clearing bank. Final
settlement loss or profit amount for option contracts on index and
individual securities are credited or debited to the relevant CM’s
clearing bank account on the T+1 working day, where T is the day of
expiry. After the expiration day, open positions in option contracts do
not exist. The pay-in and pay-out of funds for a CM on a day is the net
amount across settlements of all TMs and clients.
2.12 WRITING OF OPTIONS

The process of selling an option contract is known as writing of options. The
seller of the option is the writer and the counterparty is the buyer. A call writer
has the obligation to sell the underlying asset to the option buyer whereas the
put buyer has the obligation to buy the underlying asset from the put buyer. An
option buyer can abandon the option which an option writer cannot do. If the
buyer decides to exercise the option, the seller has to meet his commitment.
Writing of options is explained with examples in the next chapter.
Summary
In this chapter, we have discussed the basics of option contracts and various
terminologies used in option-related transactions. We have also discussed the
trading systems, margins and settlement for investors and TMs in a brief
manner. These will be revisited at appropriate places in the remaining
chapters.
Keywords
Call option Put option Strike price In the money
Deep in the money At the money Deep out of the
Out of the money money
Time value Intrinsic value premium Volatility
Long position Short position Opening sell
Open interest
Opening buy Close out Closing buy Closing sell
Margin Short option minimum charge Settlement
American option European option
CHAPTER 03
OPTION TRADING
3.1 OBJECTIVES
In the last chapter we explained the concept of options, features of option
contracts, how options are different from forwards and futures, option
terminologies, margins and settlement mechanism. In this chapter we will
discuss the art of writing put options.
3.2 INTRODUCTION
Trading in options involve buying or selling options. Selling of options is
called writing of options. An investor can write an option by paying the
initial margin, which is the same as in the case of buying options, and also
the mark-to-market margin calculated by the NSE at the end of every day.
The investor should be aware of the trading mechanism, contract cycle and
charges other than the margin amount. This chapter will help the reader to
gain knowledge in these fields.
3.3 MARKET-WIDE LIMITS

Everyday at the end of the trading session, the exchange will check whether
the total trade done in calls and puts exceed 95% of the market-wide position
limit for that scrip set by the exchange. The exchange will collect details of
positions taken by clients at the end of the trading session on that particular
scrip and will see to it that trading done on the scrip from next day will be to
reduce such positions held by the clients till normal trading in the scrip is
resumed. Normal trading will only resume when the outstanding position in
the scrip moves down to 80% of the market wide position limits. An alert
comes on the trading screen when the open interest in a security moves
above 60% of the market-wide position limits set for the stock.
If any of the clients who places new order in spite of the ban on trade due
to the crossing of market-wide limits, apart from reducing his existing
positions in the stock, will be charged a penalty of 1% of the value of the
increased position subject to a minimum of Rs. 5000 and maximum of Rs.
10,00,00. This penalty will be recovered from the clearing member affiliated
with the trading members/clients on a T+1 basis along with the pay-in.
26 Option Trading
Trading Member-Wise Position Limits*: The position limits set for the
equity index options shall be higher of about 15% of the total open interest in
the market in all equity index options. The limit will be applicable on all option
contracts open positions in a particular underlying index.
Client Level Position Limits*: The total open position held by a client in all
the derivative contracts on any underlying index should not exceed the
following:
(1) 1% of the free float market capitalization.
(2) 5% of the open interest in all derivative contracts in the same underlying
stock. (whichever is higher in the above two cases)
Collateral Limits for Trading Members*: The clearing members who are
clearing and settling for trading members can specifically mention the
maximum collateral limit towards initial margin for each and every trading
member. These limits can be set through the facility provided on the trading
system at any time till the close of trading hours by the clearing member. The
limits thus set are applicable to the trading members and other participants for
that particular day unless otherwise modified by the clearing member.
3.3.1 Trading Mechanism*

NEAT-F&O trading system provides fully automated screen-based trading for
Nifty Futures & Options and Stock Futures & Options on a nationwide basis,
with an online monitoring and surveillance mechanism. Anonymous order-
driven market provides complete transparency of trading operations and
operates on a strict price-time priority. Trading Members and Clearing
Members only have the access to the NEAT-F&O trading system, of which,
trading members can perform functions such as order entry, order matching
and order and trade management. Clearing Members monitors trading
member’s trader workstation for which they clear the trades. Also, Clearing
Members can enter and set limits to positions just like that of a trading member.
Orders are matched automatically through the NEAT F&O system, done on the
basis of security’s price, time and quantity of which quantity fields are in units
and price in rupees. The lot size and tick size for each option contracts traded
are notified by the stock exchange from time to time. A trade is generated when
an active order finds a match on the other side of the order book. Active order
is the most recent order entering into the system. If there is no match in terms of
the price, quantity and time, the order will become inactive and will go and sit
into the respective outstanding order book in the system.
3.3.2 Contract Cycle*
In India, Futures and Options contracts on Stocks and Index expire on the last
Thursday of every month. At any point of time, there exists three contracts
available for trading for Stock options, one will be the current month contract,
second one will be the next month contract and the other one being the third
month contract. For example, in the month of November, there will be three
* Source: www.nseindia.com.
Option Trading 27
contracts: first is the November contract which should expire on the last
Thursday of November, second one is the December contract which expires on
the last Thursday of December and the last one is the January contract expiring
on the last Thursday of January. But on the other hand, option contracts
available for Nifty has now been extended to three years from three months.
That means on November 2008, option contracts available for Nifty options
are those ranging from Nov 2008 to Dec 2011.
Table 3.1 Contract Specification for S&P CNX Nifty Options*
Underlying Index S&P CNX NIFTY

Exchange of Trading NSE
Security Descriptor OPTIDXNIFTY
Contract Size Permitted Lot size is 50
Price Steps Rs. 0.05
Trading Cycle Maximum of three year trading cycle
Expiry Day Last Thursday of the expiry month or previous
trading day, if the last Thursday is a trading
holiday
Settlement Basis Cash settlement on a T+1 basis
Style of Option European
Strike Price Interval Rs. 50
Final Settlement Price Closing Value of Index on the last trading day
Table 3.2 Contract Specification for Stock Options*
Underlying Index Individual Securities Available for Trade in the

F&O Segment
Exchange of Trading NSE
Security Descriptor OPTSTK
Style of Option American
Strike Price Interval As specified by the exchange
Contract Size As specified by exchange
Price Steps Rs. 0.05
Price Bands Not Applicable
Trading Cycle Option contracts have a maximum of three-month
trading cycle—near month, next month and far
month(third)
Expiry Day Last Thursday of expiry month or previous trading
day, if the last Thursday is a holiday
(Contd.)
*Source: www.nseindia.com
28 Option Trading
Settlement Basis Daily settlement on T+1 basis and final option

exercise settlement on T+3 basis
Daily Settlement Price Premium Value (Net)
Final Settlement Price Closing price of underlying on exercise day or
expiry day
Settlement Day Last trading day
3.3.3 Generation of Strikes*

Based on the range in which previous day’s closing value of the index falls,
various strikes are introduced in Nifty and Stock options and are given
below:
· For Nifty Options
Table 3.3
Nifty Index Level Strike Price Interval Scheme of Strikes to be

Introduced
Up to 1500 10 3-1-3†
>1500 up to 2000 10 5-1-5
>2000 up to 2500 50 7-1-7
>2500 50 9-1-9
Up to 1500 Nifty level, the strike interval will be 10 and should have one at the money strike
price, three out of money and three in the money strike prices.
· For Stock options
Table 3.4
Underlying Price Strike Price Interval Scheme of Strikes

Introduced
Less than or equal to Rs.50 2.5 3-1-3
>Rs.50 – Rs.250 5 3-1-3
>Rs.250-Rs.500 10 3-1-3
>Rs.500-Rs.1000 20 3-1-3
>Rs.1000-Rs.2500 30 3-1-3
>Rs.2500 50 3-1-3
Option Trading 29
3.3.4 Charges*
In the F&O segment, the maximum brokerage chargeable by a trading member
fixed by NSE is at 2.5% of the contract value in the case of Index and Stock
Futures. (Contract Value = Futures price * Market Lot). For Index and Stock
options, it is 2.5% of the product of notional value of premium and quantity,
exclusive of statutory levies. Trading members are advised to charge brokerage
from the clients only on the Premium price, rather than Strike price.
3.3.5 Corporate Action Adjustments*

The basis for any adjustment for corporate actions shall be such that the value
of the position of the market participants, on the cum and ex-dates for the
corporate action, shall continue to remain the same as far as possible. This
will facilitate in retaining the relative status of positions viz., in-the-money, at-
the-money and out-of-money. This will also address issues related to exercise
and assignments.
3.3.5.1 Corporate Actions to be Adjusted*

The corporate actions may be broadly classified under stock benefits and cash
benefits.
The various stock benefits declared by the issuer of capital are:
· Bonus
· Rights
· Merger / De-merger
· Amalgamation
· Splits
· Consolidations
· Hive-off
· Warrants, and
· Secured Premium Notes (SPNs) among others.
The cash benefit declared by the issuer of capital is cash dividend.
3.3.5.2 Time of Adjustment

Any adjustment for corporate actions would be carried out on the last day on
which a security is traded on a cum basis in the underlying equities market,
after the close of trading hours.
3.3.5.3 Adjustment
Adjustments may entail modifications to positions and/or contract
specifications as listed below, such that the basic premise of adjustment laid
down above is satisfied:
(a) Strike Price
(b) Position
(c) Market Lot/Multiplier
30 Option Trading
The adjustments would be carried out on any or all of the above, based on
the nature of the corporate action. The adjustments for corporate actions
would be carried out on all open, exercised as well as assigned positions.
3.3.5.4 Methodology for Adjustment

The methodology to be followed for adjustment of various corporate actions to
be carried out are as follows:
A. Bonus, Stock Splits and Consolidations
Strike Price:
The new strike price shall be arrived at by dividing the old strike
price by the adjustment factor as under.
Market Lot / Multiplier:
The new market lot / multiplier shall be arrived at by multiplying
the old market lot by the adjustment factor as under.
Position:
The new position shall be arrived at by multiplying the old
position by the adjustment factor as under.
Adjustment factor:
Bonus - Ratio A:B Adjustment factor : (A+B)/B
Stock Splits and Consolidations
Ratio - A : B Adjustment factor : A/B
The above methodology may result in fractions due to the corporate
action, e.g., a bonus ratio of 3:7. With a view to minimizing fraction
settlements, the following method is adopted :
1. Compute value of the position before adjustment
2. Compute value of the position taking into account the exact
adjustment factor
3. Carry out rounding off for the Strike Price and Market Lot
4. Compute value of the position based on the revised strike
price and market lot
The difference between 1 and 4 above, if any, is decided in the
manner laid down by the relevant authority by adjusting Strike
Price or Market lot so that no forced closure of open position is
mandated.
B. Dividends

Dividends which are below 10% of the market value of the
underlying stock, would be deemed to be ordinary dividends and
no adjustment in the Strike Price would be made for ordinary
dividends. For extra-ordinary dividends, above 10% of the market
value of the underlying security, the Strike Price would be
adjusted.
To decide whether the dividend is “extra-ordinary” (i.e., over 10% of
the market price of the underlying stock.), the market price would
mean the closing price of the scrip on the day prior to the date on
Option Trading 31
which the announcement of the dividend is made by the company

after the meeting of the Board of Directors. However, in cases where
the announcement of dividend is made after the close of market
hours, the same day’s closing price would be taken as the market
price. Further, if the shareholders of the company in the AGM
change the rate of dividend declared by the Board of Directors, then
to decide whether the dividend is extraordinary or not would be
based on the rate of dividend communicated to the exchange after
AGM and the closing price of the scrip on the day prior to the date of
the AGM.
In case of the declaration of “extraordinary” dividend by any
company, the total dividend amount (special and/or ordinary)
would be reduced from all the strike prices of the option contracts on
that stock.
The revised strike prices would be applicable from the ex-dividend
date specified by the exchange.
C. Mergers
On the announcement of the record date for the merger, the exact
date of expiration (Last Cum-date) would be communicated to
members.
After the announcement of the Record Date, no fresh contracts on
Futures and Options would be introduced on the underlying, that
will cease to exist subsequent to the merger.
Unexpired contracts outstanding as on the last cum-date would be
compulsorily settled at the settlement price. The settlement price
shall be the closing price of the underlying on the last cum-date.
GTC/GTD orders for the futures & options contracts on the
underlying, outstanding at the close of business on the last cum-
date would be cancelled by the Exchange.
D. Rights
Rights Ratio A : B, Adjustment factor = (P–E)/P
Benefit per right entitlement To be multiplied by old strike price
(C) : P – S and divided into old lot size to
Benefit per share (E) : (P – S) arrive at the new strike price and lot
/ A+B size
Underlying close price on the
last cum date (P)
Issue price of the rights (S)
E.
The relevant authority may, on a case by case basis, carry out
adjustments for other corporate actions in conformity with the above
guidelines, including compulsory closing out, where it deems
necessary.
32 Option Trading
3.3.6 Collateral for Margins

Margin for options trading by clients in the F&O segment can be provided in
the form of collaterals. The collaterals can be segregated into cash and non
cash components- Cash, Bank Guarantee, Fixed Deposit Receipts (FDRs) and
Treasury Bills. Cash component includes cash, bank guarantee, fixed deposit
receipts, T-bills and dated government securities. Non-cash component
includes all other forms of collateral deposits like deposit of approved demat
securities. It is mandatory to have 50% of the Effective deposits in the form of
cash. The margin granted for trading in F&O segment is the sum of cash and
specified securities. Actual payment is needed for F&O segment in the case
of settlement dues from mark to market losses.
Cash: Margins given in the form of cash is done by way of allocation of funds
from the client’s bank account. For this, cash has to be made available in
client’s bank account on the end of trading hours on the date of which the
amount is due. In case, cash is not available with the client’s bank account,
trading member has the right to sell the securities deposited as margin. Pay-
in obligations of the clients are thus met by the trading members on sale of
securities.
Securities: Securities included in Group I are eligible as collateral for options
trading and has to be in the demat form. They are required to be valued or
marked to market on a daily basis after applied haircut, which is equivalent
to the VAR of the equity security. The securities are chosen by way of
depositing securities allocated from the client’s demat account. These
securities are selected by NSE and are attached in the website for the margin
purpose. Also, trading member has the right of choice to select securities on
selected criteria such as liquidity, volume etc. The securities would be subject
to a minimum margin of 15% on Nifty securities, and a minimum margin of
30% margin on other securities or such other margin percentage as may be
decided by NSCCL from time to time. It is mandatory that at least weekly
marking to market is to be carried out on all securities. In the case of debt
securities, collateral is sanctioned only for those having an investment grade.
In addition, 10% haircut with weekly mark to market is applied on debt
securities.
Units of Mutual Funds and Gilt Funds: Based on the Net Asset Value,
collaterals are allowed on Money market Mutual funds and Gilt Funds after
applying a 10% haircut on the NAV and any exit load charged by these
mutual funds. Other Mutual Funds are valued based on their NAV after
applying an haircut which is same as the VAR of the units NAV and any exit
load charged by the mutual fund.
Source: www.nseindia.com.
Option Trading 33
3.3.7 Eligibility Criteria for Securities in Options

Trading *
The eligibility of a stock / index for trading in Derivatives segment is based
upon the criteria laid down by SEBI through various circulars issued from
time to time. The latest circular issued in this respect is circular No. : SEBI/
DNPD/Cir-31/2006 dated September 22, 2006.
Based on various circulars, the following criteria will be adopted by the
Exchange w.e.f. September 22, 2006, for selecting stocks and indices on which
Futures & Options contracts would be introduced:
1. Eligibility criteria of stocks
· The stock shall be chosen from amongst the top 500 stocks in terms
of average daily market capitalisation and average daily traded
value in the previous six months on a rolling basis.
· The stock’s median quarter-sigma order size over the last six months
shall be not less than Rs. 0.10 million (Rs. 1 lakh). For this purpose,
a stock’s quarter-sigma order size shall mean the order size (in value
terms) required to cause a change in the stock price equal to one-
quarter of a standard deviation.
· The market wide position limit in the stock shall not be less than Rs.
500 million (Rs. 50 crore). The market wide position limit (number of
shares) shall be valued taking the closing prices of stocks in the
underlying cash market on the date of expiry of contract in the
month. The market wide position limit of open position (in terms of
the number of underlying stock) on futures and option contracts on
a particular underlying stock shall be 20% of the number of shares
held by non-promoters in the relevant underlying security i.e. free-
float holding.
2. Continued Eligibility
· For an existing stock to become ineligible, the criteria for market
wide position limit shall be relaxed upto 10% of the criteria
applicable for the stock to become eligible for derivatives trading. To
be dropped out of Derivatives segment, the stock will have to fail the
relaxed criteria for 3 consecutive months.
· If an existing security fails to meet the eligibility criteria for three
months consecutively, then no fresh month contract shall be issued
on that security.
· Further, the members may also refer to circular no. NSCC/F&O/
C&S/365 dated August 26, 2004, issued by NSCCL regarding
Market Wide Position Limit, wherein it is clarified that a stock
which has remained subject to a ban on new position for a
significant part of the month consistently for three months, shall be
phased out from trading in the F&O segment.
However, the existing unexpired contracts may be permitted to trade till
expiry and new strikes may also be introduced in the existing contract months.
*Source: www.nseindia.com.
34 Option Trading
3. Re-introduction of dropped stocks

A stock which is dropped from derivatives trading may become eligible
once again. In such instances, the stock is required to fulfill the eligibility
criteria for three consecutive months to be re-introduced for derivatives
trading.
4. Eligibility criteria of Indices
· Futures & Options contracts on an index can be introduced only if
80% of the index constituents are individually eligible for
derivatives trading. However, no single ineligible stock in the index
shall have a weightage of more than 5% in the index. The index on
which futures and options contracts are permitted shall be required
to comply with the eligibility criteria on a continuous basis.
· SEBI has subsequently modified the above criteria, vide its
clarification issued to the Exchange “The Exchange may consider
introducing derivative contracts on an index if the stocks
contributing to 80% weightage of the index are individually eligible
for derivative trading. However, no single ineligible stocks in the
index shall have a weightage of more than 5% in the index.”
· The above criteria is applied every month, if the index fails to meet
the eligibility criteria for three months consecutively, then no fresh
month contract shall be issued on that index, However, the existing
unexpired contacts shall be permitted to trade till expiry and new
strikes may also be introduced in the existing contracts.
3.3.8 Calculation of Quarter Sigma Order Size of Stock*

The following procedure is adopted for calculating the Quarter Sigma Order
Size:
1. The applicable VAR (Value at Risk) is calculated for each security based
on the J. R. Varma Committee guidelines. (The formula suggested by J. R.
Varma for computation of VAR for margin calculation is statistically
known as ‘Exponentially weighted moving average (EWMA)’ method.
In comparison to the traditional method, EWMA has the advantage of
giving more weight to the recent price movements and less weight to the
historical price movements.)
2. Such computed VAR is a value (like 0.03), which is also called standard
deviation or Sigma. (The meaning of this figure is that the security has
the probability to move 3% to the lower side or 3% to the upper side on
the next trading day from the current closing price of the security).
3. Such arrived at standard deviation (one sigma), is multiplied by 0.25 to
arrive at the quarter sigma.
(For example, if one sigma is 0.09, then quarter sigma is 0.09 * 0.25 =
0.0225.)
Option Trading 35
4. From the order snapshots (taken four times a day from NSE’s Capital
Market Segment order book) the average of best buy price and best sell
price is computed which is called the average price.
5. The quarter sigma is then multiplied with the average price to arrive at
quarter sigma price. The following example explains the same :
Security XYZ
Best Buy (in Rs.) 306.45
Best Sell (in Rs.) 306.90
Average Price 306.70
One Sigma 0.009
Quarter sigma 0.00225
Quarter sigma price (Rs.) (Average Price *Quarter sigma) 0.70
6. Based on the order snapshot, the value of the order (order size in Rs.),
which will move the price of the security by quarter sigma price in buy
and sell side is computed. The value of such order size is called
Quarter Sigma order size. (Based on the above example, it will be
required to compute the value of the order (Rs.) to move the stock price
to Rs. 306.00 in the buy side and Rs. 307.40 on the sell side. That is Buy
side = average price – quarter sigma price and Sell side = average price
+ quarter sigma price). Such an exercise is carried out for four order
snapshots per day for all stocks for the previous six months period.
7. From the above determined quarter sigma order size (Rs.) for each
order book snap shot for each security, the median of the order sizes
(Rs.) for buy side and sell side separately, are computed for all the
order snapshots taken together for the last six months.
8. The average of the median order sizes for buy and sell side are taken as
the median quarter sigma order size for the security.
9. The securities whose median quarter sigma order size is equal to or
greater than Rs. 0.1 million (Rs. 1 Lakh) qualify for inclusion in the F&O
segment.
Futures & Options contracts may be introduced on new securities which
meet the above mentioned eligibility criteria, subject to approval by SEBI.
New securities being introduced in the F&O segment are based on the
eligibility criteria which take into consideration average daily market
capitalization, average daily traded value, the market wide position limit in
the security, the quarter sigma values and as approved by SEBI. The average
daily market capitalisation and the average daily traded value would be
computed on the 15th of each month, on a rolling basis, to arrive at the list of
top 500 securities. Similarly, the quarter sigma order size in a stock would
also be calculated on the 15th of each month, on a rolling basis, considering
the order book snapshots of securities in the previous six months and the
market wide position limit (number of shares) shall be valued taking the
36 Option Trading
closing prices of stocks in the underlying cash market on the date of expiry of
contract in the month. The number of eligible securities may vary from month
to month depending upon the changes in quarter sigma order sizes, average
daily market capitalisation and average daily traded value calculated every
month on a rolling basis for the past six months and the market wide position
limit in that security. Consequently, the procedure for introducing and
dropping securities on which option and future contracts are traded will be as
stipulated by SEBI in its circular no. SEBI/DNPD/Cir-26/2004/07/16 dated
July 16, 2004.
3.3.9 Selection Criteria for Mini Derivative Contracts*
Mini derivative contracts (Futures and options) shall be made available for
trading on such indices/securities as specified by SEBI from time to time.
3.3.10 Eli.gibility Criteria for Long Term Option
Contracts*
Vide its circular no. SEBI/DNPD/Cir-34/2008 dated January 11, 2008 SEBI
has specifically permitted introduction of option contracts with longer tenure
on S&P CNX Nifty index.
3.3.11 Selection Criteria for Unlisted Companies*
For unlisted companies coming out with initial public offering, if the net public
offer is Rs. 500 crore. or more, then the Exchange may consider introducing
stock options and stock futures on such stocks at the time of its’ listing in the
cash market.
Source: www.nseindia.com.
3.3.12 Stocks in F&O Segment*

Stock Futures available in the F&O segment of NSE as on 31st March, 2009 are
given below. Currently, 240 scrips have been trading in the F&O segment.
Derivatives on Individual Securities
Aban Offshore Ltd. Asian Layland Ltd

Abb Ltd. Asian Paints Limited
Aditya Birla Nuvo Limited Associated Cement Co.Ltd.
Adlabs Films Ltd Aurobindo Pharma Ltd.
Allahabad Bank Axis Bank Ltd.
Alstom Projects India Ltd Bajaj Auto Limited
Ambuja Cements Ltd. Bajaj Hindustan Ltd.
Andhra Bank Bajaj Holdings & Investment Ltd.
Ashok Leyland Ltd Balrampur Chini Mills Ltd
Option Trading 37
Bank of Baroda Financial Technologies (I) Ltd.

Bank of India Firstsource Solutions Limited
Bharat Earth Movers Ltd. Gail (India) Ltd.
Bharat Electronics Ltd. Glaxosmithkline Pharma Ltd.
Bharat Forge Co. Ltd GMR Infrastructure Ltd.
Bharat Heavy Electricals Ltd. Grasim Industries Ltd.
Bharat Petroleum Corporation Ltd. Great Offshore Ltd.
Bharti Airtel Ltd GTL Infrastructure Limited
Bhushan Steel & Strips Ltd. GTL Ltd.
Biocon Limited. Gujarat State Petronet Ltd.
Bombay Rayon Fashions Ltd.
GVK Power & Infrastructure Ltd.
Cairn India Limited
HCL Technologies Ltd.
Canara Bank
HDFC Bank Ltd.
Century Textiles Ltd.
Hero Honda Motors Ltd.
Cesc Ltd.
Hindalco Industries Ltd.
Chambal Fertilizers Ltd.
Hindustan Construction Co.
Chennai Petroleum Corporation Ltd.
Hindustan Petroleum Corporation Ltd.
Cipla Ltd.
Hindustan Unilever Ltd.
Colgate Palmolive Ltd.
Hindustan Zinc Limited
Container Corpation of India Ltd.
Hotel Leela Ventures Ltd.
Corporation Bank
Housing Development and
Crompton Greaves Ltd.
Infrastructure Ltd.
Cummins India Ltd.
Housing Development Finance
Dabur India Ltd. Corporation Ltd.
Deccan Chronicle Holdings Ltd. ICICI Bank Ltd.
Dena Bank ICSA (India) Limited
Dish TV India Ltd. Idea Cellular Ltd.
Divi’s Laboratories Ltd. IFCI Ltd.
DLF Limited
India Cements Ltd.
Jaiprakash Hydro-Power Ltd.
India Infoline Limited
Jindal Saw Limited
Indiabulls Real Estate Limited
Dr. Reddy’s Laboratories Ltd.
Indian Bank
Educomp Solutions Ltd.
Indian Hotels Co. Ltd.
Essar Oil Ltd.
Indian Oil Corporation Ltd.
Everest Kanto Cylinder Ltd.
Indian Overseas Bank
Federal Bank Ltd.
38 Option Trading
Indusind Bank Ltd. Noida Toll Bridge Company Ltd.

Industrial Development Bank of Oil & Natural Gas Corp. Ltd.
India Ltd.
Opto Circuits (India) Ltd.
Infosys Technologies Ltd.
Oracle Financial Service Software Ltd.
Infrastructure Development Finance
Orchid Chemicals Ltd.
Company Ltd.
Ispat Industries Limited Oriental Bank of Commerce
ITC Ltd. Pantaloon Retail (I) Ltd.
IVRCL Infrastructure & Projects Ltd. Patel Engineering Ltd.
Jaiprakash Associates Ltd. Patni Computer System Ltd.
Reliance Industries Ltd. Petronet LNG Limited

Reliance Infrastucture Limited Piramal Healthcare Ltd
Jindal Steel & Power Ltd. Polaris Software Lab Ltd.
JSW Steel Ltd. Power Finance Corporation Ltd.
K S Oils Limited Power Grid Corporation of India
Kingfisher Airlines Ltd. Ltd.
Kotak Mahindra Bank Ltd. Praj Industries Ltd.
Lanco Infratech Ltd. PTC India Limited

Larsen & Toubro Ltd. Punj Lloyd Ltd.
LIC Housing Finance Ltd. Punjab National Bank
Lupin Ltd. Ranbaxy Laboratories Ltd.
Mahanagar Telephone Nigam Ltd. Rel. Nat. Resources Ltd.
Mahindra & Mahindra Ltd. Reliance Capital Ltd.
Mangalore Refinery and Petro- Reliance Communications Ltd.
chemicals Ltd.
Reliance Petroleum Ltd.
Maruti Udyog Ltd.
Reliance Power Ltd.
Mercator Lines Limited
Rolta India Ltd.
Moser-Baer (I) Ltd.
Rural Electrification Corporation Ltd.
Motor Industries Co. Ltd.
Sesa Goa Ltd.
Mphasis Ltd.
Nagarjuna Constrn. Co. Ltd. Shipping Corporation of India Ltd.
Nagarjuna Fertiliser & Chemicals Shree Renuka Sugars Ltd.

Ltd. Siemens Ltd
National Aluminium Co. Ltd. Sintex Industries Ltd.
National Thermal Power Corpora- State Bank of India
tion Ltd.
Steel Authority of India Ltd.
Neyveli Lignite Corporation Ltd.
Option Trading 39
Sterling Biotech Ltd. The Great Eastern Shipping Co. Ltd.
Sterlite Industries (I) Ltd. Titan Industries Ltd.
Sun Pharmaceuticals India Ltd. Triveni Engg. & Inds. Ltd.
Sun TV Network Ltd. Tulip IT Services Ltd.
Suzlon Energy Ltd. UCO Bank
Syndicate Bank Ultratech Cement Ltd.
Tata Chemicals Ltd. Union Bank of India
Tata Communications Ltd Unitech Ltd.
Tata Consultancy Services Ltd. United Phosphorous Ltd.
Tata Motors Ltd. United Spirits Ltd.
Tata Power Co. Ltd. Vijaya Bank
Tata Steel Ltd. Voltas Ltd.

Welspun Guj. St. Ro. Ltd.
Tata Tea Ltd.
Tata Teleserv(Maharashtra) Wipro Ltd.
Yes Bank Limited
Tech Mahindra Limited
Zee Entertainment Enterprises Ltd.
Television Eighteen India Ltd.
* These are stocks that are excluded from the F&O segment from March 2009
onwards.
Summary
In this chapter we have explained the market-wide limits and the trading
mechanism that exists in the option market which the investors should keep in
mind. More details regarding the contract cycle, charges involved and
collateral margins are also given in this chapter. Finally, we have explained
the criteria for including stock in the F&O segment, detailed the scrips
included in the F&O segment and discussed the calculation of quarter sigma.
In the next chapter we present the price indices and how they are constructed,
their uses etc.
Keywords
Market-wide limits Contract cycle Collateral for margins
Quarter sigma Bonus Stock split
Dividend Mergers Rights
40 Option Trading
CHAPTER 04
PRICE INDEX
4.1 OBJECTIVES
In the previous chapter, we discussed about the basics of options as well as the
process of writing options together with some of the market practices. We have
also explained some of the basic practices followed in option trading. Apart
from individual stock options there are index options also. In this chapter, we
will explain the concept of price index, construction of index and the scrips
included in the index.
4.2 INTRODUCTION
Market sentiment is expressed through index. We can say that traders are the
barometer of a stock market. Various sectors have different indices such as the
IT index, which relates to the information and technology stocks. Nifty is the
most preferred index in India. Fifty stocks constitute Nifty.
4.3 WHAT IS AN INDEX?

An Index is a barometer for the stock market. It also represents a country’s
growth, weakness, and strength. as it is a numerical measure indicating the
movement of prices of a basket of items specified over a period of time based
on the prices prevalent on a base year. Index can be created for any series of
data. Consumer price index, wholesale price index etc. are examples of indices.
In stock market, the price movement is measured using stock index. BSE has its
index, which is called as Sensex and NSE having S&P CNX Nifty. Each of
these have sub-indices representing sectors like Banking, FMCG, Automobile,
etc. Similarly, the indices based on size of market capitalization like midcap,
small cap, large cap, etc. also is used for measuring the price movement.
Newspapers also have created their own indices for evaluation purpose.
Economic Times 100, Economic Times midcap, ET Automobiles etc. are examples of
the indices created by Economic Times. Other newspapers also have created
similar indices.
42 Option Trading
4.4 ELIGIBILITY CRITERIA OF INDICES

· Futures & Options contracts on an index can be introduced only if 80%
of the index constituents are individually eligible for derivatives
trading. However, no single ineligible stock in the index shall have a
weightage of more than 5% in the index. The index on which futures and
options contracts are permitted shall be required to comply with the
eligibility criteria on a continuous basis.
· SEBI has subsequently modified the above criteria; vide its clarification
issued to the Exchange “The Exchange may consider introducing
derivative contracts on an index if the stocks contributing to 80%
weightage of the index are individually eligible for derivative trading.
However, no single ineligible stocks in the index shall have a weightage
of more than 5% in the index.”
· The above criteria is applied every month, if the index fails to meet the
eligibility criteria for three months consecutively, then no fresh month
contract shall be issued on that index, However, the existing unexpired
contacts shall be permitted to trade till expiry and new strikes may also
be introduced in the existing contracts.
4.5 CONSTRUCTION OF INDEX

In NSE, indices are owned and managed by India Index Services and Products
Ltd. (IISL), a joint venture between NSE and CRISIL. Standard & Poors (S&P)
has marketing and licensing agreement with IISL, which is India’s first
specialized company with index as the core product. In NSE, nine indices are
maintained, computed and traded.
Table 4.1 provides the market capitization of an index.
Table 4.1 Market Capitalization of an Index
Company Current market cap (lakhs) Base market cap (lakhs)

XYZ 1665682 1613285.5
NMO 821545 813005.25
TES 1289632.55 1295489.6
QAR 2482149.8 2421882.05
GTA 594229.25 598117.4
Total 6853238.6 6741779.8
Index = (Current market capitalization/base market capitalization) ´ Base

value
Current market capitalization = 6853238.6
Base market capitalization = 6741779.8
Base value = 100
So the index value works out to be 101.65.
Price Index 43
4.6 DESIRABLE ATTRIBUTES OF AN INDEX

The three main attributes of an index are:
1. It should capture the behavior of a large variety of different portfolios in
the market. This is achieved by diversification in such a manner that a
portfolio is not vulnerable to any individual stock or industry risk. If
illiquid stocks are included in the index calculation, then the index will
not reflect the current price behaviour of the market and it may show
stale price behavior.
2. It should include liquid stocks. Liquidity is the ability to transact at a
price which is very close to the current price. A liquid stock has very
tight bidask spread.
3. It should be maintained professionally. The index should contain
stocks with little impact cost as possible. A good index methodology
must therefore incorporate a steady pace. It is quite healthy to make a
few changes every year, each of which is small and does not dramatically
alter the character of the index.
S&P CNX NIFTY*:
S&P CNX Nifty is a well diversified 50-stock index accounting for 22 sectors of
the Indian economy. It is used for a variety of purposes such as benchmarking
fund portfolios, index based derivatives and index funds.
S&P CNX Nifty is owned and managed by India Index Services and
Products Ltd. (IISL), which is a joint venture between NSE and CRISIL. IISL is
India’s first specialised company focused upon the index as a core product.
IISL has a Marketing and licensing agreement with Standard & Poor’s (S&P),
who are world leaders in index services.
· The average total traded value for the last six months of all Nifty stocks
is approximately 62.45% of the traded value of all stocks on the NSE
· Nifty stocks represent about 63.98% of the total market capitalization
as on January 30, 2009.
· Impact cost of the S&P CNX Nifty for a portfolio size of Rs. 2 crore is
0.16%
· S&P CNX Nifty is professionally maintained and is ideal for
derivatives trading.
Criteria for Selection of Constituent Stocks

The constituents and the criteria for the selection judge the effectiveness of
the index. Selection of the index set is based on the following criteria:
Liquidity (Impact Cost)

For inclusion in the index, the security should have traded at an average
impact cost of 0.50% or less during the last six months for 90% of the
observations for a basket size of Rs. 2 crore.
* Source: www.nseindia.com
44 Option Trading
Impact cost is the cost of executing a transaction in a security in proportion

to the weightage of its market capitalization as against the index market
capitalisation at any point of time. This is the percentage mark-up suffered
while buying/selling the desired quantity of a security compared to its ideal
price (best buy + best sell)/2.
Floating Stock
Companies eligible for inclusion in S&P CNX Nifty should have atleast 10%
floating stock. For this purpose, floating stock means stocks which are not held
by the promoters and associated entities (where identifiable) of such
companies.
Others
(a) A company which comes out with a IPO will be eligible for inclusion in
the index, if it fulfills the normal eligibility criteria for the index like
impact cost, market capitalization and floating stock, for a 3 month
period instead of a 6 month period.
(b) Replacement of Stock from the Index:
A stock may be replaced from an index for the following reasons:
(i) Compulsory changes like corporate actions, delisting etc. In such a
scenario, the stock having largest market capitalization and satisfying
other requirements related to liquidity, turnover and free float will be
considered for inclusion.
(ii) When a better candidate is available in the replacement pool, which can
replace the index stock, i.e., the stock with the highest market
capitalization in the replacement pool has at least twice the market
capitalization of the index stock with the lowest market capitalization.
With respect to (2) above, a maximum of 10% of the index size (number of
stocks in the index) may be changed in a calendar year. Changes carried out
for (2) above are irrespective of changes, if any, carried out for (1) above.
Table 4.2 List of Nifty 50 Stocks*
Company Name Industry Symbol

ABB Ltd. ELECTRICAL EQUIPMENT ABB
ACC Ltd. CEMENT AND CEMENT PRODUCTS ACC
Ambuja Cements Ltd. CEMENT AND CEMENT PRODUCTS AMBUJACEM
Axis Bank Ltd. BANKS AXIS BANK
Bharat Heavy ELECTRICAL EQUIPMENT BHEL
Electricals Ltd.
Bharat Petroleum REFINERIES BPCL
Corporation Ltd.
Price Index 45

Bharti Airtel Ltd. TELECOMMUNICATION - BHARTIARTL
SERVICES
Cairn India Ltd. OIL EXPLORATION/ CAIRN
PRODUCTION
Cipla Ltd. PHARMACEUTICALS CIPLA
DLF Ltd. CONSTRUCTION DLF
GAIL (India) Ltd. GAS GAIL
Grasim CEMENT AND CEMENT GRASIM
Industries Ltd. PRODUCTS
HCL Technologies Ltd. COMPUTERS - SOFTWARE HCLTECH
HDFC Bank Ltd. BANKS HDFCBANK
Hero Honda AUTOMOBILES - 2 AND 3 HEROHONDA
Motors Ltd. WHEELERS
Hindalco ALUMINIUM HINDALCO
Industries Ltd.
Hindustan DIVERSIFIED HINDUNILVR
Unilever Ltd.
Housing Development FINANCE - HOUSING HDFC
Finance Corporation Ltd.
I T C Ltd. CIGARETTES ITC
ICICI Bank Ltd. BANKS ICICIBANK
Idea Cellular Ltd. TELECOMMUNICATION- IDEA
SERVICES
Infosys Technologies Ltd. COMPUTERS -SOFTWARE INFOSYSTCH
Jindal Steel & Power Ltd. STEEL AND STEEL PRODUCTS JINDALSTEL
Larsen & Toubro Ltd. ENGINEERING LT
Mahindra & AUTOMOBILES -4 WHEELERS M&M
Mahindra Ltd.
Maruti Suzuki India Ltd. AUTOMOBILES -4 WHEELERS MARUTI
NTPC Ltd. POWER NTPC
National ALUMINIUM NATIONALUM
Aluminium Co.Ltd.
Oil & Natural Gas OIL EXPLORATION/ ONGC
Corporation Ltd. PRODUCTION
46 Option Trading

Power Grid POWER POWERGRID
Corporation of India Ltd.
Punjab National Bank BANKS PNB
Ranbaxy Laboratories Ltd. PHARMACEUTICALS RANBAXY
Reliance Capital Ltd. FINANCE RELCAPITAL
Reliance TELECOMMUNICATION - RCOM
Communications Ltd. SERVICES
Reliance Industries Ltd. REFINERIES RELIANCE
Reliance Infrastructure POWER RELINFRA
Ltd.
Reliance Power Ltd. POWER RPOWER
Siemens Ltd. ELECTRICAL EQUIPMENT SIEMENS
State Bank of India BANKS SBIN
Steel Authority STEEL AND STEEL PRODUCTS SAIL
of India Ltd.
Sterlite Industries METALS STER
(India) Ltd.
Sun Pharmaceutical PHARMACEUTICALS SUNPHARMA
Industries Ltd.
Suzlon Energy Ltd. ELECTRICAL EQUIPMENT SUZLON
Tata Communi- TELECOMMUNICATION - TATACOMM
cations Ltd. SERVICES
Tata Consultancy COMPUTERS - SOFTWARE TCS
Services Ltd.
Tata Motors Ltd. AUTOMOBILES - 4 TATAMOTORS
WHEELERS
Tata Power Co. Ltd. POWER TATAPOWER
Tata Steel Ltd. STEEL AND STEEL PRODUCTS TATASTEEL
Unitech Ltd. CONSTRUCTION UNITECH
Wipro Ltd. COMPUTERS - SOFTWARE WIPRO
CNX Nifty Junior*

The next rung of liquid securities after S&P CNX Nifty is the CNX Nifty Junior.
It may be useful to think of the S&P CNX Nifty and the CNX Nifty Junior as
making up the 100 most liquid stocks in India. As with the S&P CNX Nifty,
stocks in the CNX Nifty Junior are filtered for liquidity, so they are the most
liquid of the stocks excluded from the S&P CNX Nifty. The maintenance of the
S&P CNX Nifty and the CNX Nifty Junior are synchronized so that the two
Price Index 47
indices will always be disjoint sets, i.e., a stock will never appear in both
indices at the same time. Hence, it is always meaningful to pool the S&P CNX
Nifty and the CNX Nifty Junior into a composite 100 stock index or portfolio.
· CNX Nifty Junior represents about 9.62 % of the total market capitaliz-
ation as on Jan 30, 2009.
· The average traded value for the last six months of all Junior Nifty stocks
is approximately 16.86% of the traded value of all stocks on the NSE
· Impact cost for CNX Nifty Junior for a portfolio size of Rs. 50 lakh is
0.23%.
The constituents and the criteria for the selection judge the effectiveness of the
index. Selection of the index set is based on the following criteria:
Liquidity (Impact Cost)
For inclusion in the index, the security should have traded at an average
impact cost of 0.5% or less during the last six months for 90% of the
observations for a basket size of Rs. 50 lakh.
Floating Stock
Companies eligible for inclusion in the CNX Nifty Junior should have atleast
10% floating stock. For this purpose, floating stock means stocks which are not
held by the promoters and associated entities (where identifiable) of such
companies.
Others
A company which comes out with a IPO will be eligible for inclusion in the
index, if it fulfills the normal eligiblity criteria for the index like impact cost,
market capitalization and floating stock, for a 3 month period instead of a 6
months period
Replacement of Stock from the Index:
A stock may be replaced from an index for the following reasons:
(i) Compulsory changes like corporate actions, delisting etc. In such a
scenario, the stock having largest market capitalization and satisfying
other requirements related to liquidity, turnover and free float will be
considered for inclusion.
(ii) When a better candidate is available in the replacement pool, which can
replace the index stock, i.e., the stock with the highest market
capitalization in the replacement pool has at least twice the market
capitalization of the index stock with the lowest market capitalization.
However where a stock is replaced due to a stock being transferred to
S&P CNX Nifty then the stock coming into CNX Nifty Junior need not
have twice the market capitalization of the stock which is being
transferred to S&P CNX Nifty.
With respect to (ii) above, a maximum of 10% of the index size (number of
stocks in the index) may be changed in a calendar year. Changes carried out
for (ii) above are irrespective of changes, if any, carried out for (i) above.
48 Option Trading
Table 4.3 List of Nifty Junior Stocks

Aditya Birla Nuvo Ltd. TEXTILES - SYNTHETIC ABIRLANUVO
Andhra Bank BANKS ANDHRABANK
Adani Enterprises Ltd. TRADING ADANIENT
Apollo Tyres Ltd. TYRES APOLLOTYRE
Ashok Leyland Ltd. AUTOMOBILES - 4 ASHOKLEY
WHEELERS
Asian Paints Ltd. PAINTS ASIANPAINT
Bank of Baroda BANKS BANKBARODA
Bank of India BANKS BANKINDIA
Bharat Electronics Ltd. ELECTRONICS BEL
- INDUSTRIAL
Bharat Forge Ltd. CASTINGS/FORGINGS BHARATFORG
Biocon Ltd. PHARMACEUTICALS BIOCON
Canara Bank BANKS CANBK
Chennai Petroleum REFINERIES CHENNPETRO
Corporation Ltd.
Container Corporation TRAVEL AND CONCOR
of India Ltd. TRANSPORT
Corporation Bank BANKS CORPBANK
Cummins India Ltd. DIESEL ENGINES CUMMINSIND
Dr. Reddy’s PHARMACEUTICALS DRREDDY
Laboratories Ltd.
Glaxosmithkline PHARMACEUTICALS GLAXO
Pharmaceuticals Ltd.
GMR Infrastructure Ltd. CONSTRUCTION GMRINFRA
Glenmark PHARMACEUTICALS GLENMARK
Hindustan Petroleum REFINERIES HINDPETRO
Corporation Ltd.
Housing Development CONSTRUCTION HDIL
and Infrastructure Ltd.
IDBI Bank Ltd. BANKS IDBI
IFCI Ltd. FINANCIAL INSTITUTION IFCI
Price Index 49

Indian Hotels Co. Ltd. HOTELS INDHOTEL
Indian Overseas Bank BANKS IOB
Infrastructure FINANCIAL INSTITUTION IDFC
Development Finance Co. Ltd.
JSW Steel Ltd. STEEL AND STEEL JSWSTEEL
PRODUCTS
Jaiprakash Associates Ltd. DIVERSIFIED JPASSOCIAT
Kotak Mahindra Bank Ltd. BANKS KOTAKBANK
LIC Housing Finance Ltd. FINANCE-HOUSING LICHSGFIN
Lupin Ltd. PHARMACEUTICALS LUPIN
Mangalore Refinery & REFINERIES MRPL
Poetrochemicals Ltd.
Moser Baer India Ltd. COMPUTERS-HARDWARE MOSERBAER
MphasiS Ltd. COMPUTERS-SOFTWARE MPHASIS
Mundra Port and Special TRAVEL AND MUNDRAPORT
Economic Zone Ltd. TRANSPORT
Oracle Financial COMPUTERS-SOFTWARE OFSS
Services Software Ltd.
Patni Computer Systems Ltd. COMPUTERS-SOFTWARE PATNI
Power Finance FINANCIAL INSTITUTION PFC
Corporation Ltd.
Raymond Ltd. TEXTILE PRODUCTS RAYMOND
Reliance Natural GAS RNRL
Resources Ltd.
Sesa Goa Ltd. MINING SESAGOA
Syndicate Bank BANKS SYNDIBANK
Tata Teleservices TELECOMMUNICATION- TTML
(Maharashtra) Ltd. SERVICES
Tech Mahindra Ltd. COMPUTERS - SOFTWARE TECHM
UltraTech Cement Ltd. CEMENT AND CEMENT ULTRACEMCO
PRODUCTS
Union Bank of India BANKS UNIONBANK
United Spirits Ltd. BREW/DISTILLERIES MCDOWELL-N
Vijaya Bank BANKS VIJAYABANK
Wockhardt Ltd. PHARMACEUTICALS WOCKPHARMA
50 Option Trading
S&P CNX IT Index*

Information Technology industry has played a major role in the Indian
economy during the last few years. A number of large, profitable Indian
companies today belong to the IT sector and a great deal of investment interest
is now focused on the IT sector. In order to have a good benchmark of the
Indian IT sector, IISL has developed the CNX IT sector index. CNX IT provides
investors and market intermediaries with an appropriate benchmark that
captures the performance of the IT segment of the market.
Companies in this index are those that have more than 50% of their turnover
from IT related activities like software development, hardware manufacture,
vending, support and maintenance.The average total traded value for the last
six months of CNX IT Index stocks is approximately 91% of the traded value of
the IT sector. CNX IT Index stocks represent about 96% of the total market
capitalization of the IT sector as on March 31, 2005. The average total traded
value for the last six months of all CNX IT Index constituents is approximately
14% of the traded value of all stocks on the NSE. CNX IT Index constituents
represent about 14% of the total market capitalization as on March 31, 2005.
Methodology
The index is a market capitalization weighted index with its base period being
December 1995 and the base date and base value being January 1, 1996 and
1,000 respectively.
The Base Value of the index is being revised from 1000 to 100 w.e.f. 28 May
2004.
Selection Criteria
Selection of the index set is based on the following criteria :
1. Company’s market capitalization rank in the universe should be less
than 500.
2. Company’s turnover rank in the universe should be less than 500.
3. Company’s trading frequency should be at least 90% in the last six
months.
4. Company should have a positive networth.
5. A company which comes out with a IPO will be eligible for inclusion in
the index, if it fulfills the normal eligibility criteria for the index for a
three-month period instead of a six-month period.
Table 4.4 List of Stocks in CNX IT Index

CMC Ltd. COMPUTERS - HARDWARE CMC
Core Projects & COMPUTERS - SOFTWARE COREPROTEC
Technologies Ltd.
Price Index 51

Educomp COMPUTERS - SOFTWARE EDUCOMP
Solutions Ltd.
Financial Techno- COMPUTERS - SOFTWARE FINANTECH
logies (India) Ltd.
Firstsource COMPUTERS - SOFTWARE FSL
Solutions Ltd.
GTL Ltd. TELECOMMUNICATION - GTL
SERVICES
HCL Infosystems Ltd. COMPUTERS - HARDWARE HCL-INSYS
Hexaware COMPUTERS - SOFTWARE HEXAWARE
Technologies Ltd.
Infosys Techno- COMPUTERS - SOFTWARE INFOSYSTCH
logies Ltd.
MindTree Ltd. COMPUTERS - SOFTWARE MINDTREE
Moser Baer India Ltd. COMPUTERS - HARDWARE MOSERBAER
Mphasis Ltd. COMPUTERS - SOFTWARE MPHASIS
Oracle Financial COMPUTERS - SOFTWARE OFSS
Patni Computer COMPUTERS - SOFTWARE PATNI
Systems Ltd.
Polaris Software COMPUTERS - SOFTWARE POLARIS
Lab Ltd.
Rolta India Ltd. COMPUTERS - SOFTWARE ROLTA
Services Ltd.
CNX Bank Index*

CNX Bank Index is an index comprised of the most liquid and large capitalized
Indian Banking stocks. It provides investors and market intermediaries with a
benchmark that captures the capital market performance of Indian Banks.The
index will have 12 stocks from the banking sector which trade on the National
Stock Exchange.
The average total traded value for the last six months of CNX Bank Index
stocks is approximately 82% of the traded value of the banking sector. CNX
Bank Index stocks represent about 88% of the total market capitalization of the
banking sector as on March 31, 2005.
52 Option Trading
The average total traded value for the last six months of all the CNX Bank
Index constituents is approximately 7% of the traded value of all stocks on the
NSE. CNX Bank Index constituents represent about 7% of the total market
capitalization as on May 31, 2008.
Methodology
The index is a market capitalization-weighted index with base date of 1
January, 2000, indexed to a base value of 1000.
Selection Criteria
Selection of the index set is based on the following criteria:
1. Company’s market capitalization rank in the universe should be less
than 500.
2. Company’s turnover rank in the universe should be less than 500.
3. Company’s trading frequency should be at least 90% in the last six
months.
4. Company should have a positive networth.
5. A company which comes out with a IPO will be eligible for inclusion
in the index, if it fulfills the normal eligiblity criteria for the index for
three months instead of a six month.
Table 4.5 List of Stocks in Bank Index

Axis Bank Ltd. BANKS AXISBANK
Oriental Bank of Commerce BANKS ORIENTBANK
CNX 100 Index*

CNX 100 is a diversified 100 stock index accounting for 35 sectors of the
economy.
*Source: www.nseindia.com
Price Index 53
CNX 100 is owned and managed by India Index Services & Products Ltd.
(IISL), which is a joint venture between CRISIL & NSE. IISL is India’s first
specialized company focused upon the index as a core products. IISL has a
licensing and marketing agreement with Standard & Poor’s (S&P), who are
leaders in index services.
· CNX 100 represents about 73.60% of the total market capitalization as
on Jan 30, 2009.
· The average traded value for the last six months of all CNX100 stocks is
approximately 79.31 % of the traded value of all stocks on the NSE
· Impact cost for CNX 100 for a portfolio size of Rs. 3 crore is 0.18%.
Method of Computation
CNX 100 is computed using market capitalization weighted method, wherein
the level of the index reflects the total market value of all the stocks in the index
relative to a particular base period. The method also takes into account
constituent changes in the index and importantly corporate actions such as
stock splits, rights, etc., without affecting the index value.
Base Date and Value
The CNX 100 Index has a base date of Jan 1, 2003 and a base value of 1000.
CNX 100 index would comprise of the securities, which are constituents of
S&P CNX Nifty, and CNX Nifty Junior. In other words this index is a
combination of the S&P CNX Nifty and CNX Nifty Junior. Any changes i.e.
inclusion and exclusion of securities in S&P CNX Nifty and CNX Nifty Junior
would be automatically mirrored in this new index.
Table 4.6 List of Stocks in CNX 100 Index

ACC Ltd. CEMENT AND ACC
CEMENT PRODUCTS
Ambuja Cements Ltd. CEMENT AND AMBUJACEM
CEMENT PRODUCTS
WHEELERS
54 Option Trading

Bank of Baroda. BANKS BANKBARODA
Bharat Electronics Ltd. ELECTRONICS - BEL
INDUSTRIAL
Bharat Heavy ELECTRICAL EQUIPMENT BHEL
Electricals Ltd.
Corporation Ltd.
SERVICES
PRODUCTION
Corporation Ltd.
Container Corporation TRAVEL AND TRANSPORT CONCOR
of India Ltd.
Laboratories Ltd.
Grasim Industries Ltd. CEMENT AND GRASIM
CEMENT PRODUCTS
Hero Honda Motors Ltd. AUTOMOBI LES - 2 HEROHONDA
AND 3 WHEELERS
Hindalco Industries Ltd. ALUMINIUM HINDALCO
Hindustan Unilever Ltd. DIVERSIFIED HINDUNILVR
Price Index 55

Corporation Ltd.
IFCI Ltd. FINANCIAL INSTITUTION IFCI
Idea Cellular Ltd. TELECOMMUNICATION - IDEA
SERVICES
Infosys Technologies Ltd. COMPUTERS - SOFTWARE INFOSYSTCH
Infrastructure Develop- FINANCIAL INSTITUTION IDFC
ment Finance Co. Ltd.
PRODUCTS
Jaiprakash DIVERSIFIED JPASSOCIAT
Associates Ltd.
Jindal Steel & Power Ltd. STEEL AND STEEL JINDALSTEL
PRODUCTS
Kotak Mahindra BANKS KOTAKBANK
Bank Ltd.
LIC Housing FINANCE - HOUSING LICHSGFIN
Finance Ltd.
Petrochemicals Ltd.
Mahindra & AUTOMOBILES - 4 M&M
Mahindra Ltd. WHEELERS
Maruti Suzuki AUTOMOBILES - 4 MARUTI
India Ltd. WHEELERS
Mundra Port and TRAVEL AND MUNDRAPORT
Special Economic TRANSPORT
Zone Ltd.
56 Option Trading

National ALUMINIUM NATIONALUM
Aluminium Co. Ltd.
Oil & Natural OIL EXPLORATION/ ONGC
Gas Corporation Ltd. PRODUCTION
Systems Ltd.
Corporation Ltd.
Power Grid Corpor- POWER POWERGRID
ation of India Ltd.
Ranbaxy PHARMACEUTICALS RANBAXY
Laboratories Ltd.
Reliance TELECOMMUNICATION - RCOM
Communications Ltd. SERVICES
Reliance Infra- POWER RELINFRA
structure Ltd.
Resources Ltd.
Siemens Ltd. ELECTRICAL EQUIPMENT SIEMENS
Steel Authority STEEL AND STEEL SAIL
of India Ltd. PRODUCTS
(India) Ltd.
Industries Ltd.
Price Index 57

Services Ltd.
WHEELERS
Tata Steel Ltd. STEEL AND STEEL TATASTEEL
PRODUCTS
Tata Teleservices TELECOMMUNICATION - TTML
UltraTech Cement Ltd. CEMENT AND ULTRACEMCO
CEMENT PRODUCTS
S&P CNX 500*

The S&P CNX 500 is India’s first broadbased benchmark of the Indian capital
market. The S&P CNX 500 represents about 93.95% of total market
capitalisation and about 93.20% of the total turnover on the NSE as on, 30
January, 2009.
The S&P CNX 500 companies are disaggregated into 72 industry indices
viz., S&P CNX Industry Indices. Industry weightages in the index reflect the
industry weightages in the market. For example, if banking sector has a 5%
weightage in the universe of stocks traded on NSE, banking stocks in the
index would also have an approx. representation of 5% in the index.
S&P CNX 500*
S&P CNX 500 is computed using market capitalization weighted method,
wherein the level of the index reflects the total market value of all the stocks in
58 Option Trading
the index relative to a particular base period. The method also takes into
account constituent changes in the index and importantly corporate actions
such as stock splits, rights, etc without affecting the index value.
Base Date and Value

The calendar year 1994 has been selected as the base year for S&P CNX 500.
The base value of the index is set at 1000.

The constituents and the criteria for the selection judge the effectiveness of
the index. Selection of the index set is based on the following criteria:
Market Capitalization
A company’s rank on market capitalization is an important consideration for
its inclusion in the Index.
Industry Representation
S&P CNX 500 Equity Index reflects the market as closely as possible. In order
to ensure that this is accomplished, industry weightages in the index mirror
the industry weightages in the universe. Consequently, companies to be
included in the index are selected from the industries which are under
represented in the index
S&P CNX 500 Equity Index currently contains 72 industries, including one
category of diversified companies and one category of miscellaneous. The
number of industries in the Index and the number of companies within each
industry have been kept flexible, in order to ensure that the index retains its
objective of being an dynamic market indicator.
Trading Interest
S&P CNX 500 Equity Index includes those companies which have a minimum
listing record of six months on the Exchange. In addition these companies
must have demonstrated high turnover and trading frequency.
Financial Performance
S&P CNX 500 Equity Index includes companies that have a minimum record
of three years with a positive networth.
Others
index, if it fulfills the normal eligiblity criteria for the index for a three-month
period instead of a six-month period.
Price Index 59
Table 4.7 List of Stocks in CNX 500

3M India Ltd. TRADING 3MINDIA
ABG Shipyard Ltd. SHIPPING ABGSHIP
ACC Ltd. CEMENT AND ACC
CEMENT PRODUCTS
Aarti Industries Ltd. CHEMICALS - ORGANIC AARTIIND
Aban Offshore Ltd. OIL EXPLORATION/ ABAN
PRODUCTION
Abhishek Industries Ltd TEXTILES - COTTON ABSHEKINDS
Adlabs Films Ltd. MEDIA & ENTERTAINMENT ADLABSFILM
Ador Welding Ltd. ELECTRODES ADORWELD
Advanta India Ltd. FOOD AND FOOD ADVANTA
PROCESSING
Aftek Ltd. COMPUTERS - SOFTWARE AFTEK
Agro Dutch FOOD AND FOOD AGRODUTCH
Industries Ltd. PROCESSING
Agro Tech Foods Ltd. SOLVENT EXTRACTION ATFL
Ajanta Pharmac- PHARMACEUTICALS AJANTPHARM
euticals Ltd.
Akruti City Ltd. CONSTRUCTION AKRUTI
Aksh Optifibre Ltd. CABLES - TELECOM AKSHOPTFBR
Alembic Ltd. PHARMACEUTICALS ALEMBICLTD
Alfa Laval (India) Ltd. ENGINEERING ALFALAVAL
Allahabad Bank BANKS ALBK
Allcargo Global TRAVEL AND TRANSPORT ALLCARGO
Logistics Ltd.
Alok Industries Ltd. TEXTILES - SYNTHETIC ALOKTEXT
Alstom Projects India Ltd. POWER APIL
Amara Raja Batteries Ltd. AUTO ANCILLARIES AMARAJABAT
Ambuja Cements Ltd. CEMENT AND CEMENT AMBUJACEM
PRODUCTS
Amtek Auto Ltd. AUTO ANCILLARIES AMTEKAUTO
Amtek India Ltd. AUTO ANCILLARIES AMTEKINDIA
60 Option Trading

Anant Raj Industries Ltd. CONSTRUCTION ANANTRAJ
Andhra Sugars Ltd. DIVERSIFIED ANDHRSUGAR
Ansal Properties & CONSTRUCTION ANSALINFRA
Infrastructure Ltd.
Apollo Hospitals MISCELLANEOUS APOLLOHOSP
Enterprises Ltd.
Aptech Ltd. COMPUTERS - SOFTWARE APTECHT
Areva T&D India Ltd. ELECTRICAL EQUIPMENT AREVAT&D
Arvind Ltd. TEXTILE PRODUCTS ARVIND
Asahi India Glass Ltd. AUTO ANCILLARIES ASAHIINDIA
WHEELERS
Asian Electronics Ltd. ELECTRONICS - ASIANELEC
INDUSTRIAL
Asian Hotels Ltd. HOTELS ASIANHOTEL
AstraZenca Pharma PHARMACEUTICALS ASTRAZEN
India Ltd.
Atul Ltd. DYES AND PIGMENTS ATUL
Aurobindo Pharma Ltd. PHARMACEUTICALS AUROPHARMA
Automotive Axles Ltd. AUTO ANCILLARIES AUTOAXLES
Avaya Global TELECOMMUNICATION - AVAYAGCL
Connect Ltd. EQUIPMENT
Aventis Pharma Ltd. PHARMACEUTICALS AVENTIS
Ballarpur Industries Ltd. PAPER AND PAPER BALLARPUR
PRODUCTS
B L Kashyap & Sons Ltd. CONSTRUCTION BLKASHYAP
BASF India Ltd. CHEMICALS - SPECIALITY BASF
BEML Ltd. ENGINEERING BEML
BOC India Ltd. GAS BOC
BPL Ltd. CONSUMER DURABLES BPL
Bajaj Auto Finance Ltd. FINANCE BAJAUTOFIN
Bajaj Auto Ltd. AUTOMOBILES - 2 AND 3 BAJAJ-AUTO
WHEELERS
Price Index 61

Bajaj Finserv Ltd. FINANCE BAJAJFINSV
Bajaj Hindusthan Ltd. SUGAR BAJAJHIND
Bajaj Holdings & FINANCE BAJAJHLDNG
Investment Ltd.
Balaji Telefilms Ltd. MEDIA & BALAJITELE
ENTERTAINMENT
Balmer Lawrie & Co. Ltd. DIVERSIFIED BALMLAWRIE
Balrampur Chini SUGAR BALRAMCHIN
Mills Ltd.
Bannari Amman SUGAR BANARISUG
Sugars Ltd.
Bata India Ltd. LEATHER AND BATAINDIA
LEATHER PRODUCTS
Berger Paints India Ltd. PAINTS BERGEPAINT
Bhansali Engineering PETROCHEMICALS BEPL
Polymers Ltd.
Bharat Electronics Ltd. ELECTRONICS - BEL
INDUSTRIAL
Bharat Heavy ELECTRICAL BHEL
Electricals Ltd. EQUIPMENT
Corporation Ltd.
SERVICES
Bhushan Steel Ltd. STEEL AND STEEL BHUSANSTL
PRODUCTS
Birla Corporation Ltd. CEMENT AND BIRLACORPN
CEMENT PRODUCTS
Blue Dart Express Ltd. TRAVEL AND TRANSPORT BLUEDART
Blue Star Ltd. AIRCONDITIONERS BLUESTARCO
Bombay Dyeing & TEXTILES - SYNTHETIC BOMDYEING
Manufacturing Co. Ltd.
Bombay Rayon TEXTILE PRODUCTS BRFL
Fashions Ltd.
62 Option Trading

Bosch Ltd AUTO ANCILLARIES BOSCHLTD
Britannia Industries Ltd. FOOD AND BRITANNIA
FOOD PROCESSING
Cadila Healthcare Ltd. PHARMACEUTICALS CADILAHC
CESC Ltd. POWER CESC
CMC Ltd. COMPUTERS - CMC
HARDWARE
CRISIL Ltd. FINANCE CRISIL
PRODUCTI ON
Can Fin Homes Ltd. FINANCE - HOUSING CANFINHOME
Carborundum ABRASIVES CARBORUNIV
Universal Ltd.
Carol Info Services Ltd. FOOD AND FOOD CAROLINFO
PROCESSING
Castrol (India) Ltd. PETROCHEMICALS CASTROL
Century Enka Ltd. TEXTILES - SYNTHETIC CENTENKA
Century Textile & DIVERSIFIED CENTURYTEX
Industries Ltd.
Century Plyboards CONSTRUCTION CENTURYPLY
(India) Ltd.
Chettinad Cement CEMENT AND CEMENT CHETTINAD
Corporations Ltd. PRODUCTS
Chambal Fertilizers & FERTILISERS CHAMBLFERT
Chemicals Ltd.
Chemplast Sanmar Ltd. PETROCHEMICALS CHEMPLAST
Corporation Ltd.
Cholamandalam FINANCE HOLADBS
DBS Finance Ltd.
City Union Bank Ltd. BANKS CUB
Clariant Chemicals DYES AND PIGMENTS CLNINDIA
(India) Ltd.
Colgate Palmolive PERSONAL CARE COLPAL
(India) Ltd.
Consolidated Finvest & FINANCE CONSOFINVT
Holdings Ltd.
Container Corporation TRAVEL AND TRANSPORT CONCOR
of India Ltd.
Price Index 63

Coromandel FERTILISERS COROMNFERT
Fertilisers Ltd.
Cosmo Films Ltd. PACKAGING COSMOFILMS
Crest Animation MEDIA & ENTERTAINMENT CRESTANI
Studios Ltd.
Crompton Greaves Ltd. ELECTRICAL EQUIPMENT CROMPGREAV
D-Link India Ltd COMPUTERS - HARDWARE D-LINK
D.S. Kulkarni CONSTRUCTION DSKULKARNI
Developers Ltd.
DCM Shriram DIVERSIFIED DCMSRMCONS
Consolidated Ltd.
DCW Ltd. PETROCHEMICALS DCW
Dabur India Ltd. PERSONAL CARE DABUR
Dalmia Cement CEMENT AND DALMIACEM
(Bharat) Ltd. CEMENT PRODUCTS
Deccan Chronicle PRINTING AND DCHL
Holdings Ltd. PUBLISHING
Deepak Fertilisers & FERTILISERS DEEPAKFERT
Petrochemicals Corp. Ltd.
Dena Bank BANKS DENABANK
Dhampur Sugar Mills Ltd. SUGAR DHAMPURSUG
Dishman Pharmaceuticals PHARMACEUTICALS DISHMAN
& Chemicals Ltd.
Divi’s Laboratories Ltd. PHARMACEUTICALS DIVISLAB
Donear Industries Ltd. TEXTILES - SYNTHETIC DONEAR
Laboratories Ltd.
Dredging Corporation MISCELLANEOUS DREDGECORP
of India Ltd.
Dwarikesh Sugar SUGAR DWARKESH
Industrial Ltd.
Dynamatic COMPRESSORS/PUMPS DYNAMATECH
Technologies Ltd.
E.I.D. Parry (India) Ltd. DIVERSIFIED EIDPARRY
EIH Ltd. HOTELS EIHOTEL
64 Option Trading

ESAB India Ltd. ELECTRODES ESABINDIA
Edelweiss Capital Ltd. FINANCE EDELWEISS
Educomp Solutions Ltd. COMPUTERS - SOFTWARE EDUCOMP
Eicher Motors Ltd. AUTOMOBILES - 4 EICHERMOT
WHEELERS
Elder Pharma- PHARMACEUTICALS ELDERPHARM
ceuticals Ltd.
Electrosteel Castings Ltd. CASTINGS/FORGINGS ELECTCAST
Elgi Equipments Ltd. COMPRESSORS / PUMPS ELGIEQUIP
Engineers India Ltd. ENGINEERING ENGINERSIN
Entertainment MEDIA & ENIL
Network India Ltd. ENTERTAINMENT
Era Infra Engineering Ltd. CONSTRUCTION ERAINFRA
Escorts Ltd. AUTOMOBILES - 4 ESCORTS
WHEELERS
Essar Oil Ltd. REFINERIES ESSAROIL
Essar Shipping Ltd. SHIPPING ESSARSHIP
Essel Propack Ltd. PACKAGING ESSELPACK
Everest Industries Ltd. CEMENT AND EVERESTIND
CEMENT PRODUCTS
Exide Industries Ltd. AUTO ANCILLARIES EXIDEIND
FDC Ltd. PHARMACEUTICALS FDC
Fag Bearings India Ltd. BEARINGS FAGBEARING
Federal Bank Ltd. BANKS FEDERALBNK
Federal-Mogul AUTO ANCILLARIES FMGOETZE
Goetze (India) Ltd.
Financial Techno- COMPUTERS - SOFTWARE FINANTECH
logies (India) Ltd.
Finolex Cables Ltd. MISCELLANEOUS FINCABLES
Finolex Industries Ltd. PETROCHEMICALS FINPIPE
First Leasing Co. FINANCE FIRSTLEASE
of India Ltd.
Firstsource Solutions Ltd. COMPUTERS - SOFTWARE FSL
Fortis Healthcare Ltd. MISCELLANEOUS FORTIS
Fresenius Kabi PHARMACEUTICALS FKONCO
Oncology Ltd.
Future Capital FINANCE FCH
Holdings Ltd.
Price Index 65

GHCL Ltd. CHEMICALS - INORGANIC GHCL
GTL Infrastructure Ltd. TELECOMMUNICATION - GTLINFRA
EQUIPMENT
GTL Ltd. TELECOMMUNICATION - GTL
SERVICES
Gammon India Ltd. CONSTRUCTION GAMMONIND
Garden Silk Mills Ltd. TEXTILES - SYNTHETIC GARDENSILK
Gateway Distriparks Ltd. TRAVEL AND TRANSPORT GDL
Geojit BNP Paribas Finan- FINANCE GEOJIT BNPP
cial Services Limited.
Geometric Ltd. COMPUTERS - SOFTWARE GEOMETRIC
Gillette India Ltd. PERSONAL CARE GILLETTE
Gitanjali Gems Ltd. GEMS JEWELLERY GITANJALI
AND WATCHES
GlaxoSmithkline FOOD AND GSKCONS
Consumer Healthcare Ltd. FOOD PROCESSING
Godfrey Phillips CIGARETTES GODFRYPHLP
India Ltd.
Godrej Consumer PERSONAL CARE GODREJCP
Products Ltd.
Godrej Industries Ltd. CHEMICALS - INORGANIC GODREJIND
Gokaldas Exports Ltd. TEXTILE PRODUCTS GOKEX
Graphite India Ltd. ELECTRODES GRAPHITE
Grasim Industries Ltd. CEMENT AND GRASIM
CEMENT PRODUCTS
Great Eastern SHIPPING GESHIP
Shipping Co. Ltd.
Greaves Cotton Ltd. DIESEL ENGINES GREAVESCOT
Gujarat Alkalies & CHEMICALS - GUJALKALI
Chemicals Ltd. INORGANIC
Gujarat Ambuja TRADING GAEL
Exports Ltd.
66 Option Trading

Gujarat Fluoro- GAS GUJFLUORO
chemicals Ltd.
Gujarat Gas Co. Ltd. GAS GUJRATGAS
Gujarat Industries POWER GIPCL
Power Co. Ltd.
Gujarat Mineral Develop- MINING GMDCLTD
ment Corporation Ltd.
Gujarat NRE Coke Ltd. MINING GUJNRECOKE
Gujarat Narmada FERTILISERS GNFC
Valley Fertilisers Co. Ltd.
Gujarat State Fertilizers FERTILISERS GSFC
& Chemicals Ltd.
GVK Power & POWER GVKPIL
Infrastructure Ltd
H.E.G. Ltd. ELECTRODES HEG
HCL Infosystems Ltd. COMPUTERS - HCL-INSYS
HARDWARE
HCL Technologies Ltd. COMPUTERS - HCLTECH
SOFTWARE
HMT Ltd. AUTOMOBILES - 4 HMT
WHEELERS
HT Media Ltd. PRINTING AND HTMEDIA
PUBLISHING
Harrisons Malayalam Ltd. TEA AND COFFEE HARRMALAYA
Havell’s India Ltd. ELECTRICAL EQUIPMENT HAVELLS
Heritage Foods (India) Ltd. FOOD AND FOOD HERITGFOOD
PROCESSING
Hero Honda Motors Ltd. AUTOMOBILES - 2 AND HEROHONDA
3 WHEELERS
Hexaware Techno- COMPUTERS - SOFTWARE HEXAWARE
logies Ltd.
Hikal Ltd. PESTICIDES AND HIKAL
AGROCHEMICALS
Himachal Futuristic TELECOMMUNICATION - HIMACHLFUT
Communications Ltd. EQUIPMENT
Himatsingka Seide Ltd. TEXTILE PRODUCTS HIMATSEIDE
Hindalco Industries Ltd. ALUMINIUM HINDALCO
Hindustan CONSTRUCTION HCC
Construction Co. Ltd.
Price Index 67

Hindustan Motors Ltd. AUTOMOBILES - 4 HINDMOTOR
WHEELERS
Hindustan Oil OIL EXPLORATION/ HINDOILEXP
Exploration Co. Ltd. PRODUCTION
Corporation Ltd.
Hindustan DIVERSIFIED HINDUNILVR
Unilever Ltd.
Hindustan Zinc Ltd. METALS HINDZINC
Honda SIEL Power ELECTRICAL HONDAPOWER
Products Ltd. EQUIPMENT
Honeywell ELECTRONICS - HONAUT
Automation India Ltd. INDUSTRIAL
Hotel Leelaventure Ltd. HOTELS HOTELEELA
House of Pearl TEXTILE PRODUCTS HOPFL
Fashions Ltd.
HSIL Ltd. CONSTRUCTION HSIL
ICI India Ltd. PAINTS ICI
IL&FS Investsmart Ltd. FINANCE INVSTSMART
ING Vysya Bank Ltd. BANKS INGVYSYABK
IVRCL Infrastructures CONSTRUCTION IVRCLINFRA
& Projects Ltd.
Idea Cellular Ltd. TELECOMMUNICATION- IDEA
SERVICES
Ind-Swift PHARMACEUTICALS INDSWFTLAB
Laboratories Ltd.
India Cements Ltd. CEMENT AND INDIACEM
CEMENT PRODUCTS
India Glycols Ltd. PETROCHEMICALS INDIAGLYCO
68 Option Trading

India Infoline Ltd. FINANCE INDIAINFO
Indiabulls FINANCE INDIABULLS
Financial Services Ltd.
Indiabulls Real CONSTRUCTION IBREALEST
Estate Ltd.
Indian Oil REFINERIES IOC
Corporation Ltd.
Indo Rama TEXTILES - SYNTHETIC INDORAMA
Synthetics Ltd.
Indraprastha Gas Ltd. GAS IGL
Indraprastha MISCELLANEOUS INDRAMEDCO
Medical Corporation Ltd.
IndusInd Bank Ltd. BANKS INDUSINDBK
Info Edge (India) Ltd. COMPUTERS - SOFTWARE NAUKRI
Infosys Technologies Ltd. COMPUTERS - SOFTWARE INFOSYSTCH
Infotech Enterprises Ltd. COMPUTERS - SOFTWARE INFOTECENT
Infrastructure Deve- FINANCIAL INSTITUTION IDFC
lopment Finance Co. Ltd.
Ingersoll Rand (India) Ltd. COMPRESSORS / PUMPS INGERRAND
Inox Leisure Ltd. MEDIA & ENTERTAINMENT INOXLEISUR
Ipca Laboratories Ltd. PHARMACEUTICALS IPCALAB
Jai Corp Ltd. STEEL AND STEEL JAICORPLTD
PRODUCTS
J.B. Chemicals & PHARMACEUTICALS JBCHEPHARM
JM Financial Ltd. FINANCE JMFINANCIL
JSL Ltd. STEEL AND STEEL JSL
PRODUCTS
PRODUCTS
Jagran Prakashan Ltd. PRINTING AND JAGRAN
PUBLISHING
Jain Irrigation Systems Ltd. PLASTIC AND JISLJALEQS
PLASTIC PRODUCTS
Jaiprakash Associates Ltd. DIVERSIFIED JPASSOCIAT
Jammu & Kashmir BANKS J&KBANK
Bank Ltd.
Price Index 69

Jay Shree Tea & TEA AND COFFEE JAYSREETEA
Industries Ltd.
Jet Airways (India) Ltd. TRAVEL AND TRANSPORT JETAIRWAYS
Jindal Poly Films Ltd. PACKAGING JINDALPOLY
Jindal Saw Ltd. STEEL AND STEEL JINDALSAW
PRODUCTS
Jindal Steel & Power Ltd. STEEL AND STEEL JINDALSTEL
PRODUCTS
Jubilant Organosys Ltd. CHEMICALS - ORGANIC JUBILANT
Jyoti Structures Ltd. TRANSMISSION TOWERS JYOTISTRUC
KCP Ltd. CEMENT AND KCP
CEMENT PRODUCTS
KPIT Cummins COMPUTERS - SOFTWARE KPIT
Infosystem Ltd.
KSB Pumps Ltd. COMPRESSORS/PUMPS KSBPUMPS
Kajaria Ceramics Ltd. CONSTRUCTION KAJARIACER
Kalpataru Power TRANSMISSION TOWERS KALPATPOWR
Transmission Ltd.
Kansai Nerolac Paints Ltd. PAINTS KANSAINER
Karnataka Bank Ltd. BANKS KTKBANK
Karur Vysya Bank Ltd. BANKS KARURVYSYA
Kesoram Industries Ltd. CEMENT AND KESORAMIND
CEMENT PRODUCTS
Kirloskar Brothers Ltd. COMPRESSORS / PUMPS KBL
Kirloskar Oil Engines Ltd. DIESEL ENGINES KIRLOSOIL
Kohinoor Foods Ltd. FOOD AND KOHINOOR
FOOD PROCESSING
K.S. Oils Ltd. SOLVENT EXTRACTION KSOILS
Koutons Retail India Ltd. TEXTILE PRODUCTS KOUTONS
LIC Housing Finance Ltd. FINANCE - HOUSING LICHSGFIN
Lakshmi Energy FOOD AND FOOD LAKSHMIEFL
and Foods Ltd. PROCESSING
Lakshmi Machine TEXTILE MACHINERY LAXMIMACH
Works Ltd.
Lakshmi Vilas Bank Ltd. BANKS LAKSHVILAS
Lanco Infratech Ltd. CONSTRUCTION LITL
70 Option Trading

Lumax Industries Ltd. AUTO ANCILLARIES LUMAXIND
MRF Ltd. TYRES MRF
MRO-TEK Ltd. COMPUTERS - MRO-TEK
HARDWARE
Madras Cements Ltd. CEMENT AND MADRASCEM
CEMENT PRODUCTS
Mahanagar TELECOMMUNICATION - MTNL
Telephone Nigam Ltd. SERVICES
Maharashtra STEEL AND STEEL MAHSEAMLES
Seamless Ltd. PRODUCTS
Mahindra & Mahindra FINANCE M&MFIN
Financial Services Ltd.
Mahindra & AUTOMOBILES - 4 M&M
Mahindra Ltd. WHEELERS
Mahindra Lifespace CONSTRUCTION MAHLIFE
Developers Ltd.
Mahindra Ugine STEEL AND STEEL MAHINDUGIN
Steel Co. Ltd. PRODUCTS
Petrochemicals Ltd.
Marico Ltd. PERSONAL CARE MARICO
Maruti Suzuki AUTOMOBILES - 4 MARUTI.
India Ltd. WHEELERS
Mastek Ltd. COMPUTERS - SOFTWARE MASTEK
Matrix Laboratories Ltd. PHARMACEUTICALS MATRIXLABS
Max India Ltd. PACKAGING MAX
McLeod Russel TEA AND COFFEE MCLEODRUSS
India Ltd.
Mercator Lines Ltd. SHIPPING MLL
Merck Ltd. PHARMACEUTICALS MERCK
Micro Inks Ltd. CHEMICALS - MICRO
SPECIALITY
Mid-Day Multimedia Ltd PRINTING AND MID-DAY
PUBLISHING
Price Index 71

MindTree Ltd. COMPUTERS - SOFTWARE MINDTREE
Mirc Electronics Ltd. CONSUMER DURABLES MIRCELECTR
Mirza International Ltd. LEATHER AND MIRZAINT
LEATHER PRODUCTS
Monnet Ispat Ltd. STEEL AND MONNETISPA
STEEL PRODUCTS
Monsanto India Ltd. PESTICIDES AND MONSANTO
AGROCHEMICALS
Motherson Sumi AUTO ANCILLARIES MOTHERSUMI
Systems Ltd.
Motial Oswal Financial FINANCE MOTILALOFS
Services Ltd.
Mukta Arts Ltd MEDIA & MUKTAARTS
ENTERTAINMENT
Mundra Port and Special TRAVEL AND TRANSPORT MUNDRAPORT
Economic Zone Ltd.
Munjal Showa Ltd. AUTO ANCILLARIES MUNJALSHOW
National Fertilizers Ltd. FERTILISERS NFL
NDTV Ltd. MEDIA & NDTV
ENTERTAINMENT
NELCO Ltd. ELECTRONICS - NELCO
INDUSTRIAL
NIIT Ltd. COMPUTERS - SOFTWARE NIITLTD
NMDC Ltd. MINING NMDC
NRB Bearings Ltd. BEARINGS NRBBEARING
Nagarjuna CONSTRUCTION NAGARCONST
Nagarjuna Fertilizers & FERTILISERS NAGARFERT
Chemicals Ltd.
National Aluminium ALUMINIUM NATIONALUM
Co. Ltd.
Nava Bharat METALS NBVENTURES
Ventures Ltd.
Navneet Publications PRINTING AND NAVNETPUBL
(India) Ltd. PUBLISHING
Neyveli Lignite POWER NEYVELILIG
Corporation Ltd.
72 Option Trading

Nilkamal Ltd. PLASTIC AND NILKAMAL
PLASTIC PRODUCTS
Nirma Ltd. DETERGENTS NIRMA
Noida-Toll TRAVEL AND NOIDATOLL
Bridge Co. Ltd. TRANSPORT
Oil & Natural OIL EXPLORATION/ ONGC
Gas Corporation Ltd. PRODUCTION
Omax Autos Ltd. AUTO ANCILLARIES OMAXAUTO
Omaxe Ltd. CONSTRUCTION OMAXE
Orchid Chemicals & PHARMACEUTICALS ORCHIDCHEM
Orient Paper & DIVERSIFIED ORIENTPPR
Industries Ltd.
Oriental Bank BANKS ORIENTBANK
of Commerce
Oriental Hotels Ltd. HOTELS ORIENTHOT
Oswal Chemicals & FERTILISERS BINDALAGRO
Fertilizers Ltd.
PNB Gilts Ltd. FINANCE PNBGILTS
PSL Ltd. STEEL AND PSL
STEEL PRODUCTS
PVP Ventures Ltd. COMPUTERS - SOFTWARE PVP
Panacea Biotec Ltd. PHARMACEUTICALS PANACEABIO
Pantaloon Retail MISCELLANEOUS PANTALOONR
(India) Ltd.
Paper Products Ltd. PAPER AND PAPERPROD
PAPER PRODUCTS
Parsvnath Developer Ltd. CONSTRUCTION PARSVNATH
Patel Engineering Ltd. CONSTRUCTION PATELENG
Systems Ltd.
Petronet LNG Ltd. GAS PETRONET
Pfizer Ltd. PHARMACEUTICALS PFIZER
Phoenix Mills Ltd. CONSTRUCTION PHOENIXLTD
Piramal Healthcare Ltd. PHARMACEUTICALS PIRHEALTH
Pidilite Industries Ltd. CHEMICALS - ORGANIC PIDILITIND
Polaris Software Lab Ltd. COMPUTERS - SOFTWARE POLARIS
Price Index 73

Corporation Ltd.
Power Grid POWER POWERGRID
Corporation of India Ltd.
Praj Industries Ltd. ENGINEERING PRAJIND
Pricol Ltd. AUTO ANCILLARIES PRICOL
Prism Cement Ltd. CEMENT AND PRISMCEM
CEMENT PRODUCTS
Procter & Gamble Hygiene PERSONAL CARE PGHH
& Health Care Ltd.
Provogue (India) Ltd. TEXTILE PRODUCTS PROVOGUE
Punj Lloyd Ltd. CONSTRUCTION PUNJLLOYD
Puravankara Projects Ltd. CONSTRUCTION PURVA
Radico Khaitan Ltd BREW/DISTILLERIES RADICO
Rajesh Exports Ltd. GEMS JEWELLERY RAJESHEXPO
AND WATCHES
Rallis India Ltd. PESTICIDES AND RALLIS
AGROCHEMICALS
Ramco Industries Ltd. CEMENT AND RAMCOIND
CEMENT PRODUCTS
Ramco Systems Ltd. COMPUTERS - RAMCOSYS
SOFTWARE
Ranbaxy PHARMACEUTICALS RANBAXY
Laboratories Ltd.
Rashtriya Chemicals & FERTILISERS RCF
Fertilizers Ltd.
Rei Agro Ltd. FOOD AND FOOD REIAGROLTD
PROCESSING
Reliance Communi- TELECOMMUNICATION - RCOM
cations Ltd. - SERVICES
Reliance Industrial ENGINEERING RIIL
Infrastructure Ltd.
Reliance POWER RELINFRA
Infrastructure Ltd.
74 Option Trading

Resources Ltd.
Religare Enterprises Ltd. FINANCE RELIGARE
Rico Auto Industries Ltd. AUTO ANCILLARIES RICOAUTO
Rolta India Ltd. COMPUTERS - SOFTWARE ROLTA
Ruchi Soya Industries Ltd. SOLVENT EXTRACTION RUCHISOYA
Rural Electrification FINANCIAL INSTITUTION RECLTD
Corporation Ltd.
S. Kumars Nation- TEXTILE PRODUCTS SKUMARSYNF
wide Ltd.
SEAMEC Ltd. OIL EXPLORATION/ SEAMECLTD
PRODUCTION
SKF India Ltd. BEARINGS SKFINDIA
SREI Infrastructure FINANCE SREINTFIN
Finance Ltd.
SRF Ltd. TEXTILES - SYNTHETIC SRF
Sakthi Sugars Ltd. SUGAR SAKHTISUG
Saregama India Ltd. MEDIA & SAREGAMA
ENTERTAINMENT
Seshasayee Paper & PAPER AND PAPER SESHAPAPER
Boards Ltd. PRODUCTS
Shanthi Gears Ltd. AUTO ANCILLARIES SHANTIGEAR
Shasun Chemicals & PHARMACEUTICALS SHASUNCHEM
Drugs Ltd.
Shipping Corporation SHIPPING SCI
of India Ltd.
Shoppers Stop Ltd. MISCELLANEOUS SHOPERSTOP
Shree Cement Ltd. CEMENT AND SHREECEM
CEMENT PRODUCTS
Price Index 75

Shree Renuka Sugars Ltd. SUGAR RENUKA
Shrenuj & Co. Ltd. GEMS JEWELLERY SHRENUJ
AND WATCHES
Shriram Transport FINANCE SRTRANSFIN
Finance Co. Ltd.
Siemens Ltd. ELECTRICAL SIEMENS.
EQUIPMENT
Simplex CONSTRUCTION SIMPLEXINF
Infrastructures Ltd.
Sintex Industries Ltd. PLASTIC AND PLASTIC SINTEX
PRODUCTS
Sirpur Paper Mills Ltd. PAPER AND PAPER SIRPAPER
PRODUCTS
Sobha Developers Ltd. CONSTRUCTION SOBHA
Sona Koyo Steering AUTO ANCILLARIES SONASTEER
Systems Ltd.
Sonata Software Ltd. COMPUTERS - SOFTWARE SONATSOFTW
South Indian Bank Ltd. BANKS SOUTHBANK
State Trading Corporation TRADING STCINDIA
of India Ltd.
Steel Authority of India Ltd. STEEL AND SAIL
STEEL PRODUCTS
Sterling Biotech Ltd PHARMACEUTICALS STERLINBIO
(India) Ltd.
Sterlite Technologies Ltd. ELECTRICAL EQUIPMENT STRTECH
Strides Arcolab Ltd. PHARMACEUTICALS STAR
Industries Ltd.
Sun TV Network Ltd. MEDIA & SUNTV
ENTERTAINMENT
Sundaram Finance Ltd. FINANCE SUNDARMFIN
76 Option Trading

Sundram Fasteners Ltd. FASTNERS SUNDRMFAST
Supreme Industries Ltd. PLASTIC AND SUPREMEIND
PLASTIC PRODUCTS
Supreme Petrochem Ltd. PETROCHEMICALS SUPPETRO
Surya Roshni Ltd. STEEL AND STEEL SURYAROSHNI
PRODUCTS
Swaraj Engines Ltd. DIESEL ENGINES SWARAJENG
TV Today Network Ltd. MEDIA & TVTODAY
ENTERTAINMENT
TVS Motor Company Ltd. AUTOMOBILES - 2 AND 3 TVSMOTOR
WHEELERS
Taj GVK Hotels and HOTELS TAJGVK
Resorts Ltd.
Tamil Nadu Newsprint PAPER AND PAPER TNPL
& Papers Ltd. PRODUCTS
Tamilnadu PETROCHEMICALS TNPETRO
Petroproducts Ltd.
Tata Chemicals Ltd. CHEMICALS - TATACHEM
INORGANIC
Tata Coffee Ltd. TEA AND COFFEE TATACOFFEE
Services Ltd.
Tata Elxsi Ltd. COMPUTERS - HARDWARE TATAELXSI
Tata Investment FINANCE TATAINVEST
Corporation Ltd.
Tata Metaliks Ltd. STEEL AND STEEL TATAMETALI
PRODUCTS
WHEELERS
Tata Sponge Iron Ltd. METALS TATASPONGE
Price Index 77

Tata Steel Ltd. STEEL AND STEEL TATASTEEL
PRODUCTS
Tata Tea Ltd. TEA AND COFFEE TATATEA
Television Eighteen MEDIA & ENTERTAINMENT TV-18
India Ltd.
Thermax Ltd. ELECTRICAL THERMAX
EQUIPMENT
Thomas Cook (India) Ltd. TRAVEL AND TRANSPORT THOMASCOOK
Titan Industries Ltd. GEMS JEWELLERY TITAN
AND WATCHES
Torrent Pharma- PHARMACEUTICALS TORNTPHARM
ceuticals Ltd.
Tourism Finance FINANCIAL TFCILTD
Corporation of India Ltd. INSTITUTION
Trent Ltd. MISCELLANEOUS TRENT
Triveni Engineering & SUGAR TRIVENI
Industries Ltd.
Tube Investments CYCLES TUBEINVEST
of India Ltd.
Tulip Telecom Ltd. TELECOMMUNICATION- TULIP
SERVICES
UCAL Fuel Systems Ltd. AUTO ANCILLARIES UCALFUEL
UCO Bank BANKS UCOBANK
UFLEX Ltd. PACKAGING UFLEX
UltraTech Cement Ltd. CEMENT AND ULTRACEMCO
CEMENT PRODUCTS
Unichem PHARMACEUTICALS UNICHEMLAB
Laboratories Ltd.
United Phosphorous Ltd. PESTICIDES AND UNIPHOS
AGROCHEMICALS
Unity Infraprojects Ltd. CONSTRUCTION UNITY
Usha Martin Ltd. STEEL AND STEEL USHAMART
PRODUCTS
Uttam Galva Steels Ltd. STEEL AND STEEL UTTAMSTL
PRODUCTS
78 Option Trading

Uttam Sugar Mills Ltd. SUGAR UTTAMSUGAR
UTV Software MEDIA & ENTERTAINMENT UTVSOF
Communication Ltd.
V.I.P. Industries Ltd. PLASTIC AND VIPIND
PLASTIC PRODUCTS
VST Industries Ltd. CIGARETTES VSTIND
Value Industries Ltd. CONSUMER DURABLES VALUEIND
Vardhman Textiles Ltd. TEXTILES - COTTON VTL
Varusn Shipping Co. Ltd. SHIPPING VARUNSHIP
Venky’s (India) Ltd. FOOD AND FOOD VENKEYS
PROCESSING
Vesuvius India Ltd. REFRACTORIES VESUVIUS
Videocon Industries Ltd. CONSUMER DURABLES VIDEOIND
Vishal Retail Ltd. MISCELLANEOUS VISHALRET
Voltas Ltd. AIRCONDITIONERS VOLTAS
Welspun Gujarat STEEL AND STEEL WELGUJ
Stahl Rohren Ltd. PRODUCTS
West Coast Paper PAPER AND PAPER WSTCSTPAPR
Mills Ltd. PRODUCTS
Wyeth Ltd. PHARMACEUTICALS WYETH
Zandu Pharmaceutical PHARMACEUTICALS ZANDUPHARM
Works Ltd.
Zee Entertainment MEDIA & ZEEL
Enterprises Ltd. ENTERTAINMENT
Zee News Ltd. MEDIA & ZEENEWS
ENTERTAINMENT
Zensar Technolgies Ltd. COMPUTERS - SOFTWARE ZENSARTECH
Zodiac Clothing Co. Ltd. TEXTILE PRODUCTS ZODIACLOTH
Zuari Industries Ltd. FERTILISERS ZUARIAGRO
ibn18 Broadcast Ltd. MEDIA & IBN18
ENTERTAINMENT
Price Index 79
CNX Midcap*
The medium capitalized segment of the stock market is being increasingly
perceived as an attractive investment segment with high growth potential.
The primary objective of the CNX Midcap Index is to capture the movement
and be a benchmark of the midcap segment of the market.
CNX Midcap is computed using market capitalization weighted method,
wherein the level of the index reflects the total market value of all the stocks
in the index relative to a particular base period. The method also takes into
such as stock splits, rights, etc., without affecting the index value.
Base Date and Value

The CNX Midcap Index has a base date of 1 January 2003 and a base value of
1000.

index. Selection of the index set is based on the following criteria :
· All the stocks, which constitute more than 5% market capitalization of
the universe (after sorting the securities in descending order of market
capitalization), shall be excluded in order to reduce the skewness in
the weightages of the stocks in the universe.
· After step (a), the weightages of the remaining stocks in the universe is
determined again.
· After step (b), the cumulative weightage is calculated.
· After step (c) companies which form part of the cumulative percentage
in ascending order unto first 75 percent (i.e. up to 74.99 percent) of the
revised universe shall be ignored.
· After, step (d), all the constituents of S&P CNX Nifty shall be ignored.
· From the universe of companies remaining after step (e) i.e. 75th
percent and above, first 100 companies in terms of highest market
capitalization, shall constitute the CNX Midcap Index subject to
fulfillment of the criteria mentioned below.
Trading Interest
All constituents of the CNX Midcap Index must have a minimum listing
record of 6 months. In addition, all candidates for the Index are also
evaluated for trading interest, in terms of volumes and trading frequency.
Financial Performance
All companies in the CNX Midcap Index have a minimum track record of
three years of operations with a positiv net worth.
80 Option Trading
Others
index, if it fulfills the normal eligibility criteria for the index for a three-month
period instead of a six-month period.
Table 4.8 List of Stocks in CNX Midcap

Akruti City Ltd. CONSTRUCTION AKRUTI
Amtek Auto Ltd. AUTO ANCILLARIES AMTEKAUTO
Anant Raj Industries Ltd. CONSTRUCTION ANANTRAJ
Apollo Hospitals MISCELLANEOUS APOLLOHOSP
Enterprises Ltd.
Areva T&D India Ltd. ELECTRICAL EQUIPMENT AREVAT&D
WHEELERS
Aventis Pharma Ltd. PHARMACEUTICALS AVENTIS
Balrampur Chini Mills Ltd. SUGAR BALRAMCHIN
Bank of Maharashtra. BANKS MAHABANK
Bombay Dyeing & TEXTILES - SYNTHETIC BOMDYEING
Manufacturing Co. Ltd.
Britannia Industries Ltd. FOOD AND FOOD BRITANNIA
PROCESSING
Century Textile & DIVERSIFIED CENTURYTEX
Industries Ltd.
Corporation Ltd.
Crompton Greaves Ltd. ELECTRICAL EQUIPMENT CROMPGREAV
Price Index 81

Colgate Palmolive PERSONAL CARE COLPAL
(India) Ltd.
Deccan Chronicle PRINTING AND DCHL
Holdings Ltd. PUBLISHING
EIH Ltd. HOTELS EIHOTEL
Engineers India Ltd. ENGINEERING ENGINERSIN
Exide Industries Ltd. AUTO ANCILLARIES EXIDEIND
Gammon India Ltd. CONSTRUCTION GAMMONIND
Gillette India Ltd. PERSONAL CARE GILLETTE
GlaxoSmithkline . FOOD AND GSKCONS
Consumer Healthcare Ltd FOOD PROCESSING
Godrej Consumer PERSONAL CARE GODREJCP
Products Ltd.
Godrej Industries Ltd. CHEMICALS - GODREJIND
Shipping Co. Ltd.
HCL Infosystems Ltd. COMPUTERS - HCL-INSYS
HARDWARE
HMT Ltd. AUTOMOBILES - 4 HMT
WHEELERS
HT Media Ltd. PRINTING AND HTMEDIA
PUBLISHING
Corporation Ltd.
ING Vysya Bank Ltd. BANKS INGVYSYABK
IVRCL Infrastructures & CONSTRUCTION IVRCLINFRA
Projects Ltd.
CEMENT PRODUCTS
Indian Bank BANKS INDIANB
82 Option Trading

Indraprastha Gas Ltd. GAS IGL
Jammu & BANKS J&KBANK
Kashmir Bank Ltd.
Jet Airways (India) Ltd. TRAVEL AND JETAIRWAYS
TRANSPORT
Jindal Saw Ltd. STEEL AND JINDALSAW
STEEL PRODUCTS
Jubilant Organosys Ltd. CHEMICALS - ORGANIC JUBILANT
KSK Energy Ventures Ltd POWER KSK
Kansai Nerolac Paints Ltd. PAINTS KANSAINER
Kirloskar Brothers Ltd COMPRESSORS / KBL
PUMPS
Madras Cements Ltd. CEMENT AND MADRASCEM
CEMENT PRODUCTS
Mahanagar TELECOMMUNICATION MTNL
Telephone Nigam Ltd. - SERVICES
Marico Ltd. PERSONAL CARE MARICO
Matrix Laboratories Ltd. PHARMACEUTICALS MATRIXLABS
Max India Ltd. PACKAGING MAX
Moser Baer India Ltd. COMPUTERS - MOSERBAER
HARDWARE
Motherson Sumi AUTO ANCILLARIES MOTHERSUMI
Systems Ltd.
Mphasis Ltd. COMPUTERS - MPHASIS
SOFTWARE
Nirma Ltd. DETERGENTS NIRMA
Omaxe Ltd. CONSTRUCTION OMAXE
Oriental Bank BANKS ORIENTBANK
of Commerce
Pantaloon Retail MISCELLANEOUS PANTALOONR
(India) Ltd.
Parsvnath Developser Ltd. CONSTRUCTION PARSVNATH
Price Index 83

Patni Computer COMPUTERS - PATNI
Systems Ltd. SOFTWARE
Pfizer Ltd. PHARMACEUTICALS PFIZER
Procter & Gamble Hygiene PERSONAL CARE PGHH
& Health Care Ltd.
Rashtriya Chemicals and FERTILISERS RCF
Fertilizers Ltd.
of India Ltd.
Shree Cement Ltd. CEMENT AND SHREECEM
CEMENT PRODUCTS
Shriram Transport FINANCE SRTRANSFIN
Finance Co. Ltd.
Sobha Developers Ltd. CONSTRUCTION SOBHA
Sterling Biotech Ltd. PHARMACEUTICALS STERLINBIO
INORGANIC
Thermax Ltd. ELECTRICAL THERMAX
EQUIPMENT
AND WATCHES
UCO Bank BANKS UCOBANK
Ultra Tech Cement Ltd. CEMENT AND CEMENT ULTRACEMCO
PRODUCTS
AGROCHEMICALS
Welspun Gujarat STEEL AND WELGUJ
Stahl Rohren Ltd. STEEL PRODUCTS
Yes Bank Ltd. BANKS YESBANK
84 Option Trading
Nifty Midcap 50*

The medium capitalized segment of the stock market is being increasingly
perceived as an attractive investment segment with high growth potential. The
primary objective of the Nifty Midcap 50 Index is to capture the movement of
the midcap segment of the market. It can also be used for index-based
derivatives trading.
Nifty Midcap 50 is computed using market capitalization weighted method,
wherein the level of the index reflects the total market value of all the stocks in
the index relative to a particular base period. The method also takes into
such as stock splits, rights, etc without affecting the index value
Base Date and Value

The Nifty Midcap 50 Index has a base date of 1 January 2004 and a base value
of 1000.

index. Selection of the index set is, inter alia, based on the following criteria:
· Stocks with average market capitalization ranging from Rs.1000 Crore
to Rs.5000 Crore at the time of selection.
· Stocks which are not part of the derivatives segment are excluded.
· Stocks which are forming part of the S&P CNX NIFTY index are
excluded.
Other Statistics
· Nifty Midcap 50 stocks represent about 3.78 % of the total market
capitalization as on January 30, 2009.
· The average traded volume for the last six months of all Nifty Midcap 50
stocks is approximately 6.27 % of the traded volume of all stocks on the
NSE.
Table 4.9 List of Stocks in Nifty Midcap 50

Price Index 85

WHEELERS
Corporation Ltd.
Corporation Bank BANKS CORPBANK.
Edelweiss Capital Ltd. FINANCE EDELWEISS
Educomp Solutions Ltd. COMPUTERS-SOFTWARE EDUCOMP
Shipping Co. Ltd.
Hindustan CONSTRUCTION HCC
Hotel Leelaventure Ltd. HOTELS HOTELEELA
IVRCL Infrastru- CONSTRUCTION IVRCLINFRA
ctures & Projects Ltd.
CEMENT PRODUCTS
Indian Bank BANKS INDIANB
Indian Hotels Co. Ltd HOTELS INDHOTEL
PRODUCTS
86 Option Trading

Mahanagar Telephone TELECOMMUNICATION MTNL
Nigam Ltd. SERVICE
Moser Baer India Ltd. COMPUTERS - MOSERBAER
HARDWARE
Mphasis Ltd. COMPUTERS - MPHASIS
SOFTWARE
Nagarjuna CONSTRUCTION NAGARCONST
Oracle Financial COMPUTERS SOFTWARE OFSS
Patel Engineering Ltd. CONSTRUCTION PATELENG
Praj Industries Ltd. ENGINEERING PRAJIND
Resources Ltd.
Rolta India Ltd. COMPUTERS - ROLTA
SOFTWARE
of India Ltd.
Sintex Industries Ltd. PLASTIC AND SINTEX
PLASTIC PRODUCTS
Sterling Biotech Ltd. PHARMACEUTICALS STERLINBIO
INORGANIC
Tata Teleservices TELECOMMUNICATION - TTML
AND WATCHES
UltraTech Cement Ltd. CEMENT AND CEMENT ULTRACEMCO
PRODUCTS
AGROCHEMICALS
Voltas Ltd. AIRCONDITIONERS VOLTAS
Welspun Gujarat Stahl STEEL AND STEEL WELGUJ
Rohren Ltd. PRODUCTS
Price Index 87
S&P CNX Defty*

Almost every institutional investor and off-shore fund enterprise with an
equity exposure in India would like to have an instrument for measuring
returns on their equity investment in dollar terms. To facilitate this, a new
index the S&P CNX Defty-Dollar Denominated S&P CNX Nifty has been
developed. S&P CNX Defty is S&P CNX Nifty, measured in dollars.
Salient Features
· Performance indicator to foreign institutional investors, off-shore
funds, etc.
· Provides an effective tool for hedging Indian equity exposure.
· Impact cost of the S&P CNX Nifty for a portfolio size of Rs. 2 crore is
0.16%.
· Provides fund managers an instrument for measuring returns on their
equity investment in dollar terms.
Calculation of S&P CNX Defty*

Computations are done using the S&P CNX Nifty index calculated on the
NEAT trading system of NSE and INR-USD exchange rate that is based on
the real time polled data feed.
S&P CNX Nifty at time t * Exchange rate as on base date
S&P CNX Defty =
Exchange rate at time t
Calculation of Closing Value of S&P CNX Defty

Closing value of S&P CNX Defty is computed by considering average of INR-
USD polled data values (exchange rate) of the last 30 minutes of the market.
Closing value of S&P CNX Defty
Closing value of S&P CNX Nifty * Exchange rate as on base date

= Average of exchange rate of last 30 minutes of the market
Specifications of S&P CNX Defty:

Base date: 03 November 1995
Base S&P CNX Defty Index Value: 1000
S&P CNX Nifty Value as on Base date: 1000
Exchange rate as on base date: 34.65
Adjustment factor as on Base date:1.00
Summary
An index represents the value of items included in a basket of items such as
share prices, wholesale prices etc. The movement of index represents the
movement in prices of items included in the basket. Stock market indices are
88 Option Trading
used to measure the price movements in the market. In the F&O segment, index-
based derivatives are used as a hedging tool. Futures and options are available
with index as the underlying asset. The two important indices traded in the
F&O segment of the Indian Capital Market are S&P CNX Nifty of NSE and
Sensex of BSE. These indices have sub-indices representing major sectors. As
an underlying asset, indices also form one of the factors in option pricing. The
mechanism of option pricing is discussed in detail in the next chapter.
Keywords
Index Nifty Sensex Impact cost
Futures CNX IT index CNX Bank Index CNX 100 Index
CNX 500 CNX Midcap Nifty Midcap 50 CNX Defty
CHAPTER 05
PRICING OF OPTIONS
5.1 OBJECTIVES
In the second chapter, we found that an option trader has to pay an upfront fee
as premium or price for buying an option. The option price may change
according to various reasons like time decay, change in implied volatility,
change in underlying asset price and change in interest rate. The readers
would be now interested to know how the options are priced. In this chapter,
we shall discuss the option pricing technique. Though there are numerous
methods of calculating option prices, we are discussing only Black-Scholes
formula and Binomial Model.
5.2 INTRODUCTION
Option premiums are classified into two: intrinsic value and time value.
Intrinsic value is the difference between the strike price of the option and the
spot price, while the time value is the difference between the option value
and the intrinsic value. Assume a stock is trading at Rs. 100 and its 100-strike
price call option is trading at Rs. 3, then Rs. 3 is the time value. The stock K
trading at Rs. 100 and its 80-strike price call option trading at Rs. 22 indicates
Rs. 20 as intrinsic value and Rs. 2 as its time value. At-the-money, out-of-the-
money call options and put options do not carry any intrinsic value but have
time value. In-the-money and deep-in-the money options have lower time
value.
5.3 BLACKSCHOLES OPTION PRICING MODEL

The option price is the upfront fee paid by the option buyer to the option writer
(Fig. 5.1). The pricing of options has been attempted by many experts like
Sprenkle (1961), Ayres (1963), Boness (1964), Samuelson (1965), Baumol,
Maikiel and Quandt (1966) Thorp and Kssouf (1967), Samuelson and Merton
(1969), Chen (1970), Black and Scholes (1973). Subsequently, Merton and Black
had attempted to modify the formula to suit the requirement of capital market
where the question of payment of dividend also arises. The Black-Scholes
formula is constructed on the basis of the following assumptions referred to by
them as ‘ideal conditions’.
90 Option Trading
5.3.1 Ideal Conditions for Black-Scholes Formula for

Option Pricing (F. Black and M. Scholes, 1973)1
(a) The short-term risk-free interest rate is known and is constant
throughout the lifetime of option.
(b) The stock price follows a random walk in continuous time with a
variance rate proportional to the square of the stock price. Thus, the
distribution of possible stock prices at the end of any finite interval is
lognormal. The variance rate of the return on stock is constant.
(c) There should not be any takeovers or other events that prematurely
end the life of the option.
(d) Volatility of the asset is constant throughout the lifetime of option.
(e) The stock pays no dividend or other distributions.
(f) The option is ‘European’ i.e., it can only be exercised upon maturity.
(g) There are no transaction costs in buying or selling the stock or the option.
(h) It is possible to borrow any fraction of the price of a security to buy it
or to hold it, at the short-term interest rate.
(i) Short selling in securities is permitted.
(j) For the same risk-free rate, borrowing and lending of securities should
be available.
Option price for a call, C = [S * N (d1)] – [X * e–r (T–t) * N (d2)]

Option price for a put, P = [X * e–r (T–t) * N(– d2) – [S * N (– d1)]
Where, d1 = {[ln(S/X) + (r + s 2/2) * (T – t)]/[s * (T – t) ]}
d 2 = {[ln(S/X) + (r + s 2/2) * (T – t)]/[s * (T – t) ]}
= d1 – [s * (T – t) ]
C – Price of call option
P – Price of put option
S – Underlying asset price
X – Option strike price
r – Rate of interest
(T– t) – Time to expiry
s – Volatility of underlying
N – Normal distribution
e – Exponential function
ln – Logarithmic function
Fig. 5.1 BlackSholes Option Pricing Model
1. F. Black and M. Scholes, The Pricing of Options and Corporate Liabilities, Strategic Issues
in Finance, (Ed.) Keith Ward. Butterworth-Heinemann, 1994, pp. 288-289.
Pricing of Options 91
5.3.2 Factors Affecting Option Price

The factors affecting the option price under the Black-Scholes formula are the
spot price of the underlying asset, the exercise price, volatility of the underlying
asset, risk-free interest rate and time for maturity. The difference between the
spot price and the exercise price determines whether the option is in-the-
money, at-the-money or out-of-the-money. Volatility is the tendency of the asset
price to move upwards or downwards. The frequency of such movements
decides how much the asset is volatile. Volatility is represented by the
annualized standard deviation of the continuously compounded returns and
is measured by using the natural logarithm of the asset/price relative. We
shall learn the art of calculating option price with the help of examples.
Example 1: Call Option
An investor is holding one share of Infosys. The spot price of Infosys shares as
on 20 June is Rs. 3500. S/he decides to buy a call option at a strike price of Rs.
3600 for delivery on 19 June next year. The annual volatility in the stock market
is 57.96%. What would be the price he may have to pay if the risk-free interest
rate is 7.5 % p.a.?
Call Premium, C = [S* N – (d1)] – [X * e – r (T– t) N– (d2)] (1)
S = 3500
X = 3600
r = 0.0750
s = 0.5796 (57.96 %)
s 2/2 = 0.16796
T-t = 1 ( June 20, to June 19, next year = 1 year)
d1 = ln(S/X)+(r+s 2/2)*(T– t)/s Ö(T – t)
= {[ln(3500/3600) + (0.0750+0.16796)*1] / [0.5796* Ö1]}
= [-0.0282 + 0.2429] / [0.5796]
= 0.3704
N(d1) = 0.6443 (Value to be selected from the appendix table)
S * N(d1) = 3500 * 0.6443
= 2255.05 (2)
d2 = d1 – [s Ö(T – t)]
= 0.3704 – [0.5796*Ö1]
= 0.3704 – 0.5796
= – 0.2092 (Rounded off to – 0.210)
N(d2) = N(– 0.2092)
= (1 – 0.5832) (Value to be selected from the
appendix table)
= 0.4168
92 Option Trading
Xe-r (T-t) * N(d2) = 3600* e-0.075 * 1 * 0.4168

= 3600*0.9277 * 0.4168
= 1391.99 (3)
Substituting the values of (2) and (3) in (1), we get
Call Premium, C = 2255.05 – 1391.99 = 863.06
Example 2: Calculation of Put Price (August Call)
Price of Infosys shares as on 27 July (S) Rs. 3500
Strike Price (X) Rs. 3100
Risk-free interest rate (r) 7.50% (0.075)
Daily volatility (s) 57.96% (0.5796)
Time to expiry (20 June 2002 to 19 June 2003) 1 year
In order to calculate the put premium, first we have to find out the various
values in the formula.
The Black-Scholes Model for calculation of put option is:
Put premium, P = [X * e-r (T-t) *N(– d2)] – [S *N(– d1)] (1)
Following the same steps as in the case of call premium, the values for
different variables in the formula will be as follows:
X = 3100
Xe– r (T– t)= 3100* e–.0750 * 1
= 3100 * 0.9277
= 2875.87
Next step is calculating the value of d2. The value of d2 = d1 – s *Ö(T – t).
Therefore, we have to calculate the value of d1 first.
d 1 = ln(S/X) +(r+s 2/2)*(T – t)/s Ö(T – t)
ln (S/X) = 0.1214
r = 0.0750
s /2 = (0.57962/2) = 0.1679
2
2
(r + s /2)*(T – t) = (0.0750+0.1679)*1.00 = 0.2429
s Ö(T – t) = 0.5796* Ö1.00 = 0.5796
d 1 = ln(S/X) +(r+s 2/2)*(T – t)/s Ö(T – t)
= (0.1214 + 0.2429)/0.5796
= 0.6285
d 2 = d1– [s Ö(T– t)]
= 0.6285 – 0.5796
= 0.0489
In order to find out the value of N(d1) and N(d2), the value of d1 and d2 should
be multiplied by the standardized normal distribution factor. These factors are
given in the appendix.
N(–d1) = 1– N(d1) = 1 – 0.7357 = 0.2643
N(–d2) = 1 – N(d2) = 1 – 0.5199 = 0.4801
X * e-r (T-t) *N(–d2) =2875.87 * 0.4801
=1380.705 (2)
S* N(–d1) = 3500 * 0.2643
= 925.05 (3)
Substituting (2) and (3) in (1), we get
Put premium, P = 1380.705 -925.05 = 455.65
The put premium is 455.65
Example 3: Calculation of Call Premium where the Stock is purchased
1 month prior to Maturity
In the previous example, let us assume that a July option is purchased on 28 June.
Asset price (S) 3500
Exercise price (X) 3600
Annual volatility (s) 57.96%
Risk-free interest rate (r) 7.50%
Time to maturity 1 month (0.08)
Call premium = [S *N(d1)] – [X * e – r (T – t) N(d2)] (1)
d1 = [ln(S/X) +(r+ (s2/2) (T – t)] / [s Ö(T – t)]
= [(ln (3500/3600) + (0.0750 + (0.57962/2)*0.08)] /[0.5796*
Ö0.08]
= – 0.0532
N(d1) = (1– 0.5199) = 0.4801 (* Value to be selected from the
appendix table)
SN (d1) = 3500*0.4801 = 1680.35 (2)
d2 = d1 – s * Ö(T – t)
= – 0.0532 – (0.5796* Ö0.08)
= – 0.2171
N(d2) = 1 – 0.5871 = 0.4129 (* Value to be selected from the
appendix table)
Xe – r (T-t) N(d2) = (3600 * e– 0.0750*0.08)* 0.4129 = 1477.55 (3)
By substituting (2) and (3) in (1), we get
Call premium = 1680.35 – 1477.55 = 202.80
94 Option Trading
Calculation of Time to Expiry The time to expiry in this case is different

from that in the previous example. The July option expires on 28 July,
whereas the option was purchased on 28 June. Therefore, the buyer will hold
the option for a period of 30 days only. If we convert 30 days into day count
factor (30/360), we get 0.08.
5.4 PRICING OF EQUITY OPTIONS

Pricing of equity options is different from other options since equity involves
payment of dividend periodically. All equity options are European options.
Black–Scholes formula is normally used to calculate the price of equity
options. One of the basic assumptions under which the Black–Scholes formula
is that there is no payment of dividend. However, the realities of stock market
are different. We may recapitulate the basic assumptions relating to the equity
market:
1. There are no dividend payments against the underlying assets.
However, most often, the stock traded in the equity market are ex-
dividend during the life of the option. Generally, the underlying
equities are listed in the stock exchanges and are actively traded in the
market.
2. The options are of European type and therefore could not be exercised
during the life of the option. However, the options traded in the equity
market are generally of American Type.
3. The Black–Scholes formula assumes that the asset price follows a
continuous diffusion process. In reality, the prices of shares jump on
announcement of dividends or announcements of quarterly/half
yearly/annual profits or a major turn of event in the company; this
ultimately may result into an increase in profits.
4. The volatility was known and constant during the life of the option.
But, in practice, the volatility in stock market is not constant due to the
changes in share prices according to the bull/bear behaviour of the
investors.
5. The natural logs of the price relatives are normally distributed.
6. The borrowing and lending in the market takes place at the same rate
and the risk-free rate of interest remains constant during the life of the
option. In reality, the interest rate is decided by the demand for and
supply of funds in the market. Therefore, the lender is always
benefited by the spread between the borrowing and lending and
provides him arbitrage opportunities.
7. There are no transaction costs in equity transactions. However, the
equity transactions involve brokerage, spread between buying and
selling rates, financing costs etc.
8. In the case of binomial model, the asset price follows a binomial
process, and when the time gap between two price changes is very
small, the binomial distribution approximately equals the normal
distribution.
5.5 PRICING OF OPTIONS ON DIVIDEND PAYING

SCRIPS
The general assumption of Black–Scholes model pricing of options is that the
asset does not produce any yield. However, in reality, it is not correct as far as
the equity is concerned. The equity options are listed on major equities,
which are likely to pay dividend. However, the amount of dividend may be
uncertain. The pricing of options on such stocks, where dividend is paid
periodically, has to be done by considering the dividend yield also. In order
to give effect for the dividend, the spot price of the equity is adjusted with
the discounted value of the dividend. The companies abroad pay dividend
more than one time in a year. In India, though some companies pay interim
dividend, most of them pay only annual dividend. Generally, the prices
come down when the dividend is declared and moves up after the dividend
date. Therefore, the dividend dates have some impact on calculating the
option price. The Black–Scholes formula can be adjusted to accommodate the
price volatility on account of dividend.
Example 4: Call Price Where Dividend is Paid on the Scrip
Price of Infosys shares on 25 July 2003 was Rs. 3570. The annual volatility of
the stock was 57.96%. A customer buys an August call for Rs. 3600. The risk-
free interest rate was 7.5%. The company was expected to declare a dividend
of 40% on 30 September 2003. What would be the option price the customer
may have to pay?
Spot price of Infosys shares (S) 3570
Strike price (X) 3600
Annual volatility (s) 57.96 %
Time to maturity (T – t) 33days (25.07.2003 to 25.08.2003)
Dividend 40%
Ex-dividend days 33 days (25.07.2003 to 28.08.2003 or
25.07.2003 to 30.09.2003, whichever
is earlier)
Step 1: Calculate the present value of the dividend
The present value of the dividend = De– r(Td-t), where D is the dividend, r is the
risk-free interest rate, Td – t is the number of days from the date on which the
option was purchased to the ex-dividend date or the date on which the
option expires, whichever is earlier.
Present value of the dividend = 0.40 e – 0.0750 * 33 = 0.03
Step 2: Calculate the spot price ex-dividend (Sd)
The spot price after adjusting the dividend = 3570-0.03 = 3569.97
96 Option Trading
Step 3: Apply the Black–Scholes formula by replacing S with Sd

C = Sd* N (d1)-X * e-r (T – t) * N (d2)
d1 = [ln (Sd/X) + {(r+ (s 2/2) (T – t)}] / [s Ö(T – t)]
d2 = d1 – s Ö(T – t)
d1 = ln (3569.97/3600)+{(0.075+(0.57962/2)(33/365)}/
0.5796 * Ö(33/365)
= 0.07797
N(d1) = 0.5279 (* Value to be selected from the appendix table)
d2 = 0.07799 – [0.5279* Ö(33/365)] = –0.081
N(d2) = 1 – 0.5279 = 0.4721
Call premium, C = (3569.97*0.5279) – ((3600 e–0.075 (33/365))*0.4721)
= Rs. 196.58
Example 5: Put Price Where Dividend is paid on the Stock
Put price also can be calculated by applying the Black–Scholes formula,
wherein we use the dividend-adjusted spot price as in calculating the call
price. Taking the same example where the strike price is assumed as Rs. 3400,
the put price will be:
Put premium = {Xe-r (T-t) [1-N(d2)]} – {S [1-N(d1)]}
Here, the value of d1 changes consequent to loading the present value factor
of dividend.
d1 = [ln (Sd/X) + {(r+ (s2/2) (T – t)}] / [s Ö(T – t)]
d1 = [ln (3569.97/3400) + {(0.075+ (0.57962/2) (33/365)}] /
[0.5796 Ö(33/365)]
= 0.4068
Nd1 = 0.6591 ( Value to be selected from the appendix table)
1 – N(d1) = 0.3409
d2 = 0.4068 – 0.5796 Ö(33/365) = 0.2325
N(d2) = 0.5910 ( Value to be selected from the appendix table)
1– N(d2) = 1 – 0.5910 = 0.409
Put premium = [3400 * e-0.0750 (33/365) * 0.409] – [3569.97*0.3409]
= 1381.20 – 1217.00
= 164.20
5.6 BINOMIAL MODEL OF OPTION PRICING

Another method of calculation of option price is the Binomial Model. The
Binomial Model starts from the current spot price of the asset from which the
future spot price of the asset is estimated on the basis of market volatility. The
option pay off under Binomial Model is the difference between the strike price
and the spot price. The binomial price represents the present value of the future
pay off calculated using the risk-free interest rate. The following parameters
are used for calculating the binomial price:
S = Spot price at the beginning, u = the upper movement in percentage terms
and Su = the upper level of the future spot price, d = the downward movement
of the price in percentage terms and Sd = the lower level future spot price of the
asset, X = the strike price, R = the risk-free interest r, (T – t) is the time to
maturity, N = the number of options, c = call options and p = put options. The
Binomial Model also requires that d < R < u because if d and u are less than the
risk-free interest rate, the risk-free asset would always show higher return
than the risky asset. If d and u are greater than the risk-free interest rate, the
risky asset would show higher return than the risk-free asset.
In binomial calculation a tree is created having two nodes, one upper and
the other lower, each node converging at the current spot price and the other
end resting at the upper and lower prices. The binomial tree can be calculated
covering more than one period, say four quarters in a year. In such cases, there
will be 20 nodes (10 sets). The first one is known as one period binomial tree
and the second one is known as multi-period binomial tree. The option price
using the Binomial Model can be calculated on the basis of the following
assumptions:
Calculation of Call Premium, One Period
Example 4
Price of Infosys shares as on July 27, 2003 (S) Rs. 3500
Strike price (X) Rs. 3100
Daily volatility (s ) 57.96%
Time to expiry (20 June 2002 to 19 June 2003) 1 year
An investor holds one Infosys share with the spot price (S) = Rs. 3500. He
buys a call option with a strike price (X) of Rs. 3600. The annual volatility (s)of
Infosys shares is 20%. Risk-free interest rate (r) is 7.5 %.
The formula used for calculating the values in the Binomial Model is:
c = {cu [(R – d)/ (u – d)/(u – d )] + cd [(u – R)/(u – d)]}/R
The value of all parameters except R is available in the diagram. The value
of R = 1.08% (continuously compounded risk-free interest rate).
By substituting the values in the formula:
c = {600 [( 1.08 – 0.80)/ (1.20 – 0.80 )] + 0 [(1.20 – 1.08 / 1.20 – 0.80 )]}/1.08
= [600 (0.28/0.40) + 0)]/1.08
= [600*0.69 + 0]/1.08 = 388.88
98 Option Trading
Su = 4200
u= (Pay off (Cu) = 0, Su – X )
+1.20% = (0, 4200 – 3600) = 600
S = 3500
d = – 0.80% Sd = 2800
(Pay off (Cd) = 0, X – Sd )
In the above calculation, the price of Infosys shares is estimated to go up by

1.20% or go down by 0.80% if the market volatility is 20%. This means, the
price would go up to 4200 (Su) or go down to 2800 (Sd). The pay off when the
price moves up works out to be 700 whereas the pay off when the price goes
down is negative. The option buyer will exercise the option only if the spot
price of the underlying asset (Su) is greater than the exercise price (X) and the
pay off (Su – X) will be 600. On the contrary, if the price goes down the option
buyer will abandon the option, since it would be more beneficial to him if he
buys the asset from the spot market and gives delivery as the spot price is less
than the exercise price. Therefore, the pay off will be 0.
5.7 PRICING OF BINOMIAL PUT OPTION

In a put option, the put option buyer will abandon the option if the spot price
is more than the exercise price because s/he can sell his holding at a higher
price to the market than selling it at the exercise price. The binomial price for
option as per the previous example can be calculated considering the exercise
price as Rs. 3300. The formula for calculating put option is:
p = Ppu + Pd (1 – p) R
where P = The spot price when the volatility comes down
pu = P(R – u)/(u – d)
Pd = The spot price when the spot price goes up
In the case of put option, the buyer will not exercise the option if the spot
price goes up since it would beneficial for him/her to sell in the market than
exercising the option. However, if the price comes down, s/he will exercise the
option since s/he can buy the asset from the market at the lower price, give
delivery under the option contract, and earn the profit. So, the option price
represents the present value of the pay off at the time of maturity.
Example 5
Su = 4200
(Pay off (Pd ) = 0, X – Su)
u = + 1.20% = (0, 3300 – 4200) = – 900 = 0
S = 3500
d = – 0.80% Sd = 2800
(Pay off (Pu) = 0, X – Sd )
p = Ppu + (Ppd(1-p))/R
= {500 [(1.08 – 0.80)/(1.20 – 0.80)]+ 0 [(1.20 – 1.08)/1.20 – 0.80)]}/1.08
= (500*0.70+0)/1.08 = 324.07
5.8 BINOMIAL MULTIPLE PERIOD MODEL

In the case of Binomial Multiple Period Model, the option period is divided
into a number of times in a year. Under this approach, the spot price at the end
of one period will become the spot price for the next period on which the spot
period for the next period is calculated based on the volatility. The multi-
period binomial approach fine-tunes the price calculation since the volatility
is recalculated at the end of each period. The division of period is known as the
binomial trials. The more trials over a given period (i.e. the smaller the time
interval represented by each trial), the more accurate the option valuation will
be (Terry J. Watson, 1998)2. The same principles are used for valuation of
option under each trial. Using the same example of Infosys shares, the multi-
period binomial model can be worked out for both call and put if the option
period is divided into four quarters and all the other factors remaining the
same.
Before we increase the number of binomial trials, the one-year risk-free
interest rate should be adjusted to reflect the shorter time between the trials.
The risk-free interest rate r in the example is 7.5%. The quarterly continuously
compounded interest rate (R) can be calculated by applying the following
formula:
R = er (T – t)*0.25 = Exponential value of 7.25 * 0.25. (By multiplying with 0.25
we get the quarterly value. Alternatively, we can divide by 4 also) = 1.018927.
Similarly, the value of u, d, p and (1 – p) also are to be calculated splitting
them into quarterly basis.
u = es Ö(T-t)/n = e0.20 Ö 0.25 = 1.105171
–s Ö(T-t)/n –0.20 Ö 0.25
d =e =e = 0.904837
R = 1.018927
(R – d) = 1.018927 – 0.904837 = 0.114090
(u – d) = 1.105171-0.904837 = 0.200334
(u – R) = 1.105171 – 1.018927 = 0.086244
p = (R – d)/(u – d) = (0.114090/0.200334)
= 0.569498
(1 – p) = (u – R)/(u – d) = (0.086244/0.904837)
= 0.430502
Asset price (S) = 3500
Exercise price = 3400
2
. Terry J.Watson, Futures and Option in Risk Management.
100 Option Trading
Accordingly a multi-period binomial tree can be constructed as in Fig. 5.2.

Call Price Su4
Pay off
Put Price 5221.39
1821.39
Su3 0.00
4724.51
Su2 1387.66
4274.9 Su3d
0 4274.9 874.91
Su2d
Su1 664.20 0
3868.10 3868.10
0
489.00
664.45 0
3500 Sud Su2d2
208.83
435.91 3500 3500 0
406.96 273.31 Sud2 100
373.63 3166.93
0
3166.93 668.48 Sud3
Sd1 2865.56 2865.56 –534.44
152.76 Sd2 0
534.44 0
570.27 737.86 2592.86
Sd3 0
814.84 Sd4
2346.1 –1053.88
1053.9 0
Fig. 5.2 Multi-period binomial tree
Table 5.1 Calculation of Binomial Option Pricing
Asset price (S) 3500

Strike price (X) 3400
Risk-free interest rate 7.50%
Annual volatility 20%
Period 1 year
Number of binomial trials 4
Life of option (fractions of year) (n) 0.25
Spot price at the upper level (u) es Ö(T-t)/n 1.105171
Spot price at the lower level (d) e– s Ö(T-t)/n 0.904837
Continuously compounded risk-free er*(T-t)*n 1.018927
interest rate
Call price Pcu + (1 – P)Cud)/R
Put price Ppu + (1 – p)Ppd)/R
P (R – d)/(u – d) 0.569498
(1-P) (u – R)/(u – d) 0.430502
Table 5.2 Option Premium at Various Stages
Put Call
STAGE 1 814.84 1387.66
STAGE 2 668.48 489.00
STAGE 3 737.86 982.20
STAGE 4 373.63 273.31
STAGE 5 570.27 664.45
STAGE 6 208.83 152.76
STAGE 7 406.96 435.91
It can be observed from Tables 5.1 and 5.2 that the multi-period binomial
tree approach in option pricing is a more refined process. However, Black–
Scholes is more widely used for calculation of equity-related option prices.
Summary
In this chapter, we have explained two models of option pricing. The Black–
Scholes model is based more on mathematical derivation model, whereas the
Binomial model is more of an arithmetical process. In India we use Black–
Scholes model for index-related option pricing. Due to complexity of Black–
Scholes, investors often use Binomial method, put call party etc. They also use
strategies like PC ratio, rollover etc. to find market sentiments. These strategies
are covered in the next chapter.
Keywords
Black–Scholes Binomial Call premium
Put premium Dividend Lognormal distribution
Appendix
Finding out Lognormal Value from the Table

The lognormal distribution value can be found out from the appended table.
Take for example a value of 0.37. This can be split into 0.30 + 0.07. Look for
the number 0.3 in the left column (value of z) and find out the corresponding
value in the column for 0.07. This value is 0.6443. In this way the value for the
other variable also can be found out. For negative values such as –0.37, the
answer is found by subtracting 0.6443 from 1, or equally, 1 – N(0.37).
Alternatively, instead of using tables, one can use the NORMSDIST function
in Microsoft Excel. In such a case, the input would be NORMSDIST (0.37)
and NORMSDIST (-0.37), respectively.
102 Option Trading
Standardized Normal Distribution Table
Z 0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
0 0.5000 0.5040 0.5080 0.5120 0.5160 0.5199 0.5239 0.5279 0.5279 0.5359
0.1 0.5398 0.5438 0.5478 0.5517 0.5557 0.5596 0.5636 0.5675 0.5675 0.5753
0.2 0.5793 0.5832 0.5871 0.5910 0.5948 0.5987 0.6026 0.6064 0.6064 0.6141
0.3 0.6179 0.6217 0.6255 0.6293 0.6331 0.6368 0.6406 0.6443 0.6443 0.6517
0.4 0.6554 0.6591 0.6628 0.6664 0.6700 0.6736 0.6772 0.6808 0.6808 0.6879
0.5 0.6915 0.6950 0.6985 0.7019 0.7054 0.7088 0.7123 0.7157 0.7157 0.7224
0.6 0.7257 0.7291 0.7324 0.7357 0.7389 0.7422 0.7454 0.7486 0.7486 0.7549
0.7 0.7580 0.7611 0.7642 0.7673 0.7704 0.7734 0.7764 0.7794 0.7794 0.7852
0.8 0.7881 0.7910 0.7939 0.7967 0.7995 0.8023 0.8051 0.8078 0.8078 0.8133
0.9 0.8159 0.8186 0.8212 0.8238 0.8264 0.8289 0.8315 0.8340 0.8340 0.8389
1 0.8413 0.8438 0.8461 0.8485 0.8508 0.8531 0.8554 0.8577 0.8577 0.8621
1.1 0.8643 0.8665 0.8686 0.8708 0.8729 0.8749 0.8770 0.8790 0.8810 0.8830
1.2 0.8849 0.8869 0.8888 0.8907 0.8925 0.8944 0.8962 0.8980 0.8997 0.9015
1.3 0.9032 0.9049 0.9066 0.9082 0.9099 0.9115 0.9131 0.9147 0.9162 0.9177
1.4 0.9192 0.9207 0.9222 0.9236 0.9251 0.9265 0.9279 0.9292 0.9306 0.9319
1.5 0.9332 0.9345 0.9357 0.9370 0.9382 0.9394 0.9406 0.9418 0.9429 0.9441
1.6 0.9452 0.9463 0.9474 0.9484 0.9495 0.9505 0.9515 0.9525 0.9535 0.9545
1.7 0.9554 0.9564 0.9573 0.9582 0.9591 0.9599 0.9608 0.9616 0.9625 0.9633
1.8 0.9641 0.9649 0.9656 0.9664 0.9671 0.9678 0.9686 0.9693 0.9699 0.9706
1.9 0.9713 0.9719 0.9726 0.9732 0.9738 0.9744 0.9750 0.9756 0.9761 0.9767
2 0.9772 0.9778 0.9783 0.9788 0.9793 0.9798 0.9803 0.9808 0.9812 0.9817
2.1 0.9821 0.9826 0.9830 0.9834 0.9838 0.9842 0.9846 0.9850 0.9854 0.9857
2.3 0.9893 0.9896 0.9898 0.9901 0.9904 0.9906 0.9909 0.9911 0.9913 0.9916
2.4 0.9918 0.9920 0.9922 0.9925 0.9927 0.9929 0.9931 0.9932 0.9934 0.9936
2.5 0.9938 0.9940 0.9941 0.9943 0.9945 0.9946 0.9948 0.9949 0.9951 0.9952
2.6 0.9953 0.9955 0.9956 0.9957 0.9959 0.9960 0.9961 0.9962 0.9963 0.9964
2.7 0.9965 0.9966 0.9967 0.9968 0.9969 0.9970 0.9971 0.9972 0.9973 0.9974
2.8 0.9974 0.9975 0.9976 0.9977 0.9977 0.9978 0.9979 0.9979 0.9980 0.9981
2.9 0.9981 0.9982 0.9982 0.9983 0.9984 0.9984 0.9985 0.9985 0.9986 0.9986
3 0.9987 0.9987 0.9987 0.9988 0.9988 0.9989 0.9989 0.9989 0.9990 0.9990
CHAPTER 06
STRATEGIC DERIVATIVE
TOOLS
6.1 OBJECTIVES
In the last chapter, we found that the option prices can be calculated using
Black-Scholes Model and Binomial Model. However, in practice, the dealers
may not get the time to apply the formula and arrive at the call price or put
price. Therefore, they work out the put price from the call price and vice versa
on the basis of put–call parity. In this chapter, we will explain the concept of
put–call parity and how the PC ratio is used in option trading.
6.2 INTRODUCTION
Strategic derivative tools are generally used to find market outlook. Put–call
parity is a strong indicator for determining market outlook. An arbitrage
opportunity due to high call price or put price due to good demand is an
indicator of market sentiment. With put–call parity, one can find out the put–
call premiums. Arbitrageurs always monitor put–call parity. There are other
technical indicators in the option segment such as open interest PC ratio,
weighted PC ratio, volume PC ratio etc.
6.3 PUTCALL PARITY

Arbitrage is an important area in the capital market in general and the
derivatives market in particular. In theory, arbitrage is a position where the
arbitrageur earns riskless profit due to mispricing in the market.
In an efficient market, the occurrence of arbitrage is very rare and even if
it does occur, the returns from the arbitrage would be negligible. Indian
markets have been seeing frequent arbitrage opportunities which stay for a
reasonably long time and which give decent returns.
Then comes the question: why does an arbitrage opportunity occur? The
first reason is the lack of institutional participation with deep pockets to
finance the required capital (cash or stock) to take advantage of the
opportunity. Next is the slew of advanced technologies that are required to
take full advantage of the opportunities. Right from identifying the
opportunity to executing it, the same speed and accuracy is inevitable and this
104 Option Trading
can be done only with advanced technology. If the market looses its
equilibrium, then mispricing of options will occur. In a bear market, investors
pay more money to buy put options and they will offer less money to buy call
options and vice versa. This is an early indication of a market trend. Last but
not least is the lack of awareness among market participants.
Common examples of arbitrage opportunities are put–call parity, cash and
carry and reverse cash and carry, early exercise of American options, price
differentials in calendar spreads, mispricing between exchanges etc.
Let us examine the put-call parity: Most put–call parity propositions apply to
European put and call or American options wherein stocks pay no dividends
before the options expire.
PUT CALL PARITY: C P = S K (1 + r)(t)
where C = call premium, P = put premium,
S = spot price, K = strike price,
R = rate of interest, T = time to expiry
This proposition states that the difference between the price of a call and the
price of a put on the same stock/index with the same strike price and time to
expiration equals the price of the underlying asset minus the present value of
the strike price. If it is not equal, there is a mispricing.
Let us assume that the Nifty futures are trading at 1114.10 on 1 January,
2005. The 1080 calls are trading at a premium of Rs. 49.30 and 1080 puts are
trading at a premium of Rs. 12.75. Here, an arbitrageur can exploit the
mispricing by buying the discounted Nifty futures at 1114.10 and 1080 put at
12.75; at the same time he will write the 1080 call for Rs. 49.30 and wait for
automatic expiration. In this case, s/he will make an arbitrage profit of Rs. 490
(without considering transactions cost, cost of borrowing funds etc).
On the other hand, if Nifty futures are at a premium, s/he can sell Nifty
futures, buy calls and sell puts and wait till the expiration day. For example,
Nifty futures are trading at 1085.85 on 10 February , while 1090 call premium
is at Rs. 11.30 and the 1080 puts are available for Rs. 15.90. The arbitrageur
will buy the 1080 calls for 11.30 and sell the 1080 puts for Rs. 15.90; s/he will
also sell the Nifty futures at 1085.85. On expiry, he will make a net profit of Rs. 90.
When the price of the same asset is different in two markets, there will be
operators who will buy in the market where it is cheaper and sell in the market
where it is costly. This activity is termed as arbitrage. This buying cheap and
selling expensive activity continues till the prices in the two markets reach
equilibrium. Hence, arbitrage activities facilitate to equalize prices and to
restore market efficiency. A commonly used arbitrage strategy in India is the
reverse cash and carry model/lend stock to the markets.
In this strategy if the future price of an underlying asset is trading at a
discount to the spot; an arbitrageur can deliver the stocks in hand to the spot
market and at the same time buy the discounted futures. On the day of expiry,
both futures and spot will converge (both prices will become the same). On the
day of expiry, s/he has to reverse his/her positions by selling futures and
buying back his/her sold shares.
Strategic Derivative Tools 105
Generally, stock futures are traded at a premium to the spot price due to the
cost of carry. But there are times when futures of an underlying asset trade at
the discount to spot due to dividend announcement, demand–supply
constraints and future price projections.
We shall now examine how an arbitrageur can make riskless profit by
lending stocks to the market. For example, on 1 May, Reliance Industries was
trading at Rs. 670 in the spot market, but the May future was trading at a
discount at Rs. 663 due to future price projections. Here, an arbitrageur could
earn riskless profit by lending his Reliance stock to the market for Rs. 670 and
at the same time buying the discounted futures at Rs. 663. On the day of expiry
of May contract, the trader has to reverse his positions. Let us assume that on
the day of expiry Reliance spot and futures were trading at Rs. 665. S/he had
to buy back the stocks at Rs. 665, which s/he sold at Rs. 670. At the same time,
he should sell the futures at Rs. 665, which s/he bought at Rs. 663. Thereby s/he
could earn a profit of Rs. 7, without considering brokerage, commission etc.
One question arises here whether this arbitrage opportunity is more
frequently available in India. The answer is yes. If we examine spot Nifty and
Nifty futures from April 2004 to April 2005, it has been noted that on 188 out of
272 business days, Nifty futures were trading at a discount to spot Nifty,
whereas for 84 days Nifty futures were at a premium. This clearly indicates
that stock futures are trading more frequently at a discount to spot price. Even
if we consider the dividends and other corporate announcements, the
opportunity for arbitrageurs is very high with returns ranging from 4% to
114% per annum available in the Indian derivatives market (Table 6.1).
PUT CALL PARITY: C – P = S – K (1 + r)(–t)
Table 6.1 Put Call Parity for Non-Dividend Stock
DATE 14-Jul-08 DATE OF EXPIRATION 31-Jul-08
STRIKE 920
CALL PREMIUM 16.6
PUT PREMIUM 2.2
FUTURE 934.05
(Contd.)
106 Option Trading
NUMBER OF DAYS TO 0.046

RISK FREE RATE 0.6 EXPIRATION (YEARS) 6
LEFT HAND
SIDE 14.4
NO
RESULT PARITY
RIGHT HAND
SIDE 13.74577928
STRIKE 920
CALL OPTION
PREMIUM 16.6
PUT OPTION
PREMIUM 2.2
PAYOFF TABLE
BUY PAY
SPOT SELL CALL BUY PUT FUTURE TOTAL OFF
INDEX PAY OFF PAY OFF PAY OFF PAY OFF INRs
850 16.6 67.8 – 84.05 0.35 17.5

860 16.6 57.8 – 74.05 0.35 17.5
870 16.6 47.8 – 64.05 0.35 17.5
880 16.6 37.8 – 54.05 0.35 17.5
890 16.6 27.8 – 44.05 0.35 17.5
900 16.6 17.8 – 34.05 0.35 17.5
910 16.6 7.8 – 24.05 0.35 17.5
920 16.6 – 2.2 – 14.05 0.35 17.5
930 6.6 – 2.2 – 4.05 0.35 17.5
940 – 3.4 – 2.2 5.95 0.35 17.5
(Contd.)
950 – 13.4 – 2.2 15.95 0.35 17.5

960 – 23.4 – 2.2 25.95 0.35 17.5
970 – 33.4 – 2.2 35.95 0.35 17.5
980 – 43.4 – 2.2 45.95 0.35 17.5
990 – 53.4 – 2.2 55.95 0.35 17.5
1000 – 63.4 – 2.2 65.95 0.35 17.5
1010 – 73.4 – 2.2 75.95 0.35 17.5
1020 – 83.4 – 2.2 85.95 0.35 17.5
1030 – 93.4 – 2.2 95.95 0.35 17.5
1040 –103.4 – 2.2 105.95 0.35 17.5
1050 –113.4 – 2.2 115.95 0.35 17.5
1060 –123.4 – 2.2 125.95 0.35 17.5
1070 –133.4 – 2.2 135.95 0.35 17.5

1080 –143.4 – 2.2 145.95 0.35 17.5
1090 –153.4 – 2.2 155.95 0.35 17.5
1100 –163.4 – 2.2 165.95 0.35 17.5
Table 6.2 PutCall Parity for Dividend Stock

PUTCALL PARITY USING STOCK OPTIONS
STOCK PRICE 126.87 DIVIDEND FOR FIRST YEAR 1.25
STRIKE RATE 125 TIME OF DIVIDEND 0.0274
BUY CALL PREMIUM

PAID 9.5 DIVIDEND FOR SECOND
YEAR 1.35
SELL PUT PREMIUM
RECEIVED 4.25 TIME TAKEN FOR
PAYMENT 0.2712
RATE OF INTEREST 0.10
TIME TO EXPIRATION 0.4795

108 Option Trading
LEFT HAND SIDE 7.45
MIDDLE PORTION 5.25
RIGHT HAND SIDE – 0.436864631
NET
RESULT NO PARITY
STRIKE 125
BUY CALL
PREMIUM 9.5
SELL PUT 4.25
CALL PUT SELL STOCK TOTAL

SPOT PAY-OFF PAY-OFF PAY-OFF PAY-OFF
96.87 – 9.5 – 23.88 30 – 3.38
106.87 – 9.5 – 13.88 20 – 3.38
116.87 – 9.5 – 3.88 10 – 3.38
126.87 – 7.63 9.5 0 1.87
136.87 2.37 9.5 – 10 1.87
146.87 12.37 9.5 – 20 1.87
156.87 22.37 9.5 – 30 1.87
166.87 32.37 9.5 – 40 1.87
176.87 42.37 9.5 – 50 1.87
186.87 52.37 9.5 – 60 1.87
196.87 62.37 9.5 – 70 1.87
206.87 72.37 9.5 – 80 1.87
216.87 82.37 9.5 – 90 1.87
226.87 92.37 9.5 – 100 1.87
236.87 102.37 9.5 – 110 1.87
246.87 112.37 9.5 – 120 1.87
6.4 PC RATIO
PC ratio is the sum of all put options’ open interest of an underlying asset
divided by the sum of all call options’ open interest at various strike prices of
the same underlying on same maturity date. It is used to find out over-
bought and over-sold situation of a stock. If the PC ratio of Nifty is above 1.2
and is steadily increasing, then market outlook is over-bought, that is,
investors are expecting a fall in indices and thereby they are buying the Nifty
put options. On the other hand, if the Nifty PC ratio suddenly declines
then one can assume that the market is over-sold and a recovery is
expected (Fig. 6.1).
But, there are investors who use this tool as a contrarian; when the PC ratio
steadily declines then they may buy put options than call options. On the
other hand, if the PC ratio inches above 1.2 and steadily moves up, then one
has to buy calls than put options.
The other important factor which gives a market direction is the Nifty
options’ implied volatility. If both call options and put options are expensive
(buying calls and puts of the Nifty at the same expiry and same strike), then
one can assume the market is poised for a correction. If long straddles of
Nifty (buying long call and long puts of the Nifty at the same strike and same
expiry) are less expensive, then assume that the market may trade firm. The
rationale behind this is simple. The seller of the call asks for money when
implied volatility trades higher. In the same way, the seller of the put option
also will ask for more premiums in a highly volatile market because of the
uncertainty of the market. In a less volatile market, option writers will write
options at lower premiums.
In a bull market, the volatility will always remain low; on the other hand,
if the volatility is high, then one has to assume that there can be uncertainties
in the markets.
In a typical bear market, there will not be many sellers for Nifty put
options, but at the same time the call writers will ask huge premiums. In
other words, the impact cost of Nifty options will increase faster.
In a falling market, open interest of Nifty call options (out of the money)
tend to remain low. On the other hand, the out-of-the-money put options
may witness high open interest.
Nifty support and resistance can be gauged through the open interest
built-up of Nifty put options and call options. If the out-of-the-money puts
(3500 Nifty put) attract high volume and high open interest in a falling
market, then one can assume 3500 is the key Support for Nifty. On the other
hand, a firm buying in-out-of-the-money call with high open interest
suggests major resistance for Nifty.
call volumes, bullish conditions exist as potential buying power increases.

When index call volumes reaches high levels compared to put volumes, the
ratio becomes very low, signifying excess market optimism which will give an
early warning signal for impending bearishness.
Apart from PC ratio, open interest configuration is also a good tool to find
out the market trend. The open interest configuration of a stock is simply the
number of open puts or calls at various strike rates. The study will also help
one to find out supports and resistance for an individual stock or index. The
open interest configuration can be constructed by plotting a chart with
adjacent call–put bars representing open interest at every strike rate.
6.7.1 Out-of-the-money Options: A Market Indicator

Generally, derivative analysts depend on PC ratio and open interest to predict
the future direction of the market. PC ratio can be calculated by the following
formula:
PC ratio = No. of puts/No. of calls
Other reliable indicators for market analysis are activities in both out-of-
the-money calls and puts. For example, if ONGC PC ratio goes above 1.2 with
rise in prices and if rise in open interest is bullish, a knowledgeable option
analyst will find out-of-the-money (OTM) options activity. After examination,
it is found that 920 and 950 strikes are actively traded. The number of contracts
traded are almost equal or even more than the ATM options. It clearly indicates
that there are people who anticipate that the stock may test 920 or even higher.
Hence, new long positions on ONGC can be created.
On the other hand, TISCO is weak and the current price is Rs. 370. PC ratio
and the open interest too confirms the weak trends in TISCO. While examining
the most active OTM put options of TISCO, below 360 put options were not
traded actively but activity was very high in 360 put options. This sends a
clear message to the option trader that the stock will get support at Rs. 360.
Any activity in call options above the current price indicates the underlying
trends. One should take care of the number of OTM contracts traded. Volume is
the key factor that determines the fate of a stock.
There are times when both OTM calls and puts are equally traded. It sends
a clear message that the stock will not show higher volatility during the expiry.
So, it is advisable not to trade in that stock.
Sometimes, stocks like HDFC have lower liquidity in the options segment.
This indicates that the stock normally shows abnormal moves in either
direction and that investors are afraid to trade in options.
Another simple indicator that can be used for option trading is implied
volatility of an option. If the price of an option seems excessively priced (above
the theoretical premium), it is better to avoid that option for buying purposes.
On the other hand, if the options are under-priced, one can think of buying it,
provided that all other indicators show a buy signal.
114 Option Trading
6.7.1.1 Rising PC ratio in a weak market and its impacts

PC ratio is nothing but a total of all put options’ open interest of an underlying
divided by the total number of call options’ open interest. If the figure is less
than 0.4, then one can say that the outlook for the underlying is weak. As
majority of the market participants take long positions, one has to take short
positions – the contrarian view is advisable. On the other hand, if it is higher
than 1.4, it denotes majority of the market players are having negative view on
that particular underlying and one should take long positions. This is the
general theory applicable to normal circumstances.
On the other hand if the PC ratio continuously rising above 1.4 along with
the underlying then the applicability of the theory has not much relevance.
Since 15.08.05, Nifty PC ratio was steadily rising along with the Nifty Futures.
On 21.09.05 Nifty‘s PC ratio tested the all time high of 2.2 and it was well above
1.4 continuously. On 22.09.05 market crashed by more than 3 % and the PCR
came down to 1.7.
Now, one has to think about the reliability of PC ratio. If the PC ratio is
continuously above 1.4 for quite some time, and again if it rises along with the
underlying then at any time if the underlying falls one can expect a major sell
off. How does it happen? The answer is the hedgers.
Hedgers normally buy stocks from the cash market or from futures market,
and they will hedge their portfolio using index futures or with index puts. If
the market is rising then they make money from the rising underlying. If the
market falls, they make money from short index or long puts. If the fall is more
than expected, then the hedgers normally sell their underlying in the cash
market and may hold on the short index positions or long puts. This will create
panic situations in the market. The fall in U.S on 19 October 1987 was a classic
example of over-hedging by the hedgers.
Before concluding, we have four things to keep in mind while entering into
the market.
(1) If PC ratio is above 1.4, one should buy the underlying all the time.
(2) If PC ratio is below 0.4, in normal conditions, we should take short
positions.
(3) When PC ratio is continuously rising with rise in underlying then
caution should be taken.
(4) When PC ratio is more than 2 and the market starts falling, then expect a
major fall in the underlying; therefore, short positions are advisable.
6.7.2 Open Interest and Volume Analysis

Open interest in the number of outstanding positions (both short and long) at
a particular time, followed by the net change from the previous day on an
underlying in the F&O segment. Open interest analysis along with the volumes
will give a clear picture of underlying assets’ strengths and weaknesses.
Let us understand how open interest changes:

· Create a new long position and create a new short position, then open
interest will increase by two.
· Square the old short position and square the old long position, then
open interest will decrease by two.
· Create a new long position and square the old long position, then open
interest will remain same.
Rising open interest in an uptrend is bullish.
Rising open interest in a weak market is negative.
Declining open interest in a weak market is bullish.
Declining open interest in a bullish market is weak.
However, sometimes we have seen abnormally high open interest in stock
futures and option segment; most of the time if the underlying opens slightly at
a higher price, then the long holders liquidate their long causing higher level
sell off. Moderate open interest increase coupled with slightly higher closing
is a good sign for fresh long holdings.
Open interest increase and decrease is measured along with Nifty open
interest. If Nifty open interest indicate a weak trend, and at the same time the
underlying stocks futures open interest are higher with higher closing, it
suggests a strong outlook; however, due to Nifty’s weak trend, the stock may
not perform well and sometimes we may see bull liquidation also. It is
advisable to first check the Nifty’s open interest behavior, prior to predicting
the trends of the stock futures. The high correlation of many of the F&O stocks
with Nifty has made it a compulsion to study the Nifty outlook before studying
stock futures.
While analyzing the options, especially Nifty’s options, will give us a clear
indication of Nifty. For example, if Nifty futures are trading at 3900 and Nifty
put options of 3800, 3700 and 3600 strikes open interests are declining, it gives
us a clear indication that Nifty may reverse its direction because put buyers
have already booked the profit on the assumption that downward correction
is over. Same way, if the call options’ open interests of 3900, 4000, 4100 are in
a declining mode, then it suggests bull liquidation to be followed by a
weakness.
6.7.3 Impact Cost*

Impact cost is another way of finding the market direction. Normally, Nifty
impact cost remains Rs. 0.05 in normal market conditions, whereas if the
market volatility remains high then the Nifty impact cost may move up
towards 0.11–0.16. Higher the impact cost, higher the risk; lower the impact
cost, stable the market (Table 6.3; Fig. 6.4). The monthly impact cost of Nifty can
be checked from NSE’s website.
116 Option Trading
Table 6.3 Impact Cost Change on Nifty During the Two Market Crashes
in 2004 and 2008*
Year Date Impact Cost Year Date Impact Cost

2003 JAN 0.09 2005 JAN 0.11
FEB 0.09 OCT 0.08
MAR 0.09 NOV 0.07
APR 0.1 DEC 0.07
MAY 0.1 2006 JAN 0.07
JUN 0.1 FEB 0.08
JUL 0.11 MAR 0.08
AUG 0.12 APR 0.1
SEP 0.12 MAY 0.13
OCT 0.1 JUN 0.12
NOV 0.1 JUL 0.08
DEC 0.09 AUG 0.06
2004 JAN 0.12 SEP 0.06
FEB 0.11 OCT 0.06
MAR 0.09 NOV 0.06
APR 0.09 DEC 0.08
MAY 0.17 2007 JAN 0.07
JUN 0.09 FEB 0.08
JUL 0.09 MAR 0.08
AUG 0.07 APR 0.07
SEP 0.07 MAY 0.07
OCT 0.08 JUN 0.07
NOV 0.07 JUL 0.07
DEC 0.08 AUG 0.08
2005 JAN 0.11 SEP 0.08
FEB 0.07 OCT 0.11
MAR 0.07 NOV 0.11
APR 0.07 DEC 0.09
MAY 0.06 2008 JAN 0.15
JUN 0.07 FEB 0.11
JUL 0.08 MAR 0.09
AUG 0.08 APR 0.08
SEP 0.09 MAY 0.07
0.18
0.16
Impact cost 0.14
0.12
0.1 Series1
0.08 Series2
0.06
0.04
0.02
0
ay
L
ov
ar
G
EC
B
R
P
N
N
N
T
JU
FE
SE
AP
AU
C
JU
JU
JU
M
M
N
O
Months (2003–2008)
Fig. 6.4 Impact cost
6.7.4 Rollover
Rollover simply means that open positions in the current month’s expiry has
been rolled over to the next month contract by squaring off the existing
position, whether it is of long or short positions and then taking the same
position for the next month contract. Usually, they begin a week before the
current month’s expiry or sometimes much earlier. There can be long and short
rollovers. Long rollover happens when long positions in the existing contracts
have been squared off in the current month, by simultaneously taking long
positions in the next month contract. Likewise, short rollover refers to squaring
of short positions in the current month, along with opening a new short
position in the next month contract.
Rollover for futures contract is calculated by dividing the open interest in
the middle month of the available series by the sum of open interests of current,
middle and distant months. It is expressed in percentage terms. Open interest
taken for the calculation purpose is the open interest at the end of the day or at
the moment of calculation (Fig. 6.5).
Open interest in the middle month

Rollover = Total open interest in current, middle and distant months ´ 100
The above method is the most common method for calculating the rollover
of equity index future contracts.
118 Option Trading
Fig. 6.5 Rollover

6.7.4.1 Rollover: Its relevance in F&O expiry
During the expiry of F&O segment, market volatility reaches its highest point.
Both short sellers and buyers in the futures market are busy closing out their
futures positions ahead of expiry of the contract. That makes the closing
sessions highly volatile. If the total long positions are higher than short
positions then the market will fall during the last days of expiry. On the other
hand, if the total short positions are higher than the long positions, then it will
remain firm at the closing of the futures. One who knows this ahead of the
expiry can predict the future direction. Then the question arises: how can one
quantify the total outstanding short positions and long positions ahead of the
expiry? The total rollover data will provide the futures direction.
Rollover is nothing but exiting one’s position from the near month and
simultaneously creating a new position in the far month. For example, Mr. A is
long (bought) on TISCO for one lot at Rs. 380. After he made his long position
in TISCO, the stock didnt move up above Rs. 380. But he anticipated a price rise
in the near future. He then closes out his position in August futures before the
expiry and creates a new position in September futures. Shifting of a position
from near month to far month is known as rollover of positions.
Like long positions, short positions can also be rolled over. For example, Mr.
B has a short position in Telco August futures at Rs. 450 and he wants to carry
over his short position from August to September. He simply covers his short
position in August and then creates a new short position in September.
The F&O analysts keep track of the rollover positions ahead of F&O segment
expiry. It is assumed that higher rollover before the expiry keeps the market on
the positive side. On the other hand, if the rollover figure is lower, the market
may encounter selling pressure.
How can we calculate rollover position? Compare the near month’s total
open interest with the far month’s open interest; the net change will give the
rollover figure. Open interest is nothing but the total of all unsquared positions
on that particular stock/index future. (Open interest data is available on the
NSE terminal and most newspapers.) For a smooth settlement, at least 50%
open interest positions should be rolled over ahead of expiry. If the figure is
more than 80%, the market will remain positive during the days of expiry. But
if the rollover positions are lower than 25%, then one can expect a sharp drop
in prices.
One should always correlate rollover positions with market conditions for
better prediction of the market trend during expiry.
6.7.4.2 Rollover and its impact on futures expiry

Shifting of open interest (either long or short) from near month expiry to the far
month expiry is known as rollover in F&O segment. In India expiry of futures
take place on the last Thursday of each month. Take one-month contract on
November that expired on 24 November. Rollover would require the open
interest in the November contracts to be transferred to the December contracts.
For example, Mr. A is bullish on the outlook of TISCO; therefore, he bought
one lot of TISCO at Rs. 340 in November expiry on 21st. The November futures
expiry is on 24 November (last Thursday of the month). Here Mr. A has two
options. Firstly, he can hold TISCO futures till Thursday and sell the TISCO
futures at a profit or loss. The second option in front of him will be to sell TISCO
futures at a profit or loss and buy new TISCO futures in December expiry
thereby getting more holding period.
The rollover however will not happen on a single day. Normally, rollover
of contracts starts to happen days before the expiry. Changes in open interest
in different expiry periods show the level of rollover. The rollover figure, will
give a better picture of the stock/index closing during the expiry. Higher the
rollover figure, smoother is the settlement. If the rollover figure is low, then
high volatility can be seen during the settlement.
In order to find out the rollover figure, one has to calculate the pending open
interest figure in the near month and compare it with the far month’s open
interest. For example in order to find out the 24 November rollover figure of a
stock future, we require open interests of 23 November and 24 November of the
same stock future. On 23 November we can get 23 November open interest and
23 December open interest. After that we have to find out the 24 November
futures’ open interest and 24 December futures’ open interest on 24 November.
Then compare the net change in open interest. Normally, the open interest of
24 November contract will have a decline and 24th Dec. contract will have an
increase interest. Now we have to find out the net change in open interest.
In many instances, if the open interest of a stock or index has lesser rollover
figure, then one should expect highly volatile movements in that counter. Like
stock futures, options can also be rolled over from a near month contract to the
120 Option Trading
far month contract. It will give higher holding period for the investor.
Generally speaking, the rollover figures do not have any impact on the spot
market.
6.7.5 Other Bear Market Indicators

The discount between Nifty spot and Nifty futures may get widened in a bear
market. In our market, normal average discount of Nifty varies between 12 and
20 points, but in a bear market the Nifty futures discount is more than 40
points.
Nifty index heavyweight stocks such as Reliance Industries, ICICI Bank,
SBI, TISCO, ONGC and Reliance Infra are hammered down by the bear
operators in a bear market.
In a bull market, these stocks will definitely move up continuously because
Nifty arbitrageurs normally create a replica of Nifty through these stocks.
In a bear market, midcap and smallcap F&O stocks with high beta will start
falling first. In a bullish market these are the ones which act as speculators’
paradise.
If the underlying, either the Nifty or stock falls below its weekly low,
monthly low, 52- week low or all-time low, then one should assume the market
is bearish; so he is advised to buy Nifty or stocks put options.
On the other hand, if the Nifty or the stocks are trading above their weekly
highs, monthly high, 52-week high or all-time high, one should not write calls
but should write put options or buy calls.
If one of the Nifty 50 stock is trading below its 52-week low due to various
reasons, it is advisable to buy put option of that particular stock and can buy
Nifty call options.
In a classical bear market, one can see selling happening in Nifty deep-in-
the-money call options. This is mainly from institutions as they prefer not to
buy put options of Nifty in a falling market because of cash outflows. On the
other hand, by selling Nifty deep-in-the-money calls, they can earn both time
value and intrinsic value.
Summary
In this chapter we have discussed the use of put–call parity in option trading.
We have seen how PC ratio is calculated and how this is applied in practical
terms. We have also discussed arbitrage opportunities on account of PC parity
issues and also the impact cost on account of put–call parity. Besides, we have
also discussed about open interest and its impact on volume. Another
important factor in option trading is volatility because an option trader’s
strategy depends mainly on the volatility of the market. The concept of
volatility, its computation and its application are discussed in the next
chapter. The majority of the strategies discussed in this chapter are our
experiences based on the market conditions at that point of time. Readers who
take positions based on these experiences should make their own analysis
drawing the spirit from our experiences and using their wisdom while making
investments in the F&O segment.
Keywords
Put–call parity PC ratio Market sentiment Impact cost
Volume analysis Open interest Riskless profit Weighted PC
ratio Rollover
CHAPTER 07
VOLATILITY
7.1 OBJECTIVES
In the previous two chapters, we used the term volatility several times. We
used volatility for calculating the option prices. In this chapter, we will discuss
the concept of volatility, types of volatility, measuring volatility, impact of
events on volatility etc. The objective of this chapter is to provide a better idea
about volatility and its uses to the readers.
7.2 INTRODUCTION
While calculating option prices, we normally come across the term volatility.
What is volatility? Volatility is a term associated with liquids. The
characteristic of a liquid is that it is highly volatile. The dictionary meaning of
the word 'volatile' is 'moving lightly and rapidly about' (Chambers Twentieth
Century Dictionary). Another meaning for the same is 'evaporating'. In the
context of stock market, the term volatility is used to describe the uncertainty of
the future price of the scrip or index. The frequent movement of the stock prices
up and down makes it really difficult for one to predict the future price (Fig.
7.1). Consequently, the investor has the chance of gaining as well as losing in
a volatile market. It depends on how he reads the market sentiments and fine-
tunes his investments, which in turn decides his profit or loss. Volatility is an
important factor in determining the option prices. Volatility is measured in
terms of annualized standard deviation (represented by the symbol s) of the
continuously compounded returns of the asset. Usually, it is used to quantify
the risk involved while trading in an instrument over a particular time period.
7.2.1 Annualized Volatility

The annualized volatility (s) is the standard deviation (s) of the instrument's
logarithmic returns in a year. The generalized volatility (sT ) for time horizon T
in years is expresse d as:
sT = s T
124 Option Trading
Fig. 7.1 Daily volatility
For example, if the daily returns of a stock has a standard deviation of

0.01 and there are 252 trading days in a year, then the time period of
returns is 1/252 and annualized volatility is calculated as
s SD
s =
P
0.01
s = = 0.1587
1/252
The monthly volatility (i.e. T = 1/12 of a year) would be
s month = 0.1587 1/12 = 0.0458[mps1]
7.3 TYPES OF VOLATILITY

Volatility can be historical volatility or implied volatility or realized volatility.
Historical volatility, as the name implies, is a measure of the movement of price
of the asset over a given period in the past. Historical volatility is something
that has happened already. Implied volatility is an embedded measure in
Black–Scholes model of option pricing. It is something, that is happening in
the present and is highly influenced by the market forces. As a result, the
Volatility 125
implied volatility changes every time the option price changes consequent to
the demand-supply factors. Realized volatility is the movement of the price of
the underlying asset over the time period between the day the option is traded
and its expiry. Precisely, this also represents a trade that has already taken
place; hence, it can be considered as another form of historical volatility with a
difference that the realized volatility is calculated for traded options.
Black–Scholes model of option pricing assumes that volatility will remain
constant throughout the life of the option. In practice, this never happens.
Option prices change in response to the new information received by the
market. Thus, we cannot really observe volatility. We can only estimate the
volatility from the data provided by the market.
7.4 ESTIMATING VOLATILITY

The historical volatility is used to measure the amount of volatility experienced
over a given period of time. It is the standard deviation of the 'price returns'
over a period of time multiplied by the number of trading sessions, which will
give us the annualized volatility level. Historical volatility is estimated from
the past data using mathematical calculations. Implied volatility, on the other
hand, is derived from the Black–Scholes method using an iterative search
procedure. There are a number of ways to calculate historical volatility. The
first thing to determine is the timeframe. Generally, traders observe volatility
over a long time, at least 10 years. This allows them to identify short-term
changes from normal activity. If a commodity has averaged 25% volatility over
the last year, but only 15% over the past 30 days, you may want to adjust the
volatility estimates to accommodate the most recent data. Rather than using a
figure of 25%, adjusting the figure to 20% as the midpoint may prove more
accurate.
7.5 ESTIMATING HISTORICAL VOLATILITY

Two alternative processes are generally used in estimating the historical
volatility. The first method is estimating the standard deviation as a fixed
parameter, assuming that it is a proxy of historical movement of returns and
can describe the future probability distribution of the underlying asset. The
second alternative is estimation of the historical volatility considering it a
time-varying process and use econometric models like GARCH. Statistically,
any differences in the measured volatility are functions of statistical error. This
is the reason for assuming volatility as a constant factor. Hence, if we are
estimating volatility from historical data, say 90 days or 360 days, the result
would be the same. Therefore, we may have to increase the size of the sample
until we get the desired degree of accuracy. However, as already seen, the new
126 Option Trading
information arrived at the market can change the underlying asset prices.
Consequently, the volatility also changes, thereby making the assumption that
the volatility is constant an illogical one. These controversies normally raise
the following questions:
1. What should be the frequency of data? Should it be daily, intra-day,
weekly or any other period?
2. What should be the sampling period? Should it be opening, closing,
high, low, average etc.?
3. What should be the period to be covered by the historical return data, i.e.
annual, half-yearly etc.? (Normally, volatility is quoted as annualized
percentage)
4. Which days are to be included? Is it the calendar days, trading days etc.?
The following example will try to find answers to these questions.
As already explained, historical volatility is measured by the annualized
simple standard deviation of the continuously compounded return on the
underlying asset. Accordingly, if we are using daily data, we will get daily
historical volatility, whereas weekly data will provide weekly historical data.
The following formula is used for calculating historical volatility.
æ 1 ö n
÷ * å (ri - m )
2
s = ç
è (n - 1) ø i =1
where
s = Volatility
n = Number of price observations
ri = Individual continuously compounded return
µ = Arithmetic mean of returns
The result of this equation is the daily volatility. In order to get the
annualized volatility, multiply the above equation by the square root of the
number of data observation days per year, say number of trading days. Table
7.1 shows the price movement for a period of one month.
Table 7.1
Value of Price Relative Log of Price Mean Deviation Square of

Scrip Relative or Price Mean
Relative Deviation
(ri-µ) (ri - µ)2.
181
183 1.01105 0.004773 0.004693 2.20219E-05
187 1.021858 0.009391 0.009311 8.66902E-05
(Contd.)
Volatility 127
Value of Price Relative Log of Price Mean Deviation Square of

Scrip Relative or Price Mean
Relative Deviation
(ri – µ) (ri – µ)2
188 1.005348 0.002316 0.002236 5.00185E-06
186 0.989362 – 0.00464 – 0.00472 2.23225E-05
187 1.005376 0.002329 0.002249 5.05756E-06
187 1 0 – 8E-05 6.36173E-09
187 1 0 – 8E-05 6.36173E-09
184 0.983957 – 0.00702 – 0.0071 5.04603E-05
186 1.01087 0.004695 0.004615 2.13016E-05
184 0.989247 – 0.0047 – 0.00477 2.27995E-05
182 0.98913 – 0.00475 – 0.00483 2.32922E-05
176 0.967033 – 0.01456 – 0.01464 0.000214285
177 1.005682 0.002461 0.002381 5.66839E-06
179 1.011299 0.00488 0.0048 2.304E-05
181 1.011173 0.004826 0.004746 2.25225E-05
183 1.01105 0.004773 0.004693 2.20219E-05
181 0.989071 – 0.00477 – 0.00485 2.35446E-05
186 1.027624 0.011834 0.011755 0.000138171
185 0.994624 – 0.00234 – 0.00242 5.86113E-06
184 0.994595 – 0.00235 – 0.00243 5.92273E-06
183 0.994565 – 0.00237 – 0.00245 5.98533E-06
182 0.994536 – 0.00238 – 0.00246 6.04895E-06
180 0.989011 – 0.0048 – 0.00488 2.38012E-05
180 1 0 – 8E-05 6.36173E-09
180 1 0 – 8E-05 6.36173E-09
179 0.994444 – 0.00242 – 0.0025 6.24617E-06
177 0.988827 – 0.00488 – 0.00496 2.45969E-05
180 1.016949 0.007299 0.007219 5.21209E-05
181 1.005556 0.002406 0.002326 5.41172E-06
Total of mean deviation of price relative (SMD) = 0.000849572

With this information, we shall apply the formula to find out the volatility
when n = 30.
128 Option Trading
n
å (ri – m )2 = 0.000849572
i =1
æ 1 ö
ç ÷ * (0.000849572 * 250) = 0.8558 (8.56% )
è ( 30 - 1) ø
The historical volatility on annual basis works out to be 8.56%, assuming

that there were 250 trading days in the year.
The first column of the table shows the value of the scrip. The second
column shows the price relative. Price relative is the change of price over the
previous day's price. This is calculated by dividing the current price by the
previous day's price. Log value of the price relatives are calculated and shown
in the third column. The arithmetic mean of the log value is computed and the
mean deviation (ri - µ ) is calculated. The mean deviation is shown in the fourth
column. The square of mean deviations is computed and is shown in the last
column. The mean deviation square column is summated and the aggregate
value is arrived at.
7.6 FACTORS AFFECTING THE COMPUTATION OF

HISTORICAL VOLATILITY
1. Dividends: Black-Scholes formula assumes that no dividend is paid
during the period. This assumption is not correct. Practically every company
will give dividend at the end of every year. Some companies pay interim
dividend also. Normally, the share price goes up prior to the declaration of
dividend and falls after the dividend is declared. Therefore, the value of the
scrip will increase as the dividend date comes closer and may hover around
till the dividend is declared and the price declines after a few days. It is difficult
to predict the price changes on the ex-dividend date due to two reasons. Firstly,
the amount of dividend received by each individual shareholder varies.
Secondly, the tax rates vary from person to person on account of a differential
income pattern. A viable solution to this issue is to exempt the ex-dividend
data for the purpose of calculation of volatility.
2. Frequency of Data: Another factor affecting the estimation of volatility is
the frequency of the data used for the estimation. The risk-free interest plays an
important role in determining the fair price of an option. A hedger who is long
in asset will go short in his options portfolio in order to manage the risk. He
has to review his position and re-balance the portfolios periodically. Whether
he does this re-balancing intra-day, daily, weekly etc. is important in deciding
on the frequency. The best possible method is to select the sample data that
match the frequency hedge re-balancing.
Volatility 129
3. Price Observation: Since volatility is a measure of price changes, the

type of price observed is very important in calculating volatility. It depends on
the behaviour of the hedgers. Some hedgers re-balance their portfolios based
on the opening price, whereas some others do this exercise based on the
closing balance. Hence, it is better to select the sample based on the hedger's
choice of price for re-balancing their portfolios.
4. Length of Sample Period: The sampling error can adversely affect the
calculation of historical volatility. The sampling error depends on the length
of the sample period, which is in effect to the sample size. Therefore, in order to
ensure accuracy we have to find out the standard error as well as the sample
size. The standard error can be calculated as follows:
SE = s /Ö2N
where
SE = Standard error
s = Volatility estimate
Ö2N = Size of the sample used to estimate the volatility
If we apply this formula to the previous example, the standard error works
out to:
SE = 8.56/Ö2*30 = 1.11
The second requirement in the determination of the volatility is the sample
size. The following statistical formula can be used for estimating the sample
size:
n = ((z * s) /e)2
where
n = The required sample size
z = The critical value in the distribution table for the required level of
confidence (For example, the critical value for a 99% confidence
level is 2.85)
e = The acceptable standard error
s = The standard error of the volatility distribution
Example: Suppose the acceptable standard error is 0.5 with 99% confidence
level, sample size for the above example can be calculated as follows:
n = ((2.85*1.11)/0.5)2 » 40
Thus, in order to give required degree of accuracy, the required sample size
is 40. However, since volatility is considered to be a constant factor for the
purpose of calculation of option price under Black-Scholes model, this
calculation is not fully correct. Hence, the best method is to choose a longer
sample period.
130 Option Trading
7.7 IMPLIED VOLATILITY

The implied volatility of an option is the volatility expressed indirectly by the
price of the option in the market based on an option pricing model. It gives a
theoretical value for an option equal to price of the option in the current market
when used in a pricing model. It is directly influenced by the demand and
supply of the underlying option and the expectation of the market about the
direction of the share price. When the expectation rises, demand as well as the
implied volatility increases along with it. The expensiveness of an option is
determined to a great extent by the rise or fall in the implied volatility of the
option. The options that are near to the money are seen most sensitive to
implied volatility fluctuations whereas options which are deep-in-the-money
(DITM) and out-of-the-money (OTM) are seen less sensitive to the changes or
fluctuations in implied volatility.
7.8 VOLATILITY SMILE

In finance, the volatility smile is a long-observed pattern in which at-the-
money (ATM) options tend to have lower implied volatilities than other
options. The pattern displays different characteristics for different markets
and results from the probability of extreme moves (Fig. 7.2). Equity options
traded in American markets did not show a volatility smile before the crash of
1987, but began showing one afterwards.
Implied volatility
Strike price
Fig. 7.2 Volatility smile

Modelling the volatility smile is an active area of research in quantitative
finance. Typically, a quantitative analyst will calculate the implied volatility
from liquid vanilla options and use models of the smile to calculate the price of
more exotic options.
A closely related concept is that of term structure of volatility, which refers
to how implied volatility differs for related options with different maturities.
An implied volatility surface is a 3-D plot that combines volatility smile and
term structure of volatility into a consolidated view of all options for an
underlying.
Volatility 131
For example, for volatility smile using Reliance Industries call option and its
implied volatility, see Table 7.2 and Fig. 7.3.*
Table 7.2 Implied Volatility of Reliance Options at Various Strikes
Call Strike Implied Volatility

1950 53.01
1980 54.05
2010 48.03
2040 42.5
2070 39.045
2100 35.23
2160 32
2190 34.58
2220 36.6
2250 39.47
2280 41.15
2310 45.5
2400 50.8
2500 58.53
2600 60.1
Volatility smile
70
60
50
Implied volatility
40
30
20
10
0
50
10
70
60
20
80
00
00
19
20
20
21
22
22
24
26
Reliance call option strike Smile
Fig. 7.3 Volatility smile of Reliance Industries
* Source: Terry J. Watson, Futures and Options in Risk Management, 1998.

132 Option Trading
Implied volatility is a measure embedded in the option price. Although the

option price calculated using Black–Scholes Model has implied volatility as
one of the factors, it is difficult to segregate this factor from the formula directly.
However, after extensive research in this area two models have been
developed. The first model was developed by Corrado and Miller in 1996 and
the second one was developed by Newton–Raphson. According to the first
method, the implied volatility can be calculated in the following manner:
s =1/ÖT – t[Ö2Õ/(S + Xe-r(T-t)) (c– (S – Xe-r(T-t)))/2+Ö(c – S – Xe-r(T-t))/2)2 – S

– Xe–r(T-t)2/Õ)]
Example: Assume that the asset price is Rs. 150, strike price is Rs. 150, risk-
free interest rate 6%, annual volatility 37.20%, time to maturity of 3 months and
call option premium Rs. 12.09. The implied volatility can be calculated in the
following manner by applying the above formula:
1/Ö(T-t) 2.01
Value of Õ 3.141593
SQRT 2Õ/(S+xe -rt) 0.008417
c-(S-xe -rt)/2 10.99176
c-(S+xe -rt)/2)2 120.8189
(S - xe -rt)2/Õ 1.544604
In this example, we have used 365 days for the purpose of calculation.
s = 2.01[(0.008417*10.99176) + Ö(120.8189 –1.544604)] = 22.18%
It can be observed from the above calculation that the implied volatility
used for calculating the premium for the same option was 37.20% whereas the
implied volatility extracted works out at 22.18% only.
The Black–Scholes formula is used to calculate the implied volatility; we
can't invert the formula to arrive at the implied volatility with a given option
price. What we can do is to use the Newton–Raphson method to arrive at the
implied volatility quickly. We may use the option's Vega* to arrive at the true
implied volatility after making a guess on the option's implied volatility.
In this method, the volatility parameter is changed keeping the other
parameters fixed so as to make the difference between the modelled price and
the market price zero. Here, the option price calculated using the option
pricing model and the actual price prevailing in the market is considered for
arriving at the implied volatility. Since this calculation is beyond the scope of
this book, we are not giving the formula and calculation here.
*
Refer to Chapter 8 in this book.
Volatility 133
7.9 GARCH
Volatility can also be calculated using GARCH Model that is based on the
assumption that stock returns are heteroskedastic, which means the returns
are not scattered evenly or homogenously during the observed period. The
model was initially developed as autoregressive conditional heteros-
kedasticity (GARCH). Traditionally, we presumed that the mean of the
expected value outcomes of the random variable is unconditional.
Alternatively, the unconditional mean is the weighted mean of the expected
outcomes of the random variable. Consequently, the unconditional variance of
a random variable represents the difference between the expected outcome
and the unconditional mean. However, practically this is not true because the
outcome of the random variable is highly responsive to the new information
received at the market, which makes it conditional. The difference between the
conditional mean and the random variable constitutes the conditional
variance, which is better known as function of the squared residuals of the
conditional mean equation. The process of ARCH is the modeling of the
conditional mean using autoregressive model through the autoregressive
process of the squared residuals. Subsequently, the process was more refined
by taking into consideration some value of the previous conditional variance
as well. Thus, the generalized autoregressive conditional heteroskedasticity
(GARCH) came into existence. GARCH is a constant as the current value of the
conditional variance, some value of the squared residuals from the conditional
mean equation (conditional variance) plus some value of the previous
conditional variance. GARCH is now used for estimation of implied volatility
not only in stock market, but also in currency market as well.
Beta
Beta is a measure of a stock's volatility in relation to the market. Beta can be referred
to as a measure assets sensitivity of the asset's returns to market returns. Beta value
of stocks give much idea on how much a stock is related to the market movement.
The Beta of S&P CNX Nifty comprising of 50 stocks is 1.
Beta of a stock = Covariance of stock return with respect to market return/
Variance of market return
Increase Your Portfolio Betas: Beta is a measure of risk. In a bullish
market, high beta stocks give high returns and while markets are on the
downtrend, high beta stocks tend to fall more than that of low beta stocks.
Let us assume that the beta of stock ACC is 1.2. It indicates that if Nifty has
given a return of 10%, then the investments in ACC can give a return of 12%.
Stocks with high beta are good for investment in a bullish market, but if the
markets are on the downturn then these stocks will give you higher losses.
Generally, we can call stocks which are having beta less than one as old
economy stocks, which may move very slowly and returns will also be very
low. On the other hand, stocks having more than one beta are known as
134 Option Trading
aggressive stocks because their performance on the bourses will be far better
than the indices. Stocks of sectors such as capital goods, wind energy,
electricity, infrastructure etc. come under aggressive stocks, whereas steel,
cement, automobiles, etc., normally fall under the category of below 1 beta,
because these are cyclical stocks, which may move occasionally.
A combination of leveraged positions and investments can give higher
returns on the stock markets. Punters and fund managers are using various
combinations. Creating a portfolio with high beta stocks will fetch you higher
returns. Some aggressive fund managers are even creating portfolios having
beta of 1.75. It means that if Nifty has given a 20% return; these fund managers
will make a windfall profit of 35%. There are fund managers who try to reduce
beta to one. These fund managers are looking at decent returns, but do not
want to take high risk. Traditional fund managers are not very keen on beta;
they may select midcap stocks with good fundamentals and buy the stocks
continuously, which itself will push up the prices. The danger in this old
method is that once the market falls there will not be many takers for these
stocks because midcap stocks will have liquidity problems.
Modern researchers are using the support of technical analysis to create high
beta portfolios. For example, when the stock is above 200, 100, 50 and 10 day
simple moving averages, they create highly leveraged positions in order to get
more beta for the portfolios. If the stock falls below 10, 50, 100 and 200 day
simple moving averages, then they reduce the portfolio beta to 1 or even below 1.
Portfolio Beta: Portfolio beta is defined as the weighted sum of individual
asset betas according to the weightage of each asset's investment in the
portfolio, that is, portfolio beta is the aggregate of each asset's beta times
proportion of each asset's proportion (amount) in the portfolio.
It is the relative volatility of returns earned from holding specific portfolio
of securities. Portfolio having higher beta is more vulnerable to the Nifty
movements. To understand portfolio beta is important for portfolio hedging by
the investors in the derivatives segment.
For example, consider a portfolio of three securities, A, B and C included in
Nifty with stock beta of 0.80, 1.50 and 1.2 respectively, each having an
investment of Rs. 50,000, Rs. 25,000 and Rs. 100,000 totaling Rs. 175,000.
Portfolio beta = 0.80 (50000/175000) + 1.5 (25000/175000) + 1.2
(100000/175000)
= 0.23 + 0.21 + 0.69
= 1.13
So, if Nifty moves up by 2%, the above portfolio is expected to move up by
2.26% (i.e. 1.13 ´ 2%).
Let us take another example on a real-time basis to find out portfolio beta.
The total portfolio is worth Rs. 50 lakhs. Stocks included in the portfolio in
Table 7.3 are given in the order of their proportion in the portfolio. They are
taken from S&P CNX Nifty, which include the most liquid stocks with least
impact cost in terms of market capitalization.
Volatility 135
Table 7.3 Model Portfolio and its Weightage
Sl No. Stock Name Sector Weightage (%)

1. RELIANCE Refineries 25
2. ICICI BANK Banks 19
3. L&T Engineering 15
4. ONGC Oil Exploration 11
5. INFOSYS IT 9
6. SBI Banks 7
7. NTPC Power 5
8. HDFC Banks 4
9. RELIANCE Telecommunication 3
COMMUNICATIONS
10. TATA STEEL Steel 2
Table 7.4 Calculation of Portfolio Beta
Sl Stock Name Weightage of Total Proportion Stock Product of Portfolio

No. Stocks in the Profolio of Stock Beta Stock Beta Beta
Portfolio Value (in in the and Stock
(in Rs. lakhs) Rs. lakhs) Portfolio Proportion (F) =
Sum of
(A) (B) (D) (E) = C × D (E)
(C) =
A/B
1 Reliance 1250000 5000000 0.25 1.12 0.28
2 ICICI Bank 950000 5000000 0.19 1.14 0.2166
3 L&T 750000 5000000 0.15 1.05 0.1575
4 ONGC 550000 5000000 0.11 1.04 0.1144
5 Infosys 450000 5000000 0.09 0.65 0.0585 1.05
6 SBI 350000 5000000 0.07 0.99 0.0693
7 NTPC 250000 5000000 0.05 1.19 0.0595
8 HDFC 200000 5000000 0.04 0.92 0.0368
9 Reliance 150000 5000000 0.03 1.15 0.0345
Communi-
cations
10 Tata Steel 100000 5000000 0.02 1.11 0.0222
136 Option Trading
7.10 IMPACT OF IMPLIED VOLATILITY AND UNDER-

LYING ASSET PRICE ON PURCHASE OF OPTIONS
Let us look the option premium movements after the purchase of an option in
relation to the underlying asset price and its implied volatility.
Underlying Asset Volatility of the Asset Option Price
Moves in the expected way
Moves in the expected way ¾
Moves in the expected way ¯
No change in price
No change in price ¾ slowly
No change in price
Moves the opposite way ¯
Moves the opposite way ¾ ¯
Moves the opposite way ¯ ¯¯
Impact of implied volatility and underlying asset price on sale of options.

Let us look the option premiums movements after the sale of an option in
relation to the underlying asset price and its implied volatility.
Underlying Asset Volatility of the Asset Option Price
Moves in the expected way ¯ slowly
Moves in the expected way ¾ ¯
Moves in the expected way ¯ ¯¯
No change in price slowly
No change in price ¾ ¯
No change in price ¯ ¯¯
Moves the opposite way
Moves the opposite way ¾
Moves the opposite way ¯ ¯ slowly

Volatility 137
OPTION CALCULATOR BASED ON BLACK–SCHOLES
Strike price 80
Share price 82
Time to expiry 30
Volatility 35
Annual interest rate 9.5
CALL PUT
OPTION
VALUE 4.703 2.082
Fig. 7.4 Option premium of a stock if the volatility remains at 35%
OPTION CALCULATOR BASED ON BLACK–SCHOLES
Strike price 80
Share price 82
Time to expiry 30
Volatility 50
Annual interest rate 9.5
CALL PUT
OPTION
VALUE 6.033 3.412
Fig. 7.5 Option premium of the same stocks with increase in volatility from
35% to 50%
7.11 VOLATILITY TRADING

Volatility represents the actual annualized standard deviation of the
underlying between the evaluation date and the expiration date. Of course, no
one knows exactly what the future volatility will be—we can only guess.
Volatility is defined as 'the degree to which the price of an underlying tends to
fluctuate over time'. This is generally calculated using a standard deviation of
138 Option Trading
price movements over a period of time. For example, if the volatility of an

underlying market is 20, it implies that the market can be expected to fluctuate
over the next 12 months with a range of ± 20% from the current levels, with
68% degree of probability. Generally, the more the underlying price fluctuates,
the higher the volatility. In turn, the higher the volatility level, the higher the
general level of option premiums. Generally, higher the volatility, higher the
premiums; a decrease in volatility means lower premiums. This is due to the
fact that an option writer will demand to receive a higher premium to write an
option when the underlying volatility is high.
There are several good benchmarks that traders used to estimate the
volatility variable. Such estimation methods involve calculating the recent
volatility of the underlying itself and looking at the volatility 'implied' by the
actual option market price. These estimation methods are usually effective.
Volatility is always changing, and sometimes the changes are quite sudden
and powerful. In October 1987, the implied volatility of OEX options had been
about 25, but on one day (Black Monday), volatilities actually climbed to 200 or
higher. Normally, stock index and volatility are inversely correlated. If the
underlying asset price rises, the volatility drops. On the other hand, when the
underlying falls, the volatility moves up. Generally speaking, when the
volatility of an underlying is falling, the call option premiums tend to remain
cheaper and investors should buy call options. On the other hand, if volatility
is rising, investors can expect a fall in price of underlying and can buy put
options.
There are volatility traders who plot the volatility over a period of time and
calculate the mean volatility. Whenever daily volatility falls below the mean
level, they will buy 'straddles' (buying both call options and put options) in
anticipation that volatility may move back above the mean. On the other hand,
if the volatility moves above the mean level, they may sell 'straddles' in
anticipation of a fall in premiums.
Before entering into a volatility trading strategy, one should have a clear
picture on the following factors:
1. What is the long-term mean volatility of the underlying contract?
2. What has been the recent historical volatility in relation to the mean
volatility?
3. What is the trend in the recent historical volatility?
4. What is implied volatility and its trend?
5. Are we dealing with options of shorter or longer duration?
If a trader has the answers to these questions, then s/he can play the game
of volatility trading in a successful manner.
7.12 NSE VOLATILITY INDEX

Volatility is the standard deviation of the continuously compounded returns
of a financial instrument with a specific time horizon. It is often used to
quantify the risk of the instrument over that time period.
Volatility 139
Volatility is related to, but not exactly the same as, risk. Risk is associated
with an undesirable outcome, whereas volatility as a strict measure of
uncertainty could be due to a positive outcome.
The first volatility index (VIX) was introduced by the CBOE in 1993. It was
the weighted measure of the implied volatilities of S&P 500 ATM put and call
options. There are different volatility indices in the US. VIX tracks the S&P 500,
the VXN tracks the NASDAQ 100 and the VXD tracks the Dow Jones industrial
average.
India VIX is a volatility index based on the Nifty 50 index options price.
From the best bid-ask price of Nifty 50 options contracts, a volatility figure
(%) is calculated, which indicates the expected market volatility over the next
30 calendar days.
Volatility index is a good indicator of investors' confidence in the market in
the near term. If the volatility index rises considerably, then it is an early
indication of an uncertain market. If it is steadily decreasing then it is an
indication of an impending uptrend in the market.
If the volatility index is below 15-20 levels, then buying of call options is
advised. If the volatility index is above 30, then one has to reduce naked
positions or engage in portfolio hedging. If the volatility index is above 40,
then investors should take utmost care, and they have to reduce portfolio size
and accumulate index put options because they can expect uncertain market
movements.
It was interesting to note that on 1 January 2008 the volatility index of NSE
was at 25.38, moved towards 31.17 on 16 January and even tested a high of
54.41 on 29 January. We witnessed massive sell off in Indian equities market
during that period.
It is very interesting to note that both Nifty index and volatility index of
Nifty are inversely correlated. Whenever Nifty rises, volatility falls and vice versa.
If the international volatility indices are on the higher side (above 30) and
the NSE volatility is also rising, it is an early indication of a fall in index in
India due to global factors. On the other hand, if the international volatility
indices are lower than 20 and the Indian volatility index is rising steadily, it
is an indication of a fall in the market due to domestic issues.
The regular monitoring of NSE VIX will help investors to be aware of the
market uncertainties. Traders who create high leverage positions must track
the NSE VIX on a daily basis. The volatility index study will also help the
option traders in a great way because option premiums are fully dependent
on volatility.
7.13 BEHAVIORAL STUDY OF NIFTY OPTIONS DURING

DISTRESS
May 17, 2004 regarded as the 'black Monday' when the markets fell down
drastically, causing huge distress among the investors. Taking this incident
and index option data into consideration from March to July, it could be
examined as to what actually happened and how market participants as well
140 Option Trading
as investors behaved on 17 May, pre- and post-17 May? This will give an
insight into how such distress can be tackled efficiently and what necessary
steps should be taken.
Implied volatility and its behavior at the time of distress: During the time of
distress it is interesting to note that mispricing of call options starts a few
days before the event, but when market declines further, mispricing becomes
nil. Consequently, after the event, mispricing starts again. When IV increases
generally above 25% in a bear phase, mispricing reduces, but during the fall
of IV, mispricing of call options starts again. When volatility increases,
investor's expectation about anticipated volatility is revised upwards, giving
rise to higher risk premium. As a result, discount rate increases and Nifty
index falls. Arbitrage opportunities in call options arise during a bear phase
few days prior to the event and a few days after the day of the event.
Mispricing of put options: During a bear phase, the mispricing of call and put
options will decrease substantially but the volatility will increases.
Relationship between risk premium and implied volatility: During a bear rally,
Risk premium exhibits a positive relationship with put option's implied
volatility and a negative relationship with call option's implied volatility.
Option premium of put options increases with the increase in implied
volatility just prior to and after the event day (14 and 18 May) but not on the
event day (17 May).
The event taken for the study was the period preceding and following the
general elections in May 2004. The unprecedented fluctuation in the market on
17 May was taken as a basic distressful event for the study.
Put options during a bear phase: In a bear phase, implied volatility rises, but
volume traded drops. Post the event, IV declines but options trading volume
increases. It can be summarized that there exists an inverse relationship
between implied volatility and liquidity for put options during a distress. In
the pre-event phase, as IV increases the open interest increases, but the
relationship ceases on the event day and post-event.
Call option during a bear phase: Pre-event, ATM call option is most actively
traded, while during the event, OTM call is traded most actively, and post-
event, in-the-money (ITM) call options are traded most. During a market
distress, open interest is always more in deep-out-of-money (DOTM) calls
compared to other calls. At the time of distress, there exists an inverse
relationship between the implied volatility and the Volumes traded.
Comparison: The implied volatility curve exhibits the same pattern for both
calls and puts. But the interesting thing to be noted is that the IV of calls is
less than the IV of puts. The correlation between IV of calls and IV of puts
during an event is 0.89 signifying that if IV of put option increases by 1, then
IV of call option increases by 0.89. Liquidation of call option is more than that
of put option just prior to the event, while at the time of the event and post-
event liquidation of put option is more than that of call option.
Volatility 141
Relationship between open interest, volumes and volatility: In a normal healthy

market, open interest and volume are high during the days when there is slight
fluctuation in implied volatility, but during the market distress, even though
the fluctuation in implied volatility is very high, open interest and volumes are
low. Open interest started increasing in the pre-event phase and reached the
maximum on 14 May, the day prior to the event. On and after the event, open
interest started declining.
To conclude, the study has attempted to chalk out the distinct character-
istics of the market in general, and the components of options market in
particular, during a period of distress.
7.14 IMPACT OF EVENTS ON VOLATILITYA CASE

STUDY
An efficient market is the one that rapidly absorbs information and adjusts the
price swiftly. Therefore, any information that affects the demand and supply
of the stock is valuable as far as the participants of the trading operations are
concerned. Generally, the stock prices go down by an amount reflected by the
dividend date. This happens because the demand for the shares comes down
once dividend is paid. Dividend is the reward given by the company to the
shareholders and the rate of dividend depends on the profitability of the
company. Therefore, any economic activity that affects the performance of the
company, which will ultimately either deny the dividend or reduce the
dividend rate, is valuable information for the stock market. Such news will
pull down the demand for the shares, resulting a fall in the spot price.
A study conducted on selected scrips in the BSE on the responses of
announcement of quarterly results revealed that stock returns fell during the
period between tenth and fifth day and started rising four days before the
announcement of the quarterly earnings and continued till the previous day
of announcement. The stock prices rising four days before the event day is an
indication of the good news from the quarterly earnings.
Methodology: Seven days prior to and five days after the event are taken for
observing the impact of events on the implied volatility based on the findings
in the previous studies. The event selected for the study is the announcement
of quarterly results by selected entities and the announcement of the Union
budget. We have taken 10 scrips, which contributed 80% of Nifty's total
traded volume. Also, we have selected Nifty for studying the impact of events
on the implied volatility. We observed the movement of implied volatility
prior to and after declaration of quarterly results in case of selected scrips. In
the case of Nifty, we have taken the announcement of the Union Budget as
the event. The scrips selected are Infosys, Satyam, TCS, SBI, ICICI bank,
TISCO, TELCO, Maruti, ONGC and Reliance Industries.
The implied volatility is generally calculated on the futures prices of the
underlying stocks, considering the higher trading volume in the future market
than that in the cash market. We have considered five different scenarios viz.,
DITM, ATM, OTM and DOTM scenarios.
142 Option Trading
Nifty's relevant data during the interim budget on 8 July 2004 was taken for
analysis. The volatility of the call and put prices during the pre-budget, post
budget period and the event day were taken for analysis. The event taken is
the budget presented in July 2004. Volatility is measured for different options.
The analysis showed that the volatility peaked during the event and then
came down gradually. The correlations were measured for the period before
the event (the budget) and post-event (after 8 July 2004) to establish the relation
between the call's implied volatility and the call price, put's implied volatility
and put price. In the case of ATM options, the call's implied volatility has more
correlation with the price rather than the put Implied volatility and price. The
call is more sensitive to change in the implied volatility than the put.
In general, six to seven days before the event, the Nifty's IV starts to
gradually rise. The day before the event, the IV peaks, then starts to fall on
the event day and then after four to five days, the IV slightly rises. The same
pattern is observed in all the five cases that are ATM options, ITM options,
out-of-the money options, DITM options and DOTM options. In all the cases
mentioned above, post-event, the IV falls to a level lower than the IV level pre-
event. The rise and fall of IV are common for both call and put options. The
correlation analysis found that the call IV and call price have higher degree of
direct correlation than the put options. The post-event correlation is higher
than the pre-event correlation.
The analysis indicates that the call price tends to rise a week before the
event, attains the peak a day before the event and then gradually comes
down. In the case of Nifty, volatility trading will fetch better returns in the
case of call options rather than that in the put options. Pre-event correlation
of puts suggests that in most of the cases, though there was a positive
correlation the relationship was weak. The best available option for volatility
trading can be ATM options in the case of post-event. In the case of calls, ITM
options can be used for trading in volatility both in the case of whole period
and before the event.
Infosys: Infosys showed a distinct pattern in the case of volatility. The IV of
ATM calls and puts showed 14% and 40% increases respectively during the
pre-event phase and around 50% fall in the post-event. The magnitude of
rise and fall in the IV was approximately same in all the five categories of
options taken for the test. DOTM options did not show such a drastic rise or
fall in the IV either pre-event or post-event. To put it in other words, DOTM
options in the case of Infosys are less receptive to events like Q2 results.
There was high degree of positive correlation in all the five categories of
options. ATM call options and ITM put options had the highest amount of
direct correlation. The pre-event correlation for puts in all the categories was
comparatively less. It can be inferred that the put options behave in the
direction of IV more frequently in the post-event than in the pre-event. In
case of calls, the DOTM options showed a negative correlation in the post-
event.
Volatility 143
Volatility trading will be effective for both calls and puts in the case of post-
event if OTM options are chosen. On the whole, if an investor wants to take
advantage of the volatility during an event, his best choice would be ITM
options. The unique feature with Infosys was that the DOTM option showed
very high correlation in the case of puts for post-event and negative correlation
in the case of calls for the same post-event.
TCS: In case of TCS, ATM call and put IV gained around 10 points in the pre-
event period. They peaked just two days before the result and started to decline
in the post-event phase. In the post-event the call IV lost around 15 points and
the put IV lost around 6 points. Except in the case of ATM options, the put IV
showed a slight rise in the post-event phase. This may be due to the fact that
the actual Q2 results were lower than the anticipated results. ATM calls, ITM
calls and OTM calls showed high correlation between call IV and call price.
The correlation was very less in the case of DITM and DOTM calls.
In the case of puts except ITM options, the correlation was very less. DOTM
options in the post-event showed inverse relationship in the case of calls and
highly positive relationship in the case of puts.
Satyam: Satyam announced its quarterly result on 20 October 2004. ATM calls
peaked much before the event day (8 October 2004) and came down to a lower
level by 15 October. From there the call IV gained just 2.38 points till the day
before the event. The event day saw the IV declining. But the IV again gained 14
points by the second day after the event. ATM puts gained 5 points before the
event day, but the drop in the IV after the event day was more significant in
puts rather than in calls.
The general pattern of rising IV in the pre-event period and falling IV in the
post-event period was seen, though with less degree of precision. The same
trend was also seen in the other scenarios of ITM, OTM, DITM and DOTM
options.
SBI: SBI declared its Q2 results on the 30 October 2004. The set pattern of rising
volatility in the pre-event phase and falling volatility in the post-event phase
was followed with higher degree of precision in the case, SBI in general and
call IV of SBI in particular. ATM calls of SBI gained 9 points in its call IV and 6
points in its put IV in the pre-event phase. The gain in the ITM options was
higher in the case of calls. Post-event, the ATM calls saw a fall of about 10
points while the put options in the same category fell by around 3 points. The
relationship between call IV and call price was high only in the case of DITM
options. Otherwise there was a positive moderate relationship in most of the
other categories.
Negative correlation between options price and IV was observed in around
five cases. Thus, it can be inferred that the pre-event volatility trading should
be approached with care. Post-event, ITM puts and DITM puts can be ideal for
volatility trading. Pre-event OTM calls can be a better choice.
144 Option Trading
ICICI Bank: The Q2 result was declared on 20 October 2004. Both call and put
showed a rising trend in the pre-event phase and a fall in IV in the post-event
phase. The IV rose from a lower level in all the cases of calls and puts for all
categories and then showed wave patterns suggesting volatile movements.
The relationship was generally positive both in the calls and puts. The call
and put prices generally followed the direction of IV. The IV and option price
relationship was less in the case of ITM options.
Maruti Udyog Ltd: Maruti declared Q2 results on 27 October 2004. The IV of
Maruti showed a wave pattern during the event. The call IV and put IV gained
around 10 points in the pre-event phase. The post-event phase was not
calculated as the contract ended on 28 October while the event day was 27. A
distinct volatile wave pattern of high rise and falls was witnessed in the puts
in all the five categories. DOTM call can be best described as not having any
impact for the event. There existed a high degree of direct relationship between
the IV and option prices in all the categories.
Tata Motors: The event was declaration of Q2 results by Tata Motors on 29
October 2004. In this case, the set pattern was distinct in DITM and DOTM
options. In both these cases, the IV gained around 6 points in the pre-event
phase. In the other entire category, the IV rose but its magnitude was varied.
High degree of correlation existed in the pre-event phase and for the whole
period. Post-event, the results were mixed. The relationship exhibited was
weak to inverse. This can be because of the fact that the November month
contract after the expiry of October month contract was traded more heavily
and this was the post-event period. Regardless of the volatility, the option
prices increased due to the higher demand.
Reliance Industries: The established pattern of pre-event rises, peaking of IV
and decline in the post-event was not established with high degree of volatility
change. In all the cases, the put IV showed a rise with varying magnitude
immediately after the event day. In the case of call options except in the case of
DITM call, the IV declined after the event. On the whole, it can be generalized
that a significant pattern of IV was not established for Reliance.
This can be justified by the varying degree of correlation for different
scenarios, which does not suggest a pattern.
ONGC: The oil major ONGC announced its Q2 results on 29October 2004. The
pre-event rise of IV in the call option was not very distinct. The ATM call
gained 2 points while the puts did not show any significant rise. Significant
rise was seen in ITM call and DITM calls. Except in the case of deep-in-the
money and DOTM options, there existed a post-event slide in IV of both calls
and puts.
High positive correlation was seen between the IV and volatility in all the
five categories for the whole event. Post-event relation in the case of DITM and
deep-out-of-he money puts did not signify that the IV factor was not taken into
account in these categories. Pre-OTM correlation was high in all the five
categories.
Volatility 145
7.15 COMPARATIVE STUDY OF THE BEHAVIOR OF

NIFTY AND IT STOCKS DURING AN EVENT
In this analysis, the relationship and the impact of events in the IT sector on the
index are compared. For this, ATM call IV and put IV for seven days before the
event and five days after the events of Infosys, Satyam and TCS are taken
(Table 7.5). The respective IV of Nifty on the above-mentioned days are taken.
Assigning equal weights, average IV for IT and Nifty are constructed.
Table 7.5 Behavioral Study of Nifty and IT Stocks
Day Infy TCS Satyam Average Nifty 1 Nifty 2 Nifty 3 Average

Pre- 24.06 23.72 34.09 27.29 23.42556 21.29 20.62 21.77852
event 7
Pre- 26.97 19.5 38.04 38.27 21.29 21.14 20.73 21.05333
event 6
Pre- 28.34 25.84 31.11 28.43 21.14 22.45 19.51 21.0333
event 5
Pre- 32.13 25.67 33.97 30.59 22.45 22.57 16.7 20.57333
event 4
Pre- 31.69 25.36 29.78 28.94333 22.57 22.53 16.63 20.57667
event 3
Pre- 29.94 27.44 36.09 31.15667 22.53 24.18 17.47 21.39333
event 2
Pre- 35.22 23.67 33.63 30.84 24.18 21.62 19.77 21.85667
event 1
EVENT 26.54 23.22 24.88 21.62 20.76 21.19
Post- 31.22 26.53 20.18 25.97667 20.62 20.626 20.11 20.45

event 1
Post- 26.29 27.31 32 28.53333 20.73 20.73 19.12 20.19333
event 2
Post- 21.52 20.36 33.59 25.15667 19.51 19.51 19.3 19.44
event 3
Post- 18.37 24.52 31.06 24.65 16.7 16.63 20 17.7767
event 4
Post- 20.45 20.21 32.02 24.22667 16.63 17.47 19.73 17.94333
event 5
146 Option Trading
50
40
30
20
10
0
t
e
s
EN
Pr
Pr
Pr
Pr
Pr
Pr
Pr
Po
Po
Po
Po
Po
EV
Average Average
IT Put IV Nifty Put
Fig. 7.6 Implied volatility movement during pre-event and post-event
Table 7.6 Implied Volatility of IT Stocks and Nifty on Pre-event

and Post-event
Day Infy TCS Satyam Average Nifty 1 Nifty 2 Nifty 3 Average

Pre 25.64 26.7 43.5 31.94667 19.6 19.2 20 19.6
-event 7
Pre- 31.6 30 42.97 34.85667 19.2 19.89 21.11 20.06667
event 6
Pre- 31.14 28.34 42.36 33.94667 19.89 20.18 20 20.02333
event 5
Pre- 36.81 29.69 35.81 34.10333 20.18 20.64 18.7 19.84
event 4
Pre- 34.7 34.18 34.5 34.46 20.64 20 16.97 19.20333
event 3
Pre- 40.27 35.38 36.54 37.39667 20 21.11 19.11 20.07333
event 2
Pre- 40.22 34.49 36.88 37.19667 21.11 20 16.32 19.14333
event 1
EVENT 30.64 34.4 32.52 20 16.79 18.395
Post- 19.34 29.98 30.62 26.64667 18.7 18.7 16.19 17.86333

event 1
Post- 19.04 20.92 44.86 28.27333 16.97 16.97 16.86 16.93333
event 2
Post- 27.11 22.11 35.11 28.11 19.11 19.11 16.62 18.28
event 3
Post- 26.29 19.7 30.48 25.49 16.32 16.79 16.78 16.63
event 4
Post- 23.95 19.19 31.71 24.95 16.79 16.19 18.42 17.13333
event 5
Volatility 147
40
35
30
25
Average IT IV
20
Average Nifty IV
15
10
5
0
e
e
T
Pr
Pr
Pr
Pr
Pr
Pr
Pr
Pr
Pr
Pr
Pr
Pr
EN
Fig. 7.7 EV IT and Nifty ATM calls
The charts indicate that the index has similar pattern during the event. The
index peaks during an event and falls after the event. The same relation is seen
in IT stocks. The relationship between index and IT stocks can be termed as
positive. The ATM calls and puts carry higher degree of positive relationship.
Pre-event of the Nifty generally remains dominant and does not respond to the
volatile movements, but in the post-event, Nifty's volatility also falls along
with the IT stocks volatility.
Chi square test was done to find out whether there is significant relation
between call option with respect to its sensitivity towards IV.
Correlation
Below 0.5 Above 0.5
Call 66 83 149
Put 83 78 161
149 161 310
X2 = 0.40698
P [ (X2) (r – 1) (c – 1)] @ 950 degree freedom = 0.00393
The test shows that there is no significant relation between calls and puts in
regard to correlation. In other words, it can be said that both call and put prices
respect implied volatility and there is no significant relation between call and
put and their reaction to implied volatility.
The study reveals that most of the option prices have a tendency to move
towards the direction of option volatility, which moves in a set pattern during
an event. The IV rises in the pre-event phase, peaks a day or two before the
event, and then falls to lower levels. In most of the cases, the IV falls to a level
lower than the IV level in the pre-event phase.
Table 7.7 Correlation
148
Call Put
ATM ITM OTM DITM DOTM ATM ITM OTM DITM DOTM
Whole 0.87101 0.69649 0.87462 0.51500 0.50051 0.66469 0.73898 0.70745 0.59632
0.29525
Option Trading
Pre-event 0.0576 0.00282 0.47777 0.15624 0.08114 0.1445

0.52731 0.01419 0.69501 0.01591
Post-event 0.45879 0.59370 0.02954 0.74943 0.36957 0.61121
0.27043 0.55858 0.50929 0.62893
Volatility 149
The best strategy that can be adopted is to enter long straddles seven or
eight days before the event (quarterly numbers, budget, dividend declaration,
bonus declaration) and liquidate the long straddle a day or two before the
event or atleast before the announcement of the event. Alternatively, short
straddles can be created one day before the event and can be liquidated on the
same day after the announcement of the event.
Table 7.8 Call Option Premium at Different Strike Prices
CALL
1500 strike 1560 1620 1770 1860 1920
4 0 0 0 69.34 47.18 48.99

7 0 0 0 52.92 47.15 45.87
8 0 0 0 57.57 56.64 54.26
9 0 0 0 51.78 52.13 53.84
10 0 0 0 108.56 54.51 53.94
11 0 0 0 59.12 58.41 59.52
14 0 69.61 65.59 62 69.91 70.46
15 96 84.46 65.66 67.2 72.67 73.34
16 89 62.98 60.72 60.73 62.66 69.41
17 76 58.14 56.22 55.6 60.61 63.77
18 36 49.1 54.48 56.38 68.53 67.66
120
100
1500 strike
80
1560
1620
60
1770
40 1860
1920
20
0
4 7 8 9 10 11 14 15 16 17 18
Fig. 7.8 Graphical presentation of Infosys strikes

150 Option Trading
Table 7.9 Put Option Premiums of Infosys at Various Strike Prices
PUT
1500 1560 1620 1770 1860 1920
4 0 0 0 63.06 3.18 5.16
7 0 0 0 46.44 1.66 3.42
8 0 0 0 70.93 3.91 5.73
9 0 0 0 0 73.14 2.8
10 0 0 0 73.6 80.62 3.51
11 0 0 0 126.45 129.03 8.72
14 0 59 65.59 245.59 169.48 13.42
15 20.69 76.05 102.92 289.58 182.54 15.88
16 0 60.73 131.03 293.98 184.12 15.2
17 0 31.49 116.4 295.4 184.09 13.9
18 0 59.06 120.81 324.44 230.41 17
7.16 IMPACT OF QUARTERLY RESULTS ON STOCK

FUTURES
According to efficient market hypothesis, the stock price of a security will
reflect the clear image of the corporate. All information regarding the corporate,
both past and recent happenings rapidly adjusts to the stock price preventing
from an arbitrage opportunity in the future. As no stock market in the world is
efficient in the absolute sense, it is important to find out under which category
is our market a strong, semi-strong or weak form of efficient market hypothesis
(EMH). The researchers on market efficiency have conducted various studies
and have shown that the Indian capital markets are inefficient.
In an efficient market, the average abnormal return (AAR) can tend to be
zero and cumulative average abnormal return (CAAR) can rise before the event
day (quarterly results/any corporate announcements etc.) and taper off after
the event. But in Indian market such things don't happen; the trend of AAR
and CAAR after the event day shows that they are increasing more than
decreasing. (The average returns are averaged over the number of securities to
get AAR and this is further added to find out the CAAR.)
We had conducted a study on the stock futures' behaviour before and after
the quarterly announcement of results. The year 2005 was selected for the
study because this year had experienced a dream run in the stock market as the
Sensex touched the all-time high 9443 mark. Moreover, more fresh funds were
targeted to the emerging market in the following months. Therefore it was
interesting to understand the trends. For the purpose of study, October 2005
quarterly results announcements were taken as the event day and the
respective future price before and after 30 days were taken into account. The
study was based on Nifty-based companies of the stock exchange (NSE) which
are available on stock futures segment (46 stocks).
Volatility 151
350
300
250 1500
1560
200 1620
150 1770
1860
100 1920
50
0
4 7 8 9 10 11 14 15 16 17 18
Fig. 7.9 Graphical presentation of Infosys put options at

various strike prices
A residual analysis technique was used to find out the returns of the future
price before and after 30 days surrounding the event day. The results indicate
the stock returns were highly volatile before and after the event day. It was
observed that 10 days prior to the event, the returns were negative indicating
the market expectation of forthcoming results was not satisfactory. But, soon
after the quarterly results, the CAAR of stocks were found to be rising. (The
stock prices had a net change in price of 50%.)
If we analyse this phenomenon we can come to a conclusion that future
price of stocks track the cash segment. The CAAR in both cases (cash segment
and futures segment) are high because Indian capital markets are still
inefficient and fall under the category of weak form according to the EMH. The
main reason for the inefficiency is primarily due to the lack of information
available to all the investors at the same time. This is subjected to the frequency
in which it ultimately reaches out to the investor. Moreover, in the present
scenario, the market is highly volatile. It is very difficult to judge the future of a
firm that why large standardized unexpected earnings result is abnormal.
7.17 VOLATILITY SKEW

Volatility skew is one of two curve shapes formed by charting the implied
volatility of options across the various strike prices. Basically, what the
volatility skew shows is that implied volatility is higher as the options go more
and more (ITM), forming a right skewed curve, hence the name volatility skew.
It can also skew to the left, indicating higher implied volatilities for OTM
options.
152 Option Trading
Implied volatility
Skew
Strike
Fig. 7.10 Volatility skew
For example, Fig. 7.11 shows a volatility skew using the Reliance Industries
put option and its implied volatility (IV) on the basis of data in Table 7.10.
A B C D
Strike Put IV Call IV (B-C)
1950 53.55 53.01 0.54
1980 53.09 54.05 -0.96
2010 60 48.03 11.97
2040 65 42.5 22.5
2070 73 39.045 33.955
2100 80 35.23 44.77
2130 109.04 32 77.04
2160 93.33 34.58 58.75
2190 120.33 36.6 83.73
2220 147.25 39.47 107.78
2250 174.11 41.15 132.96
7.18 STOCHASTIC VOLATILITY

Stochastic volatility models are used to evaluate derivative securities such as
options. The name derives from the model's treatment of the underlying
security's volatility as a random process, governed by state variables such as
the price level of the underlying, the tendency of volatility to change to some
long-run mean value, and the variance of the volatility process itself, among
others.
Stochastic volatility models are used to resolve a shortcoming of the Black-
Scholes model. Specifically, these models assume that the underlying volatility
is constant over the lifetime of the derivative product, and remain unaffected
Volatility 153
Volatility skew
140
120
100
80
60
40
20
–20
50
80
10
40
70
00
30
60
90
20
50
19
19
20
20
20
21
21
21
21
22
22
Reliance put/call option strike SKEW
Fig. 7.11 Volatility skew of Reliance Industries
by the changes in the price level of the underlying. However, these models
cannot explain the long-observed features of the implied volatility surface
such as volatility smile and skew, which indicate that implied volatility does
tend to vary with respect to strike price and expiration.
7.19 VOLATILITY ARBITRAGE

Volatility arbitrage is a type of statistical arbitrage that is implemented by
trading a delta neutral portfolio of an option and its underlying. The objective
is to take advantage of the differences between the implied volatility of the
option and a forecast of future realized volatility of the option's underlying. In
volatility arbitrage, volatility is used as the unit of relative measure rather than
price, that is, traders attempt to buy volatility when it is low, and sell volatility
when it is high.
7.20 VOLATILITY CHANGE

We know that volatility is expressed as the standard deviation of the
percentage change in the daily spot price of the underlying asset. If suppose
the annual volatility is 15%, single-day volatility can be worked out in the
following manner:
15% ÷v365 = 15% ÷ 19.105 = 0.785%
154 Option Trading
The larger the volatility, the larger the chance for the spot price moving into
the ITM zone and at the same time the value of the option will be great.
The impact of volatility on the option's value is expressed as:
Vega = Change in premium or volatility
If suppose the value of Vega is 0.5 and the volatility changes from 20% to
25%, then the value of the option will increase by 0.5(0.25-0.20) = 0.025. This
means an increase in volatility will normally lead to an increase in option
value. One thing to keep in mind is that the forecast volatility done on the basis
of historical data may not always be correct because of the changes in the spot
rate are influenced by a number of economic and non-economic factors that
may or may not occur in the future.
Summary
In this chapter we discussed about the concept of volatility and found that
volatility can be either historical or implied. We also discussed ways of
measuring historical volatility, and factors affecting historical volatility.
Further, we discussed about stock beta and portfolio beta and analysed some
of the study results connected with volatility, impact of events on volatility etc.
Concepts like volatility smile, volatility skew, stochastic volatility and
volatility arbitrage were also explained. While discussing about volatility we
have presented the Vega which is the impact of volatility on the option price.
Vega is otherwise known as Greek in option-trading parlance. There are other
option Greeks also which will explain in detail in the next chapter.
Keywords
Volatility Historical volatility Implied volatility
Volatility smile Volatility skew Volatility arbitrage
Volatility change GARCH Volatility
CHAPTER 08
OPTION GREEKS
8.1 OBJECTIVES
While discussing volatility in the previous chapter, we found that Option
Greeks form a part of volatility. This chapter is aimed at familiarizing the
readers with the Option Greeks used in option trading. We are explaining
only the important ones: delta, gamma, theta, vega and rho.
8.2 INTRODUCTION
The Greeks quantifies the sensitivities of derivatives market, which include
options. They actually calculate the various aspects of risk in an option
position and at the same time show a parameter on which the value of an
option is dependent. They can be used to measure the risk in owning an
option, and the portfolio can be adjusted to achieve the desired exposure.
Each risk variable is the result of a faulty assumption or is due to the
sophisticated hedging strategies which are used to neutralize the risk effect.
In order to neutralize the effect of the risk variable, we require good amount
of buying and selling, which involves high transaction cost. There are five
kinds of Greeks commonly used, which are explained in the following
sections.
8.3 DELTA
It measures the sensitivity to changes in the price of the underlying asset.
The delta of a call option ranges from 0 to 1 and that of a put option ranges
from 0 to -1. We can add, subtract and multiply deltas to calculate the delta
of a position of options and stock. The position delta is a way to see the risk/
reward characteristics of your positions in terms of shares. Delta is sensitive
to changes in volatility and time to expiration. The delta of an option mainly
depends on the price of the stock in relation to the strike price.
For example, if we talk in respect to a call option, a delta value of 0.7
means that for every Rs. 10 increase in the underlying stock, the option value
increases by Rs. 7.
156 Option Trading
Figure 8.1 shows the movement of delta and call premium in relation to
the underlying asset price.
Movement of delta of call option in relation to

underlying asset price
30 1.2
25 1
20 0.8
Premium
Premium
DELTA
15 0.6
DELTA
10 0.4
5 0.2
0 0
100 105 110 115 120 125 130
Underlying asset price
Fig. 8.1 Impact of movements of underlying asset price on Delta and

call option premiums
From the graph we can see that both delta and premium of the call option
increases when the underlying asset price increases. When the underlying
asset price increase from 100 to 105 the delta increases from 0.5478 to 0.7291
and it becomes 0.9906 when the underlying asset price is 125. Delta reaches
close to one when the call option is deep in the money.
The delta values of put option will be negative.
Movement of delta and premium of put option in

relation to underlying asset price
4 0.05
3.5
3 0.04
DELTA
2.5
Premium
0.03 Premium
2 DELTA
1.5 0.02
1
0.01
0.5
0 0
100 105 110 115 120 125 130
Fig. 8.2 Impact of movement of underlying asset price on Delta and put
option premiums
The graph shows the movement of delta and premium of put option in
relation to the underlying asset price. From the graph we can see that delta of
the put option increases when the underlying asset price increases while the
Option Greeks 157
premium of the put option decreases. When the underlying asset price
increases from 100 to 105 the delta increases from -0.4522 to -0.2709 and it
becomes -0.0094 when the underlying asset price is Rs.125. Delta reaches
close to zero when the put option is deep out the money.
8.3.1 Delta Hedging on Expiration Dates

Option premiums are mainly determined by their volatility and time value.
The latter plays a key role. Due to time decay, many of the options end as
out-of-the-money. Especially, when writers buy options at the beginning of
the month, they may ask for high premiums. On the other hand, on the last
days, options are available at throwaway prices.
Imagine that on the last Thursday of the month (expiry day), put options
of 350 Satyam were trading at a premium of Rs. 1.10 and Satyam December
futures were trading at Rs. 351, while the spot was at Rs. 351.50. Here an
investor who expects a volatile movement on the scrip can buy one lot of
Satyam Computer stock futures at Rs. 351, and at the same time he can buy
two lots of Satyam put options at Rs. 1.10.
The upside breakeven can be attained at Rs. 353.20 [351 + (2 × 1.10)] and
downside breakeven at Rs. 347.80 [350 – (1.10 × 2)]. Being the last day, a
sharp volatile movement is expected in most of the stocks. Suppose the stock
moves up from Rs. 351 to Rs. 359; the investor has to book profits by selling
Satyam futures. On the other hand, if it falls below the breakeven point, he
may have to book loss in Satyam stock futures and can make profits in long
put options.
Generally, investors may have doubts why one lot of Satyam futures
and two lots of Satyam puts? The answer is simple:here, we are creating a
delta hedge position. An at-the-money option delta should be very close to
0.05, and hence, by buying two put options we are creating a net –1200 delta
[0.5 × 2 × 1200], and buying one lot of stock futures translates into +1200
delta [1 × 1200]. Hence, the position is neutral. (Assume Satyam's lot size is
1200).
According to the rule, instead of buying puts, one can sell stocks futures
and can buy two lots of call options. This should be done in volatile stocks
where the strikes are at-the-money. Buying puts or calls purely depends on
their relative premiums.
8.3.2 Delta Neutral

When the market outlook is bearish, it is advisable to sell naked Nifty futures
of the stock. The seller of the naked Nifty futures makes profit to the extent of
the fall in the value of Nifty. But if Nifty moves up drastically, the seller
incurs loss. If the seller's stop loss gets triggered, he will lose on the particular
trade. If the trader is a swing trader and he expects some bad news on Nifty,
he will tend to hold the short position for days. And in the worst case
scenario, if Nifty bounces back in the opening hour of trade, the trader will
incur huge losses. To reduce the downside risk, instead of holding a naked
158 Option Trading
short position on Nifty, the trader can buy a call option of Nifty at the strike
price close to the price at which he had sold Nifty futures. So even if the
script bounces back the next day, the long call will act as a buffer to the losses
incurred on Nifty's futures. A trader can use this strategy to reduce the risk
involved in selling naked futures and in the meantime he can make profits if
Nifty moves down. Here the trader starts making profit if Nifty moves below
the value of the premium paid for the long call. Any loss arising due to any
upside move in the index prices by holding the naked futures is limited by
the long call. Thereby, the trader can just reduce his risk of holding a naked
short futures position with a protective call.
Sometimes investors convert this strategy to a delta neutral by buying
equal delta call options. For example, Mr. Thomas is bearish on markets and
sells 100 March 2009 Nifty futures at 3000, and he buys two 3000 strike Nifty
call options with 0.5 deltas. Selling Nifty futures will give him –100 deltas.
Buying call options of two lots with 0.5 deltas will give him +100 deltas.
Here, the net delta position becomes 0. Delta-neutral strategies are
extensively used one or two days prior to the expiry.
8.3.3 Thumb Rule on Deltas

Buying call generates positive deltas.
Selling put generates positive deltas.
Buying stock generates positive deltas.
Selling stock generates negative deltas.
Selling call generates negative deltas.
Buying put generates negative deltas.
8.3.4 Illustration to Find Delta

An investor holds one share of Infosys. The spot price of Infosys shares as on
20 June is Rs. 3500. S/he decides to buy a call option at a strike price of Rs.
3600 for delivery on 19 June, next year. The annual volatility in the stock
market is 57.96%. Risk-free interest rate is 7.5%. Calculate delta for call and
put.
S = 3500
X = 3600
T–t = 1 (June 20 to June 19 next year = 1 year)
r = 0.075 (7.5%)
s = 0.5796 (57.96%)
Delta for a call = N(d1)
Delta for a put = N(d1) – 1
where
d1 = [ln(S/X) + (r + s 2/2) × t]/[s × Ö (T – t)]
d1 = [ln(3500/3600) + (0.075+(0.57962)/2 × 1]/[0.5796 × 1]
= [ln(0.9722) + 0.075 + 0.1679]/0.5796
Option Greeks 159
= (– 0.0282 + 0.075 + 0.1679)/0.5796

= 0.2147/0.5796
= 0.3704
Delta for a call = N(d1)
= N(0.3704)
= 0.6443
Delta for a put = N(d1) – 1
= 0.6443 – 1
= – 0.3557
8.4 GAMMA
It measures the rate of change in delta and shows how the price will react to
a significant change in the price. A large gamma value shows that your delta
can change significantly when there is a small move in the stock price.
Suppose the delta of a call option is 0.45 and the delta of a put option is –
0.55 when the price of the underlying asset is Rs. 99 and the gamma value for
both call and put options is 0.07. If the underlying asset moves up from Rs. 1
to Rs. 100, then the delta value of the call option is 0.52 [0.42 + (Rs. 1 × 0.07)],
and the delta value of the put option is – 0.48 [– 0.55 + (Rs. 1 × 0.07)]. When
the price of Changes in Delta the underlying asset comes down to Rs. 1, then
the delta value of call option becomes 0.38 and that of put option becomes –
0.62.
So, here the gamma value shows the rate of change of delta value when
there is a change in the underlying asset price. For an option trader, a
position with a positive gamma is much safer because it gives deltas from an
upward or a downward move in the stock price. At the same time, a position
with a negative gamma can be equally dangerous.
Movement of gamma and premium of call option in relation

to underlying asset price
30 0.05
25 0.04
20
Premium
Gamma
0.03
15 Premium
10 0.02 Gamma
5 0.01
0 0
100 105 110 115 120 125 130
Fig. 8.3 Impact of movement of underlying asset price on Gamma and call
option premiums
160 Option Trading
The graph shows the movement of Gamma and premium of call option in
relation to the underlying asset price. From the graph we can see that Gamma
of the call option decreases when the underlying asset price increases while
the premium of the call option increases. When the underlying asset price
increase from 100 to 105 the Gamma decreases from 0.0395 to 0.0314 and it
becomes 0.0020 when the underlying asset price is 125. Gamma reaches close
to 0 when the call option is deep in the money.
Movement of gamma and premium of put option in

relation to underlying asset price
4 0.045
3.5 0.04
3 0.035
0.03
Premium
Gamma
2.5
0.025 Premium
2 Gamma
0.02
1.5
0.015
1 0.01
0.5 0.005
0 0
100 105 110 115 120 125 130
Fig. 8.4 Impact of movement of underlying asset price on Gamma and

put option premiums
The graph shows the movement of gamma and premium of put option in
relation to the underlying asset price. From the graph we can see that both
Gamma and premium of the put option decreases when the underlying asset
price increases. When the underlying asset price increase from 100 to 105 the
Gamma decreases from 0.0395 to 0.0314 and it becomes 0.0020 when the
underlying asset price is 125. Gamma reaches close to zero when the put
option is deep out of the money.
8.4.1 Illustration to Find Gamma

market is 57.96%. Risk-free interest rate is 7.5%. Calculate gamma for call
and put.
S = 3500
X = 3600
T – t = 1 (June 20 to June 19 next year = 1 year)
r = 0.075 (7.5%)
s = 0.5796 (57.96%)
Option Greeks 161
where
d1 = [ln(S/X) + (r + s 2/2) × t]/[s × Ö (T – t)]
d1 = [ln(3500/3600) + (0.075 + 0.5796 2/2 × 1]/[0.5796 × 1]
= [ln(0.9722) + 0.075 + 0.1679]/0.5796
= (– 0.0282 + 0.075 + 0.1679)/0.5796
= 0.2147/0.5796
= 0.3704
So, gamma for a call and put = N(0.3704)/3500 × (0.5796 × Ö 1)
= 0.6443/2028.60
= 0.0003176
8.5 VEGA
Vega shows the sensitiveness to volatility. It is the estimate of how much the
theoretical value of an option changes when the change in volatility is 1.00%.
Higher volatility means higher option prices. Positive vega means that the
value of an option increases when volatility increases and vice versa.
Suppose the value of a call option is Rs. 20 and the vega of the
option is 0.2 with volatility at 30%. If the volatility of the option
increases from 30% to 31%, then the value of the option rises to Rs. 22.
On the other hand, when the volatility falls from 30% to 29%, the value
of the call also falls to Rs. 18.
Movement of Vega and premium of call option in relation to

30 0.12
25 0.1
20 0.08
Premium
VEGA
15 0.06 Premium
0.04 Vega
10
5 0.02
0 0
100 105 110 115 120 125 130
Fig. 8.5 Impact of movement of underlying asset price on Vega and

put option premiums
The graph shows the movement of Vega and premium of call option in
relation to the underlying asset price. From the graph we can see that Vega of
the call option decreases when the underlying asset price increases along
with the call option premium. When the underlying asset price increases
162 Option Trading
from 100 to 105 the Vega decreases from 0.1135 to 0.0997 and it becomes
0.0091 when the underlying asset price is 125. Vega reaches close to zero
when the call option is deep in the money.
Movement of Vega and premium of put option in relation to

4 0.12
3.5 0.1
3
2.5 0.08
Premium
Premium
Vega
2 0.06
Vega
1.5 0.04
1
0.5 0.02
0 0
100 105 110 115 120 125 130
Fig. 8.6 Impact of movement of underlying asset price on Vega and

put option premium
The graph shows the movement of Vega and premium of put option in
relation to the underlying asset price. From the graph we can see that both
Vega and premium of the put option decreases when the underlying asset
price increases. When the underlying asset price increase from 100 to 105 the
Vega decreases from 0.1135 to 0.0997 and it becomes 0.0091 when the
underlying asset price is 125. Vega reaches close to zero when the put option
is deep out of the money.
8.5.1 Impact of Vega on Option Trading

Options are characterized by a very important factor known as volatility.
Vega is a sensitivity factor which attempts to measure the rate of change of
the value of the portfolio for a change in volatility of the underlying assets.
Vega neutrality protects against variance in volatility
Volatility is merely a term used to describe how fast a stock, futures or
index changes with respect to change in the price. Implied volatility (IV) is
the option market prediction of volatility of the underlying instrument over
the life of the option.
Vega quantifies the impact of volatility changes on the price of an
option. It tries to predict the extent of rise/fall in option premium for
a rise or fall in IV.
For example, a vega of 0.9 means that option premium would increase by
0.9 if IV increases by one percentage point.
Option Greeks 163
8.5.2 Hedging Volatility

Volatility exposure is conceptually distinct from price exposure. But in
practice, increase in volatility tends to be associated with large price changes.
The underlying futures or stocks have zero vega, so taking other options
positions can only offset volatility exposure.
A vega-neutral portfolio requires a short position in one option to be offset
by a long position in another. This is the same as in attaining gamma
neutrality. Options writing therefore requires traders to balance price and
volatility exposure.
8.5.3 Application of Vega

Vega trade refers to buying cheap options or selling expensive options and
holding the position until it returns to a fair valuation level. This is referred
to as volatility trading. The IV level of the options helps in determining what
strategies are to be used. When IV is very high, the market price of the
options will be greater than their theoretical price. Such options are
considered 'expensive'. Many traders favor premium-selling strategies. This
means that selling long-term options would be a better idea while selling
volatility. Long-term options tend to have higher vega.
If an option contract with higher vega is sold, this means an expensive
option is sold. The period available for the volatility levels to move closer to
the normal level is large. So one can wait for it to return to normal levels, by
when the option price would have reduced.
It can, therefore, be said that option prices are very sensitive to volatility;
trading options on this basis can be attractive. However, there is substantial
risk of loss in trading if the forecast of the direction is wrong. IV can increase
or decrease even without price changes in the underlying security. This is
because IV is the level of expected volatility; that is, it is based not on actual
prices of the security, but on expected price trends. Generally IV declines as
the option gets closer to expiration. The change in volatility becomes less
significant with fewer trading days.
8.5.4 Illustration to Find Vega

market is 57.96%. Risk-free interest rate is 7.5%. Calculate vega for call and
put.
S = 3500
X = 3600
r = 0.075 (7.5%)
s = 0.5796 (57.96%)
Vega for call and put = S × N(d1) × Ö (T – t)
164 Option Trading
where
d1 = [ln(S/X) + (r + s 2/2) × t]/[s × Ö (T – t)]
– d1 = [ln(3500/3600) + (0.075 + 0.57962/2 × 1]/[0.5796 × 1]
= [ln(0.9722) + 0.075 + 0.1679]/0.5796
= (– 0.0282 + 0.075 + 0.1679)/0.5796
= 0.2147/0.5796
= 0.3704
Vega = S × N(d1) × Ö (T – t)
= 3500 × N(0.3704) × Ö 1
= 3500 × 0.6443
= 2255.05
8.6 THETA
It measures the sensitiveness to the passage of time or the option time value.
Theta is represented by the symbol ' È ' and is the negative of the derivative
of the option value with respect to the amount of time to expiry of the option
instrument. It is an estimate of how much the theoretical value of an option
decreases when a day passes and there is no movement in either the stock
price or the volatility.
250
200
Put/call premium
150 Call premium

Put premium
100
50
0
y
y
y
11 y
y
14 y
17 y
20 ay
26 y
23 y
da
da
da
da
da
da
da
da
da
d
2
5
8
29
Expiration
Fig. 8.7 Impact of time value on option premium
Theta value for a call option and a put option would not be the same at the
same strike and same expiration period. Theta values of call and put options
also depend on the cost of carry for the underlying stock.
From Fig. 8.7, we can understand that when the days to expiration is more,
then the theoretical value of the put option would be higher, but when the
expiry comes near, the put option will lose its value.
Option Greeks 165
Table 8.1 Impact of Time Value on Option Premium
Days to Call Put Call premium Put premium

expiry premium premium change change
29 234.99 211.05
28 231.7 207.62 3.29 3.43
27 227.34 204.11 4.36 3.51
26 222.9 200.54 4.44 3.57
25 218.39 196.88 4.51 3.66
24 213.79 193.14 4.6 3.74
23 209.1 189.31 4.69 3.83

22 204.32 185.38 4.78 3.93
21 199.43 181.36 4.89 4.02
20 194.44 177.22 4.99 4.14
19 189.33 172.97 5.11 4.25
18 184.09 168.59 5.24 4.38
17 178.71 164.07 5.38 4.52
16 173.19 159.4 5.52 4.67
15 167.49 154.57 5.7 4.83
14 161.62 149.56 5.87 5.01
13 155.55 144.35 6.07 5.21
12 149.26 138.92 6.29 5.43
11 142.71 133.23 6.55 5.69
10 135.88 127.26 6.83 5.97
9 128.71 120.95 7.17 6.31
8 121.15 114.26 7.56 6.69
7 113.13 107.1 8.02 7.16
6 104.55 99.37 8.58 7.73
5 95.24 90.93 9.31 8.44
4 85 81.55 10.24 9.38
3 73.42 70.83 11.58 10.72
2 59.76 58.03 13.66 12.8
1 day 42.08 41.22 17.68 16.81
On Expiry 0 0 42.08 41.22
166 Option Trading
Table 8.1 shows the changes of 3500 strike call and put options premiums
of an underlying stock with 57% IV, 9% interest rate and Rs. 3500 stock price
from the first day of the contract month till the last day of expiry, on the
assumption that the stock price and IV remain same during this period (Figs.
8.5 and 8.7). The intensity of the time decay is very high when options are
close to expiry.
20
18
Put/call premium change
16
14
12
10
8
6
4
2
0
27 ys
23 s
21 s
19 ys
17 s
15 ys
13 s
11 s
9 s
ys
ys
ys
ys
ys
y
y
da
da
da
da
da
da
da
da
da
da
da
da
da
da
29
25
3
Expiration
Call premium change

Put premium change
Fig 8.8 Put/Call premium change
250
200
Put/call premium
150 Call premium
100 Put premium
50
0
23 s
20 s
17 s
14 s
11 s
ys
s
ys
ay
ay
ay
y
y
da
da
da
da
da
da
da
8d
5d
2d
26
29
Expiration
Fig. 8.9 Call and put premium change
8.6.1 Illustration to Find Theta

market is 57.96%. Risk-free interest rate is 7.5%. Calculate theta for call and put.
Option Greeks 167
S = 3500
X = 3600
r = 0.075 (7.5%)
s = 0.5796 (57.96%)
d1 = 0.3704
d2 = d1 – [s × Ö (T – t)]
= 0.3704 – (0.5796 × 1)
= –0.2090
Theta for call = – {[S × N(d1) × s]/[2 × Ö (T – t)]} – [r × X × e–r(T–t) × N(d2)]
= – {[3500 × N(0.3704) × 0.5796]/2 × Ö 1} – [0.075 ×
3600 × e –0.075×1 × N(–0.2090)]
= –[(3500 × 0.6443 × 0.5796)/2] – (0.075 × 3600 × 0.9277 ×
0.4168)
= – 653.51 – 104.39
= –757.90
Theta for a put = [–S × N(d1) × s] + [r × X × e–r(T–t) × N(d2)]
2 × Ö (T – t)
= –[3500 × N(0.3704) × 0.5796] + [0.075 × 3600 × e–0.075×1 × N(0.2090)
2 × Ö1
= –[3500 × 0.6443 × 0.5796] + [0.0750 × 3600 × 0.9277 × 0.5832]
2
= – 653.51 + 146.08
= –507.43
8.7 RHO
It measures the sensitiveness to the applicable interest rate. Rho is the least
used Greeks. In an economy when the interest rates are stable, the chance of
option value changing dramatically because of a rise in interest rates is low.
For example, suppose we expect stock A to rise; we could either buy 100
shares of A for Rs. 5000 or buy two call options of the same stock A for Rs.
500. Here we need to spend 10 times the money that we spend on the stock.
It means that we would need to borrow money out of the interest bearing
account to buy the stock. This interest cost is built into the call option's value.
An increase in interest rates increases the value of calls and decreases the
value of puts and vice versa.
168 Option Trading
Suppose the value of call option is Rs. 20 and a rho of 0.02, with value of
share A at Rs. 50 and interest rates at 5%. If the interest rate increases to 6%,
the value of the stock's call option would increase to Rs. 20.2, and if the
interest rate decreases to 4%, then the value of the stock option would
decrease to Rs. 21.98.
0.045
0.0445
0.044
0.0435
0.043 Call
0.0425
0.042
0.0415
0.041
0% 5% 10% 15% 20% 25%
Interest rate
Fig. 8.10 Impact of interest rate change on Rho of call option
If the interest rate increases the value of the Rho of both call option and
put option will increase.
Interest rate
0% 5% 10% 15% 20% 25%

–0.0355
–0.036
–0.0365
–0.037
–0.0375
Rho
–0.038
–0.0385
–0.039
–0.0395
–0.04
–0.0405
Put
Fig. 8.11 Impact of interest rate change on Rho of put option

Option Greeks 169
The basic principle is that when the underlying price of the asset increases,
the rho value also rises alongside, and when the underlying price comes
down, the rho value also follows suit. One more thing to keep in mind is that
when the number of days to expiration is more, then the rho value will also
be more.
8.7.1 Illustration to Find Rho

June 20 is Rs. 3500. S/he decides to buy a call option at a strike price of Rs.
3600 for delivery on June 19, next year. The annual volatility in the stock
market is 57.96%. Risk-free interest rate is 7.5%. Calculate rho for call and
put.
S = 3500
X = 3600
r = 0.075 (7.5%)
s = 0.5796 (57.96%)
d1 = 0.3704
d2 = d1 – [s × Ö (T – t)]
= 0.3704 – (0.5796 × 1)
= – 0.2090
Rho for a call = X × (T – t) × e–r(T– t) × N(d2)
= 3600 × 1 × e–0.075×1 × N(– 0.2090)
= 13.91% (rho is expressed in percentage terms)
Rho for a put = –[X × (T – t) × e–r(T–t) × N(– d2)]
= – [3600 × 1 × e– 0.075×1 × N(0.2090)]
= 19.47% (rho is expressed in percentage terms)
Summary
Option Greeks form a part of volatility and assumes great importance in
formulating trading strategies. The major Option Greeks which are discussed
in this chapter are delta, gamma, theta, vega and rho. The other Greeks are
Itto's lemma, lambda, kappa, epsilon and so on, which are not discussed in
this chapter because they are not widely used in India. We have also found
how these Greeks are used in option trading. We will move to the most
interesting part of option trading strategies in the next chapter.
Keywords
Greeks Delta Gamma Vega Theta Rho
170 Option Trading
Appendix
Standardized Normal Distribution Table
Z 0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
0 0.5000 0.5040 0.5080 0.5120 0.5160 0.5199 0.5239 0.5279 0.5279 0.5359
0.1 0.5398 0.5438 0.5478 0.5517 0.5557 0.5596 0.5636 0.5675 0.5675 0.5753
0.2 0.5793 0.5832 0.5871 0.5910 0.5948 0.5987 0.6026 0.6064 0.6064 0.6141
0.3 0.6179 0.6217 0.6255 0.6293 0.6331 0.6368 0.6406 0.6443 0.6443 0.6517
0.4 0.6554 0.6591 0.6628 0.6664 0.6700 0.6736 0.6772 0.6808 0.6808 0.6879
0.5 0.6915 0.6950 0.6985 0.7019 0.7054 0.7088 0.7123 0.7157 0.7157 0.7224
0.6 0.7257 0.7291 0.7324 0.7357 0.7389 0.7422 0.7454 0.7486 0.7486 0.7549
0.7 0.7580 0.7611 0.7642 0.7673 0.7704 0.7734 0.7764 0.7794 0.7794 0.7852
0.8 0.7881 0.7910 0.7939 0.7967 0.7995 0.8023 0.8051 0.8078 0.8078 0.8133
0.9 0.8159 0.8186 0.8212 0.8238 0.8264 0.8289 0.8315 0.8340 0.8340 0.8389
1 0.8413 0.8438 0.8461 0.8485 0.8508 0.8531 0.8554 0.8577 0.8577 0.8621
1.1 0.8643 0.8665 0.8686 0.8708 0.8729 0.8749 0.8770 0.8790 0.8810 0.8830
1.2 0.8849 0.8869 0.8888 0.8907 0.8925 0.8944 0.8962 0.8980 0.8997 0.9015
1.3 0.9032 0.9049 0.9066 0.9082 0.9099 0.9115 0.9131 0.9147 0.9162 0.9177
1.4 0.9192 0.9207 0.9222 0.9236 0.9251 0.9265 0.9279 0.9292 0.9306 0.9319
1.5 0.9332 0.9345 0.9357 0.9370 0.9382 0.9394 0.9406 0.9418 0.9429 0.9441
1.6 0.9452 0.9463 0.9474 0.9484 0.9495 0.9505 0.9515 0.9525 0.9535 0.9545
1.7 0.9554 0.9564 0.9573 0.9582 0.9591 0.9599 0.9608 0.9616 0.9625 0.9633
1.8 0.9641 0.9649 0.9656 0.9664 0.9671 0.9678 0.9686 0.9693 0.9699 0.9706
1.9 0.9713 0.9719 0.9726 0.9732 0.9738 0.9744 0.9750 0.9756 0.9761 0.9767
2 0.9772 0.9778 0.9783 0.9788 0.9793 0.9798 0.9803 0.9808 0.9812 0.9817
2.1 0.9821 0.9826 0.9830 0.9834 0.9838 0.9842 0.9846 0.9850 0.9854 0.9857
2.3 0.9893 0.9896 0.9898 0.9901 0.9904 0.9906 0.9909 0.9911 0.9913 0.9916
2.4 0.9918 0.9920 0.9922 0.9925 0.9927 0.9929 0.9931 0.9932 0.9934 0.9936
2.5 0.9938 0.9940 0.9941 0.9943 0.9945 0.9946 0.9948 0.9949 0.9951 0.9952
2.6 0.9953 0.9955 0.9956 0.9957 0.9959 0.9960 0.9961 0.9962 0.9963 0.9964
2.7 0.9965 0.9966 0.9967 0.9968 0.9969 0.9970 0.9971 0.9972 0.9973 0.9974
2.8 0.9974 0.9975 0.9976 0.9977 0.9977 0.9978 0.9979 0.9979 0.9980 0.9981
2.9 0.9981 0.9982 0.9982 0.9983 0.9984 0.9984 0.9985 0.9985 0.9986 0.9986
3 0.9987 0.9987 0.9987 0.9988 0.9988 0.9989 0.9989 0.9989 0.9990 0.9990
CHAPTER 09
OPTION TRADING
STRATEGIES
9.1 OBJECTIVES
In Chapter 2, we discussed about writing options, and in the previous two
chapters, we discussed about volatility and Greek letters which are used in
option trading. Having understood these essential aspects of trading in
options, we are now taking the readers to the most important and interesting
part of this book, that is option trading strategies. These strategies have been
found to be highly effective from our trading experiences. The objective of
this chapter is to introduce various strategies to the readers so that they will
be enthused to develop their own strategies.
9.2 INTRODUCTION
Simple trading strategies can be created by option purchases or by option
sales. Purchases and sales of different options at different strikes and
different maturities enable us to create complex strategies. Strategies help us
to predict the future profits and losses. It also helps to convert from one
strategy to other strategies according to different market conditions. For
example, buying a call option can be riskier because of time-sensitive nature of option
and that can be partially eliminated by selling a call option of the same underlying
asset at a higher strike price.
9.3 ADVANTAGES OF STRATEGIES

1. Creating strategies for directional view
(a) Maximizing return
(b) Reducing risk
2. Trading on volatility
3. Exploiting arbitrage opportunities
4. Creating cash inflow strategies by writing options
5. Hedging risk
172 Option Trading
9.4 BUYING PUT OPTION

Buying put option is the simplest strategy one can adopt in a bear market.
The maximum loss in this strategy is the premium paid for the purchase of
the put option. For example, Mr. B is bearish on market and buys Nifty put
option at a strike price of 3000 for a premium of Rs. 100. Mr. B will make
profit, if Nifty falls below 2900 (3000 – 100). If Nifty does not move below
2900, he will incur a loss of Rs. 100.
9.4.1 Long Put

In the following example, we will examine how the put option purchase will
be profitable. Here, Mr. B buys a put option of Infosys at a strike price of 1060
for a premium of Rs. 25.90 and a spot at 1060. In Table 9.1, one can find out
profits and losses on various closing prices on expiry. For example, if Infosys
closes at 980 on expiry, the investor will make a profit of Rs. 54.10. His break
even point (BEP) will be Rs. 1034.10. Maximum loss is limited to Rs. 25.90
(Fig. 9.1).
Table 9.1 Pay off of Long put
Long put 1060

Premium 25.90
Price at expiration Pay off long put

980 54.1
990 44.1
1000 34.1
1010 24.1
1020 14.1
1030 4.1
1040 – 5.9
1050 – 15.9
1060 – 25.9
1070 – 25.9
1080 – 25.9
1090 – 25.9
1100 – 25.9
The major issues confronted in the purchase of put options are high
volatility, time decay and liquidity. Sometimes, in-the-money put options
are fairly illiquid due to higher premiums. In a highly volatile market,
premiums of put options tend to remain very high, thereby causing
illiquidity.
Option Trading Strategies 173
Long put
200
150
Profit 100
50
1060
1080
1100
1120
1140
0 980
1000
1020
1040
–50
–100
Loss
–150
–200 Strike price
Long put
Fig. 9.1 Long Put
9.4.2 Short Call

If the investor is bearish, then instead of buying the put option of Nifty, he
can write the call option of Nifty. (In the following example (Table 9.2], we
have included the Nifty strike prices and its premiums as on 11 July 2008 for
your reference. The spot Nifty trades at 4162.)
Table 9.2 Strikes and Premium
Strike Premium
3700 471
3800 360
3900 312
4000 240
4050 199
4100 175
4150 146
4200 119
4250 95
4300 74
4350 58
4400 42
4450 22
4500 18
174 Option Trading
Assume that you are bearish on Nifty and according to your estimate,
Nifty may find support only at the 3700 level. In this case, instead of buying
the put option, you can sell 3700 call options at Rs. 471. If Nifty falls below
3700, you don’t gain more than the premium of Rs. 471. There is unlimited
risk above 4171 (3700 + 471) (Table 9.3; Fig. 9.2).
Table 9.3 Short Call

Index at expiration Short call pay off (3700)
3300 471
3400 471
3500 471
3600 471
3700 471
3800 371
3900 271
4000 171
4100 71
4200 – 29
4300 – 129
4400 – 229
4500 – 329
4600 – 429
4700 – 529
4800 – 629
4900 – 729
Short call pay off (3700)

600
400
200
Profit/Loss
0
0 1000 2000 3000 4000 5000 6000
–200
–400
–600
–800
Nifty
Fig. 9.2
9.5 BEAR SPREAD WITH PUTS

This strategy is good when the market remains in a range with downward
bias. For example, Nifty is expected to remain at the 4000–3800 level. The
current Nifty is at 4020. One can buy Nifty 4000 put options and can sell 3800
put options. This strategy is suited to save the time value. If you are buying the
4000 puts at Rs. 122 on the first day of the contract and the Nifty falls down
below 4000 after the 10th day, your put option can lose some value due to time
decay. If you are writing a simultaneous put at 3800 at Rs. 83, then loss in time
value can be reduced up to a certain extent (Table 9.4; Fig. 9.3).
Table 9.4 Pay off of Bear Spread with Puts
Strike Premium
Long put 4000 122.00
Written put 3800 83.00
Index at Pay off Pay off Total

expiration long put sell put pay off
(4000) (3800)
3300 578.00 – 417.00 161.00
3400 478.00 – 317.00 161.00
3500 378.00 – 217.00 161.00
3600 278.00 – 117.00 161.00
3700 178.00 – 17.00 161.00
3800 78.00 83.00 161.00
3900 – 22.00 83.00 61.00
4000 – 122.00 83.00 – 39.00
4100 – 122.00 83.00 – 39.00
4200 – 122.00 83.00 – 39.00
4300 – 122.00 83.00 – 39.00
4400 – 122.00 83.00 – 39.00
250.00
200.00
150.00
100.00
50.00
0.00
3600 3700 3800 3900 4000 4100 4200 4300
–50.00
–100.00
–150.00
Sell Put Net Pay off Buy Put
Fig. 9.3 Bear spread with puts

176 Option Trading
After creating the bear spread with put strategy, your maximum loss has
decreased from Rs. 122 to Rs. 39. Again, you are attaining the BEP at 3961.
On the other hand, if you are holding the single put, then you may attain the
breakeven only below 4000 – 122 = 3878.
9.5.1 Bear Spread with Puts: Its Importance

As days pass by, more and more market players are participating in the
options segment. They are attracted because of its cost-effectiveness. When
we examine carefully, we observe that most of the market players are still
reluctant to adopt simple strategies by which they can reduce the cost of
acquisition of options.
An investor who is bullish on an underlying stock normally buys a call
option. In the same way, if he is bearish he will buy a put option. If he buys
these in the early days of the contract month, then he has to pay high
premiums for its time value. Buying a single call or put option is riskier due
to time sensitiveness of options. If the underlying stock is not moving
according to the investor’s calculations at the earliest, then the investor may
lose the entire premium.
Instead of buying an expensive put option, a ‘bear spread with puts’ can
be created by buying put options at a higher strike rate and writing put
options at lower strike rate having same maturity of the underlying stock.
Hence, limited profits and limited losses can be realized.
Let us take an example of Mr. B, who is bearish on TISCO, when the spot
price of TISCO is trading at Rs. 300 on 1 March, and who expects a price fall
towards Rs. 280 by the end of March. In normal case, Mr. B may buy a put
option at the strike rate of 300 at a premium of Rs. 8, and he can make a profit
of Rs. 12 (i.e. 300 – (280 + 8)) if the underlying stock closes at Rs. 280 on the
expiry. But if it stays flat, as time passes, the put option premium will also
fall and Mr. B will lose the entire premium of Rs. 4800 (Rs. 8 × 600), where
600 is the lot size. To avoid this, Mr. B can buy the put option with a strike
rate of 300 for Rs. 8 and at the same time he can write (sell) a put option with
a strike rate of 280 at a premium of Rs. 3, and there he can reduce the cost to
Rs. 5 (8 – 3). Thus, he will make a maximum profit of Rs. 9000 ([(300 – 280) –
5] × 600). On the other hand, if TISCO closes at around Rs. 300, Mr. B’s loss is
limited to Rs. 3000 ((8 – 3) × 600).
Why are investors reluctant to apply this strategy in the day-to-day
market conditions? The answer is simple: additional margin requirements.
In the previous example, if an investor buys a single put option, then the
margin requirement is only the premium, that is Rs. 4800. If the investor is
creating a bear spread with puts, then the margin requirement will be around
Rs. 15,000 (i.e., an additional amount of Rs. 10,200). An investor who thinks
various ways to reduce risk can adopt this strategy, whereas a risk taker can
buy single put options and can try his luck.
9.6 LONG PUT RATIO SPREAD

This is a bearish strategy implemented through selling one lot of Nifty put
option (probably selling one lot of out-of-the-money put and buying two lots
of deep out-of-the-money put at the same strike and same expiration). Selling
a put and buying two lots of puts normally ends with a small premium
credit, without considering the direction of the market (Table 9.5; Fig. 9.4).
Table 9.5 Pay off of 2 :1 Long Put Ratio Spread
Strike Premium
Sell put 250 12.86
Buy two puts 230 5.35
Spot at Sell put Buy two puts Net

expiration (250) (230) pay off
pay off pay off
190 – 47.14 69.3 22.16
195 – 42.14 59.3 17.16
200 – 37.14 49.3 12.16
205 – 32.14 39.3 7.16
210 – 27.14 29.3 2.16
215 – 22.14 19.3 – 2.84
220 – 17.14 9.3 – 7.84
225 – 12.14 – 0.7 – 12.84
230 – 7.14 – 10.7 – 17.84
235 – 2.14 – 10.7 – 12.84
240 2.86 – 10.7 – 7.84
245 7.86 –10.7 –2.84
250 12.86 –10.7 2.16
255 12.86 –10.7 2.16
260 12.86 –10.7 2.16
265 12.86 –10.7 2.16
270 12.86 –10.7 2.16
275 12.86 –10.7 2.16
178 Option Trading
80
60
40
20
Pay off
0
190
195
200
205
210
215
220
225
230
235
245
250
255
260
265
270
575
280
285
–20
–40
–60
Sell put 250 Buy 2 puts 230 Net pay off
Fig. 9.4 Long 2/1 put ratio spread
9.7 BEAR SPREAD WITH CALL

This is another trading strategy for persons who have bearish attitude.
Earlier, we had discussed the naked call writing in a bearish market. Here,
one has to sell an in-the-money call option and simultaneously buy an out-
of-the-money call option of an underlying stock with the same maturity.
Writing call option is riskier, because if the market moves up sharply against
your expectation, you may incur huge loss. On the other hand, buying out-
of-the-money calls gives the seller protection. In fact, this trading strategy is
the extension of writing call option. Here, the risk appetite of an investor is
less (Table 9.6; Fig. 9.5).
Table 9.6 Pay off of Bear Spread with Call
Strike Premium
Sell call 260 8
Sell call 240 20
(Contd.)
Spot at Long (260) Short (240) Pay off

expiration call call
190 –8 20 12.00
200 –8 20 12.00
210 –8 20 12.00
220 –8 20 12.00
230 –8 20 12.00
240 –8 20 12.00
250 –8 10 2.00
260 –8 0 –8.00
270 2 –10 –8.00
280 12 –20 –8.00
290 22 –30 –8.00
300 32 –40 –8.00
310 42 –50 –8.00
320 52 –60 –8.00
330 62 –70 –8.00
50
40
30
LOSS & PROFIT
20
10
0
1010
1020
1030
1040
1050
1060
1070
1080
1090
1100
1120
1130
1110
-10
-20
-30
-40
-50
Long 1080 Call Short 1070 Pay off
Fig. 9.5 Bear spread with calls
9.8 SYNTHETIC SHORT

Traders with strong bearish mentality adopt this strategy. Both buying a put
and selling a call are bearish strategies. If an investor uses this combination
of buying puts and selling calls, he can get synthetic short. This is as good as
shorting the futures. Buying put gives a breakeven only after the asset’s price
180 Option Trading
falls at least by the premium. On the other hand, writing a call at the same
strike and same maturity allows the trader to get an early breakeven through
getting premium of the written call. Both buying puts and selling calls
generate negative deltas. Investors will select various strike prices according
to their risk appetite (Table 9.7; Fig. 9.6).
Table 9.7
Strike Premium
Buy put 980 7.2
Sell call 980 9.45
Stock at Short call Long put Net

expiration (980) (980) Pay off
480 9.45 492.80 502.25
530 9.45 442.80 452.25
580 9.45 392.80 402.25
630 9.45 342.80 352.25
680 9.45 292.80 302.25
730 9.45 242.80 252.25
780 9.45 192.80 202.25
830 9.45 142.80 152.25
880 9.45 92.80 102.25
930 9.45 42.80 52.25
980 9.45 – 7.20 2.25
1030 – 40.55 – 7.20 – 47.75
1080 – 90.55 – 7.20 – 97.75
1130 –140.55 – 7.20 – 147.75
80
60
Profit
40
20
0
680
480
530
580
630
730
780
830
880
930
980
1080
1130
1030
– 20
Loss
– 40
– 60
– 80 Short call 980 Long put 980
Net pay off
Fig. 9.6 Synthetic short futures

9.9 SHORT PUT LADDER

Short put ladder can be created by buying a put option at a higher strike
price and again one more put option at an equally higher strike price and
selling a put option at an equally higher strike price. The buyer is anticipating
a sharp fall in the underlying.
9.9.1 Relevance of Short Put Ladder in a Bearish
Market Scenario
An investor who is cautious and also thinks that the market may fall from the
current level can buy put options. Both call options and put options are now
being traded at higher premiums due to high volatility persisting in the
market. On 20 October, Nifty closed at 1537 and a 1530 put option was priced
at a premium of Rs. 17.40. An investor who buys a 1530 put option will get
profit if Nifty closes below 1512.60 at month end. On the other hand, if Nifty
closes above 1530, he may lose his entire premium. At this point, creating a
short put ladder on Nifty is advisable.
A short put ladder position can be created in the following way: writing a
put option at a higher strike rate and simultaneously buying two put options
at equally distant lower strike rates.
For example, writing October 1530 put options for Rs. 17.40 and buying
two put options of 1520 and 1510 for a premium of Rs. 14.80 and Rs. 11.70,
respectively, has advantage, because even if the market closes above the 1530
level, the investor may lose only Rs. 9.10. On the other hand, downside
breakeven can be attained at the level of 1489.10. But, if the market closes at
1520, the investor may suffer a loss of Rs. 19.10 (Table 9.8; Fig. 9.7).
Table 9.8
Strike Premium
Buy put 1510 11.7
Buy put 1520 14.8
Sell put 1530 17.4
Nifty at Buy put Buy put Sell put Pay off

expiration (1510) (1520) (1530)
1450 48.30 55.20 –62.60 40.90
1460 38.30 45.20 –52.60 30.90
1470 28.30 35.20 –42.60 20.90
1480 18.30 25.20 –32.60 10.90
1490 8.30 15.20 –22.60 0.90
1500 –1.70 5.20 –12.60 –9.10
1510 –11.70 –4.80 –2.60 –19.10
1520 –11.70 –14.80 7.40 –19.10
1530 –11.70 –14.80 17.40 –9.10
1540 –11.70 –14.80 17.40 –9.10
1550 –11.70 –14.80 17.40 –9.10
182 Option Trading
Short put ladder

70
60
50
40
30
20
Loss Profit
10
0
1450
1460
1470
1480
1490
1500
1510
1520
1530
1550
–10
–20
–30
–40
–50
–60
–70
Buy put 1510 Buy put 1520 Sell put Payoff
Fig. 9.7 Short put ladder
Investors can select the strike prices according to prevailing market

situations and put option premiums.
9.10 LONG COMBO

This strategy can be created by selling the call (out-of-the-money) at 1100 for
Rs. 30.75 and buying a 1080 put option (at-the-money) at Rs. 11 (Table 9.9;
Fig. 9.8).
Table 9.9
Strike Premium
Sell call 1100 30.75
Buy put 11080 11.00
Strike at Sell call Buy put Pay off

expiration (1100) (1080)
1050 30.75 19 49.75
1055 30.75 14 44.75
1060 30.75 9 39.75
1065 30.75 4 34.75
1070 30.75 –1 29.75
1075 30.75 –6 24.75
1080 30.75 – 11 19.75
Strike at Sell call Buy put Pay off

expiration (1100) (1080)
1085 30.75 – 11 19.75
1090 30.75 – 11 19.75
1095 30.75 – 11 19.75
1100 30.75 – 11 19.75
1105 25.75 – 11 14.75
1110 20.75 – 11 9.75
1115 15.75 – 11 4.75
1120 10.75 – 11 – 0.25
1125 5.75 – 11 – 5.25
1130 0.75 – 11 – 10.25
1135 – 4.25 – 11 – 15.25
1140 – 9.25 – 11 – 20.25
1145 – 14.25 – 11 – 25.25
1150 – 19.25 – 11 – 30.25
60 Sell call
50 Buy put
Net cash flow
40
30
20
10
0
1050
1060
1070
1080
1090
1100
1120
1130
1140
1150
1110
–10
–20
–30
–40
Fig. 9.8 Long combo
9.11 LONG CALL CHRISTMAS TREES

This strategy will give an investor unlimited loss once it has breached the
BEP levels. On the other hand, profit will be very low. The out-of-the-money
calls will have high implied volatility due to various reasons. One can buy
at-the-money call and can sell two calls at a higher strike price with equal
intervals on the same expiry and same underlying stock.
184 Option Trading
Generally, investors create a delta hedge strategy with long call Christmas
tree. Buying an in-the-money call option (0.75 delta) and selling two lots of
out-of-the-money call (0.25 × 2), the net delta position can be positive (0.25).
This type of reduction in deltas is normally risk-free up to a certain extent,
but one should be very careful about the net gamma positions.
Buy one lot of call at 1030 for Rs. 27.30 and sell 1040 calls at Rs. 21.65 and
sell 1050 calls at Rs. 16.65 (Table 9.10; Fig. 9.9).
Table 9.10
Strike Premium
Buzy call 1030 27.3
Spot at Long call Sell call Sell call Net

expiration (1030) (1040) (1050) pay off
960 – 27.3 21.65 16.65 11
970 – 27.3 21.65 16.65 11
980 – 27.3 21.65 16.65 11
990 – 27.3 21.65 16.65 11
1000 – 27.3 21.65 16.65 11
1010 – 27.3 21.65 16.65 11
1020 – 27.3 21.65 16.65 11
1030 – 27.3 21.65 16.65 11
1040 – 17.3 21.65 16.65 21
1050 – 7.3 11.65 16.65 21
1060 2.7 1.65 6.65 11
1070 12.7 – 8.35 –3.35 1
1080 22.7 – 18.35 – 13.35 –9
1090 32.7 – 28.35 – 23.35 – 19
1100 42.7 – 38.35 – 33.35 – 29
1110 52.7 – 48.35 – 43.35 – 39
1120 62.7 – 58.35 – 53.35 – 49
1130 72.7 – 68.35 – 63.35 – 59
1140 82.7 – 78.35 – 73.35 – 69
50
40
30
20
Loss & Profit
10
0
1000
1010
1020
1030
1040
1050
1060
1070
1080
1090
1100
1120
1130
1140
1110
960
970
980
990
–10
–20
–30
–40
–50
Long 1030 Sell 1040 Sell 1050 Net pay off
Fig. 9.9 Long call Christmas tree
9.12 SHORT PUT ALBATROSS

Limited risk and limited profits are the main attractions of this strategy. The
investor here expects a sharp movement, in either direction. But if the
movement is flat during the expiry, then one may incur minimum loss. This
strategy is commonly adopted in European options.
Sell 1150 puts at Rs. 1.2 and buy 1160 puts at Rs. 2.95 and buy 1180 puts at
Rs. 9.05 and sell 1190 puts at Rs. 16.05 (Table 9.11; Fig. 9.10).
Table 9.10
Strike Premium
Sell put 1150 1.20
Buy put 1160 2.95
Buy put 1180 9.05
Sell put 1190 16.05
Spot at Sell put Buy put Buy put Sell put Net
expiration (1150) (1160) (1180) (1190) pay off
1100 – 48.8 57.05 70.95 –73.95 5.25
1105 – 43.8 52.05 65.95 –68.95 5.25
1110 – 38.8 47.05 60.95 –63.95 5.25
1115 – 33.8 42.05 55.95 –58.95 5.25
1120 – 28.8 37.05 50.95 – 53.95 5.25
186 Option Trading
Spot at Sell put Buy put Buy put Sell put Net
1125 – 23.8 32.05 45.95 – 48.95 5.25
1130 – 18.8 27.05 40.95 – 43.95 5.25
1135 – 13.8 22.05 35.95 – 38.95 5.25
1140 – 8.8 17.05 30.95 – 33.95 5.25
1145 – 3.8 12.05 25.95 – 28.95 5.25
1150 1.2 7.05 20.95 – 23.95 5.25
1155 1.2 2.05 15.95 – 18.95 0.25
1160 1.2 – 2.95 10.95 – 13.95 – 4.75
1165 1.2 – 2.95 5.95 – 8.95 – 4.75
1170 1.2 – 2.95 0.95 – 3.95 – 4.75
1175 1.2 – 2.95 – 4.05 1.05 – 4.75
1180 1.2 – 2.95 – 9.05 6.05 – 4.75
1185 1.2 – 2.95 – 9.05 11.05 0.25
1190 1.2 – 2.95 – 9.05 16.05 5.25
1195 1.2 – 2.95 – 9.05 16.05 5.25
1200 1.2 – 2.95 – 9.05 16.05 5.25
1205 1.2 – 2.95 – 9.05 16.05 5.25
1210 1.2 – 2.95 – 9.05 16.05 5.25
60
40
20
Payoff
1120 1140 1160 1180 1200 1220

–20
–40
–60
Sell put 1150 Buy put 1160 Buy put 1180
Sell put 1190 Net pay off
Fig. 9.10 Short put albatross

9.13 SHORT STRADDLE VERSUS PUT

Here, the investor expects a stable market where volatility is expected to
decrease. But he fears a possible fall in the market below a certain extent. It is
a combination of short straddle (selling both call option and put option at the
same strike rate and at the same maturity of a same underlying stock) and a
long put. The profit is limited below a certain extent. But there is always a
risk of shorting the call. This risk can be eliminated by going long in Nifty
futures when the underlying moves above the upside BEP (Table 9.12;
Fig. 9.11).
Table 9.12
Strike Premium
Sell call 220 26.65
Sell put 220 6.92
Buy put 200 2.75
Stock at Sell call Sell put Buy put Net

– 130 26.65 – 343.08 327.25 10.82
– 80 26.65 – 293.08 277.25 10.82
– 30 26.65 – 243.08 227.25 10.82
20 26.65 – 193.08 177.25 10.82
70 26.65 – 143.08 127.25 10.82
120 26.65 – 93.08 77.25 10.82
170 26.65 – 43.08 27.25 10.82
220 26.65 6.92 – 2.75 30.82
270 – 23.35 6.92 – 2.75 – 19.18
320 – 73.35 6.92 – 2.75 – 69.18
370 – 123.35 6.92 – 2.75 – 119.18
420 – 173.35 6.92 – 2.75 – 169.18
470 – 223.35 6.92 – 2.75 – 219.18
520 – 273.35 6.92 – 2.75 – 269.18
570 – 323.35 6.92 – 2.75 – 319.18
620 – 373.35 6.92 – 2.75 – 369.18
188 Option Trading
400
300
200
100
0
Pay off
130
80
30
20
70
120
170
220
270
370
420
470
520
570
620
–100
–200
–300
–400
–500
Sell call 220 Sell put 220
Buy put 200 Total pay off
Fig. 9.11 Short straddle vs put
9.14 SHORT STRIP WITH CALLS

This is a high-risk strategy with limited profit and unlimited loss. This
bearish strategy is normally used in a bearish market, or it can be used just
few days prior to the expiry. Here, the investor is confident that the
underlying stock will not move above the strike prices. Normally, calls are to
be sold at higher strike price with equal intervals with the same expiry and
with the same underlying stock (Table 9.13; Fig. 9.12).
Table 9.13
Strike Premium
Sell call 200 41.5
Sell call 210 32.25
Sell call 220 24.55
(Contd.)
Stock at Sell call Sell call Buy call Net

140 41.5 32.25 24.55 98.3
150 41.5 32.25 24.55 98.3
160 41.5 32.25 24.55 98.3
170 41.5 32.25 24.55 98.3
180 41.5 32.25 24.55 98.3
190 41.5 32.25 24.55 98.3
200 41.5 32.25 24.55 98.3
210 31.5 32.25 24.55 88.3
220 21.5 22.25 24.55 68.3
230 11.5 12.25 14.55 38.3
240 1.5 2.25 4.55 8.3
250 – 8.5 – 7.75 – 5.45 – 21.7
260 – 18.5 – 17.75 –15.45 – 51.7
270 – 28.5 – 27.75 – 25.45 – 81.7
280 – 38.5 – 37.75 – 35.45 – 111.7
290 – 48.5 – 47.75 – 45.45 – 141.7
300 – 58.5 – 57.75 – 55.45 – 171.7
150
100
50
0
140
150
160
170
180
190
200
210
220
230
240
250
260
270
280
290
300
Payoff
–50
–100
–150
–200
Sell call 200 Sell call 220
Sell call 210 Total pay off
Fig. 9.12 Short strip with calls
9.15 LONG GUTS

This strategy is similar to long strangles strategy. The only difference is that
long guts strategy is constructed by the purchase of a long call and a long put
at different strike prices. Risk is limited, but a sudden surge in the underlying
asset price is required, along with a rise in implied volatility (Table 9.14;
Fig. 9.13).
190 Option Trading
Table 9.14
Strike Premium
Buy call 220 22.1
Buy put 240 16.85
Spot at Buy call Buy put Net

180 – 22.1 43.15 21.05
185 – 22.1 38.15 16.05
190 – 22.1 33.15 11.05
195 – 22.1 28.15 6.05
200 – 22.1 23.15 1.05
205 – 22.1 18.15 – 3.95
210 – 22.1 13.15 – 8.95
215 – 22.1 8.15 – 13.95
220 – 22.1 3.15 – 18.95
225 – 17.1 – 1.85 – 18.95
230 – 12.1 – 6.85 – 18.95
235 – 7.1 – 11.85 – 18.95
240 – 2.1 – 16.85 – 18.95
245 2.9 – 16.85 – 13.95
250 7.9 – 16.85 – 8.95
255 12.9 – 16.85 – 3.95
260 17.9 – 16.85 1.05
265 22.9 – 16.85 6.05
270 27.9 – 16.85 11.05
275 32.9 – 16.85 16.05
280 37.9 – 16.85 21.05
50
40
30
20
Pay off
10
0
180
280
185
190
195
200
205
210
215
220
225
230
235
240
245
250
255
260
265
270
275
–10
–20
–30
Buy call 220 Buy put 240 Total pay off
Fig. 9.13 Long Puts

9.16 LONG CALL LADDER

Buying in-the-money call option and selling two lots of call options at higher
strike prices of equal intervals is known as long call ladder. This is a bearish
strategy (Table 9.15; Fig. 9.14).
Table 9.15
Strike Premium
Sell call 1080 4.05
Sell call 1070 6.25
Buy call 1060 10.15
Spot at Sell call Sell call Buy call Net

1045 4.05 6.25 – 10.15 0.15
1050 4.05 6.25 – 10.15 0.15
1055 4.05 6.25 – 10.15 0.15
1060 4.05 6.25 – 10.15 0.15
1065 4.05 6.25 – 5.15 5.15
1070 4.05 6.25 – 0.15 10.15
1075 4.05 1.25 4.85 10.15
1080 4.05 – 3.75 9.85 10.15
1085 –0.95 – 8.75 14.85 5.15
1090 – 5.95 – 13.75 19.85 0.15
1095 – 10.95 – 18.75 24.85 – 4.85
1100 – 15.95 – 23.75 29.85 – 9.85
1105 – 20.95 – 28.75 34.85 – 14.85
1110 – 25.95 – 33.75 39.85 – 19.85
1115 – 30.95 – 38.75 44.85 – 24.85
1120 – 35.95 – 43.75 49.85 – 29.85
9.17 LONG IRON BUTTERFLY

The strategy is a combination of synthetic long and a synthetic short. The
holder of this position expects a sharp move in either direction and benefits
from an increase in volatility (Table 9.16; Fig. 9.15).
192 Option Trading
40
30
20
10
Loss/Profit
0
1050
1055
1060
1065
1070
1070
1075
1080
1085
1090
1095
1105
1120
1110
1115
–10
–20
–30
–40
Sell call 1080 Sell call 1070 Buy call 1060 Pay off
Fig. 9.14 Long call ladder
Table 9.16
Strike Premium
Short put 1040 14.00
Long call 1050 18.65
Long put 1050 17.05
Short call 1060 15.00
Spot at Long call Long put Short put Short call Net
970 – 18.65 62.95 –56.00 15 3.30
980 – 18.65 52.95 –46.00 15 3.30
990 – 18.65 42.95 –36.00 15 3.30
1000 – 18.65 32.95 –26.00 15 3.30
1010 – 18.65 22.95 –16.00 15 3.30
1020 – 18.65 12.95 –6.00 15 3.30
1030 – 18.65 2.95 4.00 15 3.30
1040 – 18.65 – 7.05 14.00 15 3.30
1050 – 18.65 – 17.05 14.00 15 – 6.70
1060 – 8.65 – 17.05 14.00 15 3.30
1070 1.35 – 17.05 14.00 5 3.30
1080 11.35 – 17.05 14.00 –5 3.30
(Contd.)
Spot at Long call Long put Short put Short call Net
1090 21.35 – 17.05 14.00 – 15 3.30
1100 31.35 – 17.05 14.00 – 25 3.30
1110 41.35 – 17.05 14.00 – 35 3.30
1120 51.35 – 17.05 14.00 – 45 3.30
1130 61.35 – 17.05 14.00 – 55 3.30
1140 71.35 – 17.05 14.00 – 65 3.30
80
60
40
20
Loss & Profit
0
970
980
990
1000
1010
1020
1030
1040
1060
1070
1080
1090
1100
1110
1120
1130
1140
–20
–40
–60
–80
Long call Long put Short put Short call Net pay off
Fig. 9.15 Long iron butterfly
9.18 LONG PUT SPREAD VERSUS SHORT CALL

Here, a trader takes a bear spread with puts and in addition s/he sells a call
option. This is called long put spread versus short call. S/he expects the
market to fall and also expects a decline in volatility (Table 9.17; Fig. 9.16).
194 Option Trading
Table 9.17
Strike Premium
Buy put 240 11.83
Sell put 230 8.03
Sell call 250 14.57
Spot at Buy put Sell put Sell call Net

200 28.17 – 21.97 14.57 20.77
205 23.17 – 16.97 14.57 20.77
210 18.17 – 11.97 14.57 20.77
215 13.17 – 6.97 14.57 20.77
220 8.17 – 1.97 14.57 20.77
225 3.17 3.03 14.57 20.77
230 – 1.83 8.03 14.57 20.77
235 – 6.83 8.03 14.57 15.77
240 – 11.83 8.03 14.57 10.77
245 – 11.83 8.03 14.57 10.77
250 – 11.83 8.03 14.57 10.77
255 – 11.83 8.03 9.57 5.77
260 – 11.83 8.03 4.57 0.77
265 – 11.83 8.03 – 0.43 – 4.23
270 – 11.83 8.03 – 5.43 – 9.23
275 – 11.83 8.03 – 10.43 – 14.23
40
30
20
10
Pay off
0
200
205
210
215
220
225
230
235
240
245
250
255
260
265
270
275
–10
–20
Buy put 240 Sell put 230

–30
Sell call 250 Net pay off
Fig. 9.16 Long put spread vs call

9.19 BASIC OPTION STRATEGIES
9.19.1 Long Strangles

Long strangle is normally used when the market volatility is expected to
increase and when a large move on either direction is expected. Smart traders
normally buy call options above the resistance level and put options below
the support level. A rise or fall below the support and resistance levels can
cause one-sided profit, which in turn gives the trader a handful of profit.
Maximum loss is limited to the premium paid (Table 9.18; Fig. 9.17).
Table 9.18
Strike Premium
Buy call 1050 20
Buy put 1000 21
Spot at Buy call Buy put Net

950.00 – 20 29 9.00
960.00 – 20 19 – 1.00
970.00 – 20 9 – 11.00
980.00 – 20 –1 – 21.00
990.00 – 20 – 11 – 31.00
1000.00 – 20 – 21 – 41.00
1010.00 – 20 – 21 – 41.00
1020.00 – 20 – 21 – 41.00
1030.00 – 20 – 21 – 41.00
1040.00 – 20 – 21 – 41.00
1050.00 – 20 – 21 – 41.00
1060.00 – 10 – 21 – 31.00
1070.00 0 – 21 – 21.00
1080.00 10 – 21 – 11.00
9.19.2 Short Strangles

This strategy is exactly the opposite of long strangles. If a trader believes that
the market may not break the support and resistance points, but will remain
in a range till expiry, then short strangle is the most suitable strategy.
Sometimes volatility traders sell both the call and put options in anticipation
of lower volatility. The risk is unlimited, but gains are limited to the extent of
the premium of both the call and the put (Table 9.19; Fig. 9.18).
196 Option Trading
60
40
20
Pay off
0
950.00
960.00
970.00
980.00
990.00
1 000.00
1 010.00
1 020.00
1 030.00
1 040.00
050.00
1 060.00
1 070.00
1 080.00
1 090.00
1 100.00
1 110.00
120.00
–20
–40
–60
Buy call = Buy put = Net pay off
Fig. 9.17 Long strangle
Table 9.19 Short Strangle
Strike Premium
Short call 4500 50
Short put 4400 10
Spot at Short call Short put Net

4250 50 -140 –90
4300 50 -90 –40
4350 50 -40 10
4400 50 10 60
4450 50 10 60
4500 50 10 60
4550 0 10 10
4600 –50 10 –40
4650 –100 10 –90
4700 –150 10 –140
4750 –200 10 –190
4800 –250 10 –240
100
50
0
4200 4300 4400 4500 4600 4700 4800 4900
Profit & Loss
–50
–100
–150
–200
–250
–300
Strike price
Short call Short put Net pay off
Fig. 9.18 Short strangle
9.20 TRADING STRATEGY ADOPTED BY NICK LEESON

27 February 1995 was a black day for the 233-year-old London-based
Bearings Bank. Bearings were the personal bank of Her Majesty Queen
Elizabeth and were performing well. Chairman Peter Bearing, still holding
the confession note written to him by the ‘Rogue Trader’ Nick Leeson, could
not still believe that the bank which was founded by his forefather Francis
Bearing in 1762 became bankrupt. Over 1200 employees of the bank became
jobless consequent to the winding up. He recollected how Leeson became the
blue-eyed boy of the top brasses of Bearings.
Born in a working-class family on 29 February 1967, Nicholas William
Leeson was a poor performer in his school. His father was a plasterer. He
failed in his final mathematics examination and left the school with a mere
handful of qualifications. He started his banking career as a clerk with Royal
Bank Coutts in 1980 and also worked with some other banks before taking
up his employment with Bearings. Leeson could very easily win the favour
of his bosses in Bearings and was soon promoted to the trading floor.
In 1992, Leeson was appointed the manager of the Singapore arm of
Bearings and was in charge of a new operation in futures markets on the
Singapore International Monetary Exchange (SIMEX). He was the chief trader
as well as was responsible for settling his trades. Normally, a trader is not
allowed to place his hands on the back-office operations, but Leeson enjoyed
this privilege because of the confidence he instilled among his superiors. This
placed Leeson in the position of reporting to an office inside Bearings Bank
198 Option Trading
which he himself held. His bosses back in London viewed with glee the
millions of profits brought to the bank by Leeson by betting on future direction
of the Nikkei 225 Index. Leeson and his wife Liza enjoyed their exotic life with
a fat salary of £50,000, bonuses up to £150,000, a smart flat, frequent parties
and weekends in exotic places—all gracefully given to him by his employer.
Leeson started by buying and selling the simplest kind of derivatives
futures pegged to Nikkei 225, the Japanese equivalent of UK’s FTSE 100. At
the time the trader only had to put down a small percentage of the amount
that was being traded; it was therefore easily possible for the money on the
table to exceed the losses by many times. However, to Bearings chief
executives, Leeson seemed to be infallible. By the end of 1993, he had made
more than £10 million—about 10% of total profit that year.
Leeson took advantage of the overconfidence reposed by his superiors in
him and opened a secret account 88888, better known as ‘five-eights account’
to hide his losses. This account was initially opened to cover up a mistake
made by an inexperienced team member, which led to a loss of £20,000. He
also succeeded in making his bosses believe that he was executing purchase
orders on behalf of a client. By December 1994, the balance in the account
88888 swelled to $512 million. Leeson never thought that the Nikkei Index
would fall below 19,000 points, and he continued to buy Nikkei Index
Futures against SIMEX. His strategy was to arbitrage between Osaka Stock
Exchange (OSE) and SIMEX to take advantage of the temporary price
difference between the two exchanges.
Leeson continued to build up substantial positions in Japanese equities,
interest rates, Nikkei 225, government bonds (JGB) and Euroyen contracts.
On 17 January 1995, Japan was shocked by the devastating earthquake
measuring 7.2 on the Richter scale in Kobe City. Consequently, Nikkei 225
crashed by 7% in a week. Before the earthquake, Nikkei was trading within a
range of 19,000-19,500. In order to cover up the losses, Leeson requested for
additional funds to Bearings headquarters, and the bosses pumped funds to
Singapore without asking a second question. Leeson was hopeful of a
rebound of Nikkei and expected that it would stabilize at 19,000. Before the
earthquake, he had a long position of approximately 3000 contracts on the
OSE. And the equivalent number of contracts on SIMEX was 6000 because
the SIMEX contracts were half the size of OSE. The aggressive buying to
which he resorted to move the market took Leeson’s position over 20,000
futures contracts worth $180,000 each. But his efforts proved to be futile as
the market did not move as expected. Figure 9.19 explains the movement of
the Nikkei Index and Leeson’s position before and after the earthquake.
OSE publishes the trading positions weekly for public information, and
Leeson’s position at OSE reflected only half of his sanctioned trades. In
principle, Leeson had to go short by twice the number of contracts on SIMEX
if he was on OSE for long, because his official trading strategy was to take
advantage of temporary price differences between OSE Nikkei 225 contracts
Nikkei Kobe earthquake

225 average 19 600 20 Thousand
contracts
19 400
Nikkei 19 200
225 average 19 000 15
18 800
18 600 Bearing’s net long
10 futures positions
18 400
18 200
18 000 5
17 800
17 600
17 400 0
6 13 20 27 3 10 17 24
January February
1995
Fig. 9.19
Source: Data Stream and Osaka Securities Exchange
and SIMEX. In Bearings’ parlance, this arbitrage strategy was known as

‘switching’, which required the trader to buy the cheaper contract and
simultaneously sell the expensive one. The trade would be reversed when
the price difference narrowed or disappeared. This strategy carried lesser
market risk because the positions were always matched. But, Leeson broke
the rules and was long by approximately the same number of contracts he
was supposed to be short. He routed all these unauthorized trading
transactions through his secret account 88888. Besides, he used this account
to route his trades in JGB, Euroyen Futures and Nikkei 225 options. Table
9.20 shows Leeson’s actual trade positions versus reported positions. For the
rest of this case, the contracts will be discussed as converted into SIMEX
contract sizes.
The most striking fact was that Leeson sold 70,892 Nikkei 225 options
worth $6.68 billion without the knowledge of his headquarters. Leeson’s
option strategy was to sell puts and calls simultaneously. In option parlance,
this strategy is straddle. The advantage of straddle is that the trader earns
premium at both ends. Lesson sold over 37,000 straddles over a period
of 14 months. Such trades could have been very profitable, provided Nikkei
225 was trading at the options’ strike price on expiry date since both the puts
and calls would expire worthless. The seller then enjoys the full premium
earned from selling the options. If Nikkei was trading near the options’ strike
on expiry, it could still have been profitable because the earned premium
more than offsets the small loss experienced on either the call (if the Tokyo
market had risen) or the put (if Nikkei had fallen). An example of the
straddle strategy is given in Fig. 9.20.
200 Option Trading
Table 9.20 Leesons Actual Trading Position versus Reported Position at

the End of February 1995
Reported1 Actual2 Actual position in terms

of open interest of
relevant contract3
Number Nominal Number Nominal
of value of value
contracts4 (amount contracts5 (amount
in in
millions millions
of US$) of US$)
Futures
Nikkei 30,112 2809 Long 7000 49% of March 1995
225 61,039 contract and 24% of
(Amount June 1995 contract.
7000)
JGB 15,940 8980 Short 19,650 85% of March 1995
28,034 contract and 88% of
June 1995 contract.
Euroyen 601 26.5 Short 350 5% of June 1995
6845 contract, 1% of
September 1995
contract and 1% of
December 1995
contract
Options
Nikkei Nil Calls 3580
225 37,925
Puts
32,967 3100
1. Leeson's reported futures positions were supposedly matched because they were part of
Bearings' switching activity, that is the number of contracts on the OSE or the SIMEX or
the TSE.
2. Actual positions refer to those unauthorized trades held in the error account 88888.
3. Open interest figures for each contract month of each listed contract. For Nikkei 225, JGB
and Euroyen contracts, the contract months are March, June, September and December.
4. Expressed in terms of SIMEX contract sizes, which are half the size of those of the OSE
and the TSE. For Euroyen, SIMEX and TIFFE contracts are of similar size.
5. Expressed in terms of SIMEX contract sizes which are half the size of those of the OSE
and the TSE. For Euroyen, SIMEX and TIFFE contracts are of similar size.
Source: The Report of the Board of Banking Supervision Inquiry into the Circumstances of
the Collapse of Bearings, Ordered by the House of Commons, Her Majestys Stationery
Office, 1995.
Short Straddle
If an investor believes that the market will remain in a tight range, then the
most suitable strategy can be Short Straddles. Short Straddle position can
be created by selling both call options and put options of the same expiry
and same strake price. For example, if the trader has taken short on both
call and put options at the strike rate of 100,for a call premium of Rs. 3 and
put premium of Rs. 2.10. If the market/stock remains in the range of Rs.
105.10-Rs. 94.90, the investor will make profit. On the other hand, above
and below the prescribed range, the trader may incur unlimited loss. The
maximum profit for this strategy is limited and the maximum loss for this
strategy is unlimited. The maximum profit the investor can gain is Rs. 5.10
if the market/stock closes at Rs. 100.
Stock at Pay off Pay off Net

expiration short call short put pay off
80 3 – 17.90 – 14.90
85 3 – 12.90 – 9.90
90 3 – 7.90 – 4.90
95 3 – 2.90 0.10
100 3 2.10 5.10
105 –2 2.10 0.10
110 –7 2.10 – 4.90
115 – 12 2.10 – 9.90
120 – 17 2.10 –14.90
125 – 22 2.10 – 19.90
10.00
8.00
6.00
4.00
Loss & Profit
2.00
0.00
80
85
90
95
100
105
110
115
120
125
–2.00
–4.00
–6.00
–8.00
–10.00
Strike price
Short put Net pay off Short call
Fig. 9.20 Short straddle
The strike prices of most of Leeson’s straddle positions ranged from 18,500
to 20,000. He thus needed Nikkei 225 to continue to trade in its pre-Kobe
earthquake range of 19,000-19,500 if he was to make money on his option
202 Option Trading
trades. The Kobe earthquake shattered Leeson’s options strategy. On 17

January, the day of the quake, Nikkei 225 was at 19,350. It ended that week
slightly lower, at 18,950, so Leeson’s straddle positions were starting to look
shaky. The call options Leeson had sold were beginning to look worthless,
but the put options would become very valuable to their buyers if Nikkei
continued to decline. Leeson’s losses on these puts were unlimited and
totally dependent on the level of Nikkei at expiry, while the profits on the
calls were limited to the premium earned.
Prior to the Kobe earthquake, his unauthorized book, that is account
88888, showed a flat position in Nikkei 225 futures. Yet on Friday, 20 January,
three days after the earthquake, Leeson bought 10,814 March 1995 contracts.
When Nikkei dropped by 1000 points to 17,950 on Monday, 23 January 1995,
Leeson found himself showing losses on his two-day-old long futures
position and facing unlimited damage from selling put options. Leeson tried
single-handedly to reverse the negative post-Kobe sentiments that swamped
the Japanese stock market. On 27 January, account 88888 showed a long
position of 27,158 March 1995 contracts. Over the next three weeks, Leeson
doubled his long position to reach as high as 55,206 March 1995 contracts
and 5640 June 1995 contracts on 22 February.
Leeson started unauthorized activities almost as soon as he opened
trading in Singapore in 1992. He took proprietary positions on SIMEX on
both futures and options contracts against the mandate from London, which
allowed him to take positions only if they were part of ‘switching’ and to
execute client orders. He was never allowed to sell options. Leeson lost
money from his unauthorized trades almost from day one. Yet he was
perceived in London as the wonder boy and turbo-arbitrageur who single-
handedly contributed to half of Bearings Singapore’s 1993 profits and half of
the entire firm’s 1994 profits. In 1994 alone, Leeson lost Bearings US$296
million; his bosses thought he made them a profit of US$46 million, so they
proposed paying him a bonus of US$720,000. In January and February 1995,
Bearings Tokyo and London transferred US$835 million to its Singapore
office to enable the latter meet its margin obligations on the SIMEX. Table 9.21
shows the facts and fantasy of Leeson’s trade.
Table 9.21 Facts and Fantasy of Leesons Trade
Period Reported Actual Cumulative

(million) (million) actual* (million)
1 January to 31 December 1993 + GBP 8.83 – GBP 21 – GBP 23
*Leesons cumulative losses carried forward.

Source: The Report of the Board of Banking Supervision Inquiry into the Circumstances of
the Collapse of Bearings, Ordered by the House of Commons, Her Majestys Stationery
Office, 1995.
The Board of Banking Supervision (BoBS) of the Bank of England, which

conducted an investigation into the collapse of Bearings, believes that ‘the
vehicle used to effect this deception was the cross trade’. A cross trade is a
transaction executed on the floor of an exchange by just one member who is
both buyer and seller. If a member has matching buy and sell orders from
two different customer accounts for the same contract and at the same price,
he is allowed to cross the transaction (execute the deal) by matching both his
client accounts. However, he can do this only after he has declared the bid
and offer price in the pit and no other member has taken it up. Under SIMEX
rules, the member must declare the prices three times. A cross trade must be
executed at market price. Leeson entered into a significant volume of cross-
transactions between account ‘88888’ and account ‘92000’ (Bearings Securities
JapanNikkei and JGB arbitrage), account ‘98007’ (Bearings LondonJGB
arbitrage) and account ‘98008’ (Bearings LondonEuro-yen arbitrage).
After executing these cross trades, Leeson instructed the settlements staff
to break down the total number of contracts into several different trades and
to change the trade prices thereon to cause profits to be credited to
‘switching’ accounts referred to above and losses to be charged to account
‘88888’. Thus, while the cross trades on the exchange appeared on the face of
it to be genuine and within the rules of the exchange, the books and records
of BFS, maintained in the Contac systema settlement system used
extensively by SIMEX membersreflected pairs of transactions adding up
to the same number of lots at prices bearing no relation to those executed on
the floor. Alternatively, Leeson could enter into cross trades of smaller size
than that discussed above, but when these were entered into the Contac
system, he could arrange for the price to be amended, again enabling profit
to be credited to the ‘switching’ account and losses to be charged to account
‘88888’.
The BoBS report notes: ‘In each instance, the entries in the Contac system
reflected a number of spurious contract amounts at prices different to those
transacted on the floor, reconciling to the total lot size originally traded. This
had the effect of giving the impression from a review of the reported trades
in account “92000” that these had taken place at different times during the
day. This was necessary to deceive Bearings Securities Japan into believing
the reported profitability in account “92000” was a result of authorised
arbitrage activity. The effect of this manipulation was to inflate reported
profits in account “92000” at the expense of account “88888,” which was also
incurring substantial losses from the unauthorised trading positions taken
by Leeson. In addition to crossing trades on SIMEX between account “88888”
and the switching accounts, Leeson also entered into fictitious trades
between these accounts which were never crossed on the floor of the
Exchange. The effect of these off-market trades, which were not permitted
by SIMEX, was again to credit the “switching” accounts with profits whilst
charging account “88888” with losses’.
204 Option Trading
The bottom line of all these cross trades was that Bearings was
counterparty to many of its own trades. Leeson bought from one hand and
sold to the other, and in so doing did not lay off any of the firm’s market risk.
Bearings was thus not arbitraging between SIMEX and the Japanese
exchanges, but taking open (and very substantial) positions, which were
buried in account ‘88888’. It was the profit and loss statement of this account
which correctly represented the revenue earned (or not earned) by Leeson.
Details of this account were never transmitted to the treasury or risk control
offices in London, an omission which ultimately had catastrophic
consequences for Bearings’ shareholders and bondholders. Table 9.22 shows
how Leeson manipulated the accounts.
Table 9.22 Examples of Leesons Manipulations
Dated Number Price Average Value per Value per Profit/

of contracts per price per SIMEX contract (loss) to
in account SIMEX contract JPY JPY ‘92000’ JPY
88888* millions millions millions
Buy Sell
20 6984 18,950 19,019 66,173 66,413 240
January
23 3000 17,810 18,815 26,715 28,223 1508
January
23 8082 17,810 18,147 (71,970) (73,332) (1362)
January
25 10,047 18,220 18,318 91,528 92,020 420
January
26 16,276 18,210 18,378 148,193 149,560 1367
January 2245
The size of Nikkei 225 cross-trades on the floor of SIMEX for the dates shown,
with the other side being in account ‘92000’
Source: The Report of the Board of Banking Supervision Inquiry into the
Circumstances of the Collapse of Bearings, Ordered by the House of
Commons, Her Majesty’s Stationery Office, 1995.
The BoBS in its report to the House of Commons identified five major
areas of failures on the part of Bearings’ management. These areas are as
follows: (a) segregation of front and back offices, (b) senior management
involvement, (c) adequacy of capital, (d) poor control procedures and (e)
lack of supervision.
9.20.1 Segregation of Front and Back Offices

The management of Bearings broke a cardinal rule of any trading operation
and effectively let Leeson settle his own trades by making him in charge of
both the dealing desk and the back office. Abusing his position as head of the
back office, Leeson suppressed information on account ‘88888’. But, Bearings

London did not know of its existence since Leeson had asked a systems
consultant, Dr. Edmund Wong, to remove error account ‘88888’ from the
daily reports which BFS sent electronically to London. This state of affairs
existed from on or around 8 July 1992 to the collapse of Bearings on 26
February 1995. (Information on account ‘88888’ was, however, still contained
in the margin file sent to London.)
Error accounts are set up to accommodate trades that cannot be reconciled
immediately. A compliance officer investigates the trade, records them on
the firm’s books and analyses how it affects the firm’s market risk and profit
and loss. Reports of error accounts are normally sent to senior officers of the
firm. Bearings’ management compounded their initial mistake of not
segregating Leeson’s duties by ignoring warnings that prolonging the status
quo would be dangerous. An internal auditor’s report in August 1994
concluded that his dual responsibility for both front and back offices was ‘an
excessive concentration of powers’. The report warned that there was a
significant general risk that the general manager (Mr. Nick Leeson) could
override the controls. The audit team recommended that Leeson be relieved
of four duties: supervision of the back-office team, cheque signing and
signing-off SIMEX reconciliations and bank reconciliations. Leeson never
gave up any of these duties even though Simon Jones, regional operations
manager of South Asia and chief operating officer of Bearings Securities
Singapore, had told the internal audit team that Leeson will ‘with immediate
effect cease to perform these functions’.
9.20.2 Senior Management Involvement

Every major report on managing derivative risks has stressed the need for
senior management to understand the risks of the business, to help articulate
the firm’s risk appetite and draft strategies and to control procedures needed
to achieve these objectives. But, Bearings’ senior managers had only a very
superficial knowledge of derivatives. They also miserably failed to
implement proper risk management system in that branch. Though the
internal audit report recommended hiring of a suitably experienced person
to take charge of back office, the senior managers did not consider this
recommendation, stating that there was not adequate work for a full-time
treasury and risk manager. No senior managers in London checked on
whether key internal audit recommendations had been followed up in the
Singapore back office.
While the senior managers at Bearings enjoyed the fruits of success of the
Singapore branch, they did not try to find out how the profit was made and
never analysed or properly assessed this at Management Committee
meetings. They did not even know the breakdown of Leeson’s reported
profits. They erroneously assumed that most of the switching profit came
from Nikkei 225 arbitrage, which actually only generated profits of US$7.36
million for 1994, compared with US$37.5 million for JGB arbitrage.
206 Option Trading
Peter Bearing remembered having told the BoBS that he found the
earnings ‘pleasantly surprising’. He did not even know the breakdown.
Andrew Tuckey, ex-deputy chairman, when asked whether there had ever
been any discussion about the long-term sustainability of the business, told
about the same investigation, ‘Yes ... in very general terms. We seemed to be
making money out of this business and if we can do it, can’t somebody else
do it? How can we protect our position? ....’ Senior management naively
accepted that this business was a goldmine with little risk.
Ron Baker (head of the Financial Products Group) and Mary Walz (global
head of Equity Financial Products), two of Bearings’ most senior derivatives
staff and Leeson’s bosses, got the following adverse remarks by BoBS:
‘Neither were familiar with the operations of the SIMEX floor. Both claim
that they thought that the significant and large profits were possible from a
competitive advantage that BFS had arising out of its good inter-office
communications and its large client order flow. As the exchanges were open
and competitive markets, this suggests a lack of understanding of the nature
of the business and the risks (including compliance risks) inherent in
combining agency and proprietary trading’.
Given the huge amounts of cash that Bearings had to borrow to meet the
margin demands of SIMEX, senior managers were almost negligent in their
duties when they did not press Leeson for more details of his positions or/
and the credit department for client details. Members of the Asset and
Liability Committee (ALCO), which monitored the bank’s market risk,
expressed concern at the size of the position, but took comfort in the thought
that the firm’s exposure to directional moves in Nikkei was negligible since
they were arbitrage (and hedged) positions. This same misplaced belief led
management to ignore market concerns about Bearings’ large positions, even
when queries came from high-level and reputable sources, including a query
on 27 January 1995 from the Bank for International Settlements in Basle.
The bank was haemorrhaging cash and still London took no steps to
investigate Singapore’s requests for fundspartly because senior
management assumed that a proportion of these funds represented advances
to clients. Even then the complacency is still baffling. BFS had only one third-
party client of its ownBanque Nationale de Paris in Tokyo. The rest were
clients of the London and Tokyo offices. Either London’s or Tokyo’s existing
customers had suddenly become very active or Leeson had recently gone out
and won some very lucrative accounts or Tokyo or London had a new
supersalesman who had brought new business with him. Yet no enquiries
were made on this front, which displays a blasé attitude to a potentially
important source of revenue.
9.20.3 Adequacy of Capital

An institution must have sufficient capital to withstand the impact of
adverse market moves on its outstanding positions as well as enough money
to keep the positions going. Bearings’ management thought that Leeson’s
positions were market-neutral and happily funded the margin requirements

till the contracts expired, without knowing that the positions were
unhedged. In fact, the collateral calls received from the two exchanges,
SIMEX and OSE, were very much larger than Bearings’ capital base. Bearings
was highly exposed to market risk from its naked position. Therefore, even if
it had borrowed money to fund the margin calls, it would have been
impossible for them to withstand the substantial losses on expiry of the
contracts. The agent appointed Bearings administrators closed out the
contracts at losses totalling US$1.4 billion, and Bearings was unable to meet
this obligation, which ultimately resulted in pulling down of its shutters.
9.20.4 Poor Control Procedures

Apart from separation of operational duties between front and back offices,
many trading houses provide some additional checks and balances such as
funding, credit risk, market risk and imposition of exposure limits.
9.20.4.1 Funding
The London office was automatically remitting to Leeson the sum of money
he asked for, without asking for justification of such demands. Some of the
operating staff even expressed their apprehensions about the accuracy of the
data which was not considered while making these remittances. In fact, the
London office could have calculated the margins using Standard Portfolio
Analysis of Risk (SPAN) margining programme and could have cross-
checked Leeson’s demands, which would have revealed that the money
Leeson was requesting was substantially higher than that called for under
SIMEX margining rules. The cumulative funding by Bearings London and
Tokyo at the end of December 1994 amounted to US$354 million, and in the
first 2 months of 1995, this figure went up by US$835 million to US$1.2
billion. The BoBS inquiry team made the following observations in their
report to HM:
We described ... how [Tony] Railton [futures and option settlements
senior clerk] discovered in February 1995 that the breakdown of the total US
Dollar request was meaningless, and that the BFS clerk knew the total
funding requirement for that day and made up the individual figures in the
breakdown to add up to the required total.
From November 1994, BFS usually requested a round sum number split
equally between US dollars for client accounts and proprietary positions.
Tony Hawes [group treasurer] confirmed that he identified this feature of
the requests: ‘That was one of the main reasons why during February 1995 I
paid two visits to Singapore.’ If the US Dollar requests had been in relation to
genuine positions taken by clients and house [Bearings itself], on any one
day we consider it unlikely for the margin requests for these two sets of
positions to be identical; as for having the requests split 50:50 most days, this
is in our view beyond all possibility. Tony Hawes appears to agree with this
208 Option Trading
view. He told us that: ‘It was just one of the factors that made me distrust this
information ... It was quite too much of a coincidence. ... Throughout I put it
down to poor book-keeping and sloppy treasury management in Bearings
Futures [BFS].
David Hughes [treasury department manager] also told us that the 50:50
split: ‘was a cause for concern ... we said, this cannot be right.’ He explained
that: ‘I do not think we could have house positions and client positions
running totally in tandem.’ [Brenda] Granger [manager, futures and options
settlements] confirmed that she would have spoken to Hughes about the
split. She added: ‘We would joke about Singapore. Why don’t we send
somebody’s mother [anyone] out there to run the department since Nick is
so busy now?
Staff in London could not reconcile funds remitted to Singapore to both
proprietary in-house and individual client positions. Had it been done, they
would have discovered that it was sending out far too much money just to
cover the margin calls of clients.
9.20.4.2 Credit Risk

The Credit Risk Department did not question Bearings on lending over
US$500 million to its clients to trade on SIMEX, collecting only 10% in return
and without enquiring about their profile. According to the head of credit
committee, George Maclean, it was Bearings’ policy to finance client margins
until they could be collected. The credit committee never considered the
credit aspects of the top-up balances although they could see the growth of
these advances as recorded on the balance sheets. No limit neither on per
client nor on the total ‘top-up’ funds was set. Besides, the system of credit
approval process was totally absent. In short, an effective credit risk
management system was totally absent in Bearings.
9.20.4.3 Market Risk

Leeson reported only what he wanted and what actually took place, and
there was no system of independently checking the accuracy of his reports.
As a result, the market risk reports generated by Bearings’ risk management
unit and passed on to ALCO were inaccurate. Leeson’s futures positions did
not show any market risk since trades were supposedly offset by opposite
transactions on another exchange.
9.20.4.4 Exposure Limit

Bearings did not impose any gross position limit on Leeson’s proprietary
trading activities because it felt that there was little price (directional) risk
attached to arbitrage operations. As per rule, the position at the close of
business must be flat. However, they did not consider the basis and
settlement risk. The former arises because the prices in two markets do not
always move in tandem, and the latter occurs because different markets have
different settlement systems which create liquidity and funding risks.
9.20.5 Lack of Supervision

Theoretically, Leeson had lots of supervisors; in reality, none exercised any
real control over him. Bearings operated a ‘matrix’ management system,
where managers who are based overseas report to local administrators and
to a product head (usually based at head office or the regional headquarters).
Leeson’s Singapore supervisors were James Bax, regional manager of South
Asia and a director of BFS, and Simon Jones, regional operations manager of
South Asia, also a director of BFS and chief operating officer of Bearings
Securities Singapore. Jones and the heads of the support functions in
Singapore also had reporting lines to the group-wide support functions in
London. Yet, both Bax and Jones told the BoBS inquiry that they did not feel
operationally responsible for Leeson. Bax felt Leeson reported directly to
Baker or Walz on trading matters and to settlements/treasury in London for
back-office matters. Jones felt his role in BFS was limited only to
administrative matters and concentrated on the securities side of Bearings’
activities in South Asia. Leeson’s ultimate boss was Ron Baker, head of the
Financial Products Group. But who had day-to-day control over him? Mary
Walz, global head of equity financial products, insists that she thought
Fernando Gueler, head of equity derivatives proprietary trading in Tokyo,
was in charge of Leeson’s intra-day activities since the latter’s switching
activities were booked in Tokyo. However, Gueler insists that in October
1994, Baker told him that Leeson would report to London and not Tokyo. He
thus assumed that Walz would be in charge of Leeson. Walz herself still
disputes this claim. Tapes of telephone conversations show that Leeson
spoke frequently to both Gueler and Walz. (The bottom line, however, is that
Gueler reported to Walz.) The following two incidents illustrate the
recalcitrant attitude of Bearings’ management.
The first involves two letters to BFS from SIMEX. In a letter dated 11
January 1995, SIMEX senior vice president for audit and compliance, Yu
Chuan Soo, complained about a margin shortfall of about US$116 million in
account ‘88888’ and that Bearings had appeared to break SIMEX rule 822 by
previously financing the margin requirements of this account (which
appeared in SIMEX’s system as a customer account). SIMEX also noted that
the initial margin requirement of this account was in excess of US$342
million. BFS was asked to provide a written explanation of the margin
difference on account ‘88888’ and of its inability to account for the problem
in the absence of Leeson. No warning lights went off in Singapore. No one
investigated who this customer really was and why he was having
difficulties in meeting margin payments or why he had such a huge position
or the credit risk Bearings faced if this ‘customer’ defaulted on the margins
that Bearings had paid on its behalf. A copy of the letter was not sent to
210 Option Trading
operational heads in London. Simon Jones did not press Leeson for an
explanation; indeed, he dealt with the matter by allowing Leeson to draft
Bearings’ response to SIMEX.
The second incident did come to the attention of London, but again was
dealt with unsatisfactorily, perhaps because Bearings’ personnel themselves
were unsure about what really happened. At the beginning of February 1995,
Coopers & Lybrand brought to the attention of London and Simon Jones the
fact that US$83 million apparently due from Spear, Leeds & Kellogg (SLK), a
US investment group, had not been received. No one is sure how this multi-
million dollar receivable came about. One version of events is that BFS,
through Leeson, had traded or broked an over-the-counter deal between SLK
and BNP, Tokyo. The transaction involved 20,050,000 call options, resulting
in a premium of 7.778 billion (US$83 million). The second version was that
an ‘operational error’ had occurred; that is a payment had been made to a
wrong third party in December 1994. Both versions had very serious control
implications for Bearings. If Leeson had sold or broked an OTC option, it
should have been considered as an unauthorized activity. Yet he was not
admonished for doing so; nor is there any record of Bearings’ management
taking any steps to ensure that it did not happen again. If the SLK receivable
was an operational error, Bearings had to tighten up its back-office
procedures.*
9.21 SHORT STRADDLE

If an investor believes that the market will remain in a tight range, then the
most suitable strategy can be short straddle. Short straddle position is
created by selling both call options and put options of the same expiry and
same strike price. For example, if the trader has taken short on both call and
put options at the strike rate of 100, for a call premium of Rs. 3 and a put
premium of Rs. 2.10, and if the market/stock remains in the range of Rs.
105.1–Rs. 94.90, the investor will make profit. But on the other hand, above
and below the prescribed range, the trader may incur unlimited losses. For
this strategy, the maximum profit is limited to the premium received and the
maximum loss is unlimited. The maximum profit the investor can gain is
Rs. 5.10 if the market/stock closes at Rs. 100 (Table 9.23; Fig. 9.21).
Table 9.23
Strike Premium
Sell call 100 3
Sell put 100 2.10
(Contd.)
*Source: Financial Services and System, Dr. Sasidharan and Alex K Mathews.
Stock at Pay off Pay off Net

expiration short call short put pay off
(100) (100)
80 3 –17.90 –14.90
85 3 –12.90 –9.90
90 3 –7.90 –4.90
95 3 –2.90 0.10
100 3 2.10 5.10
105 –2 2.10 0.10
110 –7 2.10 –4.90
115 –12 2.10 –9.90
120 –17 2.10 –14.90
125 –22 2.10 –19.90
10.00
8.00
Profit
6.00
4.00
2.00
0.00
80
85
90
95
100
105
110
115
120
125
–2.00
–4.00
Loss
–6.00
–8.00
–10.00 Strike price
10.00
8.00
Profit
6.00
4.00
2.00
0.00
80
85
90
95
100
105
110
115
120
125
–2.00
–4.00
Loss
–6.00
–8.00
–10.00
Fig. 9.21 Short straddle

212 Option Trading
9.22 LONG STRADDLE

If the underlying volatility is expected to rise and a single directional move is
also expected, then one can buy both call options of an underlying asset at a
fixed strike and a fixed maturity. The risk is limited to the extend of the
premiums paid to purchase the options. In the following example Rs. 3,630
will be the maximum loss if the trader buys 100 call option and 100 put option
at the strike price of 970 (Table 9.24; Fig. 9.22).
Table 9.24
Strike Premium
Long call 970 20.80
Long put 970 15.50
Index at Pay off Pay off Net

expiration long call long put pay off
(970) (970)
910 – 20.8 44.50 23.70
920 – 20.8 34.50 13.70
930 – 20.8 24.50 3.70
940 – 20.8 14.50 – 6.30
950 – 20.8 4.50 – 16.30
960 – 20.8 – 5.50 – 26.30
970 – 20.8 – 15.50 – 36.30
980 – 10.8 – 15.50 – 26.30
990 – 0.8 – 15.50 – 16.30
1000 9.2 – 15.50 – 6.30
1010 19.2 – 15.50 3.70
1020 29.2 – 15.50 13.70
1030 39.2 – 15.50 23.70
60.00
45.00
Profit
30.00
15.00
0.00
910
920
930
940
950
960
970
980
990
1000
1010
1020
1030
– 15.00 Long put

Loss
– 30.00 Net pay off
– 45.00 Long call

Strike price
– 60.00
(Contd.)
60.00
45.00
Profit 30.00
15.00
0.00
910
930
950
970
990
1010
1030
–15.00
Loss
Long put
–30.00
Net pay off
–45.00 Long call
–60.00
Fig. 9.22 Long straddle
9.23 COVERED CALL WRITING

Call option writing (option selling) is of two types, namely ‘covered call
writing’ and ‘naked call writing’. The former strategy is built by buying stock
from the spot and writing its call in the option market, or holders of a stock
can also write its call options. It is a hedge position and one of the popular
strategies for serious option traders.
On the other hand, selling call option alone is called ‘naked call writing’,
which involves high risk because if the underlying stock increases, the writer
of the option will lose substantially. The purpose of the covered call strategy
is to generate income from the sale of the call, and also some of the upside
potential of the stock.
Usually, the covered call writer believes that the stock is substantially
priced and offers some upside potential for price appreciation. Thus, an out-
of-the-money call is written. If his calculation is right, then he will receive the
call premiums and also some price increase (up to the strike price). On the
other hand, if he is wrong, and the stock is down, the loss on the stock is
cushioned by the retention of the option premium.
For example, Mr. A, who buys TELCO 3300 stocks at a price of Rs. 165,
assumes that during the month the stock has a potential to move above Rs.
168. Thus, he sells its call with strike at 170 (out-of-the-money) for a premium
of Rs. 3 (maturing on 29 May, lot size 3300). While writing the call for Rs. 3,
he earns Rs. 9900, which, in turn, reduces the cost of acquisition from Rs. 165
to Rs. 162.
After writing the call, three situations may arise:
1. The stock moves above the strike of Rs. 170.
2. The stock trades around Rs. 165.
3. The stock falls below Rs. 162.
In the first situation, as soon as the stock moves above Rs. 170, Mr. A
covers the short call position in the option at a loss, and at the same time he
sells the stock for a profit at Rs. 170.
214 Option Trading
In the second scenario, if the stock stays flat during the lifetime of the
option, Mr. A can pocket the whole premium of Rs. 9900, and he may sell his
stock at Rs. 165.
In the third situation, if the stock starts trading below Rs. 162, then Mr. A
can liquidate the stocks in the spot market and cover the short position in the
option market, which will be less than his sold premium. Buying high-
dividend-yielding stocks and writing its calls is an attractive cash
management tool.
The disadvantage of the covered call strategy is that if the call is exercised,
delivery of the stock will not take place because now in India it is settled in
cash. If the holder exercises his option, the writer of the option will come to
know the obligation only on the next day morning, when the stock can open
even at a lower side gap.
9.23.1 Covered Call Writer

Buying a stock in the cash market and selling its call is called covered call
strategy. An investor can buy stock futures instead of stocks and sell its call
options. The call premium received will act as a cushion for a downward
movement in the stock prices. Consistent call writing is an art, especially in a
falling market. Normally, investors write out-of-the-money calls in a bullish
market. Sometimes in-the-money options are also written to get maximum
protection (Table 9.25).
In India, options are settled in cash, whereas in many developed countries
it is settled in stock. In India option writers will have to pay the difference,
i.e., strike price at which we sell call option + premium received while
writing call – exercise price. Even though it can be a loss while early exercise,
as call writer owns his stock future which can be sold (if he wants) at around
exercise price, it will reduce initial capital.
9.24 PROBABILITY
Probability, in simple terms, is the chance of occurrence of an event.
Statisticians generally quote throwing a dice as an example. Dice is used in
gambling where we throw the dice to get a specific number. The dice has six
sides, and the player throws the dice to get the specific number he desires.
The number required by the player is only on one side of the dice. By using
probability, we can find out the pattern of occurrences. For example, if we
want to find the probability of getting an even number, how many times
should we throw the dice?
The numbers marked on the sides of the dice are 1, 2, 3, 4, 5 and 6, and the
even numbers are 2, 4 and 6. This means, out of six numbers, three are even
and the other three are odd. Hence, the probability of getting an even number
can be 3/6 or ½. So, we can assume that there is a probability of getting an
even number on every second throw.
Probability is only an estimation. It may or may not happen. Hence, the

risk of non-happening is also present.
Probability can be a continuous probability or a discrete probability. In
the case of continuous probability, the events appear in a continuous sample
space, for example the points in a line. The discrete probability events occur
in a countable sample space, for example throwing a dice. The two important
theorems of probability are the additional theorem or total probability and
the multiplication theorem or compound probability.
The additional theorem or total probability states that if the events are
mutually exclusive, then the probability of happening of any one of them is
equal to the sum of the probabilities of happening of the separate events.
The second theorem of compound probability states that the probability
of simultaneous occurrence of two events, A and B, is equal to the probability
of one of the events multiplied by the conditional probability of the other,
given the occurrence of the first.
9.24.1 Probability of Stock Price Moving Downward

Buying or holding stocks and selling call option at higher strike price is
known as covered call writing. Covered call writing gives some protection to
the writer at lower levels. For example, if Mr. A buys 200 Infosys at Rs. 1400
and writes one month of 1500 Infosys call at Rs. 50, the call premium will act
as a protection at the lower level. Here, Mr. A will get downward protection
up to Rs. 1350 (1400 – 50). He can calculate the probability of the asset price
being below the protected level at expiry in one-month time, with the help of
implied volatility of Infosys. Implied volatility is the best predictor of the
future volatility.
The option contracts are based on the assumption that either the
underlying asset price will go up or the underlying asset price will go down.
A call buyer will always hope for an upward movement of price so that he
can increase his pay off, whereas a put buyer will be happy if the underlying
asset price goes below the strike. The probability of the future value of an
underlying asset moving down to a desired lower level can be estimated
using the probability distribution as follows:
æ ln(Q/P ) ö
P (below Q) = N ç
è s T – t ÷ø
where
P (below Q) = Probability of asset price going below Q on expiry
Q = Price level of the downside protection (asset price –
premium)
ln = Natural logarithm
P = Current asset price
216 Option Trading
s = Volatility of the asset for the period of the option

N = Cumulative normal distribution
(T – t)/365 = Life of option expressed in the decimal of the year
Example
Asset price Rs. 1150, strike price Rs. 1200, implied volatility 56%, premium
Rs. 50 and contract period from 28 March 2008 to 30 April 2008. A trader can
find out the probability of the asset price going down to Rs. 1100 by applying
this formula.
Q = 1100 (1150 – 50)
P = 1150
s = 0.56 (56%)
Ö(T – t)/365 = 0.2867 (Ö(30/365))
æ ln(Q/P ) ö
P (below Q) = N ç
è s T – t ÷ø
æ ln(1100/1150) ö
P (below 1100)= N ç
è 0.56 ´ 0.2867 ÷ø
æ ln(0.9565) ö
= Nç
è 0.1605 ÷ø
= N (– 0.2771)
= 1– N (0.2771)
= 1 – 0.6064
= 0.3936
= 39.36%
This indicates that there is 39.36% probability of the price of the
underlying asset moving down to 1100.
9.24.2 Probability of Stock Price Moving up

Writing call options is riskier, because of unlimited loss, if the underlying
asset moves above the protection level. For example, spot Nifty is at 3000
and Nifty one month 3100 calls is at Rs. 120. If you want to write the call at
Rs. 120, your upside protection is at 3220 (3100 + 120). If Nifty moves up
above 3220, you may stand to lose. Here, you can calculate the probability of
Nifty being above 3220 using Nifty call’s implied volatility.
The probability of the future value of an asset reaching a desired upper
level can be estimated by applying the same formula, but replacing the
values.
P (above Q) = 1 – P (below Q)
æ ln(Q/P ) ö
P (above Q) =1 – N ç
è s T - t ÷ø
where
P (above Q) = Probability of asset price going above Q on expiry
Q = Price level of the upside protection (strike price +
premium)
ln = Natural logarithm
P = Current asset price
s = Volatility of the asset for the period of the option
N = Cumulative normal distribution
(T – t)/365 = Life of option expressed in the decimal of the year
Example
Asset price Rs. 100, strike price Rs. 110, option premium Rs. 5, implied
volatility of the asset 35%, contract period from 27 January 2008 to 27 March
2008. The breakeven level of the trader in this case is Rs. 115 (strike price Rs.
110 + option premium Rs. 5). Any amount above this level would be his
profit. The probability of the price going above this level can be verified by
applying the above formula as follows:
Q = 115 (110 + 5)
P = 100
s = 0.35 (35%)
Ö(T – t)/365 = 0.4054
æ ln(115/100) ö
P (above 115) = 1 – N ç
è 0.35 ´ 0.4054 ÷ø
æ -0.1398 ö
= 1 – Nç
è -0.1419 ÷ø
= 1 – N(0.9844)
= 1 – 0.8340
= 0.1660
= 16.60 %
The result indicates that given the present conditions, the probability of
the asset price moving up above the breakeven level of Rs. 115 is 16.60%.
9.25 SPREAD TRADING

Spread trading is a strategy usually adopted in commodity futures and
options. Here, one buys an asset in one expiry and sells the same quantity in
218 Option Trading
another expiry. In India, natural rubber output remains very high in the
month of December, January and February, whereas shortage is expected in
August and September. A spread trader exploits this situation and sells the
December/January/February natural rubber futures and buys the August/
September futures. The major attraction is the low margins and low risks.
There are traders who exploit inter-exchange arbitrage by buying an
underlying stock in one exchange and selling a far-month contract in another
exchange of the same commodity and vice versa.
9.25.1 Collapse of Amaranth: A Classic Example of

Spread Trading
Amaranth is the name of an imaginary flower that never fades. But
Amaranth Advisors LLC, the US-based hedge fund manager with $9.5
billion asset base, lost heavily in their investments in natural gas futures. The
First Post, the online daily magazine, published a report on 23 September
that Amaranth had admitted a loss of $5 billion so far in the trade. According
to an estimate by the Energy Hedge Fund Center, nearly $60 billion had been
invested in often volatile energy markets by hedge funds. No wonder, Brian
Hunter, a 32-year-old trader at the Amaranth’s trading desk, preferred to bet
extensively on natural gas trades.
After 2000, more capital came to the equity and commodity derivative
markets to exploit the arbitrage opportunities. As the capital flown to the
market was high, the return from the adoption of arbitrage strategies came
down. This forced many of the hedge fund managers to create highly risky
strategies with highly leveraged positions.
They were creating positions without much consideration of weather
conditions, which normally controls the price, other than demand and
supply. Amaranth’s energy desk was run by Brian Hunter, who placed
spreads in the natural gas futures. The fund had made huge profits in the
year 2005 while trading in natural gas, because of Hurricane Katrina’s
devastation. In the year 2006, they had created a spread position by taking
long natural gas futures March 2007 contracts, and April 2008 shorts were
created against the long futures . Their view on natural gas was bullish on
the short term and bearish on the long term.
Each natural gas future contract is 10,000 million BTUs or 10 million cubic
feet of gas, which means for each 1 point movement in price, the contract
value changes by $10,000.
Natural gas futures have plunged 17% during end of September. ‘The
losses may have been exacerbated by Amaranth’s attempt to exit bets on
rising prices’, said Robert Van Batenburg, head of research at Louis Capital
Markets LP in New York. The near-month long futures dropped sharply, but
the far-month contract remained weak, and the fall was comparatively low.
The lowest risky trading strategy gave a whopping $6 billion dollar loss to
the firm.
Analysts estimate that in order to fund his positions, Hunter borrowed $8
for every $1 of Amaranth’s own funds. When the bets went in his favour, he
could pay back the debt and keep the rest of the profit for Amaranth.
However, the inverse happened. The bets went against him, and his
borrowing amplified his losses.
To quote The Wall Street Journal, ‘Much of the blame is being put on a single
trader, Brian Hunter, 32, a Canadian. Hunter’s bold bets and deep
understanding of the natural gas market had propelled him through Wall
Street and into Amaranth, which is based in Connecticut. Such was his
success in trading natural gas futures, or bets on the future price of the
commodity, that Amaranth allowed him to work from his home in Calgary,
where he drove a Ferrari in summer and a Bentley in winter’. Traders in the
natural gas market referred to Mr. Hunter of Amaranth as a ‘bully’, in
reference to not his personality but his ability to move the price of natural
gas artificially, because of the huge positions he was taking.
Energy trading has its own distinct qualities. ‘Energy trades a bit
differently from most other commodities, in that the volatilities are quite
high and liquidity can be varied and or poor’, said Michael Denton, an
energy risk expert at Towers Perrin Risk Capital. Both issues present ‘risk
control challenges’, Mr. Denton added, which can be managed by limiting
concentration and providing adequate capital to support trading. Still,
energy trading will always entail ‘significant risk’, he said, ‘because storage
and transportation are limited and demand is stochastic and highly
inelastic’.
‘In addition, data used to build quantitative models to control risk are also
more difficult to obtain or of poorer quality in the energy markets’, Denton
added. Most people investing in commodities are ‘investing on the
sustainability of the cycle, on things going higher’, said Louis Gargour, a
former RAB Capital fund manager who recently founded his own fund, LNG
Capital. Because so many people are buying and not selling, the short-term
volatility has increased, which can particularly hurt people who are highly
leveraged, as commodity traders are. ‘When the market retreats, it is vicious’,
Mr. Gargour said.
He added, ‘No one listens to the risk managers until it is too late’.
Especially the younger traders, said fund managers and long-time traders.
They say the commodity markets are full of Brian Hunters, traders in their
late 20s or early 30s, who have never traded through severe conditions like
220 Option Trading
the plummet in crude oil prices in the 1980s. Instead, they have watched as
natural gas prices, as well as prices of many other commodities, rose since
2001—unevenly, but with clear annual gains. (The trading desk Mr. Hunter
ran at Deutsche Bank suffered losses in 2003, but he contended in a lawsuit
that he personally made money for the firm that year.)
Where more experienced traders in commodities have pulled out of the
market in recent months, or have made long-term bets that these historically
cyclic investments would fall, younger traders may have been convinced the
market could keep going up, for example their peers. Emerging-market
demand for commodities and fears about petroleum supplies have created
what traders refer to as a supercycle, one that has driven prices higher, for
longer, than ever.
In a bid to stem losses, Amaranth gave up its energy trades to Citadel
Investment Group LLC, a $12 billion hedge fund in Chicago, and to New
York-based bank JPMorgan Chase & Co. The market speculated that
Citigroup Inc., the largest US bank by assets, may buy a stake in Amaranth.
Amaranth has managed money for Wall Street banks Morgan Stanley, Credit
Suisse Group, Deutsche Bank AG and Bank of New York Co., according to
US Securities and Exchange Commission filings. A $2.3 billion Morgan
Stanley pool that invests in other hedge funds had about $126 million in
Amaranth as of 30 June, according to regulatory filings. Bank of New York
allocated $10 million of a $165 million fund to the firm.
MotherRock LP, a $400 million fund run by former Nymex President
Robert ‘Bo’ Collins, shut down last August after unsuccessful bets on the
direction of natural gas. Both funds attempted to profit from spreads, or
discrepancies in price, between different gas futures contracts. Amaranth
used loans to expand its bets, increasing its losses. Hedge fund investors
should take Amaranth as a warning to do better homework before trusting
money with a fund.
9.26 CONTANGO AND BACKWARDATION

In the futures markets, sometimes the far-month contracts are traded at a
premium to the near-month contract. The far-month futures premium
attributed by higher cost of carry is known as contango. Sometimes the near-
month contracts trade at a premium to the far-month contracts because of
the anticipated supply–demand mismatch. This kind of price decline in
which far month is compared with near month is known as backwardation.
9.26.1 RanbaxyDaiichi Deal: A Case Study on

Backwardation
On 11 June 2008, Daiichi Sankyo, a Japanese drug manufacturer and founder
of Ranbaxy Lab, agreed to buy about 130 million shares from the Ranbaxy’s
promoter Malvinder Singh and his family at Rs. 737 per share and also
decided to buy 46.26 million new shares from the company at Rs. 737 per
share. It also decided to buy 23.83 million options that could be converted
into shares at Rs. 737 per share, sometime in the next 6-18 months, and to
make an open offer to the general public at a price of Rs. 737 per share up to
20% of the emerging capital, as per the SEBI regulations. This is somewhere
around 462.6 million shares. Malvinder Singh and his family get to sell all
their shares at Rs. 737, and all other shareholders get to sell only one out of
three shares they own at Rs. 737. The share buyback that opens on 8 August
is to close on 27 August. The balance two out of three shares that the investors
have in Ranbaxy will fluctuate with the market price after 27 August.
Ranbaxy futures as on 18 July 2008

Ranbaxy closing price in the spot market on 18 July 2008 (Rs. 432)
Table 9.25 Ranbaxy Futures on Different Maturity
Month Closing Net Open High Low Volume Open

Change Interest
July 433.05 –20.10 449.95 455.00 425.00 7,841,600 1,021,680
August 420.20 –24.85 441.10 442.25 417.00 1,072,800 2,170,400
September 388.30 –17.20 400.00 403.00 382.05 734,400 17,896
9.27 TRADING STRATEGIES WITH LONG-TERM

OPTIONS
After the introduction of LEAPS in India, the fascination for the calendar
spread has increased in the trading community. First, let us explain what
calendar spread is. Buying an underlying asset in the far month and selling
the same underlying asset in the near month or vice versa is called the
calendar spread. Buying December 2008 call option at the strike price of 4500
and selling October 2008, 4500 calls is said to be a calendar spread. The theta
of the short-term options will vanish faster than that of the long-term options
and will give traders immense trading opportunities. But, if the underlying
asset price changes very fast and the volatility of the long-term options
diminishes faster then the calendar spread, positions will give troubles to the
option traders.
Fig. 9.24 Nifty July option spread sheet as on July 08

224 Option Trading
9.27.1 Long-term Call/Put Options Expiring on June 2010

Spot Nifty on 14 August 2008 = 4039
Call options and put options strike price and their premiums as on 14 July
2008 (Table 9.26).
Table 9.26
Call Premium (Rs.) Put Premium (Rs.)

5000 985.20 5000 1056.05
4900 1015.65 4900 1004.30
4800 1047.10 4800 953.50
4700 1079.60 4700 903.80
4600 1113.15 4600 855.15
4500 1147.75 4500 807.55
4400 1183.50 4400 761.10
4300 1220.45 4300 715.80
4200 1258.55 4200 671.70
4100 1297.85 4100 628.80
4000 1338.45 4000 587.20
9.27.2 Short-Term Call/Put Options Expiring on 31 July 2008

2008 (Table 9.27).
Table 9.27

5000 1.8 5000 975
4900 2.15 4900 880
4800 2.85 4800 784.55
4700 4.40 4700 680
4600 7.05 4600 570
4500 12.25 4500 481.1
4400 21.3 4400 386.45
4300 38.3 4300 310.2
4200 66.6 4200 238.25
4100 106.2 4100 177.85
4000 156 4000 132.25
9.27.3 Short-Term Call/Put Options Expiring on

28 August 2008
2008 (Table 9.28).
Table 9.28 Nifty Call and Put Option Premium on July 14th

5000 13 5000 934
4900 18.5 4900 846
4800 20 4800 760
4700 30.45 4700 715
4600 40 4600 596
4500 50.95 4500 452
4400 70.00 4400 450
4300 94.4 4300 375
4200 133.3 4200 330
4100 172.6 4100 241
4000 227 4000 216.15
We have already mentioned about the spread traders activities, such as

buying options in the far month and selling them in the near month. We have
given the various Nifty options with premiums and expiries. Let us assume
that on 14 July 2008 a spread trader buys both call and put options at the
strike price of 4000 expiring on June 2010 and sells August put and calls at
the strike price of 4000.
While buying 4000 calls and puts (both one lot each) expiring on June
2010, the investor invests nearly Rs. 48,141.25 (1338.45 + 587.20/2 × 50), and
he sells the July or August Nifty 4000 calls and puts one lot each. Imagine
that the investor here writes both call and put options at 4000 August series;
thus, he gets Rs. 11,078.75 (227 + 216.15/2 × 50). As long as the investor holds
the long put and long call, he can write the near-month call options and put
options because of low risk. This process can be continued till the expiry of
the June 2010 contract. In this strategy, the investor gets 5 expiries in 2008, 12
expiries in 2009 and 6 expiries in 2010. Altogether the investor gets nearly 23
contract expiries. If everything is fine, he looks for a positive cash flow of
above Rs. 2093.10 per month (48,141.25/23 months) while writing the calls
and puts on each expiry.
If historical volatility rises, then the implied volatility of the assets also
tends to rise. In the same way, if the historical volatility falls, then the implied
volatility will also fall. Rise and fall of the implied volatility of the long-term
options happen slowly, whereas changes in implied volatility have much
226 Option Trading
impact on the short-term maturities. A spread trader should take utmost care
of implied volatility changes, which is the one and only main risk associated
with spreading.
9.28 PORTFOLIO HEDGING BY CALL WRITING

If you are holding a portfolio worth Rs. 1,000,000 and the portfolio beta is 1.5
and you are expecting a 10% market fall, then your portfolio value will
decline by 15% and your loss on portfolio will be Rs. 150,000. Hence, the
portfolio would be equal to Rs. 850,000. In this case if you want to sell call
option in anticipation of a 10% fall, how many lots of call should be written?
Assume that the current Nifty futures are trading at 5000, and you are
expecting a decline of 500 points (10%) before the contract expiry. The Nifty
4500 call option is trading at a premium of Rs. 540. One lot of Nifty is 50.
Number of calls to be written = 150,000/(540/50)
That is, portfolio loss anticipated/(premium of Nifty 4500 calls/50)
Premium of Nifty 4500 calls is 540, and the lot size is 50
Number of calls to be written = 5.55 lots = 6 lots (approx.)
That is, 6 lots × 50 × 540 premiums = Rs. 162,000
While selling the 4500 call options, you get Rs. 40 [(4500 + 540) – 5000] as
extra money (the time value). Instead, if you are selling the Nifty 5000 futures
and Nifty closed at 4500, then you will make only Rs. 500 as profit. If you are
buying the put, then you have to pay the premium, so you will attain the
breakeven slightly at lower levels.
Portfolio hedging through call writing can be used if you know the
intensity of the fall of the market. Writing American calls (stock call in-the-
money) are dangerous, so one should avoid writing the American call
options of the stocks.
9.29 PORTFOLIO HEDGING THROUGH DELTA HEDGE

Like portfolio hedging through call writing, one can hedge the risks
associated with shorting the securities in the market. Suppose you are
holding 200 shares of Infosys and you want to create a hedge against the
market risks, then you have to calculate your portfolio deltas. Stocks have a
delta of one, and different strike prices of options have different deltas.
According to the rule of thumb, at-the-money options have 0.5 delta (if the
underlying stock increases or decreases, the option premium will increase or
decrease by Rs. 0.5). Out-of-the money options have a delta of 0.25, and deep
out-of-the-money options have a delta of less than 0.01. In-the-money
options have a delta of 0.75. Deep in-the-money options have a delta of
almost one.
In the above example, you are holding 200 shares of Infosys, so you have
200 positive deltas. In order to hedge your Infosys risks, you need to create
200 negative deltas, either by selling 200 shares in stock futures market or the
Infosys call or by buying the Infosys put option.
If you have decided to hedge the risks in Infosys by selling the at-the-
money call option with 0.50 delta, you have to sell 400 call options (two lots
of Infosys calls). If you want to write the out-of-the-money call options (0.25
deltas), then you have to write eight lots of Infosys calls. Writing the deep in-
the-money call of Infosys is not advisable, because a deep in the call options
can attract early exercise. Buying Infosys put options in the money (0.75
delta) is not advisable, because the position may be either over-hedged or
under-hedged. So, deep in-the-money put (1 delta) or at-the-money put (0.5
delta) is advisable. In order to create a delta neutral position, out-of-the-
money calls and puts are used.
9.30 DIAGONAL SPREAD

Spreads are created by selling a contract in one expiry and buying a similar
contract in another expiry. Diagonal spreads are spreads, but the strike prices
in the different maturities will differ from one another. Advanced option
traders use diagonal spread on the basis of implied volatility changes.
9.31 SCALPING
If a trader can buy a commodity or futures or even an option at bid price and
can sell the same underlying contract at ask price, then the investor may
make a small profit risklessly. A scalper here looks into the theoretical price,
but always traders on bid ask differentials. In an illiquid counter, the scalpers
will take the advantage of this kind.
Summary
In the foregoing paragraphs, we have discussed extensively about various
option strategies. These strategies were mainly aimed at a bear market. We
also discussed about the traditional strategies like straddles and strangles
and how the Bearings Bank lost in option trading due to the speculative
trading done by its dealer Nick Leeson. We have explained the concept of
spread trading with examples from the Indian capital market, quoting the
cases of Ranbaxy–Daiichi Deal, and have presented the case of Amaranth as
an example of how spread trading can lead to losses also. The option
strategies discussed here are developed considering the Indian market
conditions. However, the investors, traders and professionals using these
strategies are advised to analyse the market and examine the suitability of
these strategies for their portfolio. The market analysis has to be done from
drawing data from various sources. Readers may have a doubt as to where
the reliable data can be obtained. In the next chapter, we present some of the
sources of data.
228 Option Trading
Keywords
Long put Short call Portfolio hedging
Delta hedge Bear spread Put ratio spread
Synthetic short Synthetic index futures Long combo
Long call Christmas trees Albatross Short straddle
Short strip Long guts Long call ladder
Long strangles Long straddles Covered call
Spread trading Contango Backwardation
CHAPTER 10
MARKET INFORMATION
10.1 OBJECTIVES
Having understood the basics of options, techniques of writing options and
option strategies, readers may raise a question about the source of the price
information. In this chapter we have provided information about the sources
of data relating to stock prices and indices.
10.2 INTRODUCTION
For analysis and interpretation, we need current and historical data.
Historical data can be collected from newspapers and from NSE website
(www.nseindia.com). Current and historical data for Index options, Stock
options and for Index futures and Stock futures and spot markets are
available in NSE website.
Some of the typical news paper quotes taken from www.economictimes.
com.
Figures 10.1–10.5 show some of the typical newspaper quotes taken from
www.economictimes.com.
230 Option Trading
Fig. 10.1
Market Information 231
Fig. 10.2
232 Option Trading
Fig. 10.3
Fig. 10.4
234 Option Trading
Fig. 10.5
Database from NSE Website

NSE offers an extensive data base to investors on various segments like
Equity, Derivative, Debt and IPO market. We shall look in detail how we can
get details on equities and derivatives segments from NSE website.
Derivatives: Just like data retrieving for equities, we can access information
on derivatives too. It can be obtained from Market Today, Charting and
Historical Data directly.
Fig. 10.6
Market Today: Trade statistics for the day, with number of contracts,
turnover and PC ratio of Index & Stock Options, with aggregate of F&O can
be obtained from this page. Cumulative FII positions on the derivative
segment as a percentage of total gross market position is also obtained from
this page.
236 Option Trading
Fig. 10.7
Get Quote: Quotes of selected instruments like Index Futures, Stock

Futures, Index Options and Stock Options can be obtained for the respective
expiry dates, strike prices, and option types which are available. Following
print screens on various instruments will give a clear picture on data
collection.
Source: www.economictimes.com
Fig. 10.8
Fig. 10.9
To find out the spot interest rates, we use N-S (Nielson-Siegel) parameters
using the traded bonds. From this page, you will get the N-S parameters for
the day, along with historical data of all trades and trades up to 3:00 pm.
Next in the Market Today is the Bhavcopy of Derivatives daily that gives
you the information on Futures and Options price, Net Change, % Change,
Open Interest at the end of the day, Traded Quantity, Traded number of
Contracts and Traded Value.
Fig. 10.10
Also, Archives of derivatives data can be obtained for various dates and
its print screen is Daily Settlement prices are obtained from the Market
Today by downloading from the page. Next to that, in the Daily Volatility
link, we can obtain volatility of underlying and futures in terms of daily and
annualized, with respect to applicable daily volatility and applicable
annualized volatility. Archives can also be obtained for daily volatility of
futures segment. Client wise position limits in the derivatives segment on a
daily basis, along with Archives, is published by NSE and is obtained from
the Market Today page. Base prices for illiquid contracts of stock options are
released on a daily basis.
238 Option Trading
Historical Data: Historical data on derivatives are obtained from the

Historical Data page given below.
Fig. 10.11
Archives: Lot of information on derivatives trades are included in Archives

segment.
Fig. 10.12
Historical Contract-wise Price Volume Data: In this page, historical data

on various ‘F&O’ instruments for the selected expiry dates having a data
range of 90 days can be obtained. The expiry dates and strike price are
optional fields.
Fig. 10.13
Facts and Figures

In the Facts and Figures segment, a complete data on derivatives segment,
particularly for analysis purpose is provided by NSE.
Business Growth in Derivatives Segment: In this section, F&O details on
number of contracts traded and their corresponding turnover for each days
are available in terms of daily, monthly and on an yearly basis. At present,
data is available from 2000 onwards.
Business growth in derivatives

segments (NSE)
250000000
Index futures
(in Rs. crores)
200000000
Amount
150000000 Stock futures

100000000 Index options
50000000
Stock options
0
3
9
2
6
4
5
7
-0
-0
-0
-0
-0
-0
-0
-0
02
08
07
01
05
03
04
06
20
20
20
20
20
20
20
20
Years
Fig. 10.14 Business growth in derivatives segment

240 Option Trading
Monthly Derivatives Update: A tri-monthly derivatives update is issued

from NSE with overview of F&O segment for three months and previous
month’s update on Futures and Options segment with proper analysis is
obtained. Also, derivatives update of previous months can be obtained from
Archives file.
Nifty Close on Expiry: An excel sheet giving Nifty closing values of expiry
dates for the past one year, with % change from previous close is obtained.
Quantity Freeze: Volume Freeze quantity for those stocks in the F&O
segment is obtained on a daily basis in excel sheet.
Average Quarter Sigma: Average Quarter Sigma is calculated for those
securities that satisfies the Top 500 securities criteria for the past six months
along with their corresponding market wide position limits.
Source: - www.nseindia.com
Summary
In this chapter we have seen how to gather information pertaining to markets
from the daily business news papers, where to get different information, how
to interpret the information available from the NSE website and put
ourselves in a position to check the positions of the stocks in our portfolio.
The option trading is aimed at managing risks in the portfolio of investments.
It would be interesting to know what are the risks in option trading. We are
throwing light on this aspect in the next chapter.
Keywords
Market Today Get Quote Historical Data
Archives Bhavcopy
CHAPTER 11
RISK IN DERIVATIVES
11.1 OBJECTIVES
Derivatives are tools for managing risk. In the previous few chapters we
discussed how derivatives can be used for risk management. But derivatives
themselves can be risky. In this chapter we have explained various types of
risks to which trading in option market is exposed.
11.2 INTRODUCTION
Warren Buffett, the financial Guru, says that ‘derivatives are like hell… easy
to enter and it is almost impossible to exit’. According to him, derivatives
pose dangerous incentives for false accounting, profits and losses from
derivative deals are booked straight away, even though no actual money
changes hands. In many cases the real costs hit companies only many years
later.
11.3 RISK IN OPTIONS

Options are highly complex in nature; options in India are settled in cash and
thus pose high risks. Options’ time sensitivity is the most dangerous element
in trading. As each day passes, the time value tends to come down, and it
becomes difficult for traders to make profit. Writing naked calls and puts
carries high risk. Options are extremely risky investments that need a lot of
attention and knowledge especially for preparing strategies, or otherwise
you may end up with massive losses.
11.4 IS WRITING OPTIONS A HIGH RISKY STRATEGY?

This question always arises when we discuss the risks associated with the
writing of an option to our clients. First of all, the writer of the option gets
only a nominal amount as premium. When the reward is too low, then the
risk associated with writing the options is also low. The probability of losing
money while writing options is too low. In exceptional conditions the risk
242 Option Trading
can be very high, but in a trending market, the risk in writing an option is
low. Secondly, the time decay factor always supports the writers of the
option than the buyers of the option. Many knowledgeable option writers
are using various ways and strategies to protect their risks associated with
writing of both call and put options. A knowledgeable call option writer
should always have a long position in the cash market or in the futures
market. A put option buyer is always ready to buy the underlying assets
which he might have sold at a higher rate previously, or he should always
calculate the probability of the underlying asset falling below a certain level.
This has been explained in the previous chapters.
11.5 CLASSIFICATION OF RISKS*
Liquidity risk: Liquidity risk arises when one party wants to trade in an asset
but cannot do it because of the reason that there are no perspective takers for
that particular offer. Liquidity risk becomes particularly important to parties
who are about to hold or currently hold an asset, since it affects their ability
to trade. In the case of index options, once the liquidity dries up (deep-in-
the-money call and put option becomes illiquid), option traders particularly
find it difficult to exit from the trade. Due to the high premiums, demand for
deep-in-the-money calls and puts will fall making them illiquid. Also, as the
index options are European options, the holders of options can’t exercise
their option until the expiry.
Market risk: Market risk is the risk that the value of an investment will
decrease due to movements in market factors. The Reserve Bank of India has
defined market risk as ‘the possibility of loss to a bank caused by changes in
the market variables’. According to the Bank for International Settlement
(BIS), market risk is ‘the risk that the value of ‘on’ or ‘off’ balance sheet
positions will be adversely affected by movements in equity and interest rate
markets, currency exchange rates and commodity prices’. Market risk is
typically measured using a value-at-risk methodology. The price of a stock
depends on fundamental values, but sometimes the prices can fluctuate due
to various other reasons like interest rate variations, inflation, geo-political
tensions etc. For example, an investor is expecting very strong quarterly
numbers from Infosys, which is expected to announce the quarterly number
on 13 April 2007, and expecting 10% price appreciation from the current
levels. So s/he bought 100 shares of Infosys at a price of Rs. 2000 on 10 April
2007. As expected, the company came with strong quarterly numbers on 13
April 2007, but due to RBI’s decision to hike the CRR on the same day, the
stock market (the Nifty) crashed by 150 points. Even though the quarterly
numbers of Infosys were good, the stock closed at Rs. 1920 due to Infy’s beta
relationship with Nifty. The four standard market risks are equity risk,
interest rate risk, currency risk and commodity risk.
*
Sasidharan K and Alex K Mathews, Financial Services and System.
Risk in Derivatives 243
Financial analysts are using various methods to reduce the market risk of
a security or an underlying. The most preferred method is known as hedging.
Holding the financial asset and selling the indices or selling an underlying
which has highest correlation with the underlying asset held by you, that is
holding SBI stocks in hand (SBI is an index heavy weight) and selling PNB
(PNB is also a heavy weight but has low weightage comparing with SBI.)
Futures and options are said to be the best products to hedge the market risks.
11.6 ELIMINATION OF MARKET RISK THROUGH

HEDGING
The major risk associated with the financial market is market risks. The
spillover of volatility, political uncertainties, geo-political tension and
inflationary trends all come under the roof of market risk. If an investor is
able to reduce the market risk to a certain extent, he can make profits easily.
Market risk can be eliminated by buying put options of Nifty or of stocks.
We can hedge the market risk by shorting the Nifty futures and stock
futures or by buying the put options of the stock options or by buying the
index options. If the investor is looking for 100% hedge, then one has to apply
the delta neutral strategies. Stock futures, index futures and stocks-in-hand
are all having delta of one. Suppose, you are holding 250 shares of ABB stock
(one lot), it means that you are holding 250 positive deltas. If you want to
hedge your risk by buying the put option, then you have to bring down the
+100 deltas to neutral, by buying ABB put options or Nifty put options.
Generally speaking, all at-the-money put options are having delta of 0.5; all
in-the-money put options are having delta very close to 0.75 and all deep-in-
the-money put options are having delta of one. On the other hand, if you are
buying the out-of-the-money put option, then your delta position will only
be 0.25, and deep-out-of-the-money put options are having almost 0.1 deltas.
To elaborate the same, assume that you are holding 250 ABB shares (one
lot), and you want to hedge the stock’s risk at least 99%, then you have to buy
at least 2 lots of 0.5 delta at-the-money put options of ABB. So your total
delta position will come down to zero. On the other hand, if you are holding
250 shares of ABB and would like to buy a deep-in-the-money put option,
then purchase of 1 lot of deep-in-the-money put option is sufficient to protect
your risks in the portfolio.
There are groups of traders in the US and other stock exchanges known as
market makers; they always recalculate their portfolio deltas on regular basis
in order to reduce the market risk. In India options are so complex that
investors are reluctant to trade freely in the options market.
Interest rate risk: Interest rate is the one of the key factors affecting price
movements of stocks, bonds and currencies. If the interest rates are moving
up, then the stock prices may tend to stay lower because the purchaser of the
stock, who uses the funds borrowed for the investment, has to pay a high
rate of interest for the borrowed fund. For example, Mr. Alok borrowed four
lakh rupees from a financier at the rate of 13% per annum, in anticipation of
marking a return of 25% while investing in equities. Assume that the interest
244 Option Trading
rate has gone up from 13% to 18%. In this case, Mr. A may not borrow funds
because it is less rewarding to him. It means that higher the interest rate,
lower the demand for stocks.
When the interest rate moves up, the call option premium will move up
and the premium of put option will come down (Figs. 11.1 and 11.2).
OPTION CALCULATOR BASED ON BLACK–

SCHOLES
STRIKE PRICE 100
SHARE PRICE 120
TIME TO EXPIRY 23
VOLATILITY% 47
ANNUAL INTEREST
RATE 6.5
CALL PUT
OPTION
VALUE 20.75 0.334
Fig. 11.1 Option calculator

SCHOLES
STRIKE PRICE 100
SHARE PRICE 120
TIME TO EXPIRY 23
VOLATILITY% 47
ANNUAL INTEREST
RATE 11
CALL PUT
OPTION
VALUE 20.89 0.20

Model risk: Different models are used in financial operations for valuation
of assets, pricing of products, measuring risk, etc. The risk associated is very
high with complex derivatives models, due to wrong values. For example,
LTCM suffered substantial losses due to the failure of the model they
selected.
Volatility risk: One of the key factors affecting option premium is implied
volatility. If volatility increases, the implied volatility also increases
alongside. Option writing is very dangerous if the volatility is on the rise.
Even if the underlying asset price remains the same, the option premium can
rise if the implied volatility increases.
Figures 11.3 and 11.4 show that when the implied volatility of the option
increases, even if the underlying asset price remains the same, the option
premium will also rise. In Fig. 11.3, we can see that the strike price and the
share price are at Rs. 200. The volatility is 25, the time to expiry is 17 days and
the annual interest rate is 7%. The option premium that we see in the first
diagram is Rs. 7.49 for the call option and Rs. 6.4 for the put option. In Fig.
11.4, we can see that the strike price, the share price and the interest rate
remain the same. The things that have changed are the volatility, which is at
40, and the expiration day, which has reduced to 13. Now, we can see that
both the call option premium and the put premium have come down to
Rs. 5.82 and 5.33 respectively.

SCHOLES
STRIKE PRICE 200
SHARE PRICE 200
TIME TO EXPIRY 17
VOLATILITY% 25
ANNUAL INTEREST
RATE 7
CALL PUT
OPTION
VALUE 7.49 6.4

246 Option Trading
OPTION CALCULATOR BASED ON BLACK-

SCHOLES
STRIKE PRICE 200
SHARE PRICE 200
13
VOLATILITY% 40
ANNUAL INTEREST
RATE 7
CALL PUT
OPTION
VALUE 5.82 5.33
Time risk: One of the key risks associated with option trading is the decay of
time value. As the time passes, the time value of an option quickly decreases.
So, switching from one expiry to another is the easiest way of protecting the
time value. Another way of protection can be availed by selling lower strike
options in the case of a put option and higher strike call in the case of a call
option. Sometimes, changing the option’s strike price also protects the time
value to a certain extent. Instead of selling the existing out-of-the-money put
(the time value will be eroded in out-of-the-money option very fast) which
we bought earlier, we can buy a new put option at at-the-money strike price
(where time value will be high). Time decay is the only major reason why
traders are constructing spreads. Buying at-the-money call and selling an
out-of-the-money call is a spread. In the same way, one can create spread
position by buying at-the-money put and selling an out-of-the-money put
option.
Summary
We have seen that though derivatives are tools for managing risks, they
themselves are exposed to different types of risks. These risks can be liquidity
risk, interest rate risk, model risk, volatility risk and time risk. The list is
exhaustive. As time passes, the market may bring in more complex risks
necessitating sophisticated risk management plans to mitigate these risks.

The risks also may arise due to accounting and taxation issues. In the next
chapter we are discussing about certain accounting and taxation issues
regarding derivatives.
Keywords
Risk Interest rate risk Liquidity risk
Model risk Volatility risk Risk of time
CHAPTER 12
ACCOUNTING AND
TAXATION OF OPTION
TRADING
12.1 OBJECTIVES
Having discussed about trading in F&O segment and the risk associated with
the F&O transactions, one should know the accounting treatment of these
transactions and the taxation issues involved. We will explain these two vital
issues in this chapter.
12.2 INTRODUCTION
Guidance notes on accounting of equity and stock index and on equity and
stock options have been issued by the Institute of Chartered Accountants of
India (ICAI) for the buyers and sellers in the F&O segment. Accounting
norms at various stages of positions right from the inception to the final
settlement for equity index and stock options are given in the following
sections.
12.3 ACCOUNTING NORMS FOR EQUITY AND INDEX

OPTIONS*
Given below are guidelines for accounting treatment in the case of cash-
settled index and stock options:
Accounting at the time of inception of a contract: An initial margin is
required for the seller or writer of an option to enter into the contract. This
margin is debited to the 'Equity Index Option Margin Account' or in the
'Equity Stock Option Margin Account'. Such account is shown under the
head, 'Current Assets'. On the other hand, the buyer or holder of an option
need not be paid any margin, but only the premium amount. So, in the
buyer's book, premium is debited to 'Equity Index Option Premium Account'
or 'Equity Stock Option Premium Account'. The premium received by the
seller/writer is credited to 'Equity Index Option Premium Account' or Equity
Stock Option Premium Account'.
* Source: www.nseindia.com (NCFM Derivative Module)

250 Option Trading
Accounting at the time of payment/receipt of margin: Payments

received by the seller for the margin is credited to the client's account and the
payments to be made by the seller is debited to the client's bank account. If
client has already deposited lump sum amount with the trading member for
margin purpose, then the amount of margin from such account is debited or
credited, as the case may be.
Accounting for open positions: Equity Index and Equity Stock option
premium account is shown under the head Current Assets and Current
Liabilities. In the case of a buyer/holder, a provision is made for the amount
by which the premium paid for the option increases or decreases for the
premium prevailing on the balance sheet date. This provision is shown as
deduction from Equity Index or Equity Stock Option Premium and is shown
under 'Current Assets'. In the case of option seller/writer, provision is made
for the amount by which premium prevailing on the balance sheet date
exceeds the premium received for that option. This provision is credited to
provision for loss on 'Equity Index option or Equity Stock Option Account' as
the case may be.
Accounting at the time of final settlement: The buyer or holder of an
option will incur premium as an expense and will debit the profit and loss
account by crediting 'Equity Index or Equity Stock Option Premium
Account'. In addition, the buyer/holder will receive a difference of the
amount between the final settlement price and the strike price on the expiry/
exercise date and is considered as an income. On the exercise of the option,
the seller or writer will get premium as the income and credit the profit and
loss account by debiting Equity Index Option Premium Account or Equity
Stock Option Premium Account. In addition, seller or writer has to pay
adverse difference, if any, between final settlement price and strike price.
Stock exchange will credit the margin paid towards option and is credited to
the Equity Index or Equity Stock Option Margin Account.
Accounting at the time of squaring off of an option contract: On the
squaring off of option contracts, a difference between premium paid and
received is transferred to the profit and loss account of the client. If an option
expires unexercised at the time of settlement, then the accounting entries
will be same for cash settled options. If options are exercised, then shares are
transferred in cash at the strike price. In the case of a call option being
exercised, buyer or holder will receive equity shares at the strike price, for
which the call option was entered and should debit relevant equity shares
account and have to credit cash. In the case of a put option being exercised,
the buyer or holder of put option has to deliver equity shares for the strike
price at which put option was entered into. The buyer or holder must credit
the relevant equity shares account and debit cash. For the seller or writer of a
call option, equity shares have to be delivered for the strike price at which
the call option was entered into, thereby crediting relevant equity shares
account and debit cash. The seller or writer of a put option will receive equity
Accounting and Taxation of Option Trading 251
shares for the strike price at which put option was entered into and must
debit relevant equity shares account and debit cash. Also, premium paid or
received is transferred to the profit and loss account with accounting entries
as same as those in cash settled options.
12.4 CHARGES IN F&O SEGMENT

We already mentioned that the maximum brokerage that is chargeable by a
trading member for the transactions executed in F&O by clients is fixed as
2.5% of the contract price, exclusive of statutory levies like SEBI turnover fee,
service tax and stamp duty. The service tax charge is about 12% of the
brokerage, as mentioned by the exchange. Education cess to be paid is 2% of
the service tax. Stamp duty for the F&O segment is 0.002% of the transaction
value of the contract. Exchange levy is 0.0021% for the F&O segment.
Securities transaction tax (STT) (needs to be paid by the sellers of the
transaction only) is 0.017% in the F&O segment.
12.5 TAXATION OF DERIVATIVES

It is mandatory to pay STT on all derivative transactions which are traded in
a recognized stock exchange. The seller of the transaction is liable to pay tax
on the derivative contract, in the case of both futures and options. In the case
of options, the taxable amount is calculated based on the option premium of
stock or index options times' market lot of the contract.
Consider the case of options. If a client sells Infosys with a strike price of
1260 call for Rs. 80 (lot size of 132), STT is calculated in the following manner:
1. 1620 call option's value = Rs. 10,560 (Rs. 80 x 132)
2. STT payable = 0.017% x 10,560
= Rs. 1.79
12.6 INCOME TAX

Security transactions are subject to the capital gains tax payable for short-
term and long-term gains. According to Section 73 (1) and 43 (5) of the
Income Tax Act, any loss, computed in respect of a speculative business
carried on by the assessee, shall not be set off except against profits and gains,
if any, of speculative business. Section 43 (5) of the Act defines speculation as
a transaction in which a contract for purchase or sale of any commodity,
including stocks and shares, is periodically or ultimately settled otherwise
than by actual delivery or transfer of the commodity or scrip. However, the
following transactions are exempted from the purview of speculation:
- A contract in respect of stocks and shares entered into by a dealer or
investor therein to guard against loss in his holding of stocks and
shares through price fluctuations.
252 Option Trading
- A contract entered into by a member of a forward market or a stock

exchange in the course of any transaction in the nature of jobbing or
arbitrage to guard against loss, which may arise in ordinary course of
business as such member.
These provisions necessitate derivatives to be considered as speculative
transactions where actual delivery does not take place except in the above
two exceptions. As a result, the hedging and arbitrage will have to be
considered normal securities transactions and accordingly the tax rules
applicable for securities transactions will have to be made applicable to these
transactions also. But, the problem arises in the case of index options and
index futures where physical delivery of underlying is not possible and
accordingly the hedger or arbitrageur loses the facility of set-off as available
in the case of shares and securities.
This being the case with Income Tax Law, the Securities Contracts
(Regulations) Act 1956, as amended up to 2004, permits derivative trading in
recognized stock exchanges. Section 18A of the Act reads as 'not
withstanding any thing contained in any other law for the time being in force,
contracts in derivatives shall be legal and valid if such contracts are (a)
traded on a recognized stock exchange and (b) settled on the clearing house
of the recognized stock exchange in accordance with the rules and bye-laws
of such stock exchange. Section 2 (ac) of the above Act defines derivatives as
(A) a security derived from a debt instrument, share, loan, whether secured
or unsecured, risk instrument or contract for differences or any other form
of security and (B) a contract which derives its value from the prices, or index
of prices, of underlying securities'. Again Sub-section (h) (ia) of the same
Section includes derivatives under securities. All these indicate that
derivatives are legal form of securities transactions and therefore there is no
reason for any doubt regarding treatment of derivatives also as securities for
taxation purpose.
Summary
We have seen that the ICAI has issued extensive guidelines regarding
accounting of option transactions, and how these liabilities under these
heads are to be shown in the balance sheet. We have also discussed the
taxation issues and found that ambiguity still prevails with regard to carry
forward of losses and set off of losses on derivative trading. Before we
conclude this chapter, two other important areas to be covered are the
technical terms used in F&O operations and clarifying some of the general
doubts on F&O trading. We will cover these areas in the next two chapters.
Keywords
Securities transaction tax Brokerage charges Educational cess
Income tax Carry forward Set off
CHAPTER 13
FAQs ON OPTIONS
13.1 OBJECTIVES
In this chapter, we will clarify some of the doubts on F&O transactions raised
by various people at different points.
Under option trading, who is in a relatively safe position: the buyer or the
seller?
In the world of options, the buyers are in a better position than the sellers as
far as risk and rewards are concerned. As mentioned earlier, the buyer enjoys
only the right either to buy (call option) or sell (put option) and he is no way
obliged to exercise his right. If the situation is not favorable to the buyer, he
can simply walk out of the contract and the maximum loss he has to incur is
the premium paid for buying the contract. Thus, the risk or loss is certain as
well as limited in the case of an option buyer.
On the other side, the return to the buyer may be fairly large and no limit
can be placed in advance. In the case of a call option buyer, profit emerges
when the market value of the contracted asset exceeds the strike price, and it
goes on increasing so long as the price of the asset is moving up. Similarly, a
put option holder makes profit when the market value of the asset in
question decreases below the strike price, and every fall in the value of the
asset will add up to his profit.
From the option seller’s point of view, the profit is fixed while the risk or
loss is unlimited. This is due to the fact that the seller is obliged to honour the
rights of the option buyer. Take the case of a call option writer. If the price of
the asset is going up and surpassing the strike price, the option buyer will
exercise his/her right to buy and the option seller may have to buy the
security from the market at a higher price in order to honour his/her
commitment. No limit can be placed to such losses in advance. On the other
hand, his/her income from this deal is limited to the premium he/she
received earlier.
The case of a put option writer too is not different in case the value of the
contracted asset is falling. As the market price of the asset falls below the
strike price, the put option buyer will exercise his/her right to sell, and this
254 Option Trading
right has to be honoured by the option writer by purchasing the asset at the
strike price. The loss will continue to widen with every fall in the value of the
asset in relation to the strike price. On the other hand, the maximum income
to the option seller is limited to the extent of the premium received.
Is there a way out to minimise losses of option sellers?
Yes. As in the case of option buyers, option writers too have the freedom to
square up their positions by entering into an opposite transaction. For
example, a call option seller can square up his sale position by purchasing a
call option on the same asset. Similarly, a sale position on a put contract can
be settled by purchasing a put option on the same asset. In both the cases,
care should be taken to ensure that the options bought are identical to the
options sold in all respects like strike price, expiry date etc.
Needless to say, options are bought or sold on the basis of the expectation
of the trader regarding the probable price movements of the underlying asset
in future. For example, a call option is bought when the buyer expects an
increase in the price of the asset before the contract expires, and he/she
hopes to make a profit by executing his/her right (purchase at the strike
price) and then selling the asset at the market price which is expected to be
higher than the strike price. On the other hand, the seller of the call expects
that an upward movement in the price of the asset is quite unlikely and hence
the contract buyer would not come forward to exercise his/her right.
Similarly, a put option is bought on the anticipation that the price of the
asset would fall, whereas the put option is written on the expectation that the
asset price may go up or remain steady during the tenure of the contract.
When any of these expectations is belied, the person (buyer or seller) who is
likely to be affected will square up his/her position by entering into an
opposite transaction instead of waiting for the expiry day of the contract.
What is meant by European and American options?
In the European model of options, contract buyers are allowed to exercise
their right to buy or sell (the asset) on the settlement day alone, which may
probably be the expiry day of the contract. However, buying and selling
positions could be squared up at any time in the market by entering into a
reverse transaction.
In American model of options, call or put option holders can settle their
claims by exercising the right to buy or sell on any day that falls between the
date of entry and the date of expiry.
At what price are the options settled?
All outstanding contracts on the settlement day or the date of expiry are
settled at the settlement price. The settlement price is arrived at on the basis
of the market value of the underlying asset on the settlement/expiry day.
FAQs on Options 255
What are covered and naked calls?

A call option written with the possession of the underlying asset is a covered
call. Possession means the asset is either in hand or the option writer is
having a purchase position of the asset in the cash market. Naked call is one
where the seller of the call option does not have the possession of the
underlying asset.
In the case of covered calls, the risk to the option writer is lower as
compared to naked calls. Even if the price of the asset is shooting up in the
cash market, the covered call option writer will not be affected much since he
has already acquired the asset from the market to fulfil his obligation of
delivering it to the option buyer.
Who can buy put options?
Any investor who is ready to pay the put option premium upfront to the
exchange can buy put options. Normally, investors with a bearish attitude
buy put options. The maximum risk is limited to the extent of premium he
pays upfront. The maximum profit is unlimited in the case of a buyer of the
put option.
What are the risks for an option writer?
An option writer’s risk is unlimited, while his/her gains are limited to the
premium received. When a physical delivery uncovered call is exercised, the
writer will have the obligation to deliver the underlying stock, at the strike
price. In the case of cash settlement the writer of the call option has the
obligation to pay the difference between exercise price minus strike price of
the call reduced by the premium received for writing the call. The writer of a
put option will face the risk of loss if the value of the underlying asset falls
below the strike price. If it is settled in stock, the writer of the put has the
obligation to buy the stock at the strike price, when underlying asset price is
below the strike price.
Who can be the seller of put options?
Any investor who is ready to take the unlimited risk of writing put options
can sell put options. The risk in writing a put option is unlimited, so the
exchange will collect sufficient collaterals initially. The writer has to pay
mark-to-market margins also. If there is deficiency of margins, then the
broker will advise the investor to liquidate the position. Generally,
institutional investors are writing put options.
How is the strike price selected for buying puts?
Option premium contains both intrinsic and extrinsic values. Out-of-the-
money put options attract high extrinsic value and these strike prices will
retain this quality till expiry. But, if you are buying some in-the-money put
options, you may pay less for the extrinsic value because very soon these
strike prices can become in-the-money options.
256 Option Trading
What is the logic behind writing the put options?

Investors who find value in stocks at lower levels write the put options. For
example, Infosys is trading at Rs. 1800 and an investor is ready to buy Infosys
option below Rs. 1700. Here, the investor can sell Infosys put option of 1700
at a premium of Rs. 40. During the period of expiry, if Infosys falls below Rs.
1700, the investor can buy Infosys stock at Rs. 1700 and get Rs. 40 as put
premium. If Infosys doesn’t fall below 1700 during the period, the investor
can gain Rs. 40 per share.
Are writing Nifty puts safer than writing stocks put options?
You are aware that Nifty options are European, which means you can trade
on premiums, but cannot exercise your options during the period of the
contract. As stock options are American, an investor can exercise his option
during the maturity. European put option holders have to hold till the expiry
for exercising their put option.
How do we exercise American put options?
Imagine that you are holding Infosys Rs. 1700 put option and your cost of
acquisition is Rs. 40 per stock and the lot size is 200. Hence you pay Rs. 8000
as premium. Before the expiry of the contract, the Infosys stock falls below
Rs. 1700 and tests Rs. 1500. In this case, you are supposed to get a profit of Rs.
200 per share, and a total of Rs. 40,000 for 200 shares. Unfortunately, due to
liquidity problems, the buyer was available only at Rs. 175. That means if
you are selling your option you will make a profit of only Rs. 35,000. In this
case you can approach your broker and can ask him/her to exercise your put
option; if he/she does then you will get the intrinsic value of the option, that
is Rs. 200 per share.
After getting the intimation from the broker, NSE will find out the
perspective put writers of Infosys and inform the assignment. The writer of
the Infosys put option has the obligation to provide the intrinsic value to the
NSE in exchange of the premium he/she received while writing the put
option. Both put options and call options will be exercised only after the
closing session, and exercise price will be determined on the weighted
closing price, rather than the closing price at 3.30 pm.
How do we exercise European put options?
American options can be exercised earlier, but European put options cannot
be exercised earlier; its exercise will take place only on the expiry date. Both
American and European options can be traded on premiums. For example,
you bought a Nifty put option at Rs. 120, and after the purchase Nifty falls
down and the put option premium increases to Rs. 160. Here the investor
will have the freedom to sell the put option at a profit of Rs. 2000 (Rs. 160 –
Rs. 120 = 40 ´ 50 (lot size) = Rs. 2000).
FAQs on Options 257
How should one manage purchased put option positions?

It is advisable to manage the purchased put option positions. Several times,
we have received calls from investors asking what they would do with their
purchased put positions though they are at profits. The simple answer for
this question is book profits, in another words sell the long put and realize
the profit. The other way to manage the profitable long put position is to
liquidate existing long and buying a new put at slightly lower strike price.
Sometimes, holding the long position of put option and simultaneously
selling an out-of-the-money put is also advisable.
If you are holding a purchased put position and still you are not in profit,
it is advisable to roll over your long put to another preceding month. In other
words, exit the long put position and buy a new put position in the far month
before the expiry of the contract. Please keep in mind that the intensity of the
fall in the premium due to time decay will be higher when the expiry comes
closer.
What is meant by synthetic put options?
Earlier in the US, only call options were traded. At that time, the investors
used call options as put options; in other words, they were creating synthetic
put options. If you are selling your stocks in the market, simultaneously
selling its put options and buying call option is known as synthetic put
option. In a bearish market, investors prefer to buy put options than call
options. They are even ready to pay more premiums for the purchases of put
options than that for calls. In this situation, the call premium tends to stay
lower due to lower demand and put premium will stay very high due to high
demand. Whenever the situation persists, investors do not buy the expensive
put options, but they will sell them. Also, they sell their stocks and buy the
cheap calls. Tomorrow if the stock rises above your sale value, there would
be no problems as you are holding the call option of the stock and are going
to benefit out of it. On the other hand, if the stock falls, there is no need to
worry as you have already sold your stock to buy at lower levels, so buy it
back.
Why derivative strategies?
Derivative strategies are tailormade to various situations and different
market scenarios. But most of the derivative strategies are well suited for
index options because they are European in nature. Simple trading strategies
are adopted (bulls spread, bear spread, long straddles, long call, long put,
short futures with protective calls and long future with long put) commonly
by the investors. Strategy can be a single position or a combination of
multiple positions one strategy can be easily converted to another. Risk and
reward can be easily estimated, so an investor can create various strategies
according to his risk taking capacities. Risk-reward ratios and its probability
for success can easily be estimated in the initial phase. Derivative strategies
can be created to mitigate market risk, interest rate risk, volatility risk and
time value risk.
.
258 Option Trading
What is the difference between futures and options?

Futures contracts have similar risk profile for both the buyer as well as the
seller, but in options the risk profile is not the same. In case of options, for a
buyer, the downside risk is limited to the premium he has paid while the
profits may be unlimited. For a seller of an option, the downside is unlimited
while profits are limited to the premium he has received from the buyer.
It costs nothing to enter into a futures contract, whereas there is a cost of
entering into an options contract known as premium.
Futures are contracts to buy or sell specified quantity of the assets at an
agreed-upon price by the buyer and seller, on or before a specified time. Both
the buyer and the seller are obliged to buy/sell the underlying asset. In case
of options the buyer has the right and not the obligation to buy or sell the
underlying asset.
The futures contract prices are influenced mainly by the prices of the
underlying asset. The prices of options are affected by prices of the
underlying asset, time remaining for expiry of the contract and volatility of
the underlying asset.
What is in-the-money option?
A call option is said to be in the money when the strike price is lesser than the
current price of the underlying asset. For example, a stock option of strike
220 is said to be in the money when the current price of the underlying asset
is at Rs. 250 which is greater than the strike price.
What is the intrinsic value of an option?
Intrinsic value is the value by which the option is said to be in the money and
the value can only be positive.
Call option intrinsic value = Spot price – Strike price
Put option intrinsic value = Strike price – Spot price
What is time value of an option?
Time value is the amount that the option buyer is ready to pay the seller
hoping that the option price will grow, making it profitable when it nears its
expiration. The time value of an option cannot be a negative digit.
Who decides the option premium?
The premium of the option is not fixed by the stock exchange but calculated
using different option pricing models, market conditions and of course by
competitive bids and offers on the trading platform. The option premium is
the sum of the time value and the intrinsic value.
What is the need for investing in options?
It provides high leverage even as small amount of capital is invested; one can
take exposure in the underlying asset of much greater value. The maximum
risk involved in the trade is known to the investor in advance. It can also be
FAQs on Options 259
used as a hedge to protect ones equity portfolio from a decline in the market.
Hence, by paying a relatively small premium, an investor knows that no
matter how far the stock drops, it can be sold at the strike price of the put
anytime until the put expires.
How can the option be put to use?
When an investor hopes the price of an underlying to rise or fall in near
future, the investor can get hold of an option which gives him/her the right
to buy or sell the stock at a pre-determined price. If the investor expects the
underlying asset to rise, then s/he can go for a call option, but if his
expectation is a fall in the price of the stock, then s/he may go for a put
option which will earn him profit if the stock price falls.
How does the settlement of an option take place?
The settlement of an option takes place in two ways: one in which the
investor can sell an option of the same series which the investor is currently
holding and close the position in that option any time before expiration; the
other way is to exercise the option on or before the expiration.
Who would use index options?
Index options are effective enough to a broad spectrum of users, from
conservative investors to more aggressive stock market traders. Individual
investors may use index options to have an upper hand on market opinions
by acting on their views of the broad market or any of its sectors. The more
sophisticated market participants may find variety of index option contracts
as excellent tools for enhancing market timing decisions and adjusting asset
mixes for asset allocation. To market participants, managing the risk
involved in large equity positions may mean using index options to mitigate
their exposed risk or to increase market exposure.
What is SPAN?
Standard portfolio analysis (SPAN) of risk is a globally acknowledged risk
management system developed by Chicago Mercantile Exchange. It is a
portfolio-based margin calculating system adopted by all major derivatives
exchanges. It identifies overall risk in a complete portfolio of futures and
options, and at the same time recognizes the unique exposures associated
with both inter-month and inter-commodity risk relationships. It determines
the largest loss that a portfolio might suffer within the period specified by
the exchange.
What are KYC norms?
Know your customer (KYC) norms are mandatory details of customers
required by banks and financial institutions before opening of customer’s
account. These norms were issued by RBI and came into effect from the
260 Option Trading
second half of 2002. This was an attempt to prevent identity theft, identity
fraud, money laundering, terrorist financing, etc. from the customer’s side.
Mandatory details include proof of identity and residence. Quite often,
passport, voter’s ID card, PAN card, driving licence, ration card, electricity
or telephone bill, organization letter etc. are proofs of identity. It’s main
objective is to restrict money laundering and terrorist financing. The
objectives of the KYC framework are of two–fold: (i) to ensure appropriate
customer identification and (ii) to monitor transactions of a suspicious
nature.
What are the account opening procedures with a broker/sub-broker?
After selecting a SEBI-approved broker/sub-broker, the first step is to open
a trading account with the sub-broker. Firstly, clients have to fill in a client
registration form with the broker/sub-broker. Every client should read and
understand the Risk Disclosure document, which is issued by the stock
exchange, before trading in equities or derivatives segment. The trading
member will obtain a signed copy of the same from all clients. Secondly,
every client needs to enter into the broker/sub-broker agreement and he/
she has to read carefully the terms and conditions of the agreement, before
executing them on a valid stamp paper. The client or his/her authorized
signatory should sign on all pages of the agreement. The agreement has also
to be signed by the witnesses along with their names and addresses. The
client has to give in details such as name, address, copy of client’s PAN card,
photo identity documents, details of bank account, proof of residence etc.
What is the maximum brokerage chargeable by a broker/sub-broker?
The maximum brokerage that can be charged by a broker/sub-broker is 2.5%
of the contract price, and there is no stipulation on minimum brokerage that
can be charged to the clients. The trade price should be shown separately
from the brokerage charged. The maximum brokerage that can be charged is
Rs. 0.25 per share/debenture or 2.5% of the contract price per share/
debenture, whichever is higher. Any additional charges that the trading
member can charge are securities transaction tax, service tax on brokerage,
stamp duty etc. as may be applicable from time to time. The brokerage and
service tax are required to be indicated separately in the contract note.
What are the different taxes to be paid by the customer?
The different taxes payable by the customer includes:
· Service tax (charged as 12% of the brokerage)
· Education cess on service tax (3% including secondary and higher
educational cess at 1% of service tax from May 11, 2007)
· Security transaction tax (STT), which is charged based on the volume
traded by the client
- for cash delivery it is 0.125%
- for cash speculation it is 0.025% (sell side only)
- for F&O, it is 0.017% (sell side only)
FAQs on Options 261
· Education cess on STT is nil

· Exchange levy, which is charged on volume
- for cash market, it is 0.0035%
- for F&O, it is 0.0021%
· Stamp duty, which is charged on volume
- for cash delivery, it is 0.01%
- for cash speculation, it is 0.002%
- for F&O, it is 0.002%
What is contract note and trade confirmation?
It is mandatory that a stock broker should give trade confirmation and
contract notes to the client for every transactions done. The main details that
the contract note contains are:
à The name, address and the registration number of the member broker
with the SEBI.
à Dealing office address, telephone number and the code number of the
member given by the exchange.
à Name of the authorised signatory or partner or the proprietor.
à Client name and code number.
à The number and kind of security bought or sold by the client.
à Trade number and the time at which the trade was executed.
à Time of entering the order and the order number.
à The purchase/sale rate and the brokerage.
à Securities Transaction Tax (STT), Service Tax rates and other charges
that are levied by the broker is shown on the contract note.
à Appropriate stamps have to be affixed on the contract note or it is
mentioned that the consolidated stamp duty is paid.
à Signature of the stock broker or the authorized signatory.
You have different strategies in option trading. Can we use all these
strategies in index and stock options?
No. All these strategies are not good in the case of stock options, because
these options are American in nature.
When should we exit from the strategy?
One can hold till date of expiry or can send it for automatic expiration,
especially strategies like butterflies. Strategies like long call, long put, etc.
can be exited before expiry if there is a good profit.
Summary
We have answered frequently asked queries raised by our clients as well as
investors. We will answer the questions from investors on a continuous basis
through our website www.derivativeforum.com.
262 Option Trading
Keywords
Covered and Naked calls Synthetic Put option SPAN Intrinsic Value
Time value KYC Securities Transaction
Tax Education Cess Service Tax Exchange
Levy Stamp Duty Contract Note
Trade confirmation
CHAPTER 14
DERIVATIVE GLOSSARY
14.1 OBJECTIVES
The objective of this chapter is to familiarize the investors and practitioners
with the terminologies used in options and futures trading.
Alpha
The amount an investment’s average rate of return exceeds the riskless rate,
adjusted for the inherent systematic risk is known as Alpha. One way to
compute alpha is to regress an investment’s excess rate of return against the
market portfolio’s excess rate of return. The intercept in this regression is an
estimate of the risk-adjusted excess rate of return.
American Depository Receipt (ADR)
A receipt showing a claim on certain number of shares in a foreign
corporation that a depository bank holds for the U.S. investors.
Arbitrage
The art of taking advantage of the price differential of two markets.
Arbitrageur
A person who engages in arbitrage activity.
Atlantic Spread
Option strategy in which a trader holds long (or short) on an American
option and short (or long) on the otherwise identical European option—
hence, long (short) on the value of early exercise.
Asset Class
A broadly defined generic group of financial assets which includes stocks or
bonds.
Ask (Asked)
The price at which a dealer is ready to sell. Ordinarily, the ask exceeds the
bid and the bid–ask spread is what the dealer stands to make by quickly
turning around one unit of product. It is also known as offer, offered or
offering price.
264 Option Trading
Asset-Backed Security (ABS)

An asset-backed security is a type of debt security that is based on pools of
assets, or collateralized by the cash flows from a specified pool of underlying
assets. Assets are pooled to make otherwise minor and uneconomical
investments worthwhile, while also reducing the risks by diversifying the
underlying assets.
Asset Swap
A swap that converts a fixed (or floating) coupon asset into a floating (or
fixed) coupon asset. This is in contrast to the more familiar (liability) swap
that converts a fixed (or floating) coupon liability into a floating (or fixed)
coupon liability.
At-the-money Forward
Having a strike price which equals the forward price.
At-the-money
Having a strike price that which equals the spot price.
Basis
The difference between spot price of an asset and the futures price of the
same asset.
Basis Point
A basis point is a unit that is equal to 1/100th of a percentage point.
Basis Risk
Risk arising out of widening and narrowing the difference between spot and
future price.
Back Months
Futures contracts with delivery dates in the more distant future.
Benchmark Portfolio
A portfolio against which the investment performance of an investor can be
compared for the purpose of determining investment skill. A benchmark
portfolio represents a relevant and feasible alternative to the investor’s actual
portfolio and is similar in terms of risk exposure.
Best-of-two Option
A pay off which equals the maximum of two option payoffs, such as the
maximum of a call on asset 1 and a put on asset 2.
Benchmark Notes
Agency notes aimed at filling the partial vacuum in the Treasury note
market, now that the deficit appears somewhat under control. Fannie Mae
began issuing benchmark notes, and Freddie Mac and other agencies have
followed. Apparently, the U.S. Treasury is considering halting its auction of
two-, three- or five-year notes.
Derivative Glossary 265
Bid
The price at which a dealer (market maker) is ready to buy. Ordinarily, the
bid is less than the ask (q.v.), and the bid–ask spread is what the dealer stands
to make by quickly turning around one unit of product.
BidAsk Spread
The difference between the price that a market-maker is willing to pay for a
security and the price at which the market-maker is willing to sell the same
security.
Bidder
In the context of a corporate takeover, the firm making a tender offer to the
target firm.
Bid Price
The price at which a market-maker is willing to purchase a specified quantity
of a particular security.
Bet Option
A binary option.
Binary Option
An option with a pay off function that has two levels, such as zero dollars or
one million dollars.
Binary Call (Put) Option
Typically, a binary call (put) option (q.v.) that pays off nothing if the
underlying risk factor is below (above) the strike, and a constant amount if
the risk factor exceeds (is below) the strike.
BOBL Futures Option
An American option that settles into a BOBL futures (q.v.) contract. Payment
of the option premium is ‘futures-style’, which means none of it occurs
immediately, and a piece of it occurs with each daily mark-to-market. An
implication of this is that the ‘buyer’ (really, the ‘long’) may pay no premium
and the ‘seller’ (really, the ‘short’) may pay all the premium!
Book Value of Equity
The sum of the cumulative retained earnings and other balance sheet entries
classified under stockholder’s equity, such as common stock and capital
contributed in excess of par value.
Bowie Bond
A specific, $55-million issue of 10-year asset-backed bonds (q.v.) that British
rock star David Bowie issued and Prudential Insurance Co. bought. The
specific collateral consists of royalties from 25 of Mr. Bowie’s albums that he
recorded before 1990.
266 Option Trading
Bullet Bond
A bond that amortizes fully on a single date. Its cash flows consist of regular
coupon payments of interest and a final repayment of principal.
BUND Futures
The DTB futures contract on a notional long-term debt security of the
German Federal Government or the Treuhandanstalt, with a notional
interest rate of 6%. The BUND (q.v.) and other instruments qualify.
Bundle
A strip of consecutive, quarterly Eurodollar or Euroyen futures contracts.
Markets, such as Simex, offer a bundle as a convenient package of futures
contracts, without the execution risk inherent in building up the strip,
contract by contract. A trader can use bundles and packs to implement bets
on the change in shape of the forwards curve.
Buy-Write
An investment strategy that consists of buying an asset and selling a call on
it. Thus, the investor sells upside potential to elevate the rest of his/her pay
off function.
Callable Bond
A (no callable) bullet bond, minus a call option on the bond. The call price as
a function of calendar time is the call schedule.
Call Option
The right, but not the obligation, to buy the underlying asset at the
previously agreed-upon price on (European) or anytime through (American)
the expiration date.
Call Market
A security market in which trading is allowed only at certain specified times.
At those times, persons interested in trading a particular security are
physically brought together and a market clearing is established.
Call Money Rate
The interest paid by brokerage firms to banks on loans used to finance
margin purchases by the brokerage firm’s customers.
Capital Gain (Loss)
The difference between the current market value of an asset and the original
cost of an asset, with the cost adjusted for any improvement or depreciation
in the asset.
Catastrophe Bond
A bond that promises a coupon that starts out high, but drops after a suitable
catastrophe occurs. A suitable catastrophe might be an earthquake or
hurricane of sufficient magnitude and within a particular region.
Clean Price
The quoted bond price without the accrued interest.
Clearing House
A cooperative venture among banks, brokerage firms and other financial
intermediaries that maintains records of transactions made by member firms
during a trading day. At the end of the trading day, the clearing house
calculates net amounts of securities and cash to be delivered among the
members, permitting each member to settle once with the clearing house.
Commission
The fee an investor pays to a brokerage firm for services rendered in the
trading of securities.
Common Factor
A factor that affects the return on virtually all securities to a certain extent.
Constant Growth Model
A type of dividend discount model in which dividends are assumed to
exhibit a constant growth rate.
Constant Price Index
A cost of living index representative of the goods and services purchased by
U.S. consumers.
Contrarian
An investor who has opinions opposite to most other investors, leading to
actions such as buying recent losers and selling recent winners.
Cost of Carry
The differential between the futures and spot prices of a particular asset. It
equals the interest foregone less the benefits plus the costs of ownership.
Common Share
A sort of call option on the assets of the corporation, because the common
shareholder get those assets if he pays off everyone else with a claim against
the assets. The common share represents a fractional ownership interest in
the corporation; it has voting rights and may receive a dividend.
Concentration Risk
According to ‘Risk Concentrations Principles’, which the BIS released in 12/
99, risk concentrations in financial conglomerates come in seven categories
of exposures to: individual counterparties, groups of individual
counterparties, counterparties in specified geographical locations,
counterparties in industries, counterparties in products, key business
services (such as back-office services), and natural disasters.
Contract for Difference
An OTC currency forward contract that settles for a cash amount, perhaps in
a third currency, without requiring the exchange of the two underlying
currencies.
268 Option Trading
Costless Collar
A collar in which the proceeds of the sale of the short call option exactly
finance the purchase of the long put option.
Coupon Payments
The periodic payment of interest on a bond.
Coupon Rate
The annual coupon payments in dollar terms made by a bond expressed as a
percentage of the bond’s par value.
Covariance
A statistical measure of the relationship between two random variables. It
measures the extent of mutual variation between two random variables.
Credit Default Swap
A swap in which B pays C the periodic fee, and C pays B the floating
payment that depends on whether a pre-defined credit has occurred or not.
The fee might be quarterly, semiannual or annual. The floating payment
would likely occur only once, and might be proportional to the discount of
the reference loan below par.
Credit Option on Brady Bonds (COBRA)
A credit spread option with a payoff that depends on the yield spread
between a Brady bond and another bond—usually, a comparable maturity
Treasury.
Currency Swap
The exchange of specified amounts of currencies on one (nearby) date,
exchange of specified amounts of currencies in opposite directions on a
future date, and (possibly) exchange of specified coupons in between. A
currency swap is like the exchange of bills, notes or bonds in different
currencies.
Defensive Stocks
Stocks that have betas-less than one.
Dirty Price
The dirty price of a bond represents the value of a bond, exclusive of any
commissions or fees. The dirty price is also called the ‘full price’.
Dividends
Cash payments made to stockholders by the corporation.
Efficient Market
A market for securities in which every security’s price equals its investment
value at all times, implying that a specified set of information is fully and
immediately reflected in market prices.
Equal-Weighted Market Index

A market index in which all the component securities contribute equally to
the value of the index, regardless of the various attributes of those securities.
Equity Swap
A swap in which one of the payment streams derives from an equity
instrument. For example, in one sort of ordinary equity swap, each period,
Party A receives (and Party B pays) the capital gains on an equity investment
of a given notional amount, while Party B receives (and Party A pays) a
floating interest based on LIBOR and the same notional amount. This swap is
practically equivalent to buying the underlying equity with 100% borrowing
and realizing the gain or loss in each period.
Eurobond
A bond that is offered outside of the country of the borrower and usually
outside of the country in whose currency the security is denominated.
Euro LIBOR
The British Bankers Association’s Euro-denominated analog to dollar
LIBOR. As of January 1999, the European Banking Federation’s Euribor (q.v.)
seems to be winning its battle for acceptance over Euro LIBOR, but London
still hopes to win the war for the financial business. On 1 July, 1999 LIFFE
announced plans for new contracts, based on 5- and 10-year Euribor swaps.
Exotic Option
In finance, an exotic option is a derivative which has features that make it
more complex than commonly traded products (vanilla options). These
products are usually traded over-the-counter (OTC), or are embedded in
structured notes.
Expiration Date
The date on which the right to buy or sell a security under an option contract
ceases.
Financial Leverage
The use of debt to fund a portion of an investment.
Forward Rate
The interest rate that links the current spot interest rate over one holding
period. Equivalently, the interest rate agreed upon at a point in time where
the associated loan will be made at a future date.
Flex Option
Exchange-traded options that do not have the standard terms of listed
options. The customer and the market-maker can negotiate various terms,
such as strike price and expiration date.
270 Option Trading
Forward Contract**
A contract to exchange (buy or sell) an underlying instrument for a fixed
forward price at a specific future delivery date. In certain cases—but not
always—the forward price exceeds the spot price by the cost of carrying the
underlying asset from the spot delivery date to the forward delivery date.
The cost of carry is an increasing function of the rate of interest and storage
costs, and a decreasing function of the rate of dividends, interest or other
cash flows from the underlying instrument (cf. Futures Contract).
Futures Option
A listed option that settles into a futures contract.
Greenshoe Option
A greenshoe option can provide additional price stability to a security issue
because the underwriter has the ability to increase supply and smooth out
price fluctuations if demand surges. Greenshoe options typically allow
underwriters to sell up to 15% more shares than the original number set by
the issuer, if demand conditions warrant such action.
Hedging
To offset the potential risks and returns of one position by taking out an
opposing position to create an outcome of greater certainty.
Hedge Ratio
A ratio comprising the value of a position protected via hedge with the size
of the entire position itself.
Indexation
A method of linking the payments associated with a bond to the price level
in order to provide a certain real return on the bond.
Index Arbitrage
An investment strategy that involves buying a stock index futures contract
and selling the individual stocks in the index, or selling a stock index futures
contract and buying the individual stocks in the index. The strategy is
designed to take advantage of a mispricing between the stock index futures
contract and the underlying.
Inflation Hedge
An asset that preserves the value of its purchasing power over time despite
changes in the price level.
Interest Rate Risk
The uncertainty in the return on a fixed income security caused by
unanticipated fluctuations in the value of the asset owing to changes in
interest rates.
Intrinsic Value of an Option

The value of an option if it was exercised immediately. It is same as the
market price of the asset upon which a call option is written less the exercise
price of the option, or the exercise price less the market price of an asset in
the case of put option.
Initial Margin
It is the margin which is paid by a investor for the purchase and sale of
futures and option of any security. Initial margin is refundable to the investor
after the close out of the prevailing contracts.
Jamming
Executing a large sell (or buy) order in stages by asking for a market on a
small size, hitting the bid (offer) and then repeating the process with a
different market-maker, ultimately driving the price considerably lower
(higher).
Knock-in Option
An option that ‘comes to life’ when a trigger event occurs. Typically when a
price crosses a particular barrier, it pulls the trigger (cf. Knock-out Option).
Knock-out Option
An option that ‘dies’ when a trigger event occurs. Typically when a price
crosses a particular barrier, it pulls the trigger (cf. Knock-in Option).
Ladder Option
An option somewhere between a lookback (q.v.) and a European option. A
ladder call option has one or more ‘rungs’ (price levels) above the initial spot
level. The call’s payoff equals the greater of the European call’s payoff or the
excess over strike (q.v.) of the highest rung that the underlying price reaches.
Lambda
The expected return premium (above the risk-free rate of interest) per unit of
sensitivity to a particular common factor. It is also the sensitivity of the price
of an option to changes in its volatility.
Long-term Equity Anticipation Securities (LEAPS)
Listed call and put options on shares and indexes with expiration dates as
many as two years in future. Ordinary listed calls and puts expire within 9
months. LEAPS permit investors to express longer-term views, without
buying the underlying instruments.
Limit Order
A trading order that specifies a limit price at which the broker is to execute
the order. The trade will be executed only if the broker can meet or better the
limit price.
Limit Price
The price specified when a limit order is placed with a broker, defining the
maximum purchase price or minimum selling price at which the order can
be executed.
272 Option Trading
Liquidity
The ability of investors to convert securities to cash at a price similar to the
price of the previous trade in the security, assuming that no significant new
information has arrived since the previous trade; in other words, the ability
to sell an asset quickly without having to make a substantial price concession.
Margin Account
An account maintained by an investor with a brokerage firm in which
securities may be purchased by borrowing a portion of the purchase price
from the brokerage firm, or may be sold short by borrowing the securities
from the brokerage firm.
Margin Call
A demand upon an investor by a brokerage firm to increase the equity in the
investor’s margin account. The margin call is initiated when the investor’s
actual margin falls below the maintenance margin requirement.
Market Risk
The risk of loss from being on the wrong side of a bet about a market move.
Modified Duration
A measure of the sensitivity of a financial instrument’s value to a change in
its yield.
Mark-to-market
The process of determining the present market value of a security or
derivative position (cf. market contingent credit derivative, mark-to-market
swap, mark-to-market cap, swap guarantee).
Money market rates
Interest rates on short-term instruments, including bankers’ acceptances,
commercial paper, LIBOR and U.S. Treasury bills. The accrual rate to
maturity equals the quoted rate times a day count fraction that has 360 in the
denominator. The days in the numerator might be actual days or days
according to a 30/360 calendar.
Naked Call Writing
The process of writing a call option on a stock that the option writer does not
own.
Naked Put Writing
The process of writing a put option on a stock when the writer does not have
sufficient cash (or securities) in his or her brokerage account to purchase the
stock.
National Association of Securities Dealers (NASD)
NASD operates an automated nationwide communications network that
connects dealers and brokers in the over-the-counter market. Nasdaq
provides current market-maker bid–asked price quotes to market
participants.
No Deliverable Forward
A cash-settled forward contract, typically on a non-convertible or thinly
traded foreign currency (probably from an emerging or submerging (q.v.)
market) or two such currencies, that settles into a convertible currency
(typically the USD). The cash value is a function of the contract’s reference
rate(s) on the fixing date, typically two business days before the value date.
Its main attraction is avoiding currency controls.
Normal Backwardation
A relationship between the futures price of an asset and the expected spot
price of the asset on the delivery date of the contract. It states that the futures
price will be greater than the expected spot price.
Normal Contango
A relationship between the futures price of an asset and the expected spot
price of the asset on the delivery date of the contract. Normal contango states
that the futures price will be greater than the expected spot price.
Notional Amount
Am stated amount in a derivatives contract on which the derivative
payments depend. The notional amount is most analogous to the principal
amount of a bond.
One-Touch Option
An option that pays off as soon as the trigger price touches the barrier. Often,
it is a binary option (q.v.).
Option
The right, but not the obligation, to buy (call, q.v.) or sell (put, q.v.) an
underlying asset at a pre-determined and fixed price, to enter into a long or
short futures position, or to receive a payoff that simulates a purchase or a
sale.
Par Value
The nominal value of shares of common stock as legally carried onto the
books of a corporation.
PCS Options
The CBOT’s option contracts with the underlying Property Claims Service
(PCS) index. Apparently, they operate more or less as a call option on the
underlying index, which could be any one of the nine indexes.
Put Option
The right, but not the obligation, to sell the underlying asset at the strike
price (cf. Call Option).
Rainbow Option
An option that has several risk factors of the same type, for example two
stock prices or three exchange rates.
274 Option Trading
Range Binary Option

An option that pays off a fixed amount at expiration if and only if the
underlying price remains in the range of the option’s entire life.
Replicating Portfolio
A portfolio of securities that either mimics the returns on a derivative
security or is part of a trading strategy that mimics those returns.
Sharpe Ratio
A measure of investment performance, namely the investment’s average
excess rate of return (investment’s rate of return minus riskless rate of return)
divided by standard deviation of its rate of return. Thus, the Sharpe ratio
measures how many standard deviations the average rate of return is from
the riskless rate of return. If the distribution of rate of return was normal and
we knew its mean and variance exactly, the Sharpe ratio would provide an
idea of the probability that the risky investment would beat a riskless
investment.
Short Hedger
A hedger who offsets risk by selling futures contracts is called a Short
Hedger..
Span Margin
Standardized portfolio analysis of risk (span) margin system determines risk
on the basis of an entire portfolio. It provides a method to integrate both
futures and option contracts and assess one-day risk for a traders account.
Speculator
An investor in futures contracts whose primary objective is to make a profit
from buying and selling these contracts.
Spot Date
The date from which interest starts accruing in a fixed income transaction, in
the USD swap market (1999), typically two business days after the
transaction date.
Spread Trade
A trade that profits from a positive move in one risk factor and a negative
move in another.
Step-payment Option
A ‘free’ ordinary European option, minus a portfolio of binary options with
successively higher or lower strikes. For example, for no premium paid up
front, Party A receives a European call option struck at 100 in return for
making one payment if the underlying price goes to 98, another if the price
goes to 96, etc.
Straddle
An option portfolio consisting of one call option and one put option, both
with the same underlying, direction (long or short), strike and expiration
date.
Strap
A straddle plus another one of the call options.
Strip
A straddle plus another one of the put options.
Structured Product
Essentially a portfolio of securities and other (often, Vanilla) derivative
products, although the dealer that creates it hopes the customer doesn’t
realize this.
Up-and-in Option
An option that pays off nothing unless the underlying price rises to an upper
barrier (cf. Up-and-out Option).
Up-and-out Option
An option that pays off as the corresponding ordinary option unless the
underlying price rises to an upper barrier.
Vega
It measures the risk exposure to changes in implied volatility and tells option
traders how much will an option’s price will increase or decrease as the
volatility of the option varies.
Value At Risk (VaR)
A measure of the maximum potential change in the value of a portfolio of
financial instruments with a given probability over a specified time period.
Vol-Vol
The volatility of volatility. This presupposes that volatility is a random
market risk factor, which is a lot more reasonable than the original
assumption of the incredibly robust Black-Scholes model that it is known
and constant.
Volatility
The annualized standard deviation of the percentage change in a risk factor.
Warrant
A warrant is a call option issued by the company whose securities
Weather Derivatives
Derivative products whose values depend on risky weather variables, such
as temperature, precipitation or dollar damage from extreme weather.
Summary
Though we have discussed many terms, the list not exhaustive. As the
market develops further, newer terms will be used in derivative trades.
276 Option Trading
Keywords
Alpha ADR Arbitrage
Arbitrageur Atlantic spread Asset Class
Ask (asked) Asset-Backed Security
Asset Swap Average Price Call/
Put Option
At-the-money forward At-the-money Basis
Basis point Basis Risk Back Mont
Benchmark Portfolio Best-of-Two Option Benchmark notes
Big dogs Bid Bid-Ask Spread
Bidder Bid Price Bet Option
Binary Option Binary Call /Put Option
BOBL Futures Option Book Value of Equity Bowie Bond
Bullet Bond BUND Futures Bundle
Option Buy-Write Callable Bond
Call Market Call Money Rate
Call Option
Capital Gain (Loss) Catastrophe Bond Clean price
Clearing House Commission Common Factor
Constant Growth Model Constant Price Index Contrarian
Cost of Carry
Common Share Contract for
Concentration risk Difference
Covariance Coupon Payments Coupon Rate
“Costless” Collar Credit Default Swap
Credit Option on
Brady Bonds
Currency swap DAXFutures Option
Defensive Stocks Dirty price
Dividends
Efficient Market Equal – Weighted
Market Index
Equity Swap Eurobond Euro LIBOR
Exotic Option Expiration Date Financial Leverage
Forward Rate Flex Option Forward Contract
Futures Option Green Shoe option Hedging
Hedge Ratio Indexation Index Arbitrage
Inflation Hedge Interest Rate Risk
Intrinsic Value of an option Jamming Knock in Option
Knock out Option Ladder Option Lambda
LEAPS Limit Order Limit Price
Liquidity
Margin Account Margin Call Market Risk

Mark-to-market Modified Duration Money market rates
Naked Call writing National Association
of Securities Dealers
Naked Put writing No deliverable Normal
forward Backwardation
Normal Contango Notional Amount One-Touch Option
Option Par Value PCS Options
Put Option Rainbow Option Range Binary
Option Option
Replicating Portfolio Sharpe ratio
Short Hedger Speculator Spot date
Spread trade Step-Payment Option Straddle
Strap Strip Structured product
Up-and-in Option Up-and-out Option Value at Risk (VaR)
Vol-Vol Volatility
Warrant
Weather Derivatives
INDEX
A Basic option strategies 195

Basis 264
A day order 21 Basis point 264
Account 88888 199, 202 Basis risk 264
Account 88888 203, 204, 205, 209 Baumol 89
Accounting norms 249 Bear spread 228
Adesi-Whaley 20 Bear spread with call 178
Albatross 228 Bear spread with puts 175
Alpha 263 Bearings 197, 198, 204
Amaranth 218 Bearings securities 205
American 6 Bearings Securities Japan 203
American and European options 16 Bearish 157
American call options 226 Behavioural study of nifty options
American Depository Receipt during distress 139
(ADR) 263 Benchmark notes 264
American option 23 Benchmark portfolio 264
Amortizes 266 Best-of-two option 264
An immediate or cancel order 21 Bet option 265
Annual volatility 153 Beta 133, 268
Annualized volatility 124 Bhavcopy 110, 240
Arbitrage 252, 263 Bid 265
Arbitrage funds 2 Bid price 265
Arbitrageur 5, 8, 252, 263 Bid–ask spread 265
Archives 240 Bidder 265
Ask (Asked) 263 Binary call (Put) option 265
Asset class 263 Binary option 265
Asset swap 264 Binomial 20, 101
Asset-Backed Security (ABS) 264 Binomial model of option pricing 96
At the money 15, 23, 157, 264 Binomial multiple period model 99
At-the-money forward 264 Black and Scholes 89
Atlantic spread 263 Black–Scholes option pricing
ATM 140 model 89
Average abnormal return 150 BlackScholes 20, 101, 125
Ayres 89 BlackScholes model 152
BOBL futures option 265
B Bombay Cotton Trade Association 3
Back months 264 Bombay Stock Exchange 8
Backwardation 228 Bonds 243
Bank of England 203 Boness 89
Banque Nationale de Paris in Bonus 39
Tokyo 206 Bonus, stock splits and consolida-
tions 30
280 Index
Book value of equity 265 CNX IT index 88

Bowie bond 265 CNX midcap 79, 88
Breakeven point 157 CNX Nifty junior 46
Brokerage 260 Collars 8
Brokerage charges 252 Collateral for margins 32, 39
Bullet bond 266 Collateral limits for trading
BUND Futures 266 members 26
Bundle 266 Commercial paper 272
Buy-Write 266 Commission 267
Commodity derivatives 5
C Commodity exchanges 8
Commodity futures and options 217
Calculation of Quarter–Sigma order
Commodity markets 219
size of stock 34
Common factor 267
Calculation of S&P CNX Defty 87
Common share 267
Calendar spread 221
Compound options 6
Calendar spread charge 21
Compound probability 215
Calendar spreads 20
Concentration risk 267
Call market 266
Constant growth model 267
Call money rate 266
Constant price index 267
Call option 10, 23, 266
Construction of index 42
Call premium 101
Consumer price index 41
Callable bond 266
Contac system 203
Capital gain (loss) 266
Contango 228
Capital gains tax 251
Contango and backwardation 220
Caplets 8
Contract cycle 26, 39
Caps 8
Contract for difference 267
Caps, floors and collars 8
Contract month 176
Carry forward 252
Contract note 262
Cash 32
Contrarian 267
Cash settled options 250
Corporate action adjustments 29
Catastrophe bond 266
Corrado and Miller 132
CBOE 139
Correlation 147
Charges 29
Cost of carry 267
Chen 89
Cost-effectiveness 176
Clean price 266
‘Costless’ collar 268
Clearing house 267
Coupon payments 268
Client level position limits 26
Coupon rate 268
Close out 12
Covariance 268
Close out closing buy 23
Covered and naked calls 262
Closing buy (buy close) 12
Covered call 228
Closing sell 23
Covered call writer 214
Closing sell (sell close) 13
Covered call writing 213
CM 18, 22, 23
Credit default swap 268
CNX 100 index 52, 88
Credit derivatives 5
CNX 500 88
Credit option on brady bonds
CNX bank index 51, 88
(COBRA) 268
CNX defty 88
Credit risk 208
Index 281
CRISIL 42 Exotic option 6, 269

Cumulative average abnormal Expiration date 13, 269
return 150 Exposure limit 208
Cumulative normal distribution 216
Currency derivatives 5 F
Currency swap 268
Factors affecting option price 91
Cyclical stocks 134
Factors affecting the computation of
D historical volatillity 128
FAQs on options 253
Dealers 4, 8 Far-month 220
Deep in the money 15, 23, 226 Final exercise settlement 22
Deep out of the money 15, 23 Financial derivatives 5
Defensive stocks 268 Financial leverage 269
Deficit 264 Fixed deposit receipts (FDRs) 32
Delta 155, 158, 169 Flex option 269
Delta hedge 228 Floating stock 44, 47
Delta hedging 157 Floorlets 8
Delta neutral 157 FMCG 41
Derivatives 8 Forward contract 270
Desirable attributes of an index 43 Forward price 264
Diagonal spread 227 Forward rate 269
Dirty price 268 Forward rate agreements 7
Dividend 39, 101 Forwards 6, 8
Dividend discount model 267 FRA 8
Dividends 30, 268 Fund managers 134
DOTM 140 Futures 6, 8, 88
Futures contracts 19
E Futures option 270
Economic Times 100 41 G
Economic Times midcap 41
Educational cess 252, 262 Gamma 159, 160, 169
Efficient market 268 GARCH 125, 133
Eligibility criteria for securities in Generalized autoregressive condi-
options trading 33 tional heteroskeda 133
Equal-weighted market index 269 Generation of strikes 28
Equity derivatives 5 Get quote 240
Equity index option premium Greek letters 171
account 249 Greeks 169
Equity swap 269 Greenshoe option 270
Estimating historical volatility 125
Estimating volatility 125 H
ET automobiles 41
Hedge fund 218
Euro LIBOR 269
Hedge ratio 270
Eurobond 269
Hedgers 4, 8, 114, 252
European 6
Hedging 252, 270
European options 23, 185
Hedging volatility 163
Exchange rates 273
282 Index
High-dividend-yielding stocks 214 K

Historical data 240
Historical volatility 16, 154, 225 Knock-in option 271
Knock-out option 271
I Kobe 202
Kobe city 198
ICAI 252 KYC 262
ICICI Bank 144 KYC norms 259
Ideal conditions for BlackScholes
formula for option pricing 90 L
IISL 42
Illiquid 172 Lack of supervision 209
Impact cost 88, 115, 121 Ladder option 271
Impacts of events on volatility—A Lambda 271
case study 141 Leveraged positions 134
Impacts of implied volatility and Levy 262
underlying asset price on pur- LIBOR 272
chase of options 136 Limit order 271
Implied volatility 16, 130, 142, 154 Limit price 271
In the money 15, 23 Liquidity 172, 272
In-the-money options 214 Liquidity (impact cost) 43
Income tax 251, 252 Liquidity risk 242, 247
Index 88 Lognormal distribution 101
Index arbitrage 270 Lognormal value 101
Index derivatives 5 Long 12
Index options, stock options 229 Long call Christmas trees 183, 228
Indexation 270 Long call ladder 191, 228
India VIX 139 Long combo 182, 228
Inflation hedge 270 Long guts 189, 228
Infosys 142 Long iron butterfly 191
Initial margin 271 Long position 23
inter-exchange arbitrage 218 Long put 172, 228
Interest rate derivatives 5 Long put ratio spread 177
Interest rate risk 243, 247, 270 Long put spread versus short
Interim exercise settlement 22 call 193
Intrinsic value 14, 256 Long rollover 117
Intrinsic value of an option 271 Long straddle 212, 228
Intrinsic value premium 23 Long strangles 195, 228
IPO 44 Long-term Equity Anticipation
IRDs 4 Securities (LEAPS) 271
ITM 140 Low margin requirement 12
Low risk and high returns 11
J
M
Jamming 271
JGB 205 Maikiel and Quandt 89
JGB arbitrage 203 Margin 23, 209
JGB, Euroyen futures 199 Margin account 272
Index 283
Margin call 272 NSCCL 18, 22, 32, 33

Margin on purchases of options 16 NSCCL-SPAN 18
Margin on selling of options 17 NSE VIX 139
Margin requirement 176 NSE volatility index 138
Margin requirements for
investors 16 O
Margins for option trading 17
OEX options 138
Margins for trading members 17
One-touch option 273
Mark-to-market 272
ONGC 144
Market capitalization 58
Open interest 13, 23, 121
Market risk 208, 272, 242
Open interest and volume
Market sentiment 121
analysis 114
Market Today 240
Opening buy 23
Market-wide limits 25, 39
Opening buy (buy open) 12
Maruti Udyog 144
Opening sell 23
Matrix management system, 209
Opening sell (sell open) 12
Mergers 31, 39
Option 273
Merton 20, 89
Option class 13
Method of computation 53, 57,
Option contracts 19
79, 84
Option Greeks 155
Methodology 52, 141
Option price 144
Methodology for adjustment 30
Option series 13
Model risk 245, 247
Option volatility 147
Modified duration 272
Options 6, 8
Money 23
OSE 200
Money market rates 272
OSE for long 198
Multi-period binomial tree 97
OSE Nikkei 225 198
N OTC (over-the-counter) 10
OTC derivatives 6
Naked call writing 272 Other bear market indicators 120
Naked Nifty futures 157 OTM 140
Naked put writing 272 OTM options 143
National Association of Securities Out of the money 15, 23
Dealers (NASD) 272 Out-of-the-money calls 214
National Stock Exchange 8 Out-of-the-money options: A market
NEAT-F&O trading system 26 indicator 113
Newton-Raphson 132
Nick Leeson 197, 205 P
Nifty 88
Par value 273
Nifty midcap 50 84, 88
Payoff function 265
Nikkei 225 198, 199
PC ratio 109, 121
Nikkei 225 options 199
PCS options 273
Nikkei index 198
Plain vanilla options 6
No deliverable forward 273
Portfolio beta 134
Normal backwardation 273
Portfolio deltas 226
Normal contango 273
Portfolio hedgers 2
Notional amount 273
284 Index
Portfolio hedging 134, 226, 228 Riskless profit 121

Portfolio hedging by call writing 226 Rollover 117
Portfolio hedging through delta Rollover and its impact on futures
hedge 226 expiry 119
Premium 14
Premium settlement 22 S
Price bands 16
S&P CNX 500 57
Price condition 21
S&P CNX Defty 87
Pricing of binomial put option 98
S&P CNX IT index 50
Pricing of equity options 94
S&P CNX NIFTY 43
Pricing of options on dividend paying
S&P CNX Nifty 41, 47
scrips 95
Samuelson 89
Probability 214
Satyam 143
Probability of stock price moving
SBI 143
up 216
Scalping 227
Procedure for margin collection 18
Schaeffer’s investment research 112
Protective call 158
SEBI regulations 221
Punters 134
Securities 32
Put option 10, 273
Securities contracts regulation act of
Put option strike price 23
1956 3
Put premium 101
Securities transaction 262
Put ratio spread 228
Securities transaction Tax 252, 261
Put–call Parity 103, 121
Sensex 88
Q service tax 251
Service tax exchange 262
Quarter sigma 34, 39 Set off 252
Settlement mechanism 22
R Settlement schedule for option
contracts 22
Rainbow option 273
Sharpe ratio 274
Ranbaxy–Daiichi deal 221
Short call 173, 228
Range binary option 274
Short hedger 274
Ratio rollover 121
Short option minimum charge
Realized volatility 153
18, 19, 23
Regression 263
Short position 23
Relationship between open interest,
Short put albatross 185
volumes and volatility 141
Short put ladder 181
Reliance Industries 144
Short rollover 117
Replicating portfolio 274
Short straddle 210, 228
Rho 167, 169
Short straddle versus Put 187
Right skewed curve 151
Short strangles 195
Rights 31, 39
Short strip with calls 188
Risk 247
Sigma 34
Risk disclosure document 260
SIMEX 197, 198, 200, 204, 205, 206,
Risk factor 275
209
Risk of time 247
Singapore 205
Risk/reward 155
Index 285
SPAN intrinsic value 262 Terry J. Watson, 1998 99

Span margin 274 Terry J. Watson, Futures and Options
Speculator 274 in Risk Management 131
Speculators 4, 8 The Board of Banking Supervi-
Spot date 274 sion 203
Spot price 153, 264 Theoretical value 164
Spread trade 274 Theta 164, 169
Spread trader 225 Thorp and Kssouf 89
Spread trading 217, 228 Time condition 21
Sprenkle 89 Time decay 157
Stamp duty 251, 262 Time risk 246
Standard deviation 153 Time value 14, 23, 164, 262
Standard Portfolio Analysis of TMs 18, 23
Risk 207 Tools to measure market
Standard Portfolio Analysis of Risk sentiment 112
(SPAN) 17, 19 Trade confirmation 262
Standardized Normal Distribution Trading interest 58
Table 102 Trading mechanism 26
Step-payment option 274 Trading member-wise position
Stochastic volatility 152 limits 26
Stock futures 150 Types of orders 21
Stock options 229 Types of volatility 124
Stock split 39
Straddle 274 U
Strap 275
U.S. Treasury 272
Strike price 13
UK’s FTSE 100 198
Strip 266
Underlying asset price 156
Structured product 275
Underlying stock 176
STT 251
Units of Mutual Funds & Gilt
Sub-broker 260
Funds 32
Swaps 7, 8
Unlimited loss 216
Swaption 6
Up-and-in option 275
Swing trader 157
Up-and-out option 275
Switching 199
Synthetic index futures 228 V
Synthetic put option 262
Synthetic short 179, 228 Value at Risk (VAR) 34, 275
Systematic risk 263 Variance 162
Vega 132, 161, 169, 275
T Vega-neutral 163
Vol-Vol 275
T+1 working day settlement 22
Volatility 16, 23, 142, 154, 275
Tata Motors 144
Volatility arbitrage 153, 154
Tax 262
Volatility change 153, 154
Taxation of derivatives 251
Volatility index 139
TCS 143
Volatility risk 245, 247
‘Teji’, ‘Mandi’ and ‘Fatak’ 3
Volatility skew 151, 154
Terminologies in options 12
286 Index
Volatility smile 130, 154 Weighted PC 121

Volatility trading 137 Weighted PC ratio 110
Volume analysis 121 Wholesale price index 41
Volume PC ratio 111 Worst scenario loss 19
Writing of options 23
W
Y
Warrant 275
Weather derivatives 5, 275 Yield 272
Weather variables 275
DR. K. SASIDHARAN
Dr. K. Sasidharan is currently the Director of
Derivative Research Forum and the Chairman of
Centre for Resource Development and Research
(CRDR), Kochi, Kerala. He has 27 years of
banking experience, primarily in credit and
foreign exchange (especially currency
derivatives), and nine years of teaching
experience in Kerala’s premier business schools.
He is an approved Research Guide with the
Faculty of Management Studies, University of
Kerala. Besides, he is a life member of the Institute
of Banking and Finance, Mumbai; the Indian
Society for Training and Development, New
Delhi; and the Institute of Management Development and Research,
Trivandrum. He is also a corporate trainer with numerous training
programmes to his credit. He has presented papers in national and
international seminars, contributed to other books, published research-based
and general articles and co-authored a book titled Financial Services and
System, published by Tata McGraw Hill Education (2008). Dr. Sasidharan is
an Associate Editor of Management Researcher published from Trivandrum.
ALEX K. MATHEWS
Alex K. Mathews is currently the Research
Head at Geojit BNP Paribas Financial
Services Ltd, one of the leading brokerage
houses in India based in Kochi, Kerala. As
a renowned financial analyst with over two
decades of industry experience, Mathews is
an empanelled analyst for channels like
ETnow, UTVi, CNBC, CNBC Awaz, ZEE
News, Manorama News and Doordarshan.
He has written several articles in leading
newspapers and magazines like Business
Line, Business Standard and The Economic
Times among others. His views on financial
markets and economics have been cited by many international news agencies
like Reuters, Bloomberg and Dow Jones. He has co-authored a book titled
Financial Services and System published by Tata McGraw Hill Education
(2008) and presented many research papers in international conferences. He
is a life member and an Academic Council Member of the Centre for
Resource Development and Research, and Honorary member of the Deriva-
tive Research Forum, Aluva, Kerala.

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OPTION TRADING

BEAR MARKET STRATEGIES

Tata McGraw Hill Education Private Limited

We have cherished the desire to write a book on derivative strategies

7.9 GARCH 133

9.14 Short Strip with Calls 188

12.6 Income Tax 251

1.2 INDIAN DERIVATIVES MARKET: AN OVERVIEW

250000000 No. of companies

Fig. 1.1 Derivative growth in India 20

Over a period of time, the growth in Nifty options has increased

Fig. 1.2 Options growth in India

1.3 WHAT ARE DERIVATIVES?

1.4 EVOLUTION OF DERIVATIVE TRADING IN INDIA

1.5 PARTICIPANTS IN DERIVATIVES MARKET

Arbitrageurs constitute another group of participants who takes the

1.6 TYPES OF DERIVATIVES

products. This hedging reduces the volatility of future revenue to a more

3 Months 3 Months 3 Months

Current Date Sanction Date Reset Date Maturity Date

Fig. 1.3 A typical FRA transaction

2.3 OPTIONS: AN OVERVIEW

Table 2.1 Distinction between Futures and Forwards

Table 2.2 Distinction between Options and Forwards

2.4 TYPES OF OPTIONS

obligation to sell a financial instrument on a certain date at a previously

STOCK OPTIONS AMERICAN OPTIONS

INDEX OPTIONS EUROPEAN OPTIONS

Fig. 2.1 Types of options

2.5 ADVANTAGES OF OPTIONS

2.6 TERMINOLOGIES IN OPTIONS

At-the-money: An option is said to be at the money when the current spot

Strike Price Spot Price Call Premium Option Type

Strike Price Spot Price Put Premium Option Type

Price Bands: To prevent erroneous order entry, operating ranges or

2.7 TRADING SYSTEM*

2.7.1.2 Margin on Selling of Options

2.7.2 Margins for Trading Members

2.7.3 Margins for Option Trading

2.7.4 Short Option Minimum Charge

2.8 PROCEDURE FOR MARGIN COLLECTION

2.8.1 Short Option Minimum Charge

2.8.2 Calendar Spread Charge

2.9 TYPES OF ORDERS

2.9.1 Time Condition

2.9.2 Price Condition

2.9.3 Other Conditions

2.10 SETTLEMENT SCHEDULE FOR OPTION CONTRACTS

2.11.2 Interim Exercise Settlement

2.11.3 Final Exercise Settlement

2.12 WRITING OF OPTIONS

3.3 MARKET-WIDE LIMITS

3.3.1 Trading Mechanism*

Table 3.1 Contract Specification for S&P CNX Nifty Options*

Underlying Index S&P CNX NIFTY

Table 3.2 Contract Specification for Stock Options*

Underlying Index Individual Securities Available for Trade in the

Settlement Basis Daily settlement on T+1 basis and final option

3.3.3 Generation of Strikes*

Nifty Index Level Strike Price Interval Scheme of Strikes to be

· For Stock options

Underlying Price Strike Price Interval Scheme of Strikes

3.3.5 Corporate Action Adjustments*