analysis of derivatives and stock broking at apollo sindhoori project report

Analysis of Derivatives and Stock Broking at Apollo Sindhoori

Executive Summary

Title of the analysis

“Analysis of Derivatives and Stock Broking at Apollo Sindhoori capital

Investment ltd.”

The function of the financial market is to facilitate the transfer of funds from surplus

sectors (lenders) to deficit sector (borrowers) Indian financial system consist of the

money market and capital market.

Depository is an organization where the securities of a shareholder are held in

the electronic form at the request of the shareholder through a medium of a depository

participant.

To handle the securities in electronic form as per the Depository Act 1996, two

Depositories are registered with SEBI. They are

1. National Securities Depository Ltd (NSDL)

2. Central Depository Services (India) ltd (CSDL)

A derivative is a financial instrument that derives its value from an underlying asset.

This underlying asset can be stocks, bonds currency, commodities, metals and even

intangible. Like stock indices. There are different types of derivatives like Forwards,

Futures, Options, and Swaps.

A future is a contract to buy or sell an asset at a specified future date at a

specified price. Options are deferred delivery contracts that give the buyers the right,

but not the obligation, to buy or sell a specified underlying at a price on or before a

specified date.

ASCI computer share private Ltd. Is a joint venture between computer share

Australia and ASCI consultant’s Ltd. India in the registry management services

industry. Computer share Australia is the world’s largest and only global share

registry providing financial market services and technology to the global securities

industry. ASCI corporate and mutual fund share registry and investor services

business, India’s No.1Registrar and transfer agent and rated as India’s “most admired

registrar” for its over all excellence in volume management, quality process and

technology driven services.

BABASAB PATIL FINANCE PROJECT REPORT 1


Computer share has over 6000 experienced professionals; computer share

operates in five continents, providing services and solutions to listed companies,

investors, employees, exchanges and other financial institutions while ASCI has

handled over 675 issues as Registrar to Issues servicing over 16 million investors

from multiple locations across India.

ASCI Computer share is all geared up to establish a new paradigm in service

delivery driven by benchmark operations management practices, the highest quality

standards and state-of –the-art technology to service its clients and the investor

community at large. The rapid developments in the Indian securities.

This report is delivered in to 2 parts; each part is prepared on the basis of the

analysis carried on in the company, of the first part of the report makes us familiar of

the company, its quality policy, quality objectives and its plans. The second part

contains the analysis on derivatives, stock broking process and its service offered by

ASCI to its clients. The objective of the analysis are to analysis of derivatives

products, trading systems and process, clearing and settlement, to know the process of

stock broking, the calculation of brokerage, how to get registered with ASCI in order

to buy and sell the shares.



Objective of the analysis

Getting an in-depth knowledge of working of derivatives market with special reference to the stock exchanges.

Understanding the role of stock broking in capital market and derivatives market.

To know the overview of the market, to study about the settlement procedure in the stock exchange.

To analysis about the intermediaries, their functioning and importance of their presence in the capital market and study about the action trading in the stock exchange

Need for the study

Financial Derivatives are quite new to the Indian Financial Market, but the derivatives market has shown an immense potential which is visible by the growth it has achieved in the recent past, In the present changing financial environment and an increased exposure towards financial risks, It is of immense importance to have a good working knowledge of Derivatives.

Methodology:-

Methodology explains the methods used in collecting information to carry out the

project.

I have collected the primary data from the internal guide and the clients who use visit and trade in the ASCI stock broking Ltd. The secondary data about the online trading is collected from the various websites.

• Websites

• Magazines

• News papers

The data for the analysis has been collected from NSE websites.

Introduction to Organization:



ASCI, is a premier integrated financial services provider, and ranked

among the top five in the country in all its business segments, services over 16

million individual investors in various capacities, and provides investor

services to over 300 corporate, comprising the who is who of Corporate India.

ASCI covers the entire spectrum of financial services such as Stock broking,

Depository Participants, Distribution of financial products - mutual funds,

bonds, fixed deposit, equities, Insurance Broking, Commodities Broking,

Personal Finance Advisory Services, Merchant Banking & Corporate Finance,

placement of equity, IPO’s, among others. ASCI has a professional

management team and ranks among the best in technology, operations and

research of various industrial segments

The birth of ASCI was on a modest scale in 1981. It began with the

vision and enterprise of a small group of practicing Chartered Accountants

who founded the flagship company …ASCI Consultants Limited. It started

with consulting and financial accounting automation, and carved inroads into

the field of registry and share accounting by 1985. Since then, they have

utilized their experience and superlative expertise to go from strength to

strength…to better their services, to provide new ones, to innovate, diversify

and in the process, evolved ASCI as one of India’s premier integrated

financial service enterprise.

Thus over the last 20 years ASCI has traveled the success route,

towards building a reputation as an integrated financial services provider,

offering a wide spectrum of services. And they have made this journey by

taking the route of quality service, path breaking innovations in service,

versatility in service and finally…totality in service.

Our highly qualified manpower, cutting-edge technology,

comprehensive infrastructure and total customer-focus has secured for us the

position of an emerging financial services giant enjoying the confidence and

support of an enviable clientele across diverse fields in the financial world.

Vision of ASCI :



“To be amongst most trusted power utility company of the country by

providing environment friendly power on most cost effective basis, ensuring

prosperity for its stakeholders and growth with human face.”

Mission of ASCI:

To ensure most cost effective power for sustained growth of India.

To provide clean and green power for secured future of countrymen.

To retain leadership position of the organization in Hydro Power generation,

while working with dedication and innovation in every project we undertake.

To maintain continuous pursuit for cost effectiveness enhanced productivity

for ensuring financial health of the organization, to take care of stakeholders’

aspirations continuously.

To be a technology driven, transparent organization, ensuring dignity and

respect for its team members.

To inculcate value system all cross the organization for ensuring trustworthy

relationship with its constituent associates & stakeholders.

To continuously upgrade & update knowledge & skill set of its human

resources.

To be socially responsible through community development by leveraging

resources and knowledge base.

To achieve excellence in every activity we undertake.

Quality policy of ASCI:



To achieve and retain leadership, ASCI shall aim for complete

customer satisfaction, by combining its human and technological resources, to

provide superior quality financial services. In the process, ASCI will strive to

exceed Customer's expectations.

Quality Objectives

As per the Quality Policy, ASCI will:

Build in-house processes that will ensure transparent and harmonious

relationships with its clients and investors to provide high quality of

services.

Establish a partner relationship with its investor service agents and

vendors that will help in keeping up its commitments to the customers.

Provide high quality of work life for all its employees and equip them

with adequate knowledge & skills so as to respond to customer's needs.

Continue to uphold the values of honesty & integrity and strive to

establish unparalleled standards in business ethics.

Use state-of-the art information technology in developing new and

innovative financial products and services to meet the changing needs

of investors and clients.

Strive to be a reliable source of value-added financial products and

services and constantly guide the individuals and institutions in making

a judicious choice of same.

Strive to keep all stake-holders (shareholders, clients, investors, employees, suppliers

and regulatory authorities) proud and satisfied

ACTIVITIES CARRIED OUT BY ASCI STOCK BROKING LIMITED



1. Share Broking.

2. Demat & Remat Services.

3. Mutual Funds.

4. Investments.

5. Personal Tax planning.

6. Insurance Advisory.

The explanation for the above –mentioned points are as follows:

Services and qualities of ASCI Ltd

Quality Objectives

As per the Quality Policy, ASCI will:

Build in-house processes that will ensure transparent and harmonious

relationships with its clients and investors to provide high quality of

services.

Establish a partner relationship with its investor service agents and

vendors that will help in keeping up its commitments to the customers.

Provide high quality of work life for all its employees and equip them

with adequate knowledge & skills so as to respond to customer's needs.

Continue to uphold the values of honesty & integrity and strive to

establish unparalleled standards in business ethics.

Use state-of-the art information technology in developing new and

innovative financial products and services to meet the changing needs

of investors and clients.

Strive to be a reliable source of value-added financial products and

services and constantly guide the individuals and institutions in making

a judicious choice of same.

Strive to keep all stake-holders (shareholders, clients, investors,

employees, suppliers and regulatory authorities) proud and satisfied.

The services provided by the ASCI:



A). my portfolio Portfolio planner

Risk quotient

Equity portfolio

My net worth

B). Planners Goal planner

Retirement planner

Yield calculator

Risk hedger

C). Publications

The Finapolis

ASCI Bazaar Baatein.

DERIVATIVES

Introduction:

BSE created history on June 9, 2000 by launching the first Exchange traded

Index Derivative Contract i.e. futures on the capital market benchmark index - the



BSE Sensex. The inauguration of trading was done by Prof. J.R. Varma, member of

SEBI and chairman of the committee responsible for formulation of risk containment

measures for the Derivatives market. The first historical trade of 5 contracts of June

series was done on June 9, 2000 at 9:55:03 a.m. between M/s Kaji and Maulik

Securities Pvt. Ltd. and M/s Emkay Share and Stock Brokers Ltd. at the rate of 4755.

In the sequence of product innovation, the exchange commenced trading in

Index Options on Sensex on June 1, 2001. Stock options were introduced on 31 stocks

on July 9, 2001 and single stock futures were launched on November 9, 2002.

September 13, 2004 marked another milestone in the history of Indian Capital

Markets, the day on which the Bombay Stock Exchange launched Weekly Options, a

unique product unparallel in derivatives markets, both domestic and international.

BSE permitted trading in weekly contracts in options in the shares of four leading

companies namely Reliance, Satyam, State Bank of India, and Tisco in addition to the

flagship index-Sensex.

Indian derivatives markets

1. Rise of Derivatives

The global economic order that emerged after World War II was a system where

many less developed countries administered prices and centrally allocated resources.

Even the developed economies operated under the Bretton Woods system of fixed



exchange rates. The system of fixed prices came under stress from the 1970s onwards.

High inflation and unemployment rates made interest rates more volatile. The Bretton

Woods system was dismantled in 1971, freeing exchange rates to fluctuate. Less

developed countries like India began opening up their economies and allowing prices

to vary with market conditions.

Price fluctuations make it hard for businesses to estimate their future production

costs and revenues. Derivative securities provide them a valuable set of tools for

managing this risk.

2. Definition and Uses of Derivatives

A derivative security is a financial contract whose value is derived from the

value of something else, such as a stock price, a commodity price, an exchange rate,

an interest rate, or even an index of prices. Some simple types of derivatives:

forwards, futures, options and swaps.

Derivatives may be traded for a variety of reasons. A derivative enables a

trader to hedge some preexisting risk by taking positions in derivatives markets that

offset potential losses in the underlying or spot market. In India, most derivatives

users describe themselves as hedgers and Indian laws generally require that

derivatives be used for hedging purposes only. Another motive for derivatives trading

is speculation (i.e. taking positions to profit from anticipated price movements). In

practice, it may be difficult to distinguish whether a particular trade was for hedging

or speculation, and active markets require the participation of both hedgers and

speculators. A third type of trader, called arbitrageurs, profit from discrepancies in the

relationship of spot and derivatives prices, and thereby help to keep markets efficient.

Jogani and Fernandez (2003) describe India’s long history in arbitrage trading,

with line operators and traders arbitraging prices between exchanges located in

different cities, and between two exchanges in the same city. Their study of Indian

equity derivatives markets in 2002 indicates that markets were inefficient at that time.

They argue that lack of knowledge, market frictions and regulatory impediments have

led to low levels of capital employed.

Price volatility may reflect changes in the underlying demand and supply

conditions and thereby provide useful information about the market. Thus, economists

do not view volatility as necessarily harmful.



Speculators face the risk of losing money from their derivatives trades, as they

do with other securities. There have been some well-publicized cases of large losses

from derivatives trading. In some instances, these losses stemmed from fraudulent

behavior that went undetected partly because companies did not have adequate risk

management systems in place. In other cases, users failed to understand why and how

they were taking positions in the derivatives.

Derivatives in arbitrage trading in India. However, more recent evidence

suggests that the efficiency of Indian equity derivatives markets may have improved.

3. Exchange-Traded and Over-the-Counter Derivative Instruments

OTC (over-the-counter) contracts, such as forwards and swaps, are bilaterally

negotiated between two parties. The terms of an OTC contract are flexible, and are

often customized to fit the specific requirements of the user. OTC contracts have

substantial credit risk, which is the risk that the counterparty that owes money defaults

on the payment. In India, OTC derivatives are generally prohibited with some

exceptions: those that are specifically allowed by the Reserve Bank of India (RBI) or,

in the case of commodities (which are regulated by the Forward Markets

Commission), those that trade informally in “havala” or forwards markets.

An exchange-traded contract, such as a futures contract, has a standardized

format that specifies the underlying asset to be delivered, the size of the contract, and

the logistics of delivery. They trade on organized exchanges with prices determined

by the interaction of many buyers and sellers. In India, two exchanges offer

derivatives trading: the Bombay Stock Exchange (BSE) and the National Stock

Exchange (NSE). However, NSE now accounts for virtually all exchange-

traded derivatives in India, accounting for more than 99% of volume in 2003-2004.

Contract performance is guaranteed by a clearinghouse, which is a wholly owned

subsidiary of the NSE. Margin requirements and daily marking-to-market of futures

positions substantially reduce the credit risk of exchange traded contracts, relative to

OTC contracts.

4. Development of Derivative Markets in India



Derivatives markets have been in existence in India in some form or other for

a long time. In the area of commodities, the Bombay Cotton Trade Association started

futures trading in 1875 and, by the early 1900s India had one of the world’s largest

futures industry. In 1952 the government banned cash settlement and options trading

and derivatives trading shifted to informal forwards markets. In recent years,

government policy has changed, allowing for an increased role for market-based

pricing and less suspicion of derivatives trading. The ban on futures trading of many

commodities was lifted starting in the early 2000s, and national electronic commodity

exchanges were created.

In the equity markets, a system of trading called “badla” involving some

elements of forwards trading had been in existence for decades. However, the system

led to a number of undesirable practices and it was prohibited off and on till the

Securities and a clearinghouse guarantees performance of a contract by becoming

buyer to every seller and seller to every buyer.

Customers post margin (security) deposits with brokers to ensure that they can

cover a specified loss on the position. A futures position is marked-to-market by

realizing any trading losses in cash on the day they occur.

“Badla” allowed investors to trade single stocks on margin and to carry

forward positions to the next settlement cycle. Earlier, it was possible to carry forward

a position indefinitely but later the maximum carry forward period was 90 days.

Unlike a futures or options, however, in a “badla” trade there is no fixed expiration

date, and contract terms and margin requirements are not standardized.

Derivatives Exchange Board of India (SEBI) banned it for good in 2001. A

series of reforms of the stock market between 1993 and 1996 paved the way for the

development of exchange traded equity derivatives markets in India. In 1993, the

government created the NSE in collaboration with state-owned financial institutions.

NSE improved the efficiency and transparency of the stock markets by offering a

fully automated screen-based trading system and real-time price dissemination. In

1995, a prohibition on trading options was lifted. In 1996, the NSE sent a proposal to

SEBI for listing exchange-traded derivatives.

The report of the L. C. Gupta Committee, set up by SEBI, recommended a

phased introduction of derivative products, and bi-level regulation (i.e., self-

regulation by exchanges with SEBI providing a supervisory and advisory role).

Another report, by the J. R. Varma Committee in 1998, worked out various



operational details such as the margining systems. In 1999, the Securities Contracts

(Regulation) Act of 1956, or SC(R)A, was amended so that derivatives could be

declared “securities.” This allowed the regulatory fMr.Xework for trading securities

to be extended to derivatives. The Act considers derivatives to be legal and valid, but

only if they are traded on exchanges.

Finally, a 30-year ban on forward trading was also lifted in 1999. The

economic liberalization of the early nineties facilitated the introduction of derivatives

based on interest rates and foreign exchange. A system of market-determined

exchange rates was adopted by India in March 1993. In August 1994, the rupee was

made fully convertible on current account. These reforms allowed increased

integration between domestic and international markets, and created a need to manage

currency risk.

5. Derivatives Users in India

The use of derivatives varies by type of institution. Financial institutions, such

as banks, have assets and liabilities of different maturities and in different currencies,

and are exposed to different risks of default from their borrowers. Thus, they are

likely to use derivatives on interest rates and currencies, and derivatives to manage

credit risk. Non-financial institutions are regulated differently from financial

institutions, and this affects their incentives to use derivatives. Indian insurance

regulators, for example, are yet to issue guidelines relating to the use of derivatives by

insurance companies.

In India, financial institutions have not been heavy users of exchange-traded

derivatives so far, with their contribution to total value of NSE trades being less than

8% in October 2005. However, market insiders feel that this may be changing, as

indicated by the growing share of index derivatives (which are used more by

institutions than by retail investors). In contrast to the exchange-traded markets,

domestic financial institutions and mutual funds have shown great interest in OTC

fixed income instruments. Transactions between banks dominate the market for

interest rate derivatives, while state-owned banks remain a small presence.

Corporations are active in the currency forwards and swaps markets, buying these

instruments from banks.



Why do institutions not participate to a greater extent in derivatives

markets?

Some institutions such as banks and mutual funds are only allowed to use

derivatives to hedge their existing positions in the spot market, or to rebalance their

existing portfolios. Since banks have little exposure to equity markets due to banking

regulations, they have little incentive to trade equity derivatives. Foreign investors

must register as foreign institutional investors (FII) to trade exchange-traded

derivatives, and be subject to position limits as specified by SEBI. Alternatively, they

can incorporate locally as under RBI directive, banks’ direct or indirect (through

mutual funds) exposure to capital markets instruments is limited to 5% of total

outstanding advances as of the previous year-end. Some banks may have further

equity exposure on account of equities collaterals held against loans in default.

FIIs have a small but increasing presence in the equity derivatives markets.

They have no incentive to trade interest rate derivatives since they have little

investments in the domestic bond markets. It is possible that unregistered foreign

investors and hedge funds trade indirectly, using a local proprietary trader as a front.

Retail investors (including small brokerages trading for themselves) are the

major participants in equity derivatives, accounting for about 60% of turnover in

October 2005, according to NSE. The success of single stock futures in India is

unique, as this instrument has generally failed in most other countries. One reason for

this success may be retail investors’ prior familiarity with “badla” trades which shared

some features of derivatives trading. Another reason may be the small size of the

futures contracts, compared to similar contracts in other countries. Retail investors

also dominate the markets for commodity derivatives, due in part to their long-

standing expertise in trading in the “havala” or forwards markets.

Why have derivatives?

Derivatives have become very important in the field finance. They are very

important financial instruments for risk management as they allow risks to be

separated and traded. Derivatives are used to shift risk and act as a form of insurance.

This shift of risk means that each party involved in the contract should be able to



identify all the risks involved before the contract is agreed. It is also important to

remember that derivatives are derived from an underlying asset. This means that risks

in trading derivatives may change depending on what happens to the underlying asset.

A derivative is a product whose value is derived from the value of an

underlying asset, index or reference rate. The underlying asset can be equity, forex,

commodity or any other asset. For example, if the settlement price of a derivative is

based on the stock price of a stock for e.g. Infosys, which frequently changes on a

daily basis, then the derivative risks are also changing on a daily basis. This means

that derivative risks and positions must be monitored constantly.

Why Derivatives are preferred?

Retail investors will find the index derivatives useful due to the high correlation of the

index with their portfolio/stock and low cost associated with using index futures for

hedging.

Looking Ahead

Clearly, the nascent derivatives market is heading in the right direction. In

terms of the number of contracts in single stock derivatives, it is probably the largest

market globally. It is no longer a market that can be ignored by any serious

participant. With institutional participation set to increase and a broader product

rollout inevitable, the market can only widen and deepen further.

How does F&O trading impact the market?

The start of a new derivatives contract pushes up prices in the cash market as

operators take fresh positions in the new month series in the first week of every new

contract. This buying in the derivatives segment pushes up future prices. Higher

future prices are seen as indicators of bullish prices in the days to come. Thus, higher

prices due to new month buying in the derivatives market lead to buying in the

physical market. This lifts prices in the cash market as well.

The huge surge in open positions has coincided with the market indexes

reaching historic highs. This shows that the two segments are linked.



FUTURES CONTRACT:

A futures contract is similar to a forward contract in terms of its working. The

difference is that contracts are standardized and trading is centralized. Futures markets

are highly liquid and there is no counterparty risk due to the presence of a

clearinghouse, which becomes the counterparty to both sides of each transaction and

guarantees the trade.



What is an Index?

To understand the use and functioning of the index derivatives markets, it is

necessary to understand the underlying index. A stock index represents the change in

value of a set of stocks, which constitute the index. A market index is very important

for the market players as it acts as a barometer for market behavior and as an

underlying in derivative instruments such as index futures.

The Sensex and Nifty

In India the most popular indices have been the BSE Sensex and S&P CNX

Nifty. The BSE Sensex has 30 stocks comprising the index which are selected based

on market capitalization, industry representation, trading frequency etc. It represents

30 large well-established and financially sound companies. The Sensex represents a

broad spectrum of companies in a variety of industries. It represents 14 major industry

groups. Then there is a BSE national index and BSE 200. However, trading in index

futures has only commenced on the BSE Sensex.

While the BSE Sensex was the first stock market index in the country, Nifty

was launched by the National Stock Exchange in April 1996 taking the base of

November 3, 1995. The Nifty index consists of shares of 50 companies with each

having a market capitalization of more than Rs 500 crore.

Futures and stock indices

For understanding of stock index futures a thorough knowledge of the

composition of indexes is essential. Choosing the right index is important in choosing

the right contract for speculation or hedging. Since for speculation, the volatility of

the index is important whereas for hedging the choice of index depends upon the

relationship between the stocks being hedged and the characteristics of the index.

Choosing and understanding the right index is important as the movement of

stock index futures is quite similar to that of the underlying stock index. Volatility of

the futures indexes is generally greater than spot stock indexes.



Everytime an investor takes a long or short position on a stock, he also has an

hidden exposure to the Nifty or Sensex. As most often stock values fall in tune with

the entire market sentiment and rise when the market as a whole is rising.

Retail investors will find the index derivatives useful due to the high

correlation of the index with their portfolio/stock and low cost associated with using

index futures for hedging

6.1 Understanding index futures

A futures contract is an agreement between two parties to buy or sell an asset

at a certain time in the future at a certain price. Index futures are all futures contracts

where the underlying is the stock index (Nifty or Sensex) and helps a trader to take a

view on the market as a whole.

Index futures permits speculation and if a trader anticipates a major rally in the

market he can simply buy a futures contract and hope for a price rise on the futures

contract when the rally occurs.

In India we have index futures contracts based on S&P CNX Nifty and the

BSE Sensex and near 3 months duration contracts are available at all times. Each

contract expires on the last Thursday of the expiry month and simultaneously a

new contract is introduced for trading after expiry of a contract.

Example: Futures contracts in Nifty in July 2001

Contract month Expiry/settlement

July 2001 July 26

August 2001 August 30

September 2001 September 27

On July 27



Contract month Expiry/settlement

August 2001 August 30

September 2001 September 27

October 2001 October 25

The permitted lot size is 200 or multiples thereof for the Nifty. That is you buy

one Nifty contract the total deal value will be 200*1100 (Nifty value)= Rs 2,20,000.

In the case of BSE Sensex the market lot is 50. That is you buy one Sensex

futures the total value will be 50*4000 (Sensex value)= Rs 2,00,000.

Hedging

The other benefit of trading in index futures is to hedge your portfolio

against the risk of trading. In order to understand how one can protect his portfolio

from value erosion let us take an example.

Illustration:

Mr.X enters into a contract with Mr.Y that six months from now he will sell to

Y 10 dresses for Rs 4000. The cost of manufacturing for X is only Rs 1000 and he

will make a profit of Rs 3000 if the sale is completed.

Cost (Rs) Selling price Profit

1000 4000 3000

However, X fears that Y may not honour his contract six months from now. So

he inserts a new clause in the contract that if Y fails to honour the contract he will

have to pay a penalty of Rs 1000. And if Y honours the contract X will offer a

discount of Rs 1000 as incentive.



‘Y’ defaults ‘Y’ honours

1000 (Initial Investment) 3000 (Initial profit)

1000 (penalty from Mr.Y) (-1000) discount given to Mr.Y

- (No gain/loss) 2000 (Net gain)

As we see above if Mr.Y defaults Mr.X will get a penalty of Rs 1000 but he

will recover his initial investment. If Mr.Y honours the contract, Mr.X will still make

a profit of Rs 2000. Thus, Mr.X has hedged his risk against default and protected his

initial investment.

The example explains the concept of hedging. Let us try understanding how

one can use hedging in a real life scenario.

Stocks carry two types of risk – company specific and market risk. While

company risk can be minimized by diversifying your portfolio, market risk cannot

be diversified but has to be hedged. So how does one measure the market risk?

Market risk can be known from Beta.

Beta measures the relationship between movement of the index to the

movement of the stock. The beta measures the percentage impact on the stock prices

for 1% change in the index. Therefore, for a portfolio whose value goes down by 11%

when the index goes down by 10%, the beta would be 1.1. When the index increases

by 10%, the value of the portfolio increases 11%. The idea is to make beta of your

portfolio zero to nullify your losses.

Hedging involves protecting an existing asset position from future adverse

price movements. In order to hedge a position, a market player needs to take an equal

and opposite position in the futures market to the one held in the cash market. Every

portfolio has a hidden exposure to the index, which is denoted by the beta. Assuming

you have a portfolio of Rs 1 million, which has a beta of 1.2, you can factor a

complete hedge by selling Rs 1.2 mn of S&P CNX Nifty futures



Steps:

1. Determine the beta of the portfolio. If the beta of any stock is not known, it is

safe to assume that it is 1.

2. Short sell the index in such a quantum that the gain on a unit decrease in the

index would offset the losses on the rest of the portfolio. This is achieved by

multiplying the relative volatility of the portfolio by the market value of his

holdings.

Therefore in the above scenario we have to shortsell 1.2 * 1 million = 1.2 million

worth of Nifty.

Now let us see the impact on the overall gain/loss that accrues:

Index up 10% Index down 10%

Gain/(Loss) in PortfolioRs 120,000 (Rs 120,000)

Gain/(Loss) in Futures(Rs 120,000) Rs 120,000

Net EffectNil Nil

As we see, that portfolio is completely insulated from any losses arising out of

a fall in market sentiment. But as a cost, one has to forego any gains that arise out of

improvement in the overall sentiment. Then why does one invest in equities if all

the gains will be offset by losses in futures market. The idea is that everyone

expects his portfolio to outperform the market. Irrespective of whether the market

goes up or not, his portfolio value would increase.

The same methodology can be applied to a single stock by deriving the beta of

the scrip and taking a reverse position in the futures market.

Thus, we understand how one can use hedging in the futures market to offset

losses in the cash market.

6.3 Speculation



Speculators are those who do not have any position on which they enter in

futures and options market. They only have a particular view on the market, stock,

commodity etc. In short, speculators put their money at risk in the hope of profiting

from an anticipated price change. They consider various factors such as demand

supply, market positions, open interests, economic fundamentals and other data to

take their positions.

Illustration:

Mr.X is a trader but has no time to track and analyze stocks. However, he

fancies his chances in predicting the market trend. So instead of buying different

stocks he buys Sensex Futures.

On May 1, 2001, he buys 100 Sensex futures @ 3600 on expectations that the

index will rise in future. On June 1, 2001, the Sensex rises to 4000 and at that time he

sells an equal number of contracts to close out his position.

Selling Price : 4000*100 = Rs.4,00,000

Less: Purchase Cost: 3600*100 = Rs.3,60,000

Net gain Rs.40,000

Mr.X has made a profit of Rs.40,000 by taking a call on the future value of the

Sensex. However, if the Sensex had fallen he would have made a loss. Similarly, if it

would have been bearish he could have sold Sensex futures and made a profit from a

falling profit. In index futures players can have a long-term view of the market up to

atleast 3 months.

6.4 Arbitrage

An arbitrageur is basically risk averse. He enters into those contracts were he

can earn riskless profits. When markets are imperfect, buying in one market and

simultaneously selling in other market gives riskless profit. Arbitrageurs are always in

the look out for such imperfections.



In the futures market one can take advantages of arbitrage opportunities by buying

from lower priced market and selling at the higher priced market. In index futures

arbitrage is possible between the spot market and the futures market (NSE has

provided a special software for buying all 50 Nifty stocks in the spot market.

Take the case of the NSE Nifty.

Assume that Nifty is at 1200 and 3 month’s Nifty futures is at 1300.

The futures price of Nifty futures can be worked out by taking the interest cost

of 3 months into account.

If there is a difference then arbitrage opportunity exists.

Let us take the example of single stock to understand the concept better. If Wipro is

quoted at Rs.1000 per share and the 3 months futures of Wipro is Rs.1070 then one

can purchase Wipro at Rs.1000 in spot by borrowing @ 12% annum for 3 months and

sell Wipro futures for 3 months at Rs 1070.

Sale = 1070

Cost= 1000+30 = 1030

Arbitrage profit = 40

These kind of imperfections continue to exist in the markets but one has to be alert to

the opportunities as they tend to get exhausted very fast.

6.5 Pricing of Index Futures

The index futures are the most popular futures contracts as they can be used in

a variety of ways by various participants in the market.

How many times have you felt of making risk-less profits by arbitraging

between the underlying and futures markets. If so, you need to know the cost-of-carry



model to understand the dynamics of pricing that constitute the estimation of fair

value of futures.

1. The cost of carry model

The cost-of-carry model where the price of the contract is defined as:

F=S+C

where:

F Futures price

S Spot price

C Holding costs or carry costs

If F < S+C or F > S+C, arbitrage opportunities would exist i.e. whenever the

futures price moves away from the fair value, there would be chances for arbitrage.

If Wipro is quoted at Rs.1000 per share and the 3 months futures of Wipro is

Rs.1070 then one can purchase Wipro at Rs.1000 in spot by borrowing @ 12% annum

for 3 months and sell Wipro futures for 3 months at Rs 1070.

Here F=1000+30=1030 and is less than prevailing futures price and hence

there are chances of arbitrage.

Sale = 1070

Cost= 1000+30 = 1030

Arbitrage profit 40

However, one has to remember that the components of holding cost vary with

contracts on different assets.

2. Futures pricing in case of dividend yield



We have seen how we have to consider the cost of finance to arrive at the

futures index value. However, the cost of finance has to be adjusted for benefits of

dividends and interest income. In the case of equity futures, the holding cost is the

cost of financing minus the dividend returns.

Example:

Suppose a stock portfolio has a value of Rs.100 and has an annual dividend

yield of 3% which is earned throughout the year and finance rate=10% the fair value

of the stock index portfolio after one year will be F= Rs.100 + Rs.100 * (0.10 – 0.03)

Futures price = Rs 107

If the actual futures price of one-year contract is Rs.109. An arbitrageur can

buy the stock at Rs.100, borrowing the fund at the rate of 10% and simultaneously sell

futures at Rs.109. At the end of the year, the arbitrageur would collect Rs.3 for

dividends, deliver the stock portfolio at Rs.109 and repay the loan of Rs.100 and

interest of Rs.10. The net profit would be Rs 109 + Rs 3 - Rs 100 - Rs 10 = Rs 2.

Thus, we can arrive at the fair value in the case of dividend yield.

Trading strategies

1. Speculation

We have seen earlier that trading in index futures helps in taking a view of the

market, hedging, speculation and arbitrage. Now we will see how one can trade in

index futures and use forward contracts in each of these instances.

Taking a view of the market



Have you ever felt that the market would go down on a particular day and feared that

your portfolio value would erode?

There are two options available

Option 1: Sell liquid stocks such as Reliance

Option 2: Sell the entire index portfolio

The problem in both the above cases is that it would be very cumbersome and

costly to sell all the stocks in the index. And in the process one could be vulnerable to

company specific risk. So what is the option? The best thing to do is to sell index

futures.

Illustration:

Scenario 1:

On July 13, 2001, ‘X’ feels that the market will rise so he buys 200 Nifties with an

expiry date of July 26 at an index price of 1442 costing Rs 2,88,400 (200*1442).

On July 21 the Nifty futures have risen to 1520 so he squares off his position at 1520.

‘X’ makes a profit of Rs 15,600 (200*78)

Scenario 2:

On July 20, 2001, ‘X’ feels that the market will fall so he sells 200 Nifties with an

expiry date of July 26 at an index price of 1523 costing Rs 3,04,600 (200*1523).

On July 21 the Nifty futures falls to 1456 so he squares off his position at 1456.

‘X’ makes a profit of Rs 13,400 (200*67).

In the above cases ‘X’ has profited from speculation i.e. he has wagered in the hope of

profiting from an anticipated price change.



2. Hedging

Stock index futures contracts offer investors, portfolio managers, mutual funds

etc several ways to control risk. The total risk is measured by the variance or standard

deviation of its return distribution. A common measure of a stock market risk is the

stock’s Beta. The Beta of stocks are available on the www.nseindia.com.

While hedging the cash position one needs to determine the number of futures

contracts to be entered to reduce the risk to the minimum.

Have you ever felt that a stock was intrinsically undervalued? That the profits

and the quality of the company made it worth a lot more as compared with what the

market thinks?

Have you ever been a ‘stockpicker’ and carefully purchased a stock based on a

sense that it was worth more than the market price?

A person who feels like this takes a long position on the cash market. When

doing this, he faces two kinds of risks:

a. His understanding can be wrong, and the company is really not worth more than the

market price or

b. The entire market moves against him and generates losses even though the

underlying idea was correct.

Everyone has to remember that every buy position on a stock is

simultaneously a buy position on Nifty. A long position is not a focused play on the

valuation of a stock. It carries a long Nifty position along with it, as incidental

baggage i.e. a part long position of Nifty.

Let us see how one can hedge positions using index futures:

‘X’ holds HLL worth Rs 9 lakh at Rs 290 per share on Jan1 2008asuming that the

beta of HLL is 1.13. How much Nifty futures does ‘X’ have to sell if the index futures

is ruling at 1527?



To hedge he needs to sell 9 lakh * 1.13 = Rs 1017000 lakh on the index futures i.e.

666 Nifty futures.

On Jan , 2008 the Nifty futures is at 1437 and HLL is at 275. ‘X’ closes both positions

earning Rs 13,389, i.e. his position on HLL drops by Rs 46,551 and his short position

on Nifty gains Rs 59,940 (666*90).

Therefore, the net gain is 59940-46551 = Rs 13,389.

Let us take another example when one has a portfolio of stocks:

Suppose you have a portfolio of Rs 10 crore. The beta of the portfolio is 1.19. The

portfolio is to be hedged by using Nifty futures contracts. To find out the number of

contracts in futures market to neutralise risk . If the index is at 1200 * 200 (market lot)

= Rs 2,40,000, The number of contracts to be sold is:

a. 1.19*10 crore = 496 contracts

2,40,000

If you sell more than 496 contracts you are overhedged and sell less than 496

contracts you are underhedged.

Thus, we have seen how one can hedge their portfolio against market risk.

3. Margins

The margining system is based on the JR Verma Committee

recommendations. The actual margining happens on a daily basis while online

position monitoring is done on an intra-day basis.

Daily margining is of two types:

1. Initial margins

2. Mark-to-market profit/loss



The computation of initial margin on the futures market is done using the

concept of Value-at-Risk (VaR). The initial margin amount is large enough to cover

a one-day loss that can be encountered on 99% of the days. VaR methodology seeks

to measure the amount of value that a portfolio may stand to lose within a certain

horizon time period (one day for the clearing corporation) due to potential changes in

the underlying asset market price. Initial margin amount computed using VaR is

collected up-front. The daily settlement process called "mark-to-market" provides

for collection of losses that have already occurred (historic losses) whereas initial

margin seeks to safeguard against potential losses on outstanding positions. The mark-

to-market settlement is done in cash.

Let us take a hypothetical trading activity of a client of a NSE futures division to

demonstrate the margins payments that would occur.

A client purchases 200 units of FUTIDX NIFTY 29JUN2001 at Rs 1500.

The initial margin payable as calculated by VaR is 15%.

Total long position = Rs 3,00,000 (200*1500)

Initial margin (15%) = Rs 45,000

Assuming that the contract will close on Day + 3 the mark-to-market position will

look as follows:

Position on Day 1

Close Price Loss Margin released Net cash outflow

1400*200 =2,80,000 20,000 (3,00,000-

2,80,000)

3,000 (45,000-

42,000)

17,000 (20,000-

3000)

Payment to be made (17,000)

New position on Day 2

Value of new position = 1,400*200= 2,80,000

Margin = 42,000



Close Price Gain Addn Margin Net cash inflow

1510*200 =3,02,000 22,000 (3,02,000-

2,80,000)

3,300 (45,300-

42,000)

18,700 (22,000-

3300)

Payment to be recd 18,700

Position on Day 3

Value of new position = 1510*200 = Rs 3,02,000

Margin = Rs 3,300

Close Price Gain Net cash inflow

1600*200 =3,20,000 18,000 (3,20,000-

3,02,000)

18,000 + 45,300* = 63,300

Payment to be recd 63,300

Margin account*

Initial margin = Rs 45,000

Margin released (Day 1) = (-) Rs 3,000

Position on Day 2 Rs 42,000

Addn margin = (+) Rs 3,300

Total margin in a/c Rs 45,300*

Net gain/loss

Day 1 (loss) = (Rs 17,000)

Day 2 Gain = Rs 18,700

Day 3 Gain = Rs 18,000

Total Gain = Rs 19,700



The client has made a profit of Rs 19,700 at the end of Day 3 and the total cash inflow

at the close of trade is Rs 63,300.

Settlement of futures contracts:

Futures contracts have two types of settlements, the MTM settlement which

happens on a continuous basis at the end of each day, and the final settlement which

happens on the last trading day of the futures contract.

1. MTM settlement:

All futures contracts for each member are marked-to-market(MTM) to the daily

settlement price of the relevant futures contract at the end of each day. The

profits/losses are computed as the difference between:

The trade price and the day’s settlement price for contracts executed during

the day but not squared up.

The previous day’s settlement price and the current day’s settlement price for

brought forward contracts.

The buy price and the sell price for contracts executed during the day and

squared up.

The CMs who have a loss are required to pay the mark-to-market (MTM) loss

amount in cash which is in turn passed on to the CMs who have made a MTM profit.

This is known as daily mark-to-market settlement. CMs are responsible to collect and

settle the daily MTM profits/losses incurred by the TMs and their clients clearing and

settling through them. Similarly, TMs are responsible to collect/pay losses/ profits

from/to their clients by the next day. The pay-in and pay-out of the mark-to-market

settlement are effected on the day following the trade day. In case a futures contract is

not traded on a day, or not traded during the last half hour, a ‘theoretical settlement

price’ is computed.

2. Final settlement for futures

On the expiry day of the futures contracts, after the close of trading hours,

NSCCL marks all positions of a CM to the final settlement price and the resulting



profit/loss is settled in cash. Final settlement loss/profit amount is debited/ credited to

the relevant CM’s clearing bank account on the day following expiry day of the

contract.

All trades in the futures market are cash settled on a T+1 basis and all

positions (buy/sell) which are not closed out will be marked-to-market. The closing

price of the index futures will be the daily settlement price and the position will be

carried to the next day at the settlement price.

The most common way of liquidating an open position is to execute an

offsetting futures transaction by which the initial transaction is squared up. The initial

buyer liquidates his long position by selling identical futures contract.

In index futures the other way of settlement is cash settled at the final

settlement. At the end of the contract period the difference between the contract value

and closing index value is paid.

How to read the futures data sheet?

Understanding and deciphering the prices of futures trade is the first challenge

for anyone planning to venture in futures trading. Economic dailies and exchange

websites www.nseindia.com and www.bseindia.com are some of the sources where

one can look for the daily quotes. Your website has a daily market commentary,

which carries end of day derivatives summary along with the quotes.

The first step is start tracking the end of day prices. Closing prices, Trading

Volumes and Open Interest are the three primary data we carry with Index option

quotes. The most important parameter are the actual prices, the high, low, open, close,

last traded prices and the intra-day prices and to track them one has to have access to

real time prices.

The following table shows how futures data will be generally displayed in the

business papers daily.

Series First

Trade

High Low Close

Volume (No of

contracts)

Value

(Rs in lakh)

No of

trades Open interest

(No of



contracts)

BSXJUN2000 4755 4820 4740 4783.1 146 348.70 104 51

BSXJUL2000 4900 4900 4800 4830.8 12 28.98 10 2

BSXAUG2000 4800 4870 4800 4835 2 4.84 2 1

Total 160 38252 116 54

Source: BSE

The first column explains the series that is being traded. For e.g.

BSXJUN2000 stands for the June Sensex futures contract.

The column on volume indicates that (in case of June series) 146 contracts

have been traded in 104 trades.

One contract is equivalent to 50 times the price of the futures, which are

traded. For e.g. In case of the June series above, the first trade at 4755

represents one contract valued at 4755 x 50 i.e. Rs.2,37,750/-.

Open interest indicates the total gross outstanding open positions in the market for

that particular series. For e.g. Open interest in the June series is 51 contracts. The

most useful measure of market activity is Open interest, which is also published by

exchanges and used for technical analysis. Open interest indicates the liquidity of a

market and is the total number of contracts, which are still outstanding in a

futures market for a specified futures contract.

A futures contract is formed when a buyer and a seller take opposite positions in a

transaction. This means that the buyer goes long and the seller goes short. Open

interest is calculated by looking at either the total number of outstanding long or short

positions – not both Open interest is therefore a measure of contracts that have not

been matched and closed out. The number of open long contracts must equal exactly

the number of open short contracts.

Action Resulting open interest

New buyer (long) and new seller (short)

Trade to form a new contract.

Rise

Existing buyer sells and existing seller buys – Fall



The old contract is closed.

New buyer buys from existing buyer. The

Existing buyer closes his position by selling

to new buyer.

No change – there is no increase in long

contracts being held

Existing seller buys from new seller. The

Existing seller closes his position by buying

from new seller.

No change – there is no increase in short

contracts being held

Open interest is also used in conjunction with other technical analysis chart

patterns and indicators to gauge market signals. The following chart may help with

these signals.

Price

Open interest Market

Strong

Warning signal

Weak

Warning signal

The warning sign indicates that the Open interest is not supporting the price

direction.

OPTIONS

What is an Option?

An option is a contract giving the buyer the right, but not the obligation, to

buy or sell an underlying asset (a stock or index) at a specific price on or before a

certain date (listed options are all for 100 shares of the particular underlying asset).

An option is a security, just like a stock or bond, and constitutes a binding

contract with strictly defined terms and properties.

Listed options have been available since 1973, when the Chicago Board Options

Exchange, still the busiest options exchange in the world, first opened.

The World With and Without Options



Prior to the founding of the CBOE, investors had few choices of where to

invest their money; they could either be long or short individual stocks, or they could

purchase treasury securities or other bonds.

Once the CBOE opened, the listed option industry began, and

investors now had a world of investment choices previously unavailable.

Options vs. Stocks

In order to better understand the benefits of trading options, one must first

understand some of the similarities and differences between options and stocks.

Similarities:

Listed Options are securities, just like stocks.

Options trade like stocks, with buyers making bids and sellers making offers.

Options are actively traded in a listed market, just like stocks. They can be bought

and sold just like any other security.

Differences:

Options are derivatives, unlike stocks (i.e, options derive their value from

something else, the underlying security).

Options have expiration dates, while stocks do not.

There is not a fixed number of options, as there are with stock shares available.

Stockowners have a share of the company, with voting and dividend rights. Options

convey no such rights.

Options Premiums

In this case, XYZ represents the option class while May 30 is the option series.

All options on company XYZ are in the XYZ option class but there will be many

different series.

An option Premium is the price of the option. It is the price you pay to

purchase the option. For example, an XYZ May 30 Call (thus it is an option to buy

Company XYZ stock) may have an option premium of $2. This means that this

option costs $200.00. Why? Because most listed options are for 100 shares of stock,

and all equity option prices are quoted on a per share basis, so they need to be



multiplied times 100. More in-depth pricing concepts will be covered in detail in other

sections of the course.

Strike Price

The Strike (or Exercise) Price is the price at which the underlying security

(in this case, XYZ) can be bought or sold as specified in the option contract. For

example, with the XYZ May 30 Call, the strike price of 30 means the stock can be

bought for $30 per share. Were this the XYZ May 30 Put, it would allow the holder

the right to sell the stock at $30 per share.

The strike price also helps to identify whether an option is In-the-Money, At-

the-Money, or Out-of-the-Money when compared to the price of the underlying

security. You will learn about these terms in another section of the course.

Exercising Options

People who buy options have a Right, and that is the right to Exercise.

For a Call Exercise, Call holders may buy stock at the strike price (from the Call

seller). For a Put Exercise, Put holders may sell stock at the strike price (to the Put

seller). Neither Call holders nor Put holders are obligated to buy or sell; they simply

have the rights to do so, and may choose to Exercise or not to Exercise based upon

their own logic.

Assignment of Options

When an option holder chooses to exercise an option, a process begins to find

a writer who is short the same kind of option (i.e., class, strike price and option type).

Once found, that writer may be Assigned. This means that when buyers exercise,

sellers may be chosen to make good on their obligations. For a Call Assignment,

Call writers are required to sell stock at the strike price to the Call holder. For a Put

Assignment, Put writers are required to buy stock at the strike price from the Put

holder.

Long Term Investing

Given the numerous opportunities that options convey, it is also important to

know that there are options available which can be used to implement longer-term

strategies (not one, two or three months, but those with holding times of one, two or

more years).



These are called LEAPS (for Long Term Equity Anticipation Securities), and

are yet another alternative that options offer to investors. LEAPS are options with

expiration dates of up to three years from the date they are first listed, and are

available on a number of individual stocks and indexes.

LEAPS have different ticker symbols than short-term options (options with

less than nine months until expiration) and, while not available on all stocks, are

available on most widely held issues and can be traded just like any other options.

7.2 The Chicago Board Options Exchange

The Chicago Board Options Exchange, or CBOE, was the world's first listed

options exchange, opened in 1973 by members of the Chicago Board of Trade.

Almost half of all listed options trades still occur on CBOE.

NOTE: Options also trade now on several smaller exchanges, including the American

Stock Exchange (AMEX), the Philadelphia Stock Exchange (PHLX), the Pacific

Stock Exchange (PSE) and the International Securities Exchange (ISE).

CBOE: The Competitive Advantage

With over 1500 competing market makers trading more than one million

options contracts per day, the CBOE is the largest and busiest options exchange in the

world.

The members of the Exchange have maintained this stature for over 25 years

by constantly providing deep and liquid markets in all options series for all CBOE

customers.

CBOE Facts

The CBOE system works to give you the options you need for your

investment strategy, quickly and easily and at the most efficient price. The CBOE

offers investors the best options markets, the most efficient support network, and the

most intensive insight and most recognized educational division in the industry, the

Options Institute.



CBOE is the market leader in the options industry, with:

Options on more than 1,332 stocks and 41 indices. More than 50,000 series

listed

Over $25 billion in contract value traded on a typical day

Over 1 million options contracts changing hands daily

The second largest listed securities market in the U.S., following only the

NYSE

Professional instructors teaching options trading to over 10,000 people a year

The premier portal for options information on the Web,\

7.3 Regulation and Surveillance:

Regulation and surveillance are necessary in the options industry in order to

protect customers and firms, and respond to customer complaints.

CBOE has one of the most technologically advanced and computer-automated

measures for regulation and surveillance, which are unparalleled in the options

industry. CBOE has the premier Regulatory Division, with staff who constantly

monitor trading activity throughout the industry.

The Securities and Exchange Commission (SEC) oversees the entire options

industry to ensure that the markets serve the public interest.

Options Clearing Corporation:

The formation of the OCC in 1973 as the single, independent, universal

clearing agency for all listed options eliminated the problem of credit risk in options

trading. Every options Exchange and every brokerage firm who offers its customers

the ability to trade options is a member or is associated with a member of the OCC.

The OCC stands in the middle of each trade becoming the buyer for all

contracts that are sold, and the seller for all contracts that are bought. Thus, the OCC

is, in fact, the issuer of all listed options contracts, and is registered as such with the

SEC.

7.5 Options Market Participants



Contrary to some beliefs, the single greatest population of CBOE users are not

huge financial institutions, but public investors, just like you. Over 65% of the

Exchange's business comes from them. However, other participants in the financial

marketplace also use options to enhance their performance, including:

Mutual Funds

Pension Plans

Hedge Funds

Endowments

Corporate Treasurers

Stock markets by their very nature are fickle. While fortunes can be made in a

jiffy more often than not the scenario is the reverse. Investing in stocks has two sides

to it –a) Unlimited profit potential from any upside (remember Infosys, HFCL etc) or

b) a downside which could make you a pauper.

Derivative products are structured precisely for this reason -- to curtail the risk

exposure of an investor. Index futures and stock options are instruments that enable

you to hedge your portfolio or open positions in the market. Option contracts allow

you to run your profits while restricting your downside risk.

Apart from risk containment, options can be used for speculation and investors

can create a wide range of potential profit scenarios.

‘Option’, as the word suggests, is a choice given to the investor to either honour

the contract; or if he chooses not to walk away from the contract.

To begin, there are two kinds of options: Call Options and Put Options.

Call options

Call options give the taker the right, but not the obligation, to buy the

underlying shares at a predetermined price, on or before a predetermined date.

Illustration 1:

Raj purchases 1 Satyam Computer (SATCOM) AUG 150 Call --Premium 8



This contract allows Raj to buy 100 shares of SATCOM at Rs 150 per share at

any time between the current date and the end of next August. For this privilege, Raj

pays a fee of Rs 800 (Rs eight a share for 100 shares). The buyer of a call has

purchased the right to buy and for that he pays a premium.

Now let us see how one can profit from buying an option.

Sam purchases a December call option at Rs 40 for a premium of Rs 15. That

is he has purchased the right to buy that share for Rs 40 in December. If the stock

rises above Rs 55 (40+15) he will break even and he will start making a profit.

Suppose the stock does not rise and instead falls he will choose not to exercise the

option and forego the premium of Rs 15 and thus limiting his loss to Rs 15.

Let us take another example of a call option on the Nifty to understand the

concept better.

Nifty is at 1310. The following are Nifty options traded at following quotes.

Option contract Strike price Call premium

Dec Nifty 1325 Rs.6,000

1345 Rs.2,000

Jan Nifty 1325 Rs.4,500

1345 Rs.5000

A trader is of the view that the index will go up to 1400 in Jan 2008 but does

not want to take the risk of prices going down. Therefore, he buys 10 options of Jan

contracts at 1345. He pays a premium for buying calls (the right to buy the contract)

for 500*10= Rs.5,000/-.

In Jan 2008 the Nifty index goes up to 1365. He sells the options or exercises

the option and takes the difference in spot index price which is (1365-1345) * 200

(market lot) = 4000 per contract. Total profit = 40,000/- (4,000*10).

He had paid Rs.5,000/- premium for buying the call option. So he earns by

buying call option is Rs.35,000/- (40,000-5000).



If the index falls below 1345 the trader will not exercise his right and will opt

to forego his premium of Rs.5,000. So, in the event the index falls further his loss is

limited to the premium he paid upfront, but the profit potential is unlimited.

Call Options-Long and Short Positions

When you expect prices to rise, then you take a long position by buying calls.

You are bullish. When you expect prices to fall, then you take a short position by

selling calls. You are bearish.

Put Options :

A Put Option gives the holder of the right to sell a specific number of shares

of an agreed security at a fixed price for a period of time. eg: Sam purchases 1

INFTEC (Infosys Technologies) AUG 3500 Put --Premium 200. This contract allows

Sam to sell 100 shares INFTEC at Rs 3500 per share at any time between the current

date and the end of August. To have this privilege, Sam pays a premium of Rs 20,000

(Rs 200 a share for 100 shares).

The buyer of a put has purchased a right to sell. The owner of a put option has

the right to sell.

Illustration 2: Raj is of the view that the a stock is overpriced and will fall in future,

but he does not want to take the risk in the event of price rising so purchases a put

option at Rs 70 on ‘X’. By purchasing the put option Raj has the right to sell the stock

at Rs 70 but he has to pay a fee of Rs 15 (premium).

So he will breakeven only after the stock falls below Rs 55 (70-15) and will

start making profit if the stock falls below Rs 55.

Illustration 3:

An investor on Dec 15 is of the view that Wipro is overpriced and will fall in

future but does not want to take the risk in the event the prices rise. So he purchases a

Put option on Wipro.



Quotes are as under:

Spot Rs.1040

Jan Put at 1050 Rs.10

Jan Put at 1070 Rs.30

He purchases 1000 Wipro Put at strike price 1070 at Put price of Rs.30/-. He

pays Rs.30,000/- as Put premium.

His position in following price position is discussed below.

1. Jan Spot price of Wipro = 1020

2. Jan Spot price of Wipro = 1080

In the first situation the investor is having the right to sell 1000 Wipro shares

at Rs.1,070/- the price of which is Rs.1020/-. By exercising the option he earns Rs.

(1070-1020) = Rs 50 per Put, which totals Rs 50,000/-. His net income is Rs (50000-

30000) = Rs 20,000.

In the second price situation, the price is more in the spot market, so the

investor will not sell at a lower price by exercising the Put. He will have to allow the

Put option to expire unexercised. He looses the premium paid Rs 30,000.

Put Options-Long and Short Positions

When you expect prices to fall, then you take a long position by buying Puts.

You are bearish. When you expect prices to rise, then you take a short position by

selling Puts. You are bullish.

CALL OPTIONS PUT OPTIONS

If you expect a fall in price(Bearish) Short Long

If you expect a rise in price (Bullish) Long Short



SUMMARY:

CALL OPTION BUYER CALL OPTION WRITER (Seller)

Pays premium

Right to exercise and buy the shares

Profits from rising prices

Limited losses, Potentially unlimited

gain

Receives premium

Obligation to sell shares if exercised

Profits from falling prices or

remaining neutral

Potentially unlimited losses, limited

gain

PUT OPTION BUYER PUT OPTION WRITER (Seller)

Pays premium

Right to exercise and sell shares

Profits from falling prices

Limited losses, Potentially unlimited

gain

Receives premium

Obligation to buy shares if exercised

Profits from rising prices or

remaining neutral

Potentially unlimited losses, limited

gain

Option styles

Settlement of options is based on the expiry date. However, there are three

basic styles of options you will encounter which affect settlement. The styles have

geographical names, which have nothing to do with the location where a contract is

agreed! The styles are:



European: These options give the holder the right, but not the obligation, to buy or

sell the underlying instrument only on the expiry date. This means that the option

cannot be exercised early. Settlement is based on a particular strike price at

expiration. Currently, in India only index options are European in nature.

eg: Sam purchases 1 NIFTY AUG 1110 Call --Premium 20. The exchange

will settle the contract on the last Thursday of August. Since there are no shares for

the underlying, the contract is cash settled.

American: These options give the holder the right, but not the obligation, to buy or

sell the underlying instrument on or before the expiry date. This means that the

option can be exercised early. Settlement is based on a particular strike price at

expiration.

Options in stocks that have been recently launched in the Indian market are

"American Options". eg: Sam purchases 1 ACC SEP 145 Call --Premium 12

Here Sam can close the contract any time from the current date till the

expiration date, which is the last Thursday of September.

American style options tend to be more expensive than European style

because they offer greater flexibility to the buyer.

Option Class and Series

Generally, for each underlying, there are a number of options available: For

this reason, we have the terms "class" and "series".

An option "class" refers to all options of the same type (call or put) and style

(American or European) that also have the same underlying.

eg: All Nifty call options are referred to as one class.

An option series refers to all options that are identical: they are the same type,

have the same underlying, the same expiration date and the same exercise price.



Calls Puts

.Jan Feb Mar Jan Feb Mar

Wipro

1300 45 60 75 15 20 28

1400 35 45 65 25 28 35

1500 20 42 48 30 40 55

eg: Wipro JUL 1300 refers to one series and trades take place at different

premiums

All calls are of the same option type. Similarly, all puts are of the same option

type. Options of the same type that are also in the same class are said to be of the

same class. Options of the same class and with the same exercise price and the same

expiration date are said to be of the same series

Pricing of options

Options are used as risk management tools and the valuation or pricing of the

instruments is a careful balance of market factors.

There are four major factors affecting the Option premium:

Price of Underlying

Time to Expiry

Exercise Price Time to Maturity

Volatility of the Underlying

And two less important factors:

Short-Term Interest Rates

Dividends

7.11 Review of Options Pricing Factors

1. The Intrinsic Value of an Option



The intrinsic value of an option is defined as the amount by which an option is

in-the-money, or the immediate exercise value of the option when the underlying

position is marked-to-market.

For a call option: Intrinsic Value = Spot Price - Strike Price

For a put option: Intrinsic Value = Strike Price - Spot Price

The intrinsic value of an option must be positive or zero. It cannot be negative.

For a call option, the strike price must be less than the price of the underlying asset for

the call to have an intrinsic value greater than 0. For a put option, the strike price must

be greater than the underlying asset price for it to have intrinsic value.

Price of underlying

The premium is affected by the price movements in the underlying instrument.

For Call options – the right to buy the underlying at a fixed strike price – as the

underlying price rises so does its premium. As the underlying price falls so does the

cost of the option premium. For Put options – the right to sell the underlying at a fixed

strike price – as the underlying price rises, the premium falls; as the underlying price

falls the premium cost rises.

The following chart summarizes the above for Calls and Puts.

Option Underlying price Premium cost

Call

Put

2. The Time Value of an Option

Generally, the longer the time remaining until an option’s expiration, the

higher its premium will be. This is because the longer an option’s lifetime, greater is



the possibility that the underlying share price might move so as to make the option in-

the-money. All other factors affecting an option’s price remaining the same, the time

value portion of an option’s premium will decrease (or decay) with the passage of

time.

Note: This time decay increases rapidly in the last several weeks of an option’s life.

When an option expires in-the-money, it is generally worth only its intrinsic value.

Option Time to expiry Premium cost

Call

Put

3. Volatility

Volatility is the tendency of the underlying security’s market price to fluctuate

either up or down. It reflects a price change’s magnitude; it does not imply a bias

toward price movement in one direction or the other. Thus, it is a major factor in

determining an option’s premium. The higher the volatility of the underlying stock,

the higher the premium because there is a greater possibility that the option will move

in-the-money. Generally, as the volatility of an under-lying stock increases, the

premiums of both calls and puts overlying that stock increase, and vice versa.

Higher volatility=Higher premium

Lower volatility = Lower premium

4. Interest rates

In general interest rates have the least influence on options and equate

approximately to the cost of carry of a futures contract. If the size of the options

contract is very large, then this factor may take on some importance. All other factors

being equal as interest rates rise, premium costs fall and vice versa. The relationship

can be thought of as an opportunity cost. In order to buy an option, the buyer must

either borrow funds or use funds on deposit. Either way the buyer incurs an interest



rate cost. If interest rates are rising, then the opportunity cost of buying options

increases and to compensate the buyer premium costs fall. Why should the buyer be

compensated? Because the option writer receiving the premium can place the funds

on deposit and receive more interest than was previously anticipated. The situation is

reversed when interest rates fall – premiums rise. This time it is the writer who needs

to be compensated.

STRATEGIES

Bull Market Strategies

a. Calls in a Bullish Strategy

An investor with a bullish market outlook should buy call options. If you

expect the market price of the underlying asset to rise, then you would rather have the

right to purchase at a specified price and sell later at a higher price than have the

obligation to deliver later at a higher price.

The investor's profit potential of buying a call option is unlimited. The

investor's profit is the market price less the exercise price less the premium. The

greater the increase in price of the underlying, the greater the investor's profit.

The investor's potential loss is limited. Even if the market takes a drastic

decline in price levels, the holder of a call is under no obligation to exercise the

option. He may let the option expire worthless.

The investor breaks even when the market price equals the exercise price

plus the premium.

An increase in volatility will increase the value of your call and increase your

return. Because of the increased likelihood that the option will become in- the-money,

an increase in the underlying volatility (before expiration), will increase the value of a

long options position. As an option holder, your return will also increase.

A simple example will illustrate the above:



Suppose there is a call option with a strike price of Rs.2000 and the option

premium is Rs.100. The option will be exercised only if the value of the underlying is

greater than Rs.2000 (the strike price). If the buyer exercises the call at Rs.2200 then

his gain will be Rs.200. However, this would not be his actual gain for that he will

have to deduct the Rs.200 (premium) he has paid.

The profit can be derived as follows

Profit = Market price - Exercise price - Premium

Profit = Market price – Strike price – Premium.

2200 – 2000 – 100 = Rs.100

b. Puts in a Bullish Strategy

An investor with a bullish market outlook can also go short on a Put option.

Basically, an investor anticipating a bull market could write Put options. If the market

price increases and puts become out-of-the-money, investors with long put positions

will let their options expire worthless.

By writing Puts, profit potential is limited. A Put writer profits when the price

of the underlying asset increases and the option expires worthless. The maximum

profit is limited to the premium received.

However, the potential loss is unlimited. Because a short put position holder

has an obligation to purchase if exercised. He will be exposed to potentially large

losses if the market moves against his position and declines.

The break-even point occurs when the market price equals the exercise price:

minus the premium. At any price less than the exercise price minus the premium, the

investor loses money on the transaction. At higher prices, his option is profitable.

An increase in volatility will increase the value of your put and decrease your

return. As an option writer, the higher price you will be forced to pay in order to buy

back the option at a later date , lower is the return.

Bullish Call Spread Strategies



A vertical call spread is the simultaneous purchase and sale of identical call

options but with different exercise prices.

To "buy a call spread" is to purchase a call with a lower exercise price and to

write a call with a higher exercise price. The trader pays a net premium for the

position.

To "sell a call spread" is the opposite, here the trader buys a call with a higher

exercise price and writes a call with a lower exercise price, receiving a net premium

for the position.

An investor with a bullish market outlook should buy a call spread. The "Bull

Call Spread" allows the investor to participate to a limited extent in a bull market,

while at the same time limiting risk exposure.

To put on a bull spread, the trader needs to buy the lower strike call and sell

the higher strike call. The combination of these two options will result in a bought

spread. The cost of Putting on this position will be the difference between the

premium paid for the low strike call and the premium received for the high strike call.

The investor's profit potential is limited. When both calls are in-the-money,

both will be exercised and the maximum profit will be realised. The investor delivers

on his short call and receives a higher price than he is paid for receiving delivery on

his long call.

The investors's potential loss is limited. At the most, the investor can lose is

the net premium. He pays a higher premium for the lower exercise price call than he

receives for writing the higher exercise price call.

The investor breaks even when the market price equals the lower exercise

price plus the net premium. At the most, an investor can lose is the net premium paid.

To recover the premium, the market price must be as great as the lower exercise price

plus the net premium.

An example of a Bullish call spread:



Let's assume that the cash price of a scrip is Rs.100 and you buy a November

call option with a strike price of Rs.90 and pay a premium of Rs.14. At the same time

you sell another November call option on a scrip with a strike price of Rs.110 and

receive a premium of Rs.4. Here you are buying a lower strike price option and

selling a higher strike price option. This would result in a net outflow of Rs.10 at the

time of establishing the spread.

Now let us look at the fundamental reason for this position. Since this is a

bullish strategy, the first position established in the spread is the long lower strike

price call option with unlimited profit potential. At the same time to reduce the cost of

puchase of the long position a short position at a higher call strike price is established.

While this not only reduces the outflow in terms of premium but his profit potential as

well as risk is limited. Based on the above figures the maximum profit, maximum loss

and breakeven point of this spread would be as follows:

Maximum profit = Higher strike price - Lower strike price - Net premium

paid

= 110 - 90 - 10 = 10

Maximum Loss = Lower strike premium - Higher strike premium

= 14 - 4 = 10

Breakeven Price = Lower strike price + Net premium paid

= 90 + 10 = 100

Bullish Put Spread Strategies

A vertical Put spread is the simultaneous purchase and sale of identical Put


To "buy a put spread" is to purchase a Put with a higher exercise price and to

write a Put with a lower exercise price. The trader pays a net premium for the

position.



To "sell a put spread" is the opposite: the trader buys a Put with a lower

exercise price and writes a put with a higher exercise price, receiving a net premium

for the position.

An investor with a bullish market outlook should sell a Put spread. The

"vertical bull put spread" allows the investor to participate to a limited extent in a bull

market, while at the same time limiting risk exposure.

To put on a bull spread, a trader sells the higher strike put and buys the lower

strikeput. The bull spread can be created by buying the lower strike and selling the

higher strike of either calls or put. The difference between the premiums paid and

received makes up one leg of the spread.

The investor's profit potential is limited. When the market price reaches or

exceeds the higher exercise price, both options will be out-of-the-money and will

expire worthless. The trader will realize his maximum profit, the net premium

The investor's potential loss is also limited. If the market falls, the options will

be in-the-money. The puts will offset one another, but at different exercise prices.

The investor breaks-even when the market price equals the lower exercise

price less the net premium. The investor achieves maximum profit i.e the premium

received, when the market price moves up beyond the higher exercise price (both puts

are then worthless).

An example of a bullish put spread.

Lets us assume that the cash price of the scrip is Rs.100. You now buy a

November put option on a scrip with a strike price of Rs.90 at a premium of Rs.5 and

sell a put option with a strike price of Rs.110 at a premium of Rs.15.

The first position is a short put at a higher strike price. This has resulted in

some inflow in terms of premium. But here the trader is worried about risk and so

caps his risk by buying another put option at the lower strike price. As such, a part of

the premium received goes off and the ultimate position has limited risk and limited



profit potential. Based on the above figures the maximum profit, maximum loss and

breakeven point of this spread would be as follows:

Maximum profit = Net option premium income or net credit

= 15 - 5 = 10

Maximum loss = Higher strike price - Lower strike price - Net premium received

= 110 - 90 - 10 = 10

Breakeven Price = Higher Strike price - Net premium income

= 110 - 10 = 100

2. Bear Market Strategies

a. Puts in a Bearish Strategy: When you purchase a put you are long and want the

market to fall. A put option is a bearish position. It will increase in value if the market

falls. An investor with a bearish market outlook shall buy put options. By purchasing

put options, the trader has the right to choose whether to sell the underlying asset at

the exercise price. In a falling market, this choice is preferable to being obligated to

buy the underlying at a price higher.

An investor's profit potential is practically unlimited. The higher the fall in

price of the underlying asset, higher the profits.

The investor's potential loss is limited. If the price of the underlying asset rises

instead of falling as the investor has anticipated, he may let the option expire

worthless. At the most, he may lose the premium for the option.

The trader's breakeven point is the exercise price minus the premium. To

profit, the market price must be below the exercise price. Since the trader has paid a

premium he must recover the premium he paid for the option.



An increase in volatility will increase the value of your put and increase your

return. An increase in volatility will make it more likely that the price of the

underlying instrument will move. This increases the value of the option.

b. Calls in a Bearish Strategy: Another option for a bearish investor is to go short on

a call with the intent to purchase it back in the future. By selling a call, you have a net

short position and needs to be bought back before expiration and cancel out your

position.

For this an investor needs to write a call option. If the market price falls, long

call holders will let their out-of-the-money options expire worthless, because they

could purchase the underlying asset at the lower market price.

The investor's profit potential is limited because the trader's maximum profit is

limited to the premium received for writing the option.

Here the loss potential is unlimited because a short call position holder has an

obligation to sell if exercised, he will be exposed to potentially large losses if the

market rises against his position.

The investor breaks even when the market price equals the exercise price: plus

the premium. At any price greater than the exercise price plus the premium, the trader

is losing money. When the market price equals the exercise price plus the premium,

the trader breaks even.

An increase in volatility will increase the value of your call and decrease your

return. When the option writer has to buy back the option in order to cancel out his

position, he will be forced to pay a higher price due to the increased value of the calls.

Bearish Put Spread Strategies

A vertical put spread is the simultaneous purchase and sale of identical put




To "buy a put spread" is to purchase a put with a higher exercise price and to

write a put with a lower exercise price. The trader pays a net premium for the

position.

To "sell a put spread" is the opposite. The trader buys a put with a lower

exercise price and writes a put with a higher exercise price, receiving a net premium

for the position. To put on a bear put spread you buy the higher strike put and sell the

lower strike put. You sell the lower strike and buy the higher strike of either calls or

puts to set up a bear spread.

An investor with a bearish market outlook should: buy a put spread. The "Bear

Put Spread" allows the investor to participate to a limited extent in a bear market,


The investor's profit potential is limited. When the market price falls to or

below the lower exercise price, both options will be in-the-money and the trader will

realize his maximum profit when he recovers the net premium paid for the options.

The investor's potential loss is limited. The trader has offsetting positions at

different exercise prices. If the market rises rather than falls, the options will be out-

of-the-money and expire worthless. Since the trader has paid a net premium

The investor breaks even when the market price equals the higher exercise

price less the net premium. For the strategy to be profitable, the market price must

fall. When the market price falls to the high exercise price less the net premium, the

trader breaks even. When the market falls beyond this point, the trader profits.

An example of a bearish put spread.

Lets assume that the cash price of the scrip is Rs.100. You buy a November

put option on a scrip with a strike price of Rs.110 at a premium of Rs.15 and sell a put

option with a strike price of Rs.90 at a premium of Rs.5.

In this bearish position the put is taken as long on a higher strike price put with

the outgo of some premium. This position has huge profit potential on downside. If

the trader may recover a part of the premium paid by him by writing a lower strike



price put option. The resulting position is a mildly bearish position with limited risk

and limited profit profile. Though the trader has reduced the cost of taking a bearish

position, he has also capped the profit potential as well. The maximum profit,

maximum loss and breakeven point of this spread would be as follows:

Maximum profit = Higher strike price option - Lower strike price option

- Net premium paid

= 110 - 90 - 10 = 10

Maximum loss = Net premium paid

= 15 - 5 = 10

Breakeven Price = Higher strike price - Net premium paid

= 110 - 10 = 100

Bearish Call Spread Strategies

A vertical call spread is the simultaneous purchase and sale of identical call


To "buy a call spread" is to purchase a call with a lower exercise price and to

write a call with a higher exercise price. The trader pays a net premium for the

position.

To "sell a call spread" is the opposite: the trader buys a call with a higher

exercise price and writes a call with a lower exercise price, receiving a net premium

for the position.

To put on a bear call spread you sell the lower strike call and buy the higher

strike call. An investor sells the lower strike and buys the higher strike of either calls

or puts to put on a bear spread.



An investor with a bearish market outlook should: sell a call spread. The "Bear

Call Spread" allows the investor to participate to a limited extent in a bear market,


The investor's profit potential is limited. When the market price falls to the

lower exercise price, both out-of-the-money options will expire worthless. The

maximum profit that the trader can realize is the net premium: The premium he

receives for the call at the higher exercise price.

Here the investor's potential loss is limited. If the market rises, the options will

offset one another. At any price greater than the high exercise price, the maximum

loss will equal high exercise price minus low exercise price minus net premium.

The investor breaks even when the market price equals the lower exercise

price plus the net premium. The strategy becomes profitable as the market price

declines. Since the trader is receiving a net premium, the market price does not have

to fall as low as the lower exercise price to breakeven.

An example of a bearish call spread.

Let us assume that the cash price of the scrip is Rs 100. You now buy a

November call option on a scrip with a strike price of Rs 110 at a premium of Rs 5

and sell a call option with a strike price of Rs 90 at a premium of Rs 15.

In this spread you have to buy a higher strike price call option and sell a lower

strike price option. As the low strike price option is more expensive than the higher

strike price option, it is a net credit startegy. The final position is left with limited risk

and limited profit. The maximum profit, maximum loss and breakeven point of this

spread would be as follows:

Maximum profit = Net premium received

= 15 - 5 = 10

Maximum loss = Higher strike price option - Lower strike price option -

Net premium received



= 110 - 90 - 10 = 10

Breakeven Price = Lower strike price + Net premium paid

= 90 + 10 = 100

Key Regulations

In India we have two premier exchanges The National Stock Exchange of

India (NSE) and The Bombay Stock Exchange (BSE) which offer options trading on

stock indices as well as individual securities.

Options on stock indices are European in kind and settled only on the last of

expiration of the underlying. NSE offers index options trading on the NSE Fifty index

called the Nifty. While BSE offers index options on the country’s widely used index

Sensex, which consists of 30 stocks.

Options on individual securities are American. The number of stock options

contracts to be traded on the exchanges will be based on the list of securities as

specified by Securities and Exchange Board of India (SEBI). Additions/deletions in

the list of securities eligible on which options contracts shall be made available shall

be notified from time to time.

Underlying: Underlying for the options on individual securities contracts shall be the

underlying security available for trading in the capital market segment of the

exchange.

Security descriptor: The security descriptor for the options on individual securities

shall be:

Market type - N

Instrument type - OPTSTK

Underlying - Underlying security

Expiry date - Date of contract expiry

Option type - CA/PA



Exercise style - American Premium Settlement method: Premium Settled; CA

- Call American

PA - Put American.

Trading cycle: The contract cycle and availability of strike prices for options

contracts on individual securities shall be as follows:

Options on individual securities contracts will have a maximum of three-

month trading cycle. New contracts will be introduced on the trading day following

the expiry of the near month contract.

On expiry of the near month contract, new contract shall be introduced at new

strike prices for both call and put options, on the trading day following the expiry of

the near month contract. (See Index futures learning centre for further reading)

Strike price intervals: The exchange shall provide a minimum of five strike prices

for every option type (i.e call and put) during the trading month. There shall be two

contracts in-the-money (ITM), two contracts out-of-the-money (OTM) and one

contract at-the-money (ATM). The strike price interval for options on individual

securities is given in the accompanying table.

New contracts with new strike prices for existing expiration date will be

introduced for trading on the next working day based on the previous day's underlying

close values and as and when required. In order to fix on the at-the-money strike price

for options on individual securities contracts the closing underlying value shall be

rounded off to the nearest multiplier of the strike price interval. The in-the-money

strike price and the out-of-the-money strike price shall be based on the at-the-money

strike price interval.

Expiry day: Options contracts on individual securities as well as index options shall

expire on the last Thursday of the expiry month. If the last Thursday is a trading

holiday, the contracts shall expire on the previous trading day.

Order type: Regular lot order, stop loss order, immediate or cancel, good till day,

good till cancelled, good till date and spread order. Good till cancelled (GTC) orders



shall be cancelled at the end of the period of 7 calendar days from the date of entering

an order.

Permitted lot size: The value of the option contracts on individual securities shall not

be less than Rs.2 lakh at the time of its introduction. The permitted lot size for the

options contracts on individual securities shall be in multiples of 100 and fractions if

any, shall be rounded off to the next higher multiple of 100.

Price steps: The price steps in respect of all options contracts admitted to dealings on

the exchange shall be Re 0.05.

Quantity freeze: Orders which may come to the exchange as a quantity freeze shall

be the lesser of the following: 1 per cent of the market wide position limit stipulated

of options on individual securities as given in (h) below or Notional value of the

contract of around Rs.5 crore. In respect of such orders, which have come under

quantity freeze, the member shall be required to confirm to the exchange that there is

no inadvertent error in the order entry and that the order is genuine. On such

confirmation, the exchange at its discretion may approve such order subject to

availability of turnover/exposure limits, etc.

Base price: Base price of the options contracts on introduction of new contracts shall

be the theoretical value of the options contract arrived at based on Black-Scholes

model of calculation of options premiums. The base price of the contracts on

subsequent trading days will be the daily close price of the options contracts.

However in such of those contracts where orders could not be placed because of

application of price ranges, the bases prices may be modified at the discretion of the

exchange and intimated to the members.

Price ranges: There will be no day minimum/maximum price ranges applicable for

the options contract. The operating ranges and day minimum/maximum ranges for

options contract shall be kept at 99 per cent of the base price. In view of this the

members will not be able to place orders at prices which are beyond 99 per cent of the

base price. The base prices for option contracts may be modified, at the discretion of

the exchange, based on the request received from trading members as mentioned

above.



Exposure limits: Gross open positions of a member at any point of time shall not

exceed the exposure limit as detailed hereunder:

Index Options: Exposure Limit shall be 33.33 times the liquid networth.

Option contracts on individual Securities: Exposure Limit shall be 20 times

the liquid networth.

Memberwise position limit: When the open position of a Clearing Member, Trading

Member or Custodial Participant exceeds 15 per cent of the total open interest of the

market or Rs 100 crore, whichever is higher, in all the option contracts on the same

underlying, at any time, including during trading hours.

For option contracts on individual securities, open interest shall be equivalent to the

open positions multiplied by the notional value. Notional Value shall be the previous

day's closing price of the underlying security or such other price as may be specified

from time to time.

Market wide position limits: Market wide position limits for option contracts on

individual securities shall be lower of: *20 times the average number of shares traded

daily, during the previous calendar month, in the relevant underlying security in the

underlying segment of the relevant exchange or, 10 per cent of the number of shares

held by non-promoters in the relevant underlying security i.e. 10 per cent of the free

float in terms of the number of shares of a company.

The relevant authority shall specify the market wide position limits once every

month, on the expiration day of the near month contract, which shall be applicable till

the expiry of the subsequent month contract.

Exercise settlement: Exercise type shall be American and final settlement in respect

of options on individual securities contracts shall be cash settled for an initial period

of 6 months and as per the provisions of National Securities Clearing Corporation Ltd

(NSCCL) as may be stipulated from time to time.

Reading Stock Option Tables



In India, option tables published in business newspapers and is fairly similarto the regular stock tables.

The following is the format of the options table published in Indian business news papers:

NIFTY OPTIONS

Contracts Exp.Date Str.Price Opt.Type Open High Low Trd.Qty No.of.Cont. Trd.Value

RELIANCE 7/26/01 360 CA 3 3 2 4200 7 1512000

RELIANCE 7/26/01 360 PA 29 39 29 1200 2 432000

RELIANCE 7/26/01 380 CA 1 1 1 1200 2 456000

RELIANCE 7/26/01 380 PA 35 40 35 1200 2 456000

RELIANCE 7/26/01 340 CA 8 9 6 11400 19 3876000

RELIANCE 7/26/01 340 PA 10 14 10 13800 23 4692000

RELIANCE 7/26/01 320 CA 22 24 16 11400 19 3648000

RELIANCE 7/26/01 320 PA 4 7 2 29400 49 9408000

RELIANCE 8/30/01 360 PA 31 35 31 1200 2 432000

RELIANCE 8/30/01 340 CA 15 15 15 600 1 204000

RELIANCE 8/30/01 320 PA 10 10 10 600 1 192000

RELIANCE 7/26/01 300 CA 38 38 38 600 1 180000

RELIANCE 7/26/01 300 PA 2 2 2 1200 2 360000

RELIANCE 7/26/01 280 CA 59 60 53 1800 3 504000

The first column shows the contract that is being traded i.e Reliance.



The second column displays the date on which the contract will expire i.e.

the expiry date is the last Thursday of the month.

Call options-American are depicted as 'CA' and Put options-American

as'PA'.

The Open, High, Low, Close columns display the traded premium rates.

Advantages of option trading

1. Risk management: Put options allow investors holding shares to hedge against a

possible fall in their value. This can be considered similar to taking out insurance

against a fall in the share price.

2. Time to decide: By taking a call option the purchase price for the shares is locked

in. This gives the call option holder until the Expiry Day to decide whether or not to

exercise the option and buy the shares. Likewise the taker of a put option has time to

decide whether or not to sell the shares.

3. Speculation: The ease of trading in and out of an option position makes it possible

to trade options with no intention of ever exercising them. If an investor expects the

market to rise, they may decide to buy call options. If expecting a fall, they may

decide to buy put options. Either way the holder can sell the option prior to expiry to

take a profit or limit a loss. Trading options has a lower cost than shares, as there is no

stamp duty payable unless and until options are exercised.

4. Leverage: Leverage provides the potential to make a higher return from a smaller

initial outlay than investing directly. However, leverage usually involves more risks

than a direct investment in the underlying shares. Trading in options can allow

investors to benefit from a change in the price of the share without having to pay the

full price of the share.

We can see below how one can leverage ones position by just paying the premium.

Option Premium Stock

Bought on Oct 15 Rs 380 Rs 4000

Sold on Dec 15 Rs 670 Rs 4500



Profit Rs 290 Rs 500

ROI (Not annualized) 76.3% 12.5%

5. Income generation: Shareholders can earn extra income over and above dividends

by writing call options against their shares. By writing an option they receive the

option premium upfront. While they get to keep the option premium, there is a

possibility that they could be exercised against and have to deliver their shares to the

taker at the exercise price.

6. Strategies: By combining different options, investors can create a wide range of

potential profit scenarios. To find out more about options strategies read the module

on trading strategies.

Settlement of options contracts

Options contracts have three types of settlements, daily premium settlement, exercise

settlement, interim exercise settlement in the case of option contracts on securities and

final settlement.

1. Daily premium settlement: Buyer of an option is obligated to pay the

premium towards the options purchased by him. Similarly, the seller of an option is

entitled to receive the premium for the option sold by him. The premium payable

amount and the premium receivable amount are netted to compute the net premium

payable or receivable amount for each client for each option contract.

2. Exercise settlement: Although most option buyers and sellers close out their

options positions by an offsetting closing transaction, an understanding of exercise

can help an option buyer determine whether exercise might be more advantageous

than an offsetting sale of the option. There is always a possibility of the option seller

being assigned an exercise. Once an exercise of an option has been assigned to an

option seller, the option seller is bound to fulfill his obligation (meaning, pay the cash

settlement amount in the case of a cash-settled option) even though he may not yet

have been notified of the assignment.



3. Interim exercise settlement: Interim exercise settlement takes place only for

option contracts on securities. An investor can exercise his in-the-money options at

any time during trading hours, through his trading member. Interim exercise

settlement is effected for such options at the close of the trading hours, on the day of

exercise. Valid exercised option contracts are assigned to short positions in the option

contract with the same series (i.e. having the same underlying, same expiry date and

same strike price), on a random basis, at the client level. The CM who has exercised

the option receives the exercise settlement value per unit of the option from the CM

who has been assigned the option contract.



CLEARING AND SETTLEMENT

National Securities Clearing Corporation Limited (NSCCL) undertakes

clearing and settlement of all trades executed on the futures and options (F&O)

segment of the NSE. It also acts as legal counterparty to all trades on the F&O

segment and guarantees their financial settlement.

Clearing entities

Clearing and settlement activities in the F&O segment are undertaken by

NSCCL with the help of the following entities:

Clearing members

In the F&O segment, some members, called self clearing members, clear and

settle their trades executed by them only either on their own account or on account of

their clients. Some others, called trading member–cum–clearing member, clear and

settle their own trades as well as trades of other trading members(TMs). Besides,

there is a special category of members, called professional clearing members (PCM)

who clear and settle trades executed by TMs. The members clearing their own trades

and trades of others, and the PCMs are required to bring in additional security

deposits in respect of every TM whose trades they undertake to clear and settle.

Clearing banks

Funds settlement takes place through clearing banks. For the purpose of

settlement all clearing members are required to open a separate bank account with

NSCCL designated clearing bank for F&O segment. The Clearing and Settlement

process comprises of the following three main activities:

1. Clearing

2. Settlement

3. Risk Management



Risk ManagementNSCCL has developed a comprehensive risk containment mechanism for the F&O segment. The salient features of risk containment mechanism on the F&O segment are:

The financial soundness of the members is the key to risk management.

Therefore, the requirements for membership in terms of capital adequacy (net

worth, security deposits) are quite stringent.

NSCCL charges an upfront initial margin for all the open positions of a CM. It

specifies the initial margin requirements for each futures/options contract on a

daily basis. It also follows value-at-risk(VaR) based margining through SPAN.

The CM in turn collects the initial margin from the TMs and their respective

clients.

The open positions of the members are marked to market based on contract

settlement price for each contract. The difference is settled in cash on a T+1

basis.

NSCCL’s on-line position monitoring system monitors a CM’s open positions

on a real-time basis. Limits are set for each CM based on his capital deposits.

The on-line position monitoring system generates alerts whenever a CM

reaches a position limit set up by NSCCL. NSCCL monitors the CMs for

MTM value violation, while TMs are monitored for contract-wise position

limit violation.

CMs are provided a trading terminal for the purpose of monitoring the open

positions of all the TMs clearing and settling through him. A CM may set

exposure limits for a TM clearing and settling through him. NSCCL assists the

CM to monitor the intra-day exposure limits set up by a CM and whenever a

TM exceed the limits, it stops that particular TM from further trading.

A member is alerted of his position to enable him to adjust his exposure or

bring in additional capital. Position violations result in withdrawal of trading

facility for all TMs of a CM in case of a violation by the CM.

A separate settlement guarantee fund for this segment has been created out of

the capital of members. The fund had a balance of Rs. 648 crore at the end of

March 2002. The most critical component of risk containment mechanism for

F&O segment is the margining system and on-line position monitoring. The

actual position monitoring and margining is carried out on–line through



Parallel Risk Management System (PRISM). PRISM uses SPAN(r) (Standard

Portfolio Analysis of Risk) system for the purpose of computation of on-line

margins, based on the parameters defined by SEBI.

NSE–SPANThe objective of NSE–SPAN is to identify overall risk in a portfolio of all

futures and options contracts for each member. The system treats futures and options

contracts uniformly, while at the same time recognizing the unique exposures

associated with options portfolios, like extremely deep out–of–the–money short

positions and inter–month risk. Its over–riding objective is to determine the largest

loss that a portfolio might reasonably be expected to suffer from one day to the next

day based on 99% VaR methodology. SPAN considers uniqueness of option

portfolios. The following factors affect the value of an option:

Underlying market price

Strike price

Volatility(variability) of underlying instrument

Time to expiration

Interest rate

As these factors change, the value of options maintained within a portfolio

also changes. Thus, SPAN constructs scenarios of probable changes in underlying

prices and volatilities in order to identify the largest loss a portfolio might suffer from

one day to the next. It then sets the margin requirement to cover this one–day loss.

The complex calculations (e.g. the pricing of options) in SPAN are executed by

NSCCL. The results of these calculations are called risk arrays. Risk arrays, and other

necessary data inputs for margin calculation are provided to members daily in a file

called the SPAN risk parameter file. Members can apply the data contained in the risk

parameter files, to their specific portfolios of futures and options contracts, to

determine their SPAN margin requirements. Hence, members need not execute

complex option pricing calculations, which is performed by NSCCL. SPAN has the

ability to estimate risk for combined futures and options portfolios, and also re–value

the same under various scenarios of changing market conditions.



CALCULATION OF BROKERAGE.

Brokerage is the amount paid to the stock broker for the services rendered by

him to the client. As per the SEBI guidelines, ASCI can charge maximum 2 percent as

brokerage to the clients. Again brokerage differs from branch to branch. Along with

brokerage, Service tax at 10 percent, Cess etc., are also added to the amount charged

to the client.

The brokerage is calculated at the rate of 0.5% or 0.50 paisa, whichever is

higher. In NSE &BSE, on Delivery base the brokerage is charged at the rate of 0.5%.

For the clients who are trading not frequently, the rate of brokerage is 0.75%.

Brokerage is calculated as follows:

=certain percentage of brokerage* price of a scrip

The answer will be multiplied with number of shares traded.

For example,

If the rate of brokerage is –0.5%

The price of a scrip is –Ts. 250

And the number of shares traded of that particular scrip is –100

Therefore, amount to be paid as brokerage is,

=0.5*250/100

=Rs. 1.25*100

=Rs.125



HIDDEN COST

Apart from brokerage other costs like Service charges, Cess, Courier charges,

Tax etc., are included in the brokerage, which is called as Hidden cost. Hidden cost

adds to the amount of brokerage. Apart from brokerage Service Tax is charged at the

rate of 12 percent, Cess is 0.2 percent and Security Transaction Tax is charged at the

rate of 0.13 percent (STT). STT is charged on turnover.

KEY COMBINATIONS USED FOR THE TRANSACTIONS:



Buying -F1 or +

Selling - F2 or -

Outstanding or pending position -F3

Delete -F4

Cancellation -F3

Market depth -F6 (no. of buyers, sellers, quantity sold, traded volume etc)

Total net position -F8 (transactions traded)

Market snapshot -F10 (company’s details – open, high, low, previous, close etc)

Choose instruments -Ctrl +Z

Total trading information _Ctrl +N

FINDINGS



1. During the analysis I found that after opening an account, the transactions,

which are made by the investors, are not updated or entered to the concerned

investor’s account and because of this, sometimes the investor has to face

some difficulties in accessing his account.

2. NSE follows the NEAT system and BSE follows the BOLT system for trading

in the securities. Both of these are Screen Based Trading Systems.

3. The ASCI having broker and sub broker. These two are faciliting the clients to

purchase and sell the securities in the secondary market, for that they charge

some commission called brokerage.

4. The ASCI Stock Broking Ltd has to fulfill the conditions framed by the SEBI.

5. Market is being divided into two parts i.e. primary market and secondary

market. Primary Market helps to raise fund through IPO’s and Secondary

Market helps the investor to buy the share from the stock market. SEBI is

regulating both the Markets.

6. T+2 rolling settlements have been introduced in the year Aug 2003.

7. NSDL and CSDL, these two are the Depositories in India.

8. Doing the work of online buying and selling of securities on behalf of the

client.

9. Trading in Derivatives products like Futures and Options.

10. Helping the client for clearing and settlements.

CONCLUSION

1. Investors can use derivatives instruments in all trends of markets especially

options where loss is restricted to the premium paid and profit is unlimited.



2. Introduction of derivatives in Indian market has really served its purpose of

reducing the volatility in the spot market. It has made the stock market

relatively safer.

3. ASCI is one of the leading brokers at Hubli and it is providing good research

reports and investment advices to keep its customers profitable.

4. ASCI is providing many services to the investors along with share broking.

Such as demat and Remat services, Mutual Funds, Investments, Personal Tax

Planning and Insurance advisory. And it has proved it self as a leading stock

broker.

Suggestions:



1. The awareness about derivatives among investors should be increased by

conducting various awareness and educational programs.

2. The company can conduct seminars to promote their services.

3. The company can think of tapping the existing demat account holders and

provide them enough information on derivatives and enable them to trade in

the same. This will help the company to increase its earnings of brokerage

income.

4. The company has to create and maintain a database of prospective customers

from time to time, to keep track of the people falling in different income levels

and their investing patterns. This is possible if continuous contacts are

maintained with the customers.

5. The problems faced by the customers in online trading like placing of orders,

delivery, margins etc. have to be attended quickly so that they carry an

outstanding and reliable image outside.

BIBLIOGRAPHY

WWW. APPOLLO SINDHOORI .COMWWW.GOOLGE.COM


http://WWW.GOOLGE.COM/

http://WWW.KARVY.COM/


WWW.ICICIDIRECT.COMWWW.NSEINDIA.COM

The data was collected from the list of Books and websites given below:

Options, Futures and Other Derivatives – John C Hull


http://WWW.NSEINDIA.COM/

http://WWW.ICICIDIRECT.COM/

analysis of derivatives and stock broking at apollo sindhoori project report

Economy & Finance