perception of derivatives @ smc investment project report

SMC INVESMENT SOLUTIONS & SERVICES

Table of Contents

Sl.no Particulars Page No.

1. Executive Summary 1.

2. Indian Economy Overview 6

3 Company Overview 7

4 Derivatives

4.1 Introduction 10

4.2 Indian Scenario 11

5 Futures Contract 18

5.1 Understanding Index Futures 20

5.2 Hedging 21

5.3 Speculation 24

5.4 Arbitrage 25

5.5 Pricing of Index Futures 26

5.6 Trading Strategies 29

5.7 Settlement Of Futures Contract 36

6 Options

6.1 What is an Option? 41

6.2 Chicago Board of Options Exchange 44

6.3 Regulation and Surveillance 45

6.4 Options Clearing Corporation 45

6.5 Options Market Participants 45

6.6 Call Options 47

6.7 Put Options 49

6.8 Option Styles 52

6.9 Option Class & Series 53

6.10 Pricing of Options 54

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6.11 Options Pricing Factors 54

6.12 Strategies 58

6,13 Key Regulations 75

6.14 Advantages of option trading 80

6.15 Settlement of Options 82

7 Clearing & Settlement 83

8 Analysis 87

9 Findings 105

10 Suggestions 107

11 Conclusion 108

12 Annexure 109

13 Bibliography 111

1. Executive Summary:

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Topic: -

“ Comprehensive Study of Derivative Products and Investors’ Perception ofDerivative products in Hubli City ”

Name of the Organization:- SMC Investment Solutions & Services, Hubli

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.

The Derivatives market in Hubli is still in a budding stage, It is necessary to understand the perception of investors in Hubli city and try to gather information regarding the behaviour of investors towards Derivatives. So that, the company can devise certain measures to improve the Derivatives market in Hubli city.

Objectives of the Study:-

To study the Investors perception of Derivatives products in Hubli city, and a detailed

study of Derivative products.

Sub Objectives:

To study the trading procedures for Derivative products

To study the features of Derivatives products such as Futures and Options.

To study the clearing and settlement procedure of Derivatives products

To know the awareness and perception of Derivative products in Hubli city.

Methodology:-

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

project.

Data collection method

Primary data as well as secondary data is used to collect the information.

Primary data

Information will be gathered through questionnaires and discussion with the

employees of SMC investment solutions & Services Hubli.

Secondary data

Secondary data will be collected from the various books on

Derivatives,

Journals

Magazines and Internet.

10. FINDINGS:

1. Futures market facilitates for buying and selling futures contracts, which state the

price per unit, type, value, quality and quantity of the commodity in question, as

well as the month the contract expires.

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2. Futures accounts are credited or debited daily depending on profits or losses

incurred. The futures market is also characterized as being highly leveraged due

to its margins; although leverage works as a double-edged sword.

3. “Going long,” “going short,” and “spreads” are the most common strategies used

when trading on the futures market.

4. Investors use options both to speculate and hedge risk.

5. Income is almost evenly distributed among the sample:- 18% less than Rs.1lakh,

27% each Rs.1 lakh-1.5lakhs and upto Rs.2 lakhs and 34% above Rs.2 lakhs.

6. The respondents’ current investments are mainly in FD, Insurance, Mutual Funds

and Shares.

7. 53% of the respondents are aware of derivatives.

8. 44 people falling in the age group of 21-30, only 26 are aware of derivatives i.e.,

43% of them are unaware. As you can see the good awareness level among the

investors of the age 30-40, Rest 43% of the age group 21-30 need to be tapped by

the company and create awareness about derivatives.

9. People above the age of 50 years are unaware of derivatives. They are fond of

traditional investment instruments.



11. 37 respondents are aware of Futures and 40 are aware of Options.

12. The main factors considered while investing in derivatives are risk[20], return

[24] and volatility [08].

13. Out of 26 people who have invested in derivatives, only 9 of them are considering

the risk factor. This means that they perceive derivatives as less risky.

14. Out of 26 people who have invested their money in derivatives, ALL of them

consider the return factor. This means that derivatives give good returns, as per

their experience.

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15. Out of 26 derivative investors, 17 of them [i.e., 65%] consider the volatility factor

which is the most important influencer in derivative segment in the market. The

investors perceive derivatives as volatile investments.

16. Lot sizes and margins are affecting the investment decisions of the investors to a

large extent. Lot sizes also determine the decisions of the investors to a large

extent.

17. Out of the 100 respondents surveyed, only 52 are willing to invest in derivatives.

And out of them 26 are already the investors. This shows that derivatives are not

known to approximately about 50% of the people in Hubli

18. Awareness of derivatives and investing in is positively correlated. This means that

if there is increase in the number of people being aware of derivatives, the flow of

investments in derivatives will also be more. Awareness is directly associated

with investments in derivatives.

19. The association of risk factor and investing in derivatives is very meager. This

means that increase in risk does not affect investing in derivatives to a greater

extent. Investors perceive derivatives as less risky.

20. Actually derivatives are considered highly volatile. The volatility in the market

directly affects the price of derivatives. The correlation between volatility and

investing in derivatives is 0.393 which is again less but it is positive. This

indicates that an increase in volatility affects the investing in derivatives to some

considerable extent.

21. 60 respondents said that they are interested to invest through SMC Investment

Solutions & Services

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 along with

educating them about the products they offer. Initially they can start off with

existing demat account holders.

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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. There is a widespread lack of awareness about the role and technique of futures

trading among the potential beneficiaries. Only traditional players who have been

participating in such trading either in the formal markets or gray markets are

conversant with the intricacies of forward trading. These players are willing to

participate in the trade only in regulated or liberal regulatory environment. The

approach should be first, to bring these traditional players to the formal market

and allow the Derivative markets to garner minimum critical liquidity.

INDIAN ECONOMY OVERVIEW

India's economy is on the fulcrum of an ever-increasing growth curve. With

positive indicators such as a stable 8-9 per cent annual growth, rising foreign exchange

reserves of close to US$ 180 billion, a booming capital market with the popular "Sensex"

index topping the majestic 18,000 mark, the Government estimating FDI flow of US$ 12

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billion in this fiscal, and a more than 35 per cent surge in exports, it is easy to understand

why India is a leading destination for foreign investment.

The economy has grown by 8.9 per cent for the April-July quarter of ’06-07, the

highest first-quarter growth rate since '00-01.

The growth rate has been spurred by the manufacturing sector, which has logged

an 11.3 per cent rise in Q1 ’06-07, according to the GDP data released by the

Central Statistical Organization. It was 10.7 per cent in the corresponding period

of the last fiscal year. The GDP numbers come just weeks after the monthly IIP

growth figures have touched 12.4 per cent.

Other propellers of GDP growth for the first quarter this fiscal have been the

trade, hotels, transport and communications sector which grew by 9.5 per cent and

construction, which grew by 13.2 per cent. In the corresponding period of last

fiscal, these sectors grew by 11.7 per cent and 12.4 per cent, respectively.

There has been exceptional growth rate in some specific industries, like

commercial vehicles at 36 per cent, telephone connections, by 48.9 per cent and

passenger growth in civil aviation by 32.2 per cent.

With its manufacturing and services sector on a searing growth path, India’s economy

may soon touch the coveted 10 per cent growth figure.

COMPANY OVERVIEW

SMC Global is one of the largest and most reputed Investment Solutions Company

that provides a wide range of services to its substantial and diversified client base.

Founded in 1990, by Mr. Subhash Chand Aggarwal and Mr. Mahesh Chand Gupta, SMC,

is a full financial services firm catering to all classes of investors. The company is having

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its corporate office in New Delhi with regional offices in Mumbai, Kolkata, Chennai,

Ahemdabad, Cochin, Hyderabad, Jaipur plus a growing network of more than 1150

offices across over 300 cities/towns in India and overseas office in Dubai.

SMC acquired membership of the Delhi Stock Exchange in 1990 and later in 1995

became a trading member of NSE. In 2000 the company became a member of BSE and a

depository participant of CDSL India Ltd. In the same year, the company acquired the

Trading & Clearing Membership of NSE Derivatives and the memberships of leading

commodity exchanges i.e. NCDEX and MCX in subsequent years. In 2006, SMC

expanded globally and acquired the Trading & Clearing Membership of Dubai Gold and

Commodity Exchange (DGCX). In the same year, the company also started its Insurance

Broking division, IPO & Mutual Fund Distribution Division and its Merchant Banking

division

PRODUCTS AND SERVICES

Equity & Derivative Trading

SMC Trading Platform offers online equity & derivative trading facilities for investors

who are looking for the ease and convenience and hassle free trading experience. We

provide ODIN Application, which is a high -end, integrated trading application for fast,

efficient and reliable execution of trades. You can now trade in the NSE and BSE

simultaneously from any destination at your convenience. You can access a multitude of

resources like live quotes, charts, research, advice, and online assistance helps you to take

informed decisions. You can also trade through our branch network by registering with us

as our client. You can also trade through us on phone by calling our designated

representatives in the branches where you are registered as a client.

Clearing Services

Being a clearing member in NSE (derivative) segment we are clearing massive volumes

of trades of our trading members in this segment.

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Commodity Trading

SMC is a member of two major national level commodity exchanges, i.e National

Commodity and Derivative Exchange and Multi Commodity Exchange and offers you

trading platform of NCDEX and MCX. You can get Real-Time streaming quotes, place

orders and watch the confirmation, all on a single screen. We use technology using ODIN

application to provide you with live Trading Terminals. In this segment, we have spread

our wings globally by acquiring Membership of Dubai Gold and Commodities Exchange.

We provide trading platform to trade in DGCX and also clear trades of trading members

being a clearing member.

Distribution of Mutual Funds & IPO’s

SMC offers distribution and collection services of various schemes of all Major Fund

houses and IPO’s through its mammoth network of branches across India . We are

registered with AMFI as an approved distributor of Mutual Funds. We assure you a

hassle free and pleasant transaction experience when you invest in mutual funds and

IPO’s through us. We are registered with all major Fund Houses including Fidelity,

Franklyn Templeton etc. We have a distinction of being leading distributors of

IPOs.Shortly we will be providing the facility of online investment in Mutual Funds and

IPO’s

Online back office support

To provide robust back office support backed by excellent accounting standards to our

branches we have ensured connectivity through FTP and Dotnet based Application. To

ensure easy accessibility to back office accounting reports to our clients, we have offered

facilities to view various user-friendly, easily comprehendible back office reports using

the link My SMC Account.

SMC Depository

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http://59.144.163.142/onlineasp/smconline.aspx


We are ISO 9001:2000 certified DP for shares and commodities. We are one of the

leading DP and enjoy the trust of more than 40,000 investors. We offer a quick, secure

and hassle free alternative to holding the securities and commodities in physical form.

We are one of the few Depository Participants offering depository facilities for

commodities. We are empanelled with both NCDEX & MCX.

SMC Research Based Advisory Services

Our massive R&D facility caters to the need of Investors, who are continuously in need

of opportunities for striking rich rewards on their investment. We have one of the most

advanced, hitech in-house R&D wing with some of the best people, process and

technology resources providing complete research solutions on Equity, Commodities,

IPO’s and Mutual Funds. We offer proactive and timely world class research based

advice and guidance to our clients so that they can take informed decisions. Click on

Research to unveil the treasure.

Derivatives

5.1 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

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http://www.contentlinks.asiancerc.com/smc/fundamental/research.asp


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 scenario

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

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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 Fernandes (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.

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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.

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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.

Securities 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

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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

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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

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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.

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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.

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-

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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.

Every time 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.

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5.1 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 January 2008

Contract month Expiry/settlement

January 2008 January 31

February 2008 February 28

March 2008 March 27

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On January 27

Contract month Expiry/settlement

February 2008 February 28

March 2008 March 27

April 2008 April 24

The permitted lot size is 100 or multiples thereof for the Nifty. That is you buy

one Nifty contract the total deal value will be 100*1100 (Nifty value)= Rs 1,10,000.

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.

5.2 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

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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. BABASAB PATIL


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%

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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.

5.3 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.

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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.

5.4 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.

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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.

5.5 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

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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

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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.

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5.6 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).

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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?

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Have you ever been a ‘stock picker’ 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 July 01, 2001. Assuming 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 July 19, 2001, 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.

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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

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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

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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)BABASAB PATIL


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.

5.7 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.BABASAB PATIL


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

affected 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.

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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 Value

No of

trades Open interest

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contracts) (Rs in lakh) (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

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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 –

The old contract is closed.

Fall

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

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Warning signal

Weak

Warning signal

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

7. OPTIONS

6.1 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).

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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.

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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.

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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.

6.2 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.

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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.

6.3 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.

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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.

6.4 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.

6.5 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

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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.

6.6 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

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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

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A trader is of the view that the index will go up to 1400 in Jan 2002 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 2002 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.

6.7 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).

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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.

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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)

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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

6.8 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.

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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.

6.9 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.

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Calls Puts

.JUL AUG SEP JUL AUG SEP

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

6.10 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: BABASAB PATIL


Short-Term Interest Rates

Dividends

6.11 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

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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

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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

Option Volatility Premium cost

Call

Put

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.

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Option Interest rates Premium cost

Call

Put

6.12 STRATEGIES

1. 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.

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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:

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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.

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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.

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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 investor’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

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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 purchase 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

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= 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.

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

strike put. 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.

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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.

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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.

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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.

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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, while at

the same time limiting risk exposure.

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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

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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.

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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, while

at the same time limiting risk exposure.

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.

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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

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= 110 - 90 - 10 = 10

Breakeven Price = Lower strike price + Net premium paid

= 90 + 10 = 100

6.13 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

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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.

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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.

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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.

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Member wise 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 are fairly similar

to the regular stock tables.

NIFTY OPTIONS

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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.

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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.

6.14 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.

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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 annualised) 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.

6.15 Settlement of options contracts

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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.

7. CLEARING AND SETTLEMENT

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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

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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 BABASAB PATIL


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,

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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.

8.ANALYSIS

OBJECTIVES OF THE STUDY

To study the consumer perception of Derivatives products in Hubli city, and a detailed

study of Derivatives and Derivatives trading

Sub- objectives: To study the features of derivative products (Futures and Options)

To study the trading procedures for Derivative products

To study the strategies used in trading of Derivatives.BABASAB PATIL


To study the clearing and settlement procedure of Derivatives products

To know the awareness of Derivative products in Hubli city.

Sampling Design

Population - All the people who are able to save a portion of their income, and possess the interest of investing those savings in stock market.

Time - During the period of 15th Dec 2007 to 15th April 2008

Sampling Frame - The investors of Hubli

Instrument of data collection. - Questionnaire.

Sample Size - 100 investors.

ANALYSIS OF THE SURVEY

Objectives:

To find out the perception of the investors about derivatives.

To find out the extent of their awareness about derivatives.

To identify the relationship of age, income and awareness with the investment decisions

in derivatives by the investors.

1. Age of the Respondents

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Your Age

45 45.0 45.0 45.0

44 44.0 44.0 89.0

7 7.0 7.0 96.0

4 4.0 4.0 100.0

100 100.0 100.0

21-30

30-40

40-50

Above 50

Total

ValidFrequency Percent Valid Percent

CumulativePercent

Your Age

Your Age

Above 5040-5030-4021-30

Fre

qu

en

cy

50

40

30

20

10

0

Out of the 100 investors surveyed, 44 of them fall in the age group of 30-40 years

and 45 of them in 21-30 years. This implies that the younger people of 21-30 age have

more income to invest, than the people of 40-50 of the age above 50.

2. Annual Income of the Respondents

Annual Income

18 18.0 18.0 18.0

27 27.0 27.0 45.0

21 21.0 21.0 66.0

34 34.0 34.0 100.0

100 100.0 100.0

< 100000

100000-150000

150000-200000

> 200000

Total


CumulativePercent

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The graph clearly shows that the income is evenly distributed in the sample of the

survey. But, majority of the investors earn above 2 lakhs per annum. These respondents

serve a better group of potentials for investments for the company’s products.

As there is almost equal share in each income category, almost all of them have

potentials to invest and save.

3. Your current investments are in

Invt Avenues No. Of RespondentsFD 39Ins 52

Bonds 16MF 42

Shares 54Dervtv 11Comm 4

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From this question and its graph, it is clear that people in Hubli prefer less risky and

regular income giving investment avenues. 39 respondents have invested in Bank FDs, 52

in Insurance and 42 in Mutual funds. As this question had a multiple choice option, we

find that the respondents’ investments are spread across more than 2 avenues. Talking of

risky instruments like shares, 54 of them have invested their money in shares. This means

that 54% of them are risk takers

4. Are you aware of the concept of derivatives?

Awareness of Deri'ves

53 53.0 53.0 53.0

47 47.0 47.0 100.0

100 100.0 100.0

Yes

No

Total


CumulativePercent

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Extending the last interpretation, by this question we find that 53% of respondents are

aware about derivatives. The concept of derivatives is well understood only if there is

thorough knowledge about investing and trading in shares. Therefore out of the 59

respondents who hold shares, 53 of them know about derivatives. This means that

derivatives are still unknown to 50% of the people in Hubli. These people must be

educated about derivatives in order to develop the market for it in Hubli.

5. Age-wise description of awareness using crosstab and bar chart

Your Age & Awareness of Derivatives Crosstabulation

Count

26 19 45

22 22 44

4 3 7

1 3 4

53 47 100

21-30

30-40

40-50

Above 50

YourAge

Total

Yes No


Total

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This graph shows that among the 44 people falling in the age group of 21-30, only 26

are aware of derivatives i.e., 43% of them are unaware. As you can see the good

awareness level among the investors of the age 30-40, Rest 43% of the age group 21-30

need to be tapped by the company and create awareness about derivatives.

6. If yes, which of the derivative products are you aware of?

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The pie chart clearly shows the number of people knowing about the concept of

different derivative products. As in India we have OTC trading of only Futures and

Options, we find 41 of them aware about Futures and 43 are aware about Options. 20

people are aware about forwards and only 12 people know about Swaps. In other

sense we can say that futures are more popular than options in Hubli.

NOTE: This was a multiple choice question.

7 . Have you invested in Derivatives?

Invested in DerivativesNo. of

RespondentsYes 26No 27

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Total 53

Out of the 53 people who are aware of derivatives 49% [26] of them have tried investing

in F&O. The company has to take steps to motivate the rest 51% [27] to invest in

derivatives.

8. Factors that respondents consider while investing in Derivatives.

Factors No. of Respondents

Savings 08

Risk 24

Returns 20

Volatility 07

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Even this was a multiple-choice question. The diagram clearly depicts that risk and return

are the main factors considered by the investors. The next share is held by volatility,

which is the main factor for derivatives trading, and 8 people consider this factor while

investing their money.

Now let us see how the investors associate the risk factor, return factor and volatility

with the investing in derivatives:-

“Invested in Dervtv?” And “Risk” : Crosstabulation

Risk

Total no Yes

Invested in Dervtv? No 55 19 74

Yes 17 9 26

Total 72 28 100

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Out of 26 people who have invested in derivatives, only 9 of them are considering


“Invested in derivatives?” and “Return factor” cross tabulation.

Return

Total No Yes Invested in Dervtv? No 52 22 74 Yes 26 26Total 52 48 100

52

22

26

no

yes

Ret

urn

Invested in Dervtv?yes

Invested in Dervtv?no

Out of 26 people who have invested their money in derivatives, ALL of them

consider the return factor. This means that derivatives give good returns, as per their

experience.

“Invested in Derivatives?” And “Volatility factor” cross tabulation.

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55

19

17

9

no

yes

Ris

k




Volatility Totalno yes

Invested in Dervtv? No 57 17 74Yes 9 17 26

Total 66 34 100

57

17

9

17

no

yes

Vo

lati

lity



Out of 26 derivative investors, 17 of them [i.e., 65%] consider the volatility factor


investors perceive derivatives as volatile investments

9. Difficulties encountered by the Respondents while investing in Derivatives.

Difficulties No. of BABASAB PATIL


RespondentsLack of Knowledge 07Clearing Positions 12

Lot Size 08Margins 16

This graph shows that Lot sizes and Clearing positions are affecting the

investment decisions of the investors to a large extent. They are facing problems in

placing the margin amount and also the leverage options associated with it. Lot sizes also

determine the decisions of the investors to some extent. The next share is the Lack of

knowledge, because of which the investors are not able to try investing in derivatives.

10. Are you interested to invest in Derivatives?

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R U interested to invest in Deri'vs

52 52.0 52.0 52.0

48 48.0 48.0 100.0

100 100.0 100.0

Yes

No

Total


CumulativePercent

Out of the 100 respondents surveyed, 52 are willing to invest in derivatives. And out of

them 26 are already the investors. This shows that derivatives are not known to

approximately about 50% of the people in Hubli. The company should take necessary

steps to educate them about the same and tap them towards investing through SMC

Investment Solutions & Services.

11. Are you aware of the following services provided by SMC Investment Solutions & Services?

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ServicesNo.of

RespondentsOn-line Share Trading 26Trading in Futures &

Options 06Mutual Funds 01

IPOs 08

Most of the people are aware of online share trading but very few are aware of the trading

in F&O service provided by SMC Investment Solutions & Serives. This shows that the

company needs to stress more on promoting this service.

12. Having made you aware of various services rendered by SMC Investment Solutions

& Services, would you prefer to invest through SMC Investment Solutions & Services?

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would u prefer to invest in SMC

60 60.0 60.0 60.0

40 40.0 40.0 100.0

100 100.0 100.0

Yes

No

Total


CumulativePercent

60% of the respondents showed the interest of investing through SMC Investment

Solutions & Services. According to the response received during the survey it was clear

that out of 100 respondents, 61 are not aware of SMC IS&S. The above graph shows that

they are ready to invest through SMC IS&S provided If we make them aware of various

services that company renders. So, the company should drag the attention of the potential

customers & educate them about the benefits you provide for the investors.

Analysis

1. Correlation between age and annual income.

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Correlations

1 .272**

. .006

100 100

.272** 1

.006 .

100 100

Pearson Correlation

Sig. (2-tailed)

N

Pearson Correlation

Sig. (2-tailed)

N

Annual Income

Your Age

AnnualIncome Your Age

Correlation is significant at the 0.01 level (2-tailed).**.

Here we see that the correlation is 0.272. This means that age and annual income

are positively correlated. But the degree of correlation is less than 0.5. This shows that

the association between these two variables is not that strong. It means that, at times these

two variables may not move in the same direction.

2. Correlation between annual income and investment in derivatives.

Correlations

1 -.337**

. .001

100 100

-.337** 1

.001 .

100 100

Pearson Correlation

Sig. (2-tailed)

N

Pearson Correlation

Sig. (2-tailed)

N

Annual Income

Have u invested in Deriv's

AnnualIncome

Have uinvestedin Deriv's


Here the correlation is Negative i.e., -0.337 but it is less than 0.5. These two variables

are not strongly correlated though positive. An increase in annual income may not

lead to increase the investments in derivatives.

3. Correlation between awareness about derivatives and investments in derivatives.

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Correlations

1 .818**

. .000

100 100

.818** 1

.000 .

100 100

Pearson Correlation

Sig. (2-tailed)

N

Pearson Correlation

Sig. (2-tailed)

N


Have u invested in Deriv's

Awarenessof Deri'ves

Have uinvestedin Deriv's


Here the correlation is very strong i.e., 0.558. This means that if there is increase in

the number of people being aware of derivatives, the flow of investments in

derivatives will also be more. Awareness is directly associated with investments in

derivatives.

4. Correlation between Risk factor and investment in derivatives.

Correlations

1 .087

. .388

100 100

.087 1

.388 .

100 100

Pearson Correlation

Sig. (2-tailed)

N

Pearson Correlation

Sig. (2-tailed)

N

Invested in Dervtv?

Risk

Investedin Dervtv? Risk

The association of risk factor and investing in derivatives is very meager. This means

that increase in risk does not affect investing in derivatives to a greater extent. Risk is

an insignificant consideration.

5. Correlation between Return and investing in derivatives.

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Correlations

1 .617**

. .000

100 100

.617** 1

.000 .

100 100

Pearson Correlation

Sig. (2-tailed)

N

Pearson Correlation

Sig. (2-tailed)

N

Invested in Dervtv?

Return

Investedin Dervtv? Return


The correlation is 0.617. This shows that increase in return definitely increases the

flow of investments in derivatives.

6. Correlation between volatility and investing in derivatives.

Correlations

1 .393**

. .000

100 100

.393** 1

.000 .

100 100

Pearson Correlation

Sig. (2-tailed)

N

Pearson Correlation

Sig. (2-tailed)

N

Invested in Dervtv?

Volatility

Investedin Dervtv? Volatility


Actually derivatives are considered highly volatile. The volatility in the market


investing in derivatives is 0.393 which is again less but it is positive. This indicates

that an increase in volatility increases the investing in derivatives to some


9. FINDINGS:

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22. Futures market facilitates for buying and selling futures contracts, which state the

price per unit, type, value, quality and quantity of the commodity in question, as

well as the month the contract expires.

23. Futures accounts are credited or debited daily depending on profits or losses

incurred. The futures market is also characterized as being highly leveraged due

to its margins; although leverage works as a double-edged sword.

24. “Going long,” “going short,” and “spreads” are the most common strategies used

when trading on the futures market.

25. Investors use options both to speculate and hedge risk.

26. Income is almost evenly distributed among the sample:- 18% less than Rs.1lakh,

27% each Rs.1 lakh-1.5lakhs and upto Rs.2 lakhs and 34% above Rs.2 lakhs.

27. The respondents’ current investments are mainly in FD, Insurance, Mutual Funds

and Shares.

28. 53% of the respondents are aware of derivatives.

29. 44 people falling in the age group of 21-30, only 26 are aware of derivatives i.e.,

43% of them are unaware. As you can see the good awareness level among the

investors of the age 30-40, Rest 43% of the age group 21-30 need to be tapped by

the company and create awareness about derivatives.





32. 37 respondents are aware of Futures and 40 are aware of Options.

33. The main factors considered while investing in derivatives are risk[20], return

[24] and volatility [08].

34. Out of 26 people who have invested in derivatives, only 9 of them are considering


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35. Out of 26 people who have invested their money in derivatives, ALL of them

consider the return factor. This means that derivatives give good returns, as per

their experience.

36. Out of 26 derivative investors, 17 of them [i.e., 65%] consider the volatility factor


investors perceive derivatives as volatile investments.

37. Lot sizes and margins are affecting the investment decisions of the investors to a

large extent. Lot sizes also determine the decisions of the investors to a large

extent.

38. Out of the 100 respondents surveyed, only 52 are willing to invest in derivatives.

And out of them 26 are already the investors. This shows that derivatives are not

known to approximately about 50% of the people in Hubli

39. Awareness of derivatives and investing in is positively correlated. This means that

if there is increase in the number of people being aware of derivatives, the flow of

investments in derivatives will also be more. Awareness is directly associated

with investments in derivatives.

40. The association of risk factor and investing in derivatives is very meager. This

means that increase in risk does not affect investing in derivatives to a greater

extent. Investors perceive derivatives as less risky.

41. Actually derivatives are considered highly volatile. The volatility in the market


investing in derivatives is 0.393 which is again less but it is positive. This

indicates that an increase in volatility affects the investing in derivatives to some


42. 60 respondents said that they are interested to invest through SMC Investment

Solutions & Services

10. SUGGESTIONS

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6. The awareness about derivatives among investors should be increased by

conducting various awareness and educational programs.

7. The company can conduct seminars to promote their services along with

educating them about the products they offer. Initially they can start off with

existing demat account holders.

8. 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.

9. 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.

10. There is a widespread lack of awareness about the role and technique of futures

trading among the potential beneficiaries. Only traditional players who have been

participating in such trading either in the formal markets or gray markets are

conversant with the intricacies of forward trading. These players are willing to

participate in the trade only in regulated or liberal regulatory environment. The

approach should be first, to bring these traditional players to the formal market

and allow the Derivative markets to garner minimum critical liquidity.

11. CONCLUSIONS

Financial derivatives market has been growing at a phenomenal rate over the past few years. Advances in derivatives market, improvements in computer and

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telecommunications capability and robust clearing and settlement, significantly expanded opportunities and lowered the costs of operations for hedging risks not readily managed in earlier decades. These products contributed to the development of a more flexible and efficient financial system, both domestically and internationally. The development of Financial Derivatives and its extensive use in the financial sector has been synonymous with the rapid growth in the financial sector itself.

In the context of the changing financial environment and the consequent increase in the nature and quantum of financial risks it is mandatory to have a thorough knowledge about financial derivatives..

Financial Derivatives are of recent origin and are quite new to the Indian Financial markets, As a finance professional one should have good working knowledge of instruments like options, futures which is necessary for managing risks in the present-day financial world.

The derivatives market in Hubli is not as developed when compared to the

metropolitan cities. It is because of lack of exposure among investors in Hubli city

towards derivatives, hence there is a need to increase the awareness and educate the

investors about derivatives, So that they can make informed and wise decisions, which

would lead to the growth in Hubli Derivatives market.

Limitations of the Project.

The period considered for study is short to understand the study of“Derivatives”.

Survey is limited to Hubli city.

The sample of respondents considered for the study is for undertaking a Market

research.

Though with these limitation, I am satisfied with the work conducted as it is carefully

administered keeping in line with the advices of experts.

12. ANNEXURES:

Questionnaire:

Dear Sir / Madam,

BABASAB PATIL


I am pursuing my MBA (IV Sem) As a part of my curriculum, I am undertaking a project on “Comprehensive Study Of Derivative Products And Investors’ Perception of Derivatives in Hubli City”, in S.M.C Investment solutions and Services at Hubli. I request you to kindly help me in making my project effective by filling this questionnaire. I assure you that the information provided by you will be used for academic purpose only.

Name __________________________________________________________________

Address __________________________________________________________________

__________________________________________________________________

Tel.No ___________________ E Mai _____________________________________

1. Your Age

21 to 30 30 to 40 40 to 50 Above 50

2. Annual Income

Less than 1 Lakh 1 Lakh to 1.5 Lakh

1.5 lakh to 2 lakh More than 2 Lakh

3. Your Current investments are in

Bank F D Insurance Bonds Mutual Funds

Shares Derivatives Commodities

4. Are you aware of the concept of Derivatives?

Yes No ( If “No” go to Question No. 9)

5. If Yes , which of the Derivatives product are you aware of ?

Futures Options Swaps Forwards

6. Have you invested in Derivatives?

Yes No

7. What are the factors you consider while investing in Derivatives?

Saving Risk Return Volatility

BABASAB PATIL


8. What are the difficulties encountered by you while investing in Derivatives?

Lack of Knowledge Clearing Positions Lot Size Margins

9. Are you interested to invest in Derivatives?

Yes No

10. Have you traded through online share trading?

Yes No

11. .Are you aware of S.M.C.Investents solutions & Services?

Yes No

12. Are you aware of the following services provided by S.M.C.Investents solutions & Services ?

On-line Share Trading Trading in Futures & Options Mutual Funds

IPO’s

13. Having made you aware of various services rendered by S.M.C.Investents solutions & Services, would you prefer to invest through S.M.C.Investents solutions & Services?

Yes No

Thank You for your Valuable Time

13. BIBILOGRAPHY

The data was collected from the list of Books and websites given below:

Options, Futures and Other Derivatives – John C Hull.

www.samgloabalsecurities.com

www.investopedia.com

www.icicidirect.com

www.nseindia.com

BABASAB PATIL


www.economywatch.com

www.businessline.com

www.economictimes.com

BABASAB PATIL

perception of derivatives @ smc investment project report

Business

financial derivatives

unaware of derivatives

futures market

company overview74 derivatives

derivative investors

aware of options

aware of futures

options market participants