EXECUTIVE SUMMARY

Conceptually the mechanism of stock market is very simple. People who are exposed to the same risk come together and agree that if anyone of the person suffers a loss the other will share the loss and make good to the person who lost. The initial part of the project focuses on the job and responsibilities I was allotted as a summer trainee. It also makes the readers aware about the techniques and methodology used to bring this report alive. It also describe about the objective of this study. The next few chapters are devoted to the study of the Derivative Market and Derivative Instruments in a very basic way. It also suggests some of the strategies that can be applied to earn more even when the market is too much volatile. The readers can also find the comparative analysis of the Derivative Market and the Cash Market in the Indian context. The next part of the project throws light upon my findings and analysis about the company and the suggestions for the company for better performance.

OBJECTIVE OF THE STUDY

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

METHODOLOGY

During this project, I have analyzed the Futures and Options. I have tried to analyze the instruments as per the Market Participant and the Market Trend. Initially, I have given a brief introduction about the instruments, so that the reader is aware of basics of the subject. I have tried to identify various terms related to derivative trading, for which I have introduced a separate chapter, Terms related to derivative market Then I have tried to segregate the use of Instruments as per the Market Participants and Market Trend. I identified hedging, arbitrage and speculation strategies using both futures and options, and then segregated them into a chapter each. Segregation involved a thorough study of the strategies and possible use. Then I have done a secondary data based study on growth of Indian Derivative Market, which includes the comparison of derivative market with cash market, data regarding the traded volume and number of contracts traded from December 2007 till May 2008. I have also analyzed the top five most traded symbols in futures and options segment.

Chapter 1 Introduction to Derivatives

INTRODUCTION TO DERIVATIVES
The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by lockingin asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors.

DERIVATIVES DEFINED
Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the underlying. In simple word it can be said that Derivatives are financial contracts whose value/price is dependent on the behavior of the price of one or more basic underlying assets (often simply known as underlying). These contracts are legally binding agreements, made on the trading screen of stock exchanges, to buy or sell an asset in future. The asset can be a share, index, interest rate, bond, rupee dollar exchange rate, sugar, crude oil, soybean, cotton, coffee, etc. In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R) A) defines derivative to include

1. A security derived from a debt instrument, share, loan whether secured or unsecured, instrument or contract for differences or any other form of security.

risk

2. A contract which derives its value from the prices, or index of prices, of underlying securities. A very simple example of derivatives is curd, which is derivative of milk. The price of curd depends upon the price of milk which in turn depends upon the demand and supply of milk.

EMERGENCE OF DERIVATIVES
Derivative products initially emerged as hedging devices against fluctuations in commodity prices, and commodity-linked derivatives remained the sole form of such products for almost three hundred years. Financial derivatives came into spotlight in the post-1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two-thirds of total transactions in derivative products. In recent years, the market for financial derivatives has grown tremendously in terms of variety of instruments available, their complexity and also turnover. In the class of equity derivatives the world over, futures and options on stock indices have gained more popularity than on individual stocks, especially among institutional investors, who are major users of index-linked derivatives. Even small investors find these useful due to high correlation of the popular indexes with various portfolios and ease of use. The lower costs associated with index derivatives visavis derivative products based on individual securities is another reason for their growing use.

HISTORY OF DERIVATIVES
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Early forward contracts in the US addressed merchants concerns about ensuring that there were buyers and sellers for commodities. However credit risk remained a serious problem. To deal with this problem, a group of Chicago businessmen formed the Chicago Board of Trade (CBOT) in 1848. The primary intention of the CBOT was to provide a centralized location known in advance for buyers and sellers to negotiate forward contracts. In 1865, the CBOT went one step further and listed the first exchange traded derivatives contract in the US, these contracts were called futures contracts. In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, was reorganized to allow futures trading. Its name was changed to Chicago Mercantile Exchange (CME). The CBOT and the CME remain the two largest organized futures exchanges, indeed the two largest financial exchanges of any kind in the world today. The first stock index futures contract was traded at Kansas City Board of Trade. Currently the most popular stock index futures contract in the world is based on S&P 500 index, traded on Chicago Mercantile Exchange. During the mid eighties, financial futures became the most active derivative instruments generating volumes many times more than the commodity futures. Index futures, futures on T-bills and Euro-Dollar futures are the three most popular futures contracts traded today. Other popular international exchanges that trade derivatives are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE in Japan, MATIF in France, Eurex etc.

GLOBAL DERIVATIVE MARKETS

The derivatives markets have grown manifold in the last two decades.. According to the Bank for International Settlements (BIS), the approximate size of global derivatives market was US$ 109.5 trillion as at endDecember 2000. The total estimated notional amount of outstanding overthe counter (OTC) contracts stood at US$ 95.2 trillion as at endDecember 2000, an increase of 7.9% over endDecember 1999. Growth in OTC derivatives market is mainly attributable to the continued rapid expansion of interest rate contracts, which reflected growing corporate bond markets and increased interest rate uncertainty at the end of 2000. The amount outstanding in organized exchange 7

markets increased by 5.8% from US$ 13.5 trillion as at end December 1999 to US$ 14.3 trillion as at endDecember 2000. The turnover data are available only for exchangetraded derivatives contracts. The turnover in derivative contracts traded on exchanges has increased by 9.8% during 2000 to US$ 384 trillion as compared to US$ 350 trillion in 1999(Table 1.2). While interest rate futures and options accounted for nearly 90% of total turnover during 2000, the popularity of stock market index futures and options grew modestly during the year. According to BIS, the turnover in exchangetraded derivative markets rose by a record amount in the first quarter of 2001, while there was some moderation in the OTC volumes.

DERIVATIVE MARKET IN INDIA

The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24member committee under the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee submitted its report on March 17, 1998 prescribing necessary pre conditions for introduction of derivatives trading in India. The committee recommended that derivatives should be declared as securities so that regulatory framework applicable to trading of securities could also govern trading of securities. SEBI also set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma, to recommend measures for risk containment in derivatives market in India. The report, which was submitted in October 1998, worked out the operational details of margining system, methodology for charging initial margins, broker net worth, deposit requirement and realtime monitoring requirements.

The SCRA was amended in December 1999 to include derivatives within the ambit of securities and the regulatory framework was developed for governing derivatives trading. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recognized stock 8

exchange, thus precluding OTC derivatives. The government also rescinded in March 2000, the threedecade old notification, which prohibited forward trading in securities.

Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2000. SEBI permitted the derivative segments of two stock exchanges, NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE30 (Sensex) index. This was followed by approval for trading in options based on these two indexes and options on individual securities. The trading in index options commenced in June 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. Trading and settlement in derivative contracts is done in accordance with the rules, byelaws, and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and notified in the official gazette.

The derivatives trading on the exchange commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001. The index futures and options contract on NSE are based on S&P CNX Nifty Index. Currently, the futures contracts have a maximum of 3-month expiration cycles. Three contracts are available for trading, with 1 month, 2 months and 3 months expiry. A new contract is introduced on the next trading day following the expiry of the near month contract.

PARTICITANTS AND FUNCTIONS

PARTICIPANTS
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Derivative contracts have several variants. The most common variants are forwards, futures, options and swaps. The following three broad categories of participants Hedgers: - Hedgers face risk associated with the price of an asset. They use futures or options markets to reduce or eliminate this risk Speculators: - Speculators wish to bet on future movements in the price of an asset. Futures and options contracts can give them an extra leverage; that is, they can increase both the potential gains and potential losses in a speculative venture. Arbitrageurs: - Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit.

FUNCTIONS
The derivatives market performs a number of economic functions. 1. Prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. 2. The derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them. 3. Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk. 4. Speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash

10

markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kind of mixed markets. 5. An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefit of which are immense. 6. Derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity.

TYPES OF DERIVATIVE INSTRUMENTS

Forwards: A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at todays pre-agreed price. 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. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts. Options: Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. Warrants: Options generally have lives of up to one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter.

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LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options having a maturity of up to three years. Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average of a basket of assets. Equity index options are a form of basket options. Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are: a. Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency. b.Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction. Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.

DERIVATIVE MARKET AT NSE

The derivatives trading on the exchange commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November

12

9, 2001. The index futures and options contract on NSE are based on S&P CNX Nifty Index. Currently, the futures contracts have a maximum of 3-month expiration cycles. Three contracts are available for trading, with 1 month, 2 months and 3 months expiry. A new contract is introduced on the next trading day following the expiry of the near month contract.

APPROVAL FOR DERIVATIVE TRADING

TRADING MECHANISM
The futures and options trading system of NSE, called NEAT-F&O trading system, provides a fully automated screenbased trading for Nifty futures & options and stock futures & options on a nationwide basis and an online monitoring and surveillance mechanism. It supports an anonymous order driven market which provides complete transparency of trading operations and operates on strict pricetime priority. It is similar to that of trading of equities in the Cash Market (CM) segment. The NEAT-F&O trading system is accessed by two types of users. The Trading Members(TM) have access to functions such as order entry, order matching, and order and trade management. It provides tremendous flexibility to users in terms of kinds of orders that can be placed on the system. Various conditions like Good-till-Day, Good-till-Cancelled, Good till- Date, Immediate or Cancel, Limit/Market price, Stop loss, etc. can be built into an order. The Clearing Members (CM) uses the trader workstation for the purpose of monitoring the trading member(s) for whom they clear the trades. Additionally, they can enter and set limits to positions, which a trading member can take.

MEMBERSHIP CRITERIA
NSE admits members on its derivatives segment in accordance with the rules and regulations of the exchange and the norms specified by SEBI. NSE follows 2tier membership structure 13

stipulated by SEBI to enable wider participation. Those interested in taking membership on F&O segment are required to take membership of CM and F&O segment or CM, WDM and F&O segment. Trading and clearing members are admitted separately. Essentially, a clearing member (CM) does clearing for all his trading members (TMs), undertakes risk management and performs actual settlement. There are three types of CMs: Self Clearing Member: A SCM clears and settles trades executed by him only either on his own account or on account of his clients. Trading Member Clearing Member: TMCM is a CM who is also a TM. TMCM may clear and settle his own proprietary trades and clients trades as well as clear and settle for other TMs. Professional Clearing Member: PCM is a CM who is not a TM. Typically, banks or custodians could become a PCM and clear and settle for TMs. The TMCM and the PCM are required to bring in additional security deposit in respect of every TM whose trades they undertake to clear and settle. Besides this, trading members are required to have qualified users and sales persons, who have passed a Certification programme approved by SEBI.

CLEARING AND SETTLEMENTS

NSCCL undertakes clearing and settlement of all deals executed on the NSEs F&O segment. It acts as legal counterparty to all deals on the F&O segment and guarantees settlement. Clearing: The first step in clearing process is working out open positions or obligations of members. A CMs open position is arrived at by aggregating the open position of all the TMs and all custodial participants clearing through him, in the contracts in which they have traded. A TMs open position is arrived at as the summation of his proprietary open position and clients open positions, in the contracts in which they have traded. TMs are required to identify the orders, whether proprietary (if they are their own trades) or client (if entered on behalf of clients). Proprietary 14

positions are calculated on net basis (buy-sell) for each contract. Clients positions are arrived at by summing together net (buy-sell) positions of each individual client for each contract. A TMs open position is the sum of proprietary open position, client open long position and client open short position. Settlement: All futures and options contracts are cash settled, i.e. through exchange of cash. The underlying for index futures/options of the Nifty index cannot be delivered. These contracts, therefore, have to be settled in cash. Futures and options on individual securities can be delivered as in the spot market. However, it has been currently mandated that stock options and futures would also be cash settled. The settlement amount for a CM is netted across all their TMs/clients in respect of MTM, premium and final exercise settlement. For the purpose of settlement, all CMs are required to open a separate bank account with NSCCL designated clearing banks for F&O segment.

INDEX DERIVATIVES
Index derivatives are derivative contracts which derive their value from an underlying index. The two most popular index derivatives are index futures and index options. Index derivatives have become very popular worldwide. In his report, Dr.L.C.Gupta attributes the popularity of index derivatives to the advantages they offer. Institutional and large equity-holders need portfolio-hedging facility. Indexderivatives are more suited to them and more costeffective than derivatives based on individual stocks. Pension funds in the US are known to use stock index futures for risk hedging purposes. Index derivatives offer ease of use for hedging any portfolio irrespective of its composition. Stock index is difficult to manipulate as compared to individual stock prices, more so in India, and the possibility of cornering is reduced. This is partly because an individual stock has a limited supply, which can be cornered. Stock index, being an average, is much less volatile than individual stock prices. This implies much lower capital adequacy and margin requirements. 15

Index derivatives are cash settled, and hence do not suffer from settlement delays and problems related to bad delivery, forged/fake certificates.

Requirements for an index derivatives market

1. Index: The choice of an index is an important factor in determining the extent to which the index derivative can be used for hedging, speculation and arbitrage. A well diversified, liquid index ensures that hedgers and speculators will not be vulnerable to individual or industry risk. 2. Clearing corporation settlement guarantee: The clearing corporation eliminates counterparty risk on futures markets. The clearing corporation interposes itself into every transaction, buying from the seller and selling to the buyer. This insulates a participant from credit risk of another. 3. Strong surveillance mechanism: Derivatives trading brings a whole class of leveraged positions in the economy. Hence the need to have strong surveillance on the market both at the exchange level as well as at the regulator level. 4. Education and certification: The need for education and certification in the derivatives market can never be overemphasized. A critical element of financial sector reforms is the development of a pool of human resources with strong skills and expertise to provide quality intermediation to market participants. With the entire above infrastructure in place, trading of index futures and index options commenced at NSE in June 2000 and June 2001 respectively.

TRADING
Here, I shall take a brief look at the trading system for NSEs futures and options market. However, the best way to get a feel of the trading system is to actually watch the screen and observe how it operates.

Futures and options trading system

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The futures & options trading system of NSE, called NEAT-F&O trading system, provides a fully automated screen-based trading for Nifty futures & options and stock futures & options on a nationwide basis as well as an online monitoring and surveillance mechanism. It supports an order driven market and provides complete transparency of trading operations. It is similar to that of trading of equities in the cash market segment. The software for the F&O market has been developed to facilitate efficient and transparent trading in futures and options instruments. Keeping in view the familiarity of trading members with the current capital market trading system, modifications have been performed in the existing capital market trading system so as to make it suitable for trading futures and options.

Entities in the trading system

There are four entities in the trading system. Trading members, clearing members, professional clearing members and participants. 1. Trading members: Trading members are members of NSE. They can trade either on their own account or on behalf of their clients including participants. The exchange assigns a Trading member ID to each trading member. Each trading member can have more than one user. The number of users allowed for each trading member is notified by the exchange from time to time. Each user of a trading member must be registered with the exchange and is assigned a unique user ID. The unique trading member ID functions as a reference for all orders/trades of different users. This ID is common for all users of a particular trading member. It is the responsibility of the trading member to maintain adequate control over persons having access to the firms User IDs. 2. Clearing members: Clearing members are members of NSCCL. They carry out risk management activities and confirmation/inquiry of trades through the trading system. 3. Professional clearing members: A professional clearing members is a clearing member who is not a trading member. Typically, banks and custodians become professional clearing members and clear and settle for their trading members.

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4. Participants: A participant is a client of trading members like financial institutions. These clients may trade through multiple trading members but settle through a single clearing member.

BASIS OF TRADING
The NEAT F&O system supports an order driven market, wherein orders match automatically. Order matching is essentially on the basis of security, its price, time and quantity. All quantity fields are in units and price in rupees. The lot size on the futures market is for 200 Nifties. The exchange notifies the regular lot size and tick size for each of the contracts traded on this segment from time to time. When any order enters the trading system, it is an active order. It tries to find a match on the other side of the book. If it finds a match, a trade is generated. If it does not find a match, the order becomes passive and goes and sits in the respective outstanding order book in the system.

ORDER TYPES AND CONDITIONS

The system allows the trading members to enter orders with various conditions attached to them as per their requirements. These conditions are broadly divided into the following categories: Time conditions Price conditions Other conditions

Several combinations of the above are allowed thereby providing enormous flexibility to the users. The order types and conditions are summarized below.

Time conditions
Day order: A day order, as the name suggests is an order which is valid for the day on which it is entered. If the order is not executed during the day, the system cancels the order automatically at the end of the day. 18

Good till canceled (GTC): A GTC order remains in the system until the user cancels it. Consequently, it spans trading days, if not traded on the day the order is entered. The maximum number of days an order can remain in the system is notified by the exchange from time to time after which the order is automatically cancelled by the system. Each day counted is a calendar day inclusive of holidays. The days counted are inclusive of the day on which the order is placed and the order is cancelled from the system at the end of the day of the expiry period.

Good till days/date (GTD): A GTD order allows the user to specify the number of days/date till which the order should stay in the system if not executed. The maximum days allowed by the system are the same as in GTC order. At the end of this day/date, the order is cancelled from the system. Each day/date counted are inclusive of the day/date on which the order is placed and the order is cancelled from the system at the end of the day/date of the expiry period.

Immediate or Cancel(IOC): An IOC order allows the user to buy or sell a contract as soon as the order is released into the system, failing which the order is cancelled from the system. Partial match is possible for the order, and the unmatched portion of the order is cancelled immediately.

Price condition
Stop loss: This facility allows the user to release an order into the system, after the market price of the security reaches or crosses a threshold price e.g. if for stoploss buy order, the trigger is 1027.00, the limit price is 1030.00 and the market (last traded) price is 1023.00, then this order is released into the system once the market price reaches or exceeds 1027.00. This order is added to the regular lot book with time of triggering as the time

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stamp, as a limit order of 1030.00. For the stoploss sell order, the trigger price has to be greater than the limit price.

Other conditions

Market price: Market orders are orders for which no price is specified at the time the order is entered (i.e. price is market price). For such orders, the system determines the price.

Trigger price: Price at which an order gets triggered from the stoploss book. Limit price: Price of the orders after triggering from stoploss book. Pro: Pro means that the orders are entered on the trading members own account.

Cli: Cli means that the trading member enters the orders on behalf of a client.

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

Placing orders on the trading system

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

Market spread/combination order entry

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

Basket trading
In order to provide a facility for easy arbitrage between futures and cash markets, NSE introduced basket-trading facility. Figure 10.4 shows the basket trading screen. This enables the generation of portfolio offline order files in the derivatives trading system and its execution in the cash segment. A trading member can buy or sell a portfolio through a single order, once he determines its size. The system automatically works out the quantity of each security to be bought or sold in proportion to their weights in the portfolio.

Futures and options market instruments

The F&O segment of NSE provides trading facilities for the following derivative instruments: 21

1. Index based futures 2. Index based options 3. Individual stock options 4. Individual stock futures

Contract specifications for index futures

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

Contract specification for index options

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

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Contract specifications for stock options

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

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

SEBI ADVISORY COMMITTEE ON DERIVATIVES

The SEBI Board in its meeting on June 24, 2002 considered some important issues relating to the derivative markets which include: Physical settlement of stock options and stock futures contracts. Review of the eligibility criteria of stocks on which derivative products are permitted. Use of sub-brokers in the derivative markets. Norms for use of derivatives by mutual funds. 23

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

REGULATORY OBJECTIVES
The LCGC outlined the goals of regulation admirably well in Paragraph 3.1 of its report. We endorse these regulatory principles completely and base our recommendations also on these same principles. We therefore reproduce this paragraph of the LCGC Report: The Committee believes that regulation should be designed to achieve specific, Well-defined goals. It is inclined towards positive regulation designed to encourage healthy activity and behavior. It has been guided by the following objectives: (a) Investor Protection: Attention needs to be given to the following four aspects: (i) Fairness and Transparency (ii) Safeguard for clients moneys (iii) Competent and honest service (b) Quality of markets: The concept of Quality of Markets goes well beyond market integrity and aims at enhancing important market qualities, such as cost-efficiency, price-continuity, and price-discovery. This is a much broader objective than market integrity.

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(c) Innovation: While curbing any undesirable tendencies, the regulatory framework should not stifle innovation which is the source of all economic progress, more so because financial derivatives represent a new rapidly developing area, aided by advancements in information technology.

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Chapter 2 Introduction to Futures and Options

INTRODUCTION TO FUTURES AND OPTIONS

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

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

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FUTURE CONTRACT
Futures markets were designed to solve the problems that exist in forward markets. 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. But unlike forward contracts, the futures contracts are standardized and exchange traded. In simple words, Futures are exchange-traded contracts to buy or sell an asset in future at a price agreed upon today. The asset can be share, index, interest rate, bond, rupee-dollar exchange rate, sugar, crude oil, soybean, cotton, coffee etc. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. It is a standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered, (or which can be used for reference purposes in settlement) and a standard timing of such settlement. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. More than 99% of futures transactions are offset this way. The standardized items in a futures contract are: Quantity of the underlying asset Quality of the underlying assets (not required in case of financial futures) The date and the month of delivery The units of price quotation (not the price) Minimum fluctuation in price (tick size) Location of settlement Settlement style.

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ADVANTAGES OF FUTURE TRADING IN INDIA

1. High Leverage: The primary attraction, of course, is the potential for large profits in a short period of time. The reason that futures trading can be so profitable is the high leverage. To own a futures contract an investor only has to put up a small fraction of the value of the contract (usually around 10-20%) as margin. 2. Profit in Both Bull & Bear Markets: In futures trading, it is as easy to sell (also referred to as going short) as it is to buy (also referred to as going long). By choosing correctly, you can make money whether prices go up or down. 3. Lower Transaction Cost: Another advantage of futures trading is much lower relative commissions. Your commission for trading a futures contract is one tenth of a percent (0.100.20%). 4. High Liquidity: Most futures markets are very liquid, i.e. there are huge amounts of contracts traded every day. This ensures that market orders can be placed very quickly as there are always buyers and sellers for most contracts.

USING FUTURES ON INDIVIDUAL SECURUTIES

Index futures began trading in India in June 2000. A year later, options on index were available for trading. July 2001 saw the launch of options on individual securities (herein referred to as stock options) and the onset of rolling settlement. With the launch of futures on individual securities (herein referred to as stock futures) on the 9th of November, 2001, the basic range of equity derivative products in India seems complete. Of the above mentioned products, stock futures are particularly appealing due to familiarity and ease in understanding. A purchase or sale of futures on a security gives the trader essentially the same price exposure as a purchase or sale of the security itself. In this regard, trading stock futures is no different from trading the security itself. Besides speculation, stock futures can be effectively used for hedging and arbitrage reasons.

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DIFFERENCES BETWEEN FORWARD AND FUTURE CONTRACT

Forward contracts are often confused with futures contracts. The confusion is primarily because both serve essentially the same economic functions of allocating risk in the presence of future price uncertainty. However futures are a significant improvement over the forward contracts. A future contract is nothing but a form of forward contract. One can differentiate a forward contract from a future contract on the following lines: Customized vs Standardized: Forward contracts are customized while future contracts are standardized. Terms of forward contracts are negotiated between the buyer and the seller. While the terms of future contracts are decided by the exchange on which these are traded. Counter Party Risk: In forward contracts there is a risk of counter party default. In case of futures, the exchange becomes counter party to each trade and guarantees settlement.

Liquidity: Futures are much more liquid and their price is transparent as their price and volume are reported in media. But this is not so in the case of forward contract.

Squaring off: A forward contract can be reversed with only the same counter party with whom it was entered into. A future contract can be reversed on the screen of the exchange as the latter is the counter party to all futures trades.

THEORETICAL WAY OF PRICING FUTURES

The theoretical price of a futures contract is spot price of the underlying plus the cost of carry. Please note that futures are not about predicting future prices of the underlying assets. In general, Futures Price = Spot Price + Cost of Carry

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The Cost of Carry is the sum of all costs incurred if a similar position is taken in cash market and carried to expiry of the futures contract less any revenue that may arise out of holding the asset. The cost typically includes interest cost in case of financial futures (insurance and storage costs are also considered in case of commodity futures). Revenue may be in the form of dividend. Though one can calculate the theoretical price, the actual price may vary depending upon the demand and supply of the underlying asset.

FUTURES TERMINOLOGIES
Spot price: The price at which an asset trades in the spot market. Futures price: The price at which the futures contract trades in the futures market. Contract cycle: The period over which a contract trades. The index futures contracts on the NSE have one-month, two-months and three-month expiry cycles which expire on the last Thursday of the month. Thus a January expiration contract expires on the last Thursday of January and a February expiration contract ceases trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three-month expiry is introduced for trading. Expiry date: It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist. Contract size: The amount of asset that has to be delivered less than one contract. For instance, the contract size on NSEs futures market is 200 Nifties. Basis: In the context of financial futures, basis can be defined as the futures price minus the spot price. There will be a different basis for each delivery month for each contract. In a 31

normal market, basis will be positive. This reflects that futures prices normally exceed spot prices. Cost of carry: The relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset. Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin. Marking-to-market: In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investors gain or loss depending upon the futures closing price. This is called markingtomarket. Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day.

OPTIONS
Options are fundamentally different from forward and futures contracts. An option gives the holder of the option the right to do something. The holder does not have to exercise this right. In contrast, in a forward or futures contract, the two parties have committed themselves to doing something. Whereas it costs nothing (except margin requirements) to enter into a futures contract, the purchase of an option requires an upfront payment.

OPTIONS TERMINOLOGIES

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Index options: These options have the index as the underlying. Some options are European while others are American. Like indexing futures contracts, indexing options contracts are also cash settled.

Stock options: Stock options are options on individual stocks. Options currently trade on over 500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified price.

Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer.

Writer of an option: The writer of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him. There are two basic types of options, call options and put options.

Call option: A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price.

Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price.

Option price: Option price is the price, which the option buyer pays to the option seller. It is also referred to as the option premium.

Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity.

Strike price: The price specified in the options contract is known as the strike price or the exercise price.

American options: American options are options that can be exercised at any time upto the expiration date. Most exchange-traded options are American.

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European options: European options are options that can be exercised only on the expiration date itself. European options are easier to analyze than American options, and properties of an American option are frequently deduced from those of its European counterpart.

In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cash flow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price > strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price.

At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cash flow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price).

Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cash flow if it were exercised immediately. A call option on the index is out-of-the-money when the current index stands at a level, which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price.

Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an options time value, all else equal. At expiration, an option should have no time value.

TYPES OF OPTIONS
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1. Call Options- A call option gives the holder (buyer/ one who is long call), the right to buy specified quantity of the underlying asset at the strike price on or before expiration date. The seller (one who is short call) however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy. Example: An investor buys One European call option on Infosys at the strike price of Rs. 3500 at a premium of Rs. 100. If the market price of Infosys on the day of expiry is more than Rs. 3500, the option will be exercised. The investor will earn profits once the share price crosses Rs. 3600 (Strike Price + Premium i.e. 3500+100). Suppose stock price is Rs. 3800, the option will be exercised and the investor will buy 1 share of Infosys from the seller of the option at Rs 3500 and sell it in the market at Rs 3800 making a profit of Rs. 200 {(Spot price - Strike price) - Premium}. In another scenario, if at the time of expiry stock price falls below Rs. 3500 say suppose it touches Rs. 3000, the buyer of the call option will choose not to exercise his option. In this case the investor loses the premium (Rs 100), paid which should be the profit earned by the seller of the call option. 2. Put Options- A Put option gives the holder (buyer/ one who is long Put), the right to sell specified quantity of the underlying asset at the strike price on or before an expiry date. The seller of the put option (one who is short Put) however, has the obligation to buy the underlying asset at the strike price if the buyer decides to exercise his option to sell. Example: An investor buys one European Put option on Reliance at the strike price of Rs. 300/- , at a premium of Rs. 25/-. If the market price of Reliance, on the day of expiry is less than Rs. 300, the option can be exercised as it is 'in the money'. The investor's Break-even point is Rs. 275/ (Strike Price - premium paid) i.e., investor will earn profits if the market falls below 275.

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Suppose stock price is Rs. 260, the buyer of the Put option immediately buys Reliance share in the market @ Rs. 260/- & exercises his option selling the Reliance share at Rs 300 to the option writer thus making a net profit of Rs. 15 {(Strike price - Spot Price) - Premium paid}. In another scenario, if at the time of expiry, market price of Reliance is Rs 320/ -, the buyer of the Put option will choose not to exercise his option to sell as he can sell in the market at a higher rate. In this case the investor loses the premium paid (i.e. Rs 25/-), which shall be the profit earned by the seller of the Put option. (Please see table)

THE OPTIONS GAME

Call Option

Put Option

1.Option buyer

Buys the right to buy the Buys the right to sell the underlying asset at the specified price specified price

or option holder underlying asset at the

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2. Option seller

Has the obligation to sell Has the obligation to buy the underlying asset (from specified price the option holder) at the the option holder) at the specified price

or option writer the underlying asset (to

LEVERAGE AND RISK

Options can provide leverage. This means an option buyer can pay a relatively small premium for market exposure in relation to the contract value (usually 100 shares of underlying stock). An investor can see large percentage gains from comparatively small, favorable percentage moves in the underlying index. Leverage also has downside implications. If the underlying stock price does not rise or fall as anticipated during the lifetime of the option, leverage can magnify the investment's percentage loss. Options offer their owners a predetermined, set risk. However, if the owner's options expire with no value, this loss can be the entire amount of the premium paid for the option. An uncovered option writer, on the other hand, may face unlimited risk.

In-the-money, At-the-money, Out-of-the-money An option is said to be at-the-money, when the option's strike price is equal to the underlying asset price. This is true for both puts and calls. A call option is said to be in-the-money when the strike price of the option is less than the underlying asset price. For example, a Sensex call option with strike of 3900 is in-the-money, when the spot Sensex is at 4100 as the call option has value. The call holder has the right to buy a

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Sensex at 3900, no matter how much the spot market price has risen. And with the current price at 4100, a profit can be made by selling Sensex at this higher price. On the other hand, a call option is out-of-the-money when the strike price is greater than the underlying asset price. Using the earlier example of Sensex call option, if the Sensex falls to 3700, the call option no longer has positive exercise value. The call holder will not exercise the option to buy Sensex at 3900 when the current price is at 3700. (Please see table) Striking the price

Call Option

Put Option

1.In-the-money

Strike Price less than Spot Strike Price greater than Price of underlying asset Spot Price of underlying asset

2. At-the-money

Strike Price equal to Spot Price of underlying asset

Strike Price equal to Spot Price of underlying asset

3. Out-of-the-money

Strike Price greater than Spot Price of underlying asset

Strike Price less than Spot Price of underlying asset

A put option is in-the-money when the strike price of the option is greater than the spot price of the underlying asset. For example, a Sensex put at strike of 4400 is in-themoney when the Sensex is at 4100. When this is the case, the put option has value because the put holder can sell the Sensex at 4400, an amount greater than the current Sensex of 4100.

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Likewise, a put option is out-of-the-money when the strike price is less than the spot price of underlying asset. In the above example, the buyer of Sensex put option won't exercise the option when the spot is at 4800. The put no longer has positive exercise value.

Options are said to be deep in-the-money (or deep out-of-the-money) if the exercise price is at significant variance with the underlying asset price. The amount by which an option, call or put, is in-the-money at any given moment is called its intrinsic value. Thus, by definition, an at-the-money or out-of-the-money option has no intrinsic value; the time value is the total option premium. This does not mean, however, these options can be obtained at no cost. Any amount by which an option's total premium exceeds intrinsic value is called the time value portion of the premium. It is the time value portion of an option's premium that is affected by fluctuations in volatility, interest rates, dividend amounts and the passage of time. There are other factors that give options value, therefore affecting the premium at which they are traded. Together, all of these factors determine time value. Option Premium = Intrinsic Value + Time Value

FACTORS THAT AFFECT THE VALUE OF AN OPTION PREMIUM

There are two types of factors that affect the value of the option premium: Quantifiable Factors: 1. Underlying stock price, 2. The strike price of the option, 3. The volatility of the underlying stock, 4. The time to expiration and; 39

5. The risk free interest rate. Non-Quantifiable Factors: 1. Market participants' varying estimates of the underlying asset's future volatility 2. Individuals' varying estimates of future performance of the underlying asset, based on fundamental or technical analysis 3. The effect of supply & demand- both in the options marketplace and in the market for the underlying asset 4. The "depth" of the market for that option - the number of transactions and the contract's trading volume on any given day.

DIFFERENT PRICING MODELS FOR OPTIONS

The theoretical option pricing models are used by option traders for calculating the fair value of an option on the basis of the earlier mentioned influencing factors. An option pricing model assists the trader in keeping the prices of calls & puts in proper numerical relationship to each other & helping the trader make bids & offer quickly. The two most popular option pricing models are:

Black Scholes Model which assumes that percentage change in the price of underlying follows a normal distribution.

Binomial Model which assumes that percentage change in price of the underlying follows a binomial distribution.

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Pricing models include the binomial options model for American options and the Black-Scholes model for European options.

OPTIONS TRADING
As described earlier, four possible option selections exist for a trader: a. long a call, b. long a put, c. short a call, and d. short a put. These four can be used independently, together, or in conjunction with other financial instruments to create a number of option-trading strategies. These combinations enable a trader to develop an option-trading model which meets the trader's specific trading needs, expectations, and style, and 41

enables him or her to anticipate every conceivable situation in the market. This trading structure can be adapted to handle any type of market outlook, whether it is bullish, bearish, choppy, or neutral. Options are unique trading instruments. They can be used for a multitude of purposes, providing tremendous versatility and utility. Among their multiple applications are the following: to speculate on the movement of an asset; to hedge an existing position in an asset; to hedge other option positions; to generate income by writing options against different quantities of options strategies that arise from these applications and the fact that the scope of this book is limited, we will devote coverage to a cursory explanation of two of the most popular strategies which are designed to take advantage of market movement: spreads and straddles.

WHY TO USE OPTIONS?

There are two main reasons why an investor would use options: to Speculate and to Hedge.

Speculation One can think of speculation as betting on the movement of a security. The advantage of options is that one isnt limited to making a profit only when the market goes up. Because of the versatility of options, one can also make money when the market goes down or even sideways. Speculation is the territory in which the big money is made - and lost. The use of options in this manner is the reason options have the reputation of being risky. This is because when one buys an option; he have to be correct in determining not only the direction of the stock's movement, but also the magnitude and the timing of this movement. To succeed, he must correctly predict whether a stock will go up or down, and he have to be right about how much the price will change as well as the time frame it will take for all this to happen.

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So why do people speculate with options if the odds are so skewed? Aside from versatility, it's all about using leverage. When one is controlling 100 shares with one contract, it doesn't take much of a price movement to generate substantial profits. Hedging The other function of options is hedging. Think of this as an insurance policy. Just as one insures his house or car, options can be used to insure your investments against a downturn. Critics of options say that if he is so unsure of his stock pick that he needs a hedge, he shouldn't make the investment. On the other hand, there is no doubt that hedging strategies can be useful, especially for large institutions. Even the individual investor can benefit. One can imagine that he wanted to take advantage of technology stocks and their upside, but say he also wanted to limit any losses. By using options, he would be able to restrict his downside while enjoying the full upside in a cost-effective way.

HOW OPTIONS WORKS?

Let's say that on May 1, the stock price of L&T is $67 and the premium (cost) is $3.15 for a July 70 Call, which indicates that the expiration is the third Friday of July and the strike price is $70. The total price of the contract is $3.15 x 100 = $315. In reality, you'd also have to take commissions into account, but we'll ignore them for this example. Remember, a stock option contract is the option to buy 100 shares; that's why you must multiply the contract by 100 to get the total price. The strike price of $70 means that the stock price must rise above $70 before the call option is worth anything; furthermore, because the contract is $3.15 per share, the break-even price would be $73.15. When the stock price is $67, it's less than the $70 strike price, so the option is worthless. But don't forget that you've paid $315 for the option, so you are currently down by this amount.

Three weeks later the stock price is $78. The options contract has increased along with the stock price and is now worth $8.25 x 100 = $825. Subtract what you paid for the contract, and your 43

profit is ($8.25 - $3.15) x 100 = $510. You almost doubled our money in just three weeks! You could sell your options, which are called "closing your position," and take your profits - unless, of course, you think the stock price will continue to rise. For the sake of this example, let's say we let it ride. By the expiration date, the price drops to $62. Because this is less than our $70 strike price and there is no time left, the option contract is worthless. We are now down to the original investment of $315. To recap, here is what happened to our option investment: Date Stock Price Option Price Contract Value Paper Gain/Loss May 1 $67 $3.15 $315 $0 May 21 $78 $8.25 $825 $510 Expiry Date $62 worthless $0 -$315

The price swing for the length of this contract from high to low was $825, which would have given us over double our original investment. This is leverage in action. Exercising Versus Trading-Out So far we've talked about options as the right to buy or sell (exercise) the underlying. This is true, but in reality, a majority of options are not actually exercised. In our example, you could make money by exercising at $70 and then selling the stock back in the market at $78 for a profit of $8 a share. You could also keep the stock, knowing you were able to buy it at a discount to the present value. However, the majority of the time holders choose to take their profits by trading out (closing out) their position. This means that holders sell their options in the market, and writers buy their positions back to close. According to the CBOE, about 10% of options are exercised, 60% are traded out, and 30% expire worthless. Intrinsic Value and Time Value

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At this point it is worth explaining more about the pricing of options. In our example the premium (price) of the option went from $3.15 to $8.25. These fluctuations can be explained by intrinsic value and time value. Basically, an option's premium is its intrinsic value + time value. Remember, intrinsic value is the amount in-the-money, which, for a call option, means that the price of the stock equals the strike price. Time value represents the possibility of the option increasing in value. So, the price of the option in our example can be thought of as the following: Premium = $8.25 = Intrinsic Value $8 + Time Value + $0.25

In real life options almost always trade above intrinsic value. If you are wondering, we just picked the numbers for this example out of the air to demonstrate how options work.

WHEN NOT TO BUY AN OPTION?

It is also important to consider the time or the date at which one should enter the option market. Avoid trading in an illiquid option market.

Avoid purchasing call options just prior to a stock going ex-dividend. Avoid buying or selling options based upon anticipated news (buyouts in particular). Besides bordering on unethical trading, the information received is more likely to be rumor than correct.

Avoid purchasing options well after the market has established a defined trend - this is especially true when day trading, as any option premium advantage will have dissipated.

Avoid purchasing way out-of-the-money options when day trading, as any favorable price movement will have a negligible effect upon premium.

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Avoid purchasing call options when the underlying security is up for the day versus the prior day's close, unless one intends to take a trend-following stance.

Avoid purchasing put options when the underlying security is down for the day versus the prior day's close, unless one intends to take a trend-following stance.

Be careful when holding long option positions beyond Friday's trading day's close unless one is option position trading. Many option theoreticians recalculate their volatility, delta, and time decay numbers once a week, usually after the close of trading on Fridays or over the weekend. The resulting adjustments in these values most often have a negative effect on the value of the long option, which may be acceptable when holding an option over an extended period of time but is detrimental when day trading.

HOW TO READ AN OPTION TABLE?

Column 1: Strike Price - This is the stated price per share for which an underlying stock may be purchased (for a call) or sold (for a put) upon the exercise of the option contract. Option strike prices typically move by increments of $2.50 or $5 (even though in the above example it moves in $2 increments). Column 2: Expiry Date - This shows the termination date of an option contract. Remember that U.S.-listed options expire on the third Friday of the expiry month.

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Column 3: Call or Put - This column refers to whether the option is a call (C) or put (P).

Column 4: Volume - This indicates the total number of options contracts traded for the day. The total volume of all contracts is listed at the bottom of each table. Column 5: Bid - This indicates the price someone is willing to pay for the options contract. Column 6: Ask - This indicates the price at which someone is willing to sell an options contract. Column 7: Open Interest - Open interest is the number of options contracts that are open; these are contracts that have neither expired nor been exercised.

PAYOFF FOR DERIVATIVES CONTRACT

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A payoff is the likely profit/loss that would accrue to a market participant with change in the price of the underlying asset. This is generally depicted in the form of payoff diagrams which show the price of the underlying asset on the Xaxis and the profits/losses on the Yaxis.

PAYOFF FOR FUTURES

Futures contracts have linear payoffs. In simple words, it means that the losses as well as profits for the buyer and the seller of a futures contract are unlimited. These linear payoffs are fascinating as they can be combined with options and the underlying to generate various complex payoffs. Payoff for buyer of futures: Long futures

The payoff for a person who buys a futures contract is similar to the payoff for a person who holds an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who buys a two-month Nifty index futures contract when the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio. When the index moves up, the long futures position starts making profits, and when the index moves down it starts making losses. Payoff for seller of futures: Short futures

The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who sells a two-month Nifty index futures contract when the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio. When the index moves down, the short futures position starts making profits, and when the index moves up, it starts making losses.

OPTIONS PAYOFF
The optionally characteristic of options results in a non-linear payoff for options. In simple words, it means that the losses for the buyer of an option are limited; however the profits are potentially 48

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

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

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Chapter 3 Hedging,Arbitrage and speculation strategies

HEDGING, ARBITRAGE AND SPECULATION STRATEGIES

HEDGING
Hedging is a way of reducing some of the risk involved in holding an investment. There are many different risks against which one can hedge and many different methods of hedging. When someone mentions hedging, think of insurance. A hedge is just a way of insuring an investment against risk. 51

Consider a simple (perhaps the simplest) case. Much of the risk in holding any particular stock is market risk; i.e. if the market falls sharply, chances are that any particular stock will fall too. So if you own a stock with good prospects but you think the stock market in general is overpriced, you may be well advised to hedge your position. There are many ways of hedging against market risk. The simplest, but most expensive method, is to buy a put option for the stock you own. (It's most expensive because you're buying insurance not only against market risk but against the risk of the specific security as well.) If you're trying to hedge an entire portfolio, futures are probably the cheapest way to do so. But keep in mind the following points.

The efficiency of the hedge is strongly dependent on your estimate of the correlation beIf the market goes up, you may need to advance more margin to cover your short position,

tween your high-beta portfolio and the broad market index.

and will not be able to use your stocks to cover the margin calls. If the market moves up, you will not participate in the rally, because by intention, you've set up your futures position as a complete hedge.

HEDGING STRATEGIES WITH EXAMPLES

Hedging: Long security, short Nifty futures
Investors studying the market often come across a security which they believe is intrinsically undervalued. It may be the case that the profits and the quality of the company make it seem worth a lot more than what the market thinks. A stock picker carefully purchases securities based on a sense that they are worth more than the market price. When doing so, he faces two kinds of risks:

52

1. His understanding can be wrong, and the company is really not worth more than the market price; or, 2. The entire market moves against him and generates losses even though the underlying idea was correct. The second outcome happens all the time. A person may buy SBI at Rs.670 thinking that it would announce good results and the security price would rise. A few days later, Nifty drops, so he makes losses, even if his understanding of SBI was correct. There is a peculiar problem here. Every buy position on a security is simultaneously a buy position on Nifty. This is because a LONG SBI position generally gains if Nifty rises and generally loses if Nifty drops. In this sense, a LONG SBI position is not a focused play on the valuation of SBI. It carries a LONG NIFTY position along with it, as incidental baggage. The stock picker may be thinking he wants to be LONG SBI, but a long position on SBI effectively forces him to be LONG SBI + LONG NIFTY. There is a simple way out. Every time you adopt a long position on a security, you should sell some amount of Nifty futures. This offsets the hidden Nifty exposure that is inside every longsecurity position. Once this is done, you will have a position, which is purely about the performance of the security. The position LONG SBI+ SHORT NIFTY is a pure play on the value of SBI, without any extra risk from fluctuations of the market index. When this is done, the stock picker has hedged away his index exposure. The basic point of this hedging strategy is that the stock picker proceeds with his core skill, i.e. picking securities, at the cost of lower risk.

Methodology

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1.

We need to know the beta of the security, i.e. the average impact of a 1% move in Nifty

upon the security. If betas are not known, it is generally safe to assume the beta is 1. Suppose we take SBIN, where the beta is 1.2, and suppose we have a LONG SBIN position of Rs.3,33,000. 2. The size of the position that we need on the index futures market, to completely remove the

hidden Nifty exposure, is 1.2 *3,33,000, i.e. Rs 4.00.000 3. Suppose Nifty is at 2000, and the market lot on the futures market is 200. Hence each mar-

ket lot of Nifty is Rs 4,00,000. To short Rs.4,00,000 of Nifty we need to sell one market lot. 4. We sell one market lot of Nifty (200 nifties) to get the position: LONG SBIN Rs.3,33,000 SHORT NIFTY Rs.4,00,000 This position will be essentially immune to fluctuations of Nifty. The profits/losses position will fully reflect price changes intrinsic to SBIN, hence only successful forecasts about SBIN will benefit from this position. Returns on the position will be roughly neutral to movements of Nifty.

Hedging: Have portfolio, short Nifty futures

The only certainty about the capital market is that it fluctuates! A lot of investors who own portfolios experience the feeling of discomfort about overall market movements. Sometimes, they may have a view that security prices will fall in the near future. At other times, they may see that the market is in for a few days or weeks of massive volatility, and they do not have an appetite for this kind of volatility. The union budget is a common and reliable source of such volatility: market volatility is always enhanced for one week before and two weeks after a budget. Many investors simply do not want the fluctuations of these three weeks. This is particularly a problem if you need to sell shares in the near future, for example, in order to finance a purchase of a house. This planning can go wrong if by the time you sell shares, Nifty has dropped sharply. When you have such anxieties, there are two alternatives: 54

Sell shares immediately. This sentiment generates panic selling which is rarely optimal Do nothing, i.e. suffer the pain of the volatility. This leads to political pressures for govern-

for the investor. ment to do something when security prices fall. In addition, with the index futures market, a third and remarkable alternative becomes available: Remove your exposure to index fluctuations temporarily using index futures. This allows rapid response to market conditions, without panic selling of shares. It allows an investor to be in control of his risk, instead of doing nothing and suffering the risk. The idea here is quite simple. Every portfolio contains a hidden index exposure. This statement is true for all portfolios, whether a portfolio is composed of index securities or not. In the case of portfolios, most of the portfolio risk is accounted for by index fluctuations (unlike individual securities, where only 3060% of the securities risk is accounted for by index fluctuations).Hence a position LONG PORTFOLIO + SHORT NIFTY can often become onetenth as risky as the LONG PORTFOLIO position! Suppose we have a portfolio of Rs.1 million which has a beta of 1.25. Then a complete hedge is obtained by selling Rs.1.25 million of Nifty futures.

Methodology 1. We need to know the beta of the portfolio, i.e. the average impact of a 1% move in Nifty

upon the portfolio. It is easy to calculate the portfolio beta: it is the weighted average of securities betas. Suppose we have a portfolio composed of Rs.1 million of Hindalco, which has a beta of 1.4 and Rs.2 million of Hindustan Lever, which has a beta of 0.8, then the portfolio beta is (1 * 1.4 + 2 * 0.8)/3 or 1. If the beta of any securities is not known, it is safe to assume that it is 1. 2. The complete hedge is obtained by adopting a position on the index futures market, which

completely removes the hidden Nifty exposure. In the above case, the portfolio is Rs.3 million with a beta of 1, hence we would need a position of Rs.3 million on the Nifty futures. 55

3.

Suppose Nifty is 1250, and the market lot on the futures market is 200. Each market lot of

Nifty costs Rs.250,000. Hence we need to sell 12 market lots, i.e. 2400 Nifties to get the position: LONG PORTFOLIO Rs.3,000,000 SHORT NIFTY Rs.3,000,000. This position will be essentially immune to fluctuations of Nifty. If Nifty goes up, the portfolio gains and the futures lose. If Nifty goes down, the futures gain and the portfolio loses. In either case, the investor has no risk from market fluctuations when he is completely hedged. The investor should adopt this strategy for the short periods of time where (a) the market volatility that he anticipates makes him uncomfortable, or (b) when his financial planning involves selling shares at a future date and would be affected if Nifty drops. It does not make sense to use this strategy for long periods of time if a twoyear hedging is desired, it is better to sell the shares, invest the proceeds, and buy back shares after two years. This strategy makes the most sense for rapid adjustments. Another important choice for the investor is the degree of hedging. Complete hedging eliminates all risk of gain or loss. Sometimes the investor may be willing to tolerate some risk of loss so as to hang on to some risk of gain. In that case, partial hedging is appropriate. The complete hedge may require selling Rs.3 million of the futures, but the investor may choose to only sell Rs.2 million of the futures. In this case, twothirds of his portfolio is hedged and one third of the portfolio is held unhedged. The exact degree of hedging chosen depends upon the appetite for risk that the investor has.

Hedging: Have funds, buy Nifty futures

Have you ever been in a situation where you had funds, which needed to get invested in equity? Or of expecting to obtain funds in the future which will get invested in equity. Some common occurrences of this include:
_

A closed-end fund, which just finished its initial public offering, has cash, which is not yet

invested.

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Suppose a person plans to sell land and buy shares. The land deal is slow and takes weeks to

complete. It takes several weeks from the date that it becomes sure that the funds will come to the date that the funds actually are in hand. An open-ended fund has just sold fresh units and has received funds.

Getting invested in equity ought to be easy but there are three problems: 1. A person may need time to research securities, and carefully pick securities that are expected

to do well. This process takes time. For that time, the investor is partly invested in cash and partly invested in securities. During this time, he is exposed to the risk of missing out if the overall market index goes up. 2. A person may have made up his mind on what portfolio he seeks to buy, but going to the

market and placing market orders would generate large impact costs. The execution would be improved substantially if he could instead place limit orders and gradually accumulate the portfolio at favorable prices. This takes time, and during this time, he is exposed to the risk of missing out if the Nifty goes up. 3. In some cases, such as the land sale above, the person may simply not have cash to immedi-

ately buy shares, hence he is forced to wait even if he feels that Nifty is unusually cheap. He is exposed to the risk of missing out if Nifty rises. So far, in India, we have had exactly two alternative strategies, which an investor can adopt: to buy liquid securities in a hurry, or to suffer the risk of staying in cash. With Nifty futures, a third alternative becomes available: The investor would obtain the desired equity exposure by buying index futures, immediate-

ly. A person who expects to obtain Rs.5 million by selling land would immediately enter into a position LONG NIFTY worth Rs.5 million. Similarly, a closed-end fund, which has just finished its initial public offering and has cash, which is not yet invested, can immediately enter into a LONG 57

NIFTY to the extent it wants to be invested in equity. The index futures market is likely to be more liquid than individual securities so it is possible to take extremely large positions at a low impact cost. Later, the investor/closed-end fund can gradually acquire securities (either based on detailed research and/or based on aggressive limit orders). As and when shares are obtained, one would scale down the LONG NIFTY position correspondingly. No matter how slowly securities are purchased, this strategy would fully capture a rise in Nifty, so there is no risk of missing out on a broad rise in the securities market while this process is taking place. Hence, this strategy allows the investor to take more care and spend more time in choosing securities and placing aggressive limit orders. Hedging is often thought of as a technique that is used in the context of equity exposure. It is common for people to think that the owner of shares needs index futures to hedge against a drop in Nifty. Holding money in hand, when you want to be invested in shares, is a risk because Nifty may rise. Hence it is equally important for the owner of money to use index futures to hedge against a rise in Nifty!

Methodology 1. A person obtained Rs.4.8 million on 13th March 2005. He made a list of 14 securities to buy,

at 13 March prices, totaling Rs.4.8 million. 2. At that time Nifty was at 2000. He entered into a LONG NIFTY MARCH FUTURES posi-

tion for 2400 Nifties, i.e. his long position was worth 4,80,000. 3. From 14 March 2005 to 25 March 2005 he gradually acquired the securities. On each day,

he purchased one securities and sold off a corresponding amount of futures. 4. On each day, the securities purchased were at a changed price (as compared to the price

prevalent on 13 March). On each day, he obtained or paid the marktomarket margin on his outstanding futures position, thus capturing the gains on the index. 58

5.

By 25 Mar 2005 he had fully invested in all the shares that he wanted (as of 13 Mar) and had

no futures position left.

ARBITRAGE
Arbitrage is the practice of taking advantage of a state of imbalance between two (or possibly more) markets. A combination of matching deals are struck that exploit the imbalance, the profit being the difference between the market prices. A person who engages in arbitrage is called an arbitrageur. Arbitrage is the safest way to make money in the market. However, the scope for making money is diminutive. With the help of the arbitrage strategies discussed above, we can exploit the market condition and earn risk-free return. Arbitrage is game of strategy and also funds. A participant with ample funds can easily earn riskfree returns. On the other hand, a strategist can make risk-less profits by making use of mispricing in the market. Arbitrage could be inter-exchange, NSE and BSE. Arbitrage could also be between two segments of the market, Cash and F&O.

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Borrowing and lending is a common practice in arbitrage transaction, therefore, bank and financial institution are very active in arbitrage activities. The below stated strategies cover all the types of arbitrage possibilities using equity derivatives.

ARBITRAGE STRATEGIES WITH EXAMPLES

Arbitrage: Have funds, lend them to the market.
Most people would like to lend funds into the security market, without suffering the risk. Traditional methods of loaning money into the security market suffer from (a) price risk of shares and (b) credit risk of default of the counter-party. What is new about the index futures market is that it supplies a technology to lend money into the market without suffering any exposure to Nifty, and without bearing any credit risk. The basic idea is simple. The lender buys all 50 securities of Nifty on the cash market, and simultaneously sells them at a future date on the futures market. It is like a repo. There is no price risk since the position is perfectly hedged. There is no credit risk since the counter party on both legs is the NSCCL which supplies clearing services on NSE. It is an ideal lending vehicle for entities which are shy of price risk and credit risk, such as traditional banks and the most conservative corporate treasuries.

Methodology 1. Calculate a portfolio which buys all the 50 securities in Nifty in correct proportion, i.e.

where the money invested in each security is proportional to its market capitalization. 2. 3. Round off the number of shares in each security. Using the NEAT or BOLT software, a single keystroke can fire off these 50 orders in rapid

succession into the NSE or BSE trading system. This gives you the buy position 60

4. 5. 6. 7. rities. 8. 9.

A moment later, sell Nifty futures of equal value. Now you are completely hedged, so flucA few days later, you will have to take delivery of the 50 securities and pay for them. This is Some days later (anytime you want), you will unwind the entire transaction. At this point, use NEAT to send 50 sell orders in rapid succession to sell off all the 50 secuA moment later, reverse the futures position. Now your position is down to 0. A few days later, you will have to make delivery of the 50 securities and receive money for

tuations in Nifty do not affect you. the point at which you are loaning money to the market.

them. This is the point at which your money is repaid to you. What is the interest rate that you will receive? We will use one specific case, where you will unwind the transaction on the expiration date of the futures. In this case, the difference between the futures price and the cash Nifty is the return to the moneylender, with two complications: the moneylender additionally earns any dividends that the 50 shares pay while he has held them, and the moneylender suffers transactions costs (impact cost, brokerage) in doing these trades. On 1 March 2005, if the Nifty spot is 2100, and the Nifty March 2005 futures are at 2142 then the difference (2% for 30 days) is the return that the moneylender obtains.

Example On 1 August, Nifty is at 2400. A futures contract is trading with 27th August expiration for 2460. A person wants to earn this return (60/2400 for 27 days). 1. He buys Rs.3 million of Nifty on the spot market. In doing this, he places 50 market orders

and ends up paying slightly more. His average cost of purchase is 0.3% higher, i.e. he has obtained the Nifty spot for 2407. 2. He sells Rs.3 million of the futures at 2460. The futures market is extremely liquid so the

market order for Rs.3 million goes through at nearzero impact cost. He takes delivery of the shares and waits. 61

3. 4.

While waiting, a few dividends come into his hands. The dividends work out to Rs.14,000. On 27 August, at 3:15, he puts in market orders to sell off his Nifty portfolio, putting 50

market orders to sell off all the shares. Nifty happens to have closed at 2420 and his sell orders (which suffer impact cost) goes through at 2413. 5. The futures position spontaneously expires on 27 August at 2420 (the value of the futures on

the last day is always equal to the Nifty spot).

6.

He has gained Rs.6 (0.25%) on the spot Nifty and Rs.40 (1.63%) on the futures for a return

of near 1.88% In addition, he has gained Rs.14000 or 0.23% owing to the dividends for a total return of 2.11% for 27 days, risk free. It is easier to make a rough calculation of the return. To do this, we ignore the gain from dividends and we assume that transactions costs account for 0.4%. In the above case, the return is roughly 2460/2400 or 2.5% for 27 days, and we subtract 0.4% for transactions costs giving 2.1% for 27 days.

Arbitrage: Have securities, lend them to the market

Owners of a portfolio of shares often think in terms of juicing up their returns by earning revenues from stocklending. However, stocklending schemes that are widely accessible do not exist in India. The index futures market offers a riskless mechanism for (effectively) loaning out shares and earning a positive return for them. It is like a repo; you would sell off your certificates and contract to buy them back in the future at a fixed price. There is no price risk (since you are perfectly hedged) and there is no credit risk (since your counterparty on both legs of the transaction is the NSCCL).

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The basic idea is quite simple. You would sell off all 50 securities in Nifty and buy them back at a future date using the index futures. You would soon receive money for the shares you have sold. You can deploy this money, as you like until the futures expiration. On this date, you would buy back your shares, and pay for them.

Methodology Suppose you have Rs.5 million of the NSE-50 portfolio (in their correct proportion, with each share being present in the portfolio with a weight that is proportional to its market capitalization). 1. Sell off all 50 shares on the cash market. This can be done using a single keystroke using the

NEAT software. 2. 3. 4. 5. Buy index futures of an equal value at a future date. A few days later, you will receive money and have to make delivery of the 50 shares. Invest this money at the riskless interest rate. On the date that the futures expire, at 3:15 PM, put in 50 orders (using NEAT again) to buy

the entire NSE-50 portfolio. 6. A few days later, you will need to pay in the money and get back your shares.

When is this worthwhile? When the spot-futures basis (the difference between spot Nifty and the futures Nifty) is smaller than the riskless interest rate that you can find in the economy. If the spotfu63

tures basis is 2.5% per month and you are loaning out the money at 1.5% per month, it is not profitable. Conversely, if the spot-futures basis is 1% per month and you are loaning out money at 1.2% per month, this stock lending could be profitable It is easy to approximate the return obtained in stock lending. To do this, we assume that transactions costs account for 0.4%. Suppose the spotfutures basis is X% and suppose the rate at which funds can be invested is Y %. Then the total return is (Y - X% - 0.4%) over the time that the position is held. This can also be interpreted as a mechanism to obtain a cash loan using your portfolio of Nifty shares as collateral. In this case, it may be worth doing even if the spotfutures basis is somewhat wider.

Example Suppose the Nifty spot is 1100 and the twomonth futures are trading at 1110. Hence the spot futures basis (10/1100) is 0.9%. Assume that the transactions costs are 0.4%. Suppose cash can be riskless invested at 1% per month. Over two months, funds invested at 1% per month yield 2.01%. Hence the total return that can be obtained in stock lending is 2.01-0.9-0.4 or 0.71% over the two month period. Let us make this concrete using a specific sequence of trades. Suppose a person has Rs.4 million of the Nifty portfolio, which he would like to lend to the market.

1.

He puts in sell orders for Rs.4 million of Nifty using the feature in NEAT to rapidly place 50

market orders in quick succession. The seller always suffers impact cost; suppose he obtains an actual execution at 1098. 2. A moment later, he puts in a market order to buy Rs.4 million of the Nifty futures. The order

executes at 1110. At this point, he is completely hedged. 3. A few days later, he makes delivery of shares and receives Rs.3.99 million (assuming an im-

pact cost of 2/1100).

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4.

Suppose he lends this out at 1% per month for two months. At the end of two months, he

get back Rs.40,70,199. Translated in terms of Nifty, this is 1098* or 1120. 5. On the expiration date of the futures, he puts in 50 orders, using NEAT, placing market or-

ders to buy back his Nifty portfolio. Suppose Nifty has moved up to 1150 by this time. This makes shares are costlier in buying back, but the difference is exactly offset by profits on the futures contract. 6. When the market order is placed, suppose he ends up paying 1153 and not 1150, owing to impact cost. He has funds in hand of 1120, and the futures contract pays 40 (1150-1110) so he ends up with a clean profit, on the entire transaction, of 1120 + 40 - 1153 or 7. On a base of Rs.4 million, this is Rs.25,400.

Arbitrage: Overpriced futures: buy spot, sell futures

As we discussed earlier, the cost-of-carry ensures that the futures price stay in tune with the spot price. Whenever the futures price deviates substantially from its fair value, arbitrage opportunities arise. If you notice that futures on a security that you have been observing seem overpriced, how can you cash in on this opportunity to earn riskless profits? Say for instance, ABB trades at Rs.1000. One month ABB futures trade at Rs.1025 and seem overpriced. As an arbitrageur, you can make riskless profit by entering into the following set of transactions. 1. 2. 3. 4. position. On day one, borrow funds; buy the security on the cash/spot market at 1000. Simultaneously, sell the futures on the security at 1025. Take delivery of the security purchased and hold the security for a month. On the futures expiration date, the spot and the futures price converge. Now unwind the

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5. 6. 7. tion. 8.

Say the security closes at Rs.1015. Sell the security. Futures position expires with profit of Rs.10. The result is a riskless profit of Rs.15 on the spot position and Rs.10 on the futures posi-

Return the borrowed funds.

When does it make sense to enter into this arbitrage? If your cost of borrowing funds to buy the security is less than the arbitrage profit possible, it makes sense for you to arbitrage. This is termed as cashandcarry arbitrage. Remember however, that exploiting an arbitrage opportunity involves trading on the spot and futures market. In the real world, one has to build in the transactions costs into the arbitrage strategy.

Arbitrage: Underpriced futures: buy futures, sell spot

Whenever the futures price deviates substantially from its fair value, arbitrage opportunities arise. It could be the case that you notice the futures on a security you hold seem underpriced. How can you cash in on this opportunity to earn riskless profits? Say for instance, ABB trades at Rs.1000. One month ABB futures trade at Rs. 965 and seem underpriced. As an arbitrageur, you can make riskless profit by entering into the following set of transactions. 1. 2. 3. 4. sition. 5. 6. Say the security closes at Rs.975. Buy back the security. The futures position expires with a profit of Rs.10. 66 On day one, sell the security in the cash/spot market at 1000. Make delivery of the security. Simultaneously, buy the futures on the security at 965. On the futures expiration date, the spot and the futures price converge. Now unwind the po-

7.

The result is a riskless profit of Rs.25 on the spot position and Rs.10 on the futures position.

If the returns you get by investing in riskless instruments is less than the return from the arbitrage trades, it makes sense for you to arbitrage. This is termed as reversecashandcarry arbitrage. It is this arbitrage activity that ensures that the spot and futures prices stay in line with the costofcarry. As we can see, exploiting arbitrage involves trading on the spot market. As more and more players in the market develop the knowledge and skills to do cashandcarry and reverse cashandcarry, we will see increased volumes and lower spreads in both the cash as well as the derivatives market.

SPECULATIONS
Speculation has a lot of risks involved. Specially speculation in derivates is even more riskier as the derivatives are leveraged instruments. Speculator is responsible for liquidity in the market. Major part of the market volumes come from speculation, be it cash market or the F&O segment. Market participants to speculate extensively use Index futures and stock futures. Index futures attract the maximum volumes in the derivatives segment. Speculation in option is not very common, because buying an option is highly leveraged transaction. Speculation in options is naked positions, which are very risky. Speculation in the market index is very common, index is less volatile and index movement is easy to analyze than the individual stock movements. Speculation in individual securities attracts highest risk, are individual securities are more volatile than the market index. The above-discussed strategies are responsible for liquidity in the Derivatives segment hence leading to volumes in the cash segment also.

SPECULATION STRATEGIES WITH EXAMPLES

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Speculation: Bullish Index, long nifty futures

Sometimes we think that the market index is going to rise and that we can make a profit by adopting a position on the index. After a good budget, or good corporate results, or the onset of a stable government, many people feel that the index would go up. How does one implement a trading strategy to benefit from an upward movement in the index? Today, a person has two choices: 1. 2. Buy selected liquid securities which move with the index, and sell them at a later date: or, Buy the entire index portfolio and then sell it at a later date.

The first alternative is widely used a lot of the trading volume on liquid securities is based on using these liquid securities as an index proxy. However, these positions run the risk of making losses owing to companyspecific news; they are not purely focused upon the index. The second alternative is cumbersome and expensive in terms of transactions costs. Taking a position on the index is effortless using the index futures market. Using index futures, an investor can buy or sell the entire index by trading on one single security. Once a person is LONG NIFTY using the futures market, he gains if the index rises and loses if the index falls.

Methodology When you think the index will go up, buy the Nifty futures. The minimum market lot is 200 Nifties. Hence, if Nifty is at 1200, the investment is done in units of Rs.240,000. When the trade takes place, the investor is only required to pay up the initial margin, which is something like Rs.20,000. Hence, by paying an initial margin of Rs.20,000, the investor gets a claim on the index worth Rs.240,000. Similarly, by paying up Rs.200,000, the investor gets a claim on Nifty worth Rs.2.4 million. Futures are available at several different expirations. The investor can choose any of them to implement this position. The choice is basically about the horizon of the investor. Longer dated

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futures go well with longterm forecasts about the movement of the index. Shorter dated futures tend to be more liquid.

Example 1. 2. 3. 4. 3. 4. 5. On 1 July 2001, a person feels the index will rise. He buys 200 Nifties with expiration date on 31st July 2001. At this time, the Nifty July contract costs Rs.960 so his position is worth Rs.192,000. On 14 July 2001, Nifty has risen to 967.35. The Nifty July contract has risen to Rs.980. He sells off his position at Rs.980. His profits from the position are Rs.4000.

Speculation: Bearish index, short Nifty futures

Sometimes we think that the market index is going to fall and that we can make profit by adopting a position on the index. After a bad budget, or bad corporate results, or the onset of a coalition government, many people feel that the index would go down. How does one implement a trading strategy to benefit from a downward movement in the index? Today a person has two choices: 1. 2. Sell selected liquid securities which move with the index, and buy them at a later date: or, Sell the entire index portfolio and then buy it at a later date.

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The first alternative is widely used a lot of the trading volume on liquid securities is based on using these securities as an index proxy. However, these positions run the risk of making losses owing to companyspecific news; they are not purely focused upon the index. The second alternative is hard to implement. This strategy is also cumbersome and expensive in terms of transactions costs. Taking a position on the index is effortless using the index futures market. Using index futures, an investor can buy or sell the entire index by trading on one single security. Once a person is SHORT NIFTY using the futures market, he gains if the index falls and loses if the index rises. Methodology When you think the index will go down, sell the Nifty futures. The minimum market lot is 200 Nifties. Hence, if Nifty is at 1200, the investment is done in units of Rs.240,000. When the trade takes place, the investor is only required to pay up the initial margin, which is something like Rs.20,000. Hence, by paying an initial margin of Rs.20,000 the investor gets a claim on the index worth Rs.240,000. Similarly, by paying up Rs.200,000, the investor gets a claim on Nifty worth Rs.2.4 million. Futures are available at several different expirations. The investor can choose any of them to implement this position. The choice is basically about the horizon of the investor. Longer dated futures go well with longterm forecasts about the movement of the index. Shorter dated futures tend to be more liquid. Example 1. 2. 3. 4. 5. On 1 June 2001, a person feels the index will fall. He sells 200 Nifties with a expiration date of 26th June 2001. At this time, the Nifty June contract costs Rs.1,060 so his position is worth Rs.212,000. On 10 June 2001, Nifty has fallen to 962.90. The Nifty June contract has fallen to Rs.990. he squares off his position. 70

His profits from the position work out to be Rs.14,000.

Chapter 4

Applicability of Derivative Instruments

APPLICABILITY OF DERIVATIVE
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INSTRUMENTS

RISK MANAGEMENT: CONCEPT AND DEFINATION

In recent years mangers have become increasingly aware of how their organizations can be affected by risks beyond their control. In many cases fluctuations in economic and financial variables such as exchange rates, interest rates and commodity prices have destabilizing affects on performance and corporate strategy.

WHAT IS RISK?
Risks are defined as internal or external causes of and reasons for deviations in actual results and forecasts/budgets, or factors that can lead to changes in the forecast. They are possibilities not included in forecast/budget and represent an upside or downside to the forecast/ budget.

WHAT IS RISK MANAGEMENT?

Risk management embraces the whole spectrum of activities and measures associated with the identification, evaluation and handling of opportunities and risks.

OBJECTIVES AND BENEFITS OF RISK MANAGEMENT

The key objectives of Risk Management are: Providing a basis for informed decision making as a consequence of creating transparency in the companys risk situation. Identifying threats to the company, its assets and its financial and earning potential.

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Implementing proper mechanism for the identification, analysis and mitigation of potential risks. Clearly prioritizing risks to the company and their mitigation strategies: and Creating opportunities through improving risk mitigation capabilities.

Effective and systematic Risk Management yields the following key benefits: Forward, rigorous, responsible thinking, so the organization is prepared for what might happen and is better prepared for making decisions to improve the effectiveness and efficiency of performance. Balance thinking a trade off must be struck between the cost of managing risk, the benefits to be gained, and what level of Risk Management it is prudent to apply; and The organization is encouraged to manage proactively rather than reactively. It helps to speed up the decision making process, giving clear priorities to each type of activity or project requiring management attention and thus giving a clear cut advantage to the business.

RISK MANAGEMENT PROCESS

The objective of risk management process is to identify and evaluate the key risks, treat and monitor these risks efficiently and effectively, and ensure ongoing reporting for informed decision making. It embraces the whole spectrum of activities and measures concerned with systematic management of risks within the organization. The overall objective of the risk management process is to optimize the risk return relationship and reject unacceptable risks. The process contains four main stages: Risk Identification Risk Evaluation Risk Handling; and Risk Controlling

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Controlling the Risk Management Process means monitoring whether the management process is actively and effectively lived throughout the organization. The efficiency of the process is the responsibility of all managers within the organization and cannot be viewed as the sole responsibility of the Risk Manager. All levels of management should manage risks. The risk management process must be established as a permanent and integral part of business process if it to be fully effective. Furthermore, since risks and risk structures change continuously, the risk management process must remain sufficiently flexible to accommodate new situations as they arise.

Risk Management Process Objectives, strategies, organization of the company

Risk Identification Identification of risks and of their sources Risk Evaluation Evaluation of risks concerning their impact &

probability

Risk Controlling Ongoing reporting and monitoring of risks and the handling mechanism.

Opportunity/Risk Handling Measures and mechanisms for influencing risks.

RISK MANAGEMENT WITH FUTURES CONTRACT

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As the futures are exchange-traded, the clearing corporation of the exchange by granting credit guarantee nullifies the counter party risk. Also the strict margining system followed in the futures market worldwide, reduces the default risk associated with the futures. The general margining system that is followed in the futures market is as follows. Depending on the position taken an initial margin is charged on the investor. This is determined by the exposure limit assigned to the investor. This can be interpreted as an advance payment made to take a larger position. For example, if the exposure limit is 33 times the base capital given by the investor, then it means that an initial margin of 3.33 is required. More than the initial margin collected, the net profit or loss on a position is paid out to or in by the investor on the very same day in the form of daily mark-to-market margins (MTM). The MTM is made compulsory to remove any default on large losses if the position is accumulated for several days. Calculating the net loss associated with a position does the calculation of MTM margin. This is paid up each evening after trading ends. The focus is on calculating the net loss on all contracts entered by the client.

ADVANTAGES AND RISKS OF TRADING IN FUTURES OVER CASH

The biggest advantage of futures is that short selling is allowed without having stock and position can be carried for a long time, which is not possible in the cash segment because of rolling settlement. Conversely futures can be bought and position can be carried for a long time without taking delivery, unlike in the cash segment where it delivery has to be taken because of rolling settlement. Further futures positions are leveraged positions, meaning a position can be taken for Rs100 by paying Rs25 margin and daily mark-to-market loss, if any. This can enhance the return on capital deployed. For example, the expectation for a Rs100 stock is to go up by Rs10. One way is to buy the stock in the cash segment by paying Rs100. In this way the profit will be Rs10 on

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investment of Rs100, giving about 10% returns. Alternatively, futures position in the stock by paying about Rs30 toward initial and mark-to-market margin the same profit of Rs10 can be made on the investment of Rs30, i.e. about 33% returns. Please note that taking leveraged position is very risky, you can even lose your full capital in case the price moves against your position.

RISK MANAGEMENT WITH OPTIONS

Risk is concerned with the unknown. Upside risk is the possibility of gain. Downside risk is the possibility of loss. One half the reasons to use options (like other derivatives) is to reduce risk. Certainty is exchanged with other players who assume the risk in hope of big gains. It is wrong to state that "options are risky."

Reduce risk: The seller of a covered call exchanges his upside risk (gains above the strike price) for the certainty of cash in hand (the premium). The buyer of a covered put limits his downside risk for a price - just like buying fire insurance for your house.

Increase risk: The buyer of a call wants the upside risk of an asset, but will only pay a small percentage of its current value, so his returns are leveraged. The seller of a put accepts the downside risk of locking in his purchase price of an asset, in exchange for the premium.

To understand risk, look at the four standard graphs of options (put-call-buy-sell). The value of the options in the interim between purchase and expiration will not be exactly like these graphs, but close enough. In all cases, the premium was a certainty.

Buyers start out-of-pocket. But going forward, the option buyer has no downside risk. The graph either flat lines or goes up on either side of the spot price.

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Sellers start with a gain. Going forward, they have no upside risk. These graphs either flat line or go down on either side of the spot price.

The extent of risk varies. Buyers/sellers of calls have unlimited upside/downside risk as the asset price increases. Buyers/sellers of puts have upside/downside risk limited to the spot price of the asset (less the premium). Long Call A trader who believes that a stock's price will increase might buy the right to purchase the stock (a call option) rather than just buy the stock. He would have no obligation to buy the stock, only the right to do so until the expiry date. If the stock price increases over the exercise price by more than the premium paid, he will profit. If the stock price decreases, he will let the call contract expire worthless, and only lose the amount of the premium. A trader might buy the option instead of shares, because for the same amount of money, he can obtain a larger number of options than shares. If the stock rises, he will thus realize a larger gain than if he had purchased shares. This is an example of the principle of leverage.

Payoffs and profits from a long call. Short Call (Naked short call) A trader who believes that a stock's price will decrease can short sell the stock or instead sell a call. Both tactics are generally considered inappropriate for small investors. The trader selling a call has an obligation to sell the stock to the call buyer at the buyer's option. If the stock price decreases, the short call position will make a profit in the amount of the premium.

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If the stock price increases over the exercise price by more than the amount of the premium, the short will lose money. Unless a trader already owns the shares which he may be required to provide, the potential loss is unlimited. However, such a trader who sells a call option for those shares he already owns has sold a covered call.

Payoffs and profits from a short call. Long Put A trader who believes that a stock's price will decrease can buy the right to sell the stock at a fixed price. He will be under no obligation to sell the stock, but has the right to do so until the expiry date. If the stock price decreases below the exercise price by more than the premium paid, he will profit. If the stock price increases, he will just let the put contract expire worthless and only lose his premium paid.

Payoffs and profits from a long put. Short Put (Naked put) A trader who believes that a stock's price will increase can sell the right to sell the stock at a fixed price. The trader now has the obligation to purchase the stock at a fixed price. The trader has sold insurance to the buyer of the put requiring the trader to insure the stockholder below the fixed price. This trade is generally considered inappropriate for a small investor. If the stock price 78

increases, the short put position will make a profit in the amount of the premium. If the stock price decreases below the exercise price by more than the premium, the short position will lose money.

Payoffs and profits from a short put.

INTRODUCTION TO OPTIONS STRATEGIES

Bullish Strategies Bullish options strategies are employed when the options trader expects the underlying stock price to move upwards. It is necessary to assess how high the stock price can go and the timeframe in which the rally will occur in order to select the optimum trading strategy. The most bullish of options trading strategies is the simple call buying strategy used by most novice options traders. In most cases, stocks seldom go up by leaps and bounds. Moderately bullish options traders usually set a target price for the Bull Run and utilize bull spreads to reduce risk. While maximum profit is capped for these strategies, they usually cost less to employ. The bull call spread and the bull put spread are common examples of moderately bullish strategies. Mildly bullish trading strategies are options strategies that make money as long as the underlying stock prices do not go down on options expiration date. These strategies usually provide a small downside protection as well. Writing out-of-the-money covered calls is a good example of such a strategy. Bearish Strategies 79

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

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Bearish on Volatility Neutral trading strategies those are bearish on volatility profit when the underlying stock price experiences little or no movement. Such strategies include the short straddle, short strangle, ratio spreads, long condor and long butterfly. Combining any of the four basic kinds of option trades (possibly with different exercise prices) and the two basic kinds of stock trades (long and short) allows a variety of options strategies. Simple strategies usually combine only a few trades, while more complicated strategies can combine several.

OPTIONS TRADING STRATEGIES

There are several basic Options Trading Strategies, but in order to execute any of them successfully an investor new to options will need to know some elementary concepts. The most basic are the call and the put. Buying a call confers the right, but not the obligation, to buy at a pre-set price. Puts grant the buyer the right to sell at a pre-set price. But options are sold as well as bought. That seller grants the buyer the right, and takes on an obligation to fulfill the other side of the trade. There are several basic variations. Long Calls The most basic, and easiest to understand, is the (long) call. MSFT (Microsoft), currently trading at $28, have June 31 options that expire on the third Friday of June, with a strike price (pre-set, 'if exercised, must-be-bought-at-price') of $31.

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

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Hedging involves taking positions that tend to move in opposite directions. They profit less than pure speculation, but make up for it by offloading some risk. 'Bull spreads', for example, use a long call with a low strike price in combination with a short call at a higher strike price and a short put with a higher strike price. 'Bear spreads', by contrast, involve a short call with a low strike price and a long call with a higher strike price. An alternative method uses a short put with low strike price and a long put with a higher strike price. Options trading software can demonstrate several concrete examples of how any of these - under different assumptions about future prices, volume, etc in combination with different expiration dates and strike prices - can result in profit (or loss).

Current Strategies
1. LONG CALL

Market View Bullish

Potential Profit Unlimited

Potential Loss Limited

Purchasing calls has remained the most popular strategy with investors since listed options were first introduced. Before moving into more complex bullish and bearish strategies, an investor should thoroughly understand the fundamentals about buying and holding call options. Situation: On 1 November, L&T is quoting at Rs 254 and the January 260 (strike price) call costs Rs 14 (premium). You expect the share price to rise significantly and want to profit from the increase

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Action: Buy 1 L&T call at 14. Net outlay is Rs 14,000 If the L&T shares do go up you can close your position either by selling the option back to the market or exercising your right to buy the underlying shares at the exercise price. Share Price Rs. 254 Rs. 300

1-Nov 20-Jan

Analysis

Rises by Rs.46 Return 18%

Option Market Buy 1 Jan 260 call at Rs 14, Cost =14,000 1. Sell 1Jan contract (Expiry) 2. Net Gain 40 (300 - 260 x 1000 units = 40,000) Your gain is: Option sale = 40,000 Premium paid = (14,000) Net profit= 26,000 Return 186%

Share Price 300 Share price < 260 Stock price > 274

Possible Outcomes at expiry Option worth 40,000. Closing the position now will produce a net profit of 26,000 Option expires worthless. The loss is Rs. 14,000 (premium) Net profit = intrinsic value of (Break even = 260+14) option i.e. by whatever amount the share price exceeds 274

Although the profit is on expiry day, the investor is obviously able to sell his option at any time prior to expiry, and such sale will result in the receipt of time value in addition to any intrinsic value. 2. LONG PUT

Market View Bearish

Potential Profit Unlimited

Potential Loss Limited

A long put can be an ideal tool for an investor who wishes to participate profitably from a downward price move in the underlying stock. Before moving into more complex bearish

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strategies, an investor should thoroughly understand the fundamentals about buying and holding put options. Situation: An investor thinks L&T, currently trading at Rs 270, is overvalued and may fall substantially. He therefore decides to buy Puts to gain exposure to its anticipated fall. Action: Buy 1 L&T October 260 Put at Rs 8 for a total consideration of Rs 8,000. If the L&T shares do go down you can close your position either by selling the option back to the market or exercising your right to buy the underlying shares at the exercise price. Share Price Rs. 270 Rs. 240 Fall of effective profit Rs 30

1-Aug 20-Oct Analysis

Option Market Buy 1 L&T Oct 260 put at Rs 8 Total Outlay = 8,000 1. Sell 1 Oct contract. 2. Net gain 20 (260 - 240 x 1000 = 20,000) Effective profits Option purchase (8,000) Option sale 20,000 Net profit 12,000 or 150%

Share Price 240 Share price 240- 260 Stock price > 240

Possible Outcomes at expiry The 260 put will be trading at Rs 20 which gives a profit of Rs 12 (20-8), if the position is closed out. Recover intrinsic value of premium. The 260 put will be trading at Rs 20 which gives a profit of Rs 12 (20-8), if the position is closed out.

Although the profit is on expiry day, the investor is obviously able to sell his option at any time prior to expiry, and such sale will result in the receipt of time value in addition to any intrinsic value. 3. Short Call Naked short call / Covered short call

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Market View Bullish

Potential Profit Limited

Potential Loss Unlimited

The covered call is a strategy in which an investor writes a call option contract while at the same time owning an equivalent number of shares of the underlying stock. If this stock is purchased simultaneously with writing the call con-tract, the strategy is commonly referred to as a "buywrite." If the shares are already held from a previous purchase, it is commonly referred to an "overwrite." In either case, the stock is generally held in the same brokerage account from which the investor writes the call, and fully collateralizes, or "covers," the obligation conveyed by writing a call option contract. This strategy is the most basic and most widely used strategy combining the flexibility of listed options with stock ownership. Situation: It is 1 November and L&T share is trading at Rs 254. An investor holds 10000 shares but does not expects their price to move very much over the next few months so decides to write call option against this shareholding. Action: The January 260 calls are trading at 14 and investor sells 10 contracts (one contract is 1,000 shares). He receives an option premium equal to Rs 1,40,000 and takes on the obligation to deliver 10000 share at 260 each if the holder exercise the option. Share Price Rs. 254 Rs. 254 No change to shareholding Option Market Sell 10 Jan 260 calls @ Rs 14 Income 1,40,000 Option expire worthless Effective profits Profit =1,40,000 (option value of premium)

1-Nov 20-Jan Analysis

Possible Outcomes at expiry

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Share Price > 260

The holder will exercise his position and if called, the investor as a writer will sell shares originally purchased for Rs 254 at 274 (260+14), a return of 7.8% over 3 months. The option expires worthless

Share price < 240

4. Short Put Naked Short Put / Covered Short Put

Market View Bearish

Potential Profit Limited

Potential Loss Unlimited

According to the terms of a put contract, a put writer is obligated to purchase an equivalent number of underlying shares at the put's strike price if assigned an exercise notice on the written contract. Many investors write puts because they are willing to be assigned and acquire shares of the underlying stock in exchange for the premium received from the put's sale. For this discussion, a put writer will be considered "covered" if he has on deposit with his brokerage firm a cash amount (or other approved collateral) sufficient to cover such a purchase. Situation: An investor owns 10,000 shares and also has a cash holding of around 60,00,000. In early March he feels that the share price of NIIT will either remain constant or, possibly, rise slightly. Action: The Investor decides to generate some additional income on his portfolio and writes 10 NIIT 550 puts at Rs 40. Thus he received premium of 4,00,000. Possible Outcomes at expiry The investor's expectation is correct and the put will expire without being exercised. Initial income remains as profit. The put option will be exercised and the stock will have to be purchased, effectively for 51,00,000 (55,00,000- 4,00,000).

Share Price =/ > 550 Share price < 550

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In relation to the Indian markets, this strategy requires a substantial investment. The net outflow in this situation is: Future Margin Option Premium.

5. Bull Call Spread

Market View Bullish

Potential Profit Limited

Potential Loss Limited

Establishing a bull call spread involves the purchase of a call option on a particular underlying stock, while simultaneously writing a call option on the same underlying stock with the same expiration month, at a higher strike price. Both the buy and the sell sides of this spread are opening transactions, and are always the same number of contracts. This spread is sometimes more broadly categorized as a "vertical spread": a family of spreads involving options of the same stock, same expiration month, but different strike prices. They can be created with either all calls or all puts, and be bullish or bearish. The bull call spread, as any spread, can be executed as a "unit" in one single transaction, not as separate buy and sell transactions. Situation: On 1 November, the share price of L&T is 204. Buy 1 L&T July 200 call option at Rs 16 and sell 1 July 220 call at Rs 8. Total outlay and maximum loss is 8. Break even is Rs 208 (200+8). Maximum profit is 12 (220-200-8). Possible Outcomes at expiry Both the 200 and 220 calls are worthless and the maximum loss is equal to the net cost of establishing the spread i.e Rs 8 The 200 call gains intrinsic value and profit is equal to the intrinsic value of the 200 calls less the net debit of Rs 8. Maximum profit is therefore realized at 220, the point just before which the 220 calls may be exercised. 88

Share Price < 200 Share price 200-220

Stock price > 220

The position can be closed for a maximum profit of Rs 12 above 220 i.e. difference in intrinsic value of two calls less than net debit (20-8).

Note: the long call position always covers the risk on the short call position. Eg. if the short option is exercised against you, it is possible to exercise the long position and acquire stock in order to satisfy the short position. Advantages Position established for less cost than a long call and breaks even more quickly. Limited loss.

6. Bear Put Spread

Market View Bullish

Potential Profit Limited

Potential Loss Limited

Establishing a bear put spread involves the purchase of a put option on a particular underlying stock, while simultaneously writing a put option on the same underlying stock with the same expiration month, but with a lower strike price. Both the buy and the sell sides of this spread are opening transactions, and are always the same number of contracts. This spread is sometimes more broadly categorized as a "vertical spread": a family of spreads involving options of the same stock, same expiration month, but different strike prices. They can be created with either all calls or all puts, and be bullish or bearish. The bear put spread, as any spread, can be executed as a "package" in one single transaction, not as separate buy and sell transactions. Expectation: This strategy is appropriate when anticipating a fall in the price of the underlying share.

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Situation: The share of Tata Tea is trading at 228. You buy 1 Tata Tea Oct 240 put at Rs 16 and sell 1 Tata 220 put at Rs 7. Maximum profit is Rs 11 and maximum loss Rs 9. Possible Outcomes at expiry Both puts are worthless and the maximum loss is equal to the

Share Price > 240

net cost of establishing the spread i.e Rs 9 Share price 240-220 The position can be closed out for the intrinsic value of the Stock price 220 Stock price < 220 Rs. 240 put. The maximum potential profit of Rs 11 is realized just before the level at which the 220 put may be exercised by the holder The position can be closed for the difference in the intrinsic value of two puts, so the profit is 11 (240-220-9)

Advantages Position established for less cost than a long put and breaks even more quickly. Limited loss.

7. Long Straddle

Market View Mixed

Potential Profit Unlimited

Potential Loss Limited

For aggressive investors who expect short-term volatility yet have no bias up or down (i.e., a neutral bias), the long straddle is an excellent strategy. This position involves buying both a put and a call with the same strike price, expiration, and underlying. The potential loss is limited to the initial investment. The potential profit is unlimited as the stock moves up or down.

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Expectation: Purchasing a straddle is appropriate when anticipating significant volatility in the underlying but when uncertain about direction. Situation: Buy 1 L&T Apr 260 call at Rs 21 and Buy 1 L&T Apr 260 Put at Rs 9. Upside breakeven = 290 (Exercise price 260 + net debit 30) Downside breakeven = 230 (260 - 30 net debit) Profit is unlimited, loss potential is limited, maximum loss Rs 30. Possible Outcomes at expiry The call expires worthless and profit is equal to the intrinsic valued of the 260 put less the premium paid Profit is equal to the intrinsic value of the 260 Premium less the paid Although profit opportunities are unlimited below Rs 230 and above Rs 290, the underlying share, in this example, has to move 11% before the strategy breaks even. Normally, however, once the direction of the underlying becomes clear the other 'leg' is closed which effectively reduces the break even. Advantages Profit potential open ended in either direction. Maximum Loss limited to the premium paid.

Share Price < 260 Share price > 260

8. Short Straddle

Market View Mixed

Potential Profit Unlimited

Potential Loss Unlimited

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

Share Price 260

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Generation of earnings from premium received. Secure known purchase and sale price.

9.Long Strangle

Market View Mixed

Potential Profit Unlimited

Potential Loss Limited

For aggressive investors who expect short-term volatility yet have no bias up or down (i.e., a neutral bias), the long strangle is another excellent strategy. This strategy typically involves buying out-of-the-money calls and puts with the same expiration and underlying. The potential loss is limited to the initial investment while the potential profit is unlimited as the market moves up or down. Situation: The share of L&T is currently standing at 247. Buy 1 L&T Oct 260 call at Rs 12, buy 1 Oct 240 put at Rs10. Upside breakeven = 282 (Exercise price 260 + net debit 22) Downside breakeven = 218 (240 - 22 net debit) Possible Outcomes at expiry Profit from the call is equal to its intrinsic value less the

Share Price > 260

premium paid Share price 240-260 Both call and put are out of money. Maximum loss of 22 Stock price < 240 premium paid. Profit potential unlimited.

Advantages Profit potential open ended in either direction. 93

Loss limited to total premium paid. 10.Short Strangle

Market View Mixed

Potential Profit Limited

Potential Loss Unlimited

For aggressive investors who don't expect much short-term volatility, the short strangle can be a risky, but profitable strategy. This strategy typically involves selling out-of the-money puts and calls with the same expiration and underlying. The profit is limited to the credit received by selling options. The potential loss is unlimited as the market moves up or down. Situation: L&T shares are currently standing at Rs 247 and you sell 1 October 260 call at Rs 12 and sell 1 October 240 put at Rs 10. Upside breakeven = 282 (Exercise price 260 + net debit 22) Downside breakeven = 218 (240 - 22 net debit) Your maximum profit is Rs 22 and loss is unlimited. Possible Outcomes at expiry The call is exercisec by the holder and the seller delivers

Share Price > 260

stock at 282. (260+22). Share price 240-260 Both the call and put would expire worthless. The 22 credit is Stock price < 240 retained The put is exercised. The seller takes delivery of the stock at 218.

Advantages Generation of earnings from premium received. Secure know sale and purchase prices.

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Disadvantages Loss is unlimited In the Indian Markets, the investment required for such a strategy is very high and should only be attempted by people with huge funds and an appetite for large losses. 11.Butterfly

Market View Mixed

Potential Profit Limited

Potential Loss Unlimited

Ideal for investors who prefer limited risk, limited reward strategies. When investors expect stable prices, they can buy the butterfly by selling two options at the middle strike and buying one option at the higher and lower strikes. The options, which must be all calls or all puts, must also have the same expiration and underlying. Situation: L&T shares are currently trading at 240. You buy one Jan 220 call at Rs. 40, sell two Jan 240 calls at Rs. 30, and buy one Jan 260 call at 25. This is called "buying a butterfly." The opposite would be to sell the butterfly. Upside breakeven = 255 Downside breakeven = 225 The maximum profit is 240-220-5 = Rs.15 Possible Outcomes at expiry The loss is Rs.5 i.e. net debit The maximum profit would be at this level. The net profit would be 240-220-5 = Rs.15

Share Price > 260 Stock price 240 Advantages Potential loss is limited

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Disadvantages Can be difficult to execute such strategies quickly. Requires big margin to execute this strategy. 12.Collar A collar can be established by holding shares of an underlying stock, purchasing a protective put and writing a covered call on that stock. The option portions of this strategy are referred to as a combination. Generally, the put and the call are both out of-the-money when this combination is established, and have the same expiration month. Both the buy and the sell sides of this combination are opening transactions, and are always the same number of contracts. In other words, one collar equals one long put and one written call along with owning 100 shares of the underlying stock. Expectation: An investor will employ this strategy after accruing unrealized profits from the underlying shares, and wants to protect these gains with the purchase of a protective put. At the same time, the investor is willing to sell his stock at a price higher than the current market price so an out-of-the-money call contract is written, covered in this case by the underlying stock Situation: Suppose you purchased 100 shares of L&T ltd. at Rs.240 in may and would like a way to protect your downside with little or no cost. You would create a collar by buying one May 220 put at 10 and selling one May 260 call at 15. Net credit is Rs.5 Maximum profit: When share is at 260. Maximum loss: When the share is at or below 220. Possible Outcomes at expiry The profit from the put offsets the loss from the stock. The profit would be equal to the net inflow i.e. Rs.5 The profit on the stock is exactly offset by the loss on the call option that was sold. Advantages The collar strategy is best used for investors looking for a conservative strategy that can offer a reasonable rate of return with managed risk and potential tax advantages. 96

Share Price @220 Stock price @240 Stock price @260

Disadvantages The primary concern in employing a collar is protection of profits accrued from underlying shares rather than increasing returns on the upside.

13. Condor Spread

The Condor Spread strategy is a neutral strategy similar to the Butterfly. In the Iron Condor, an investor will combine a Bear-Call Credit Spread and a Bull-Put Credit Spread on the same underlying security. By doing this, an investor will potentially be able to double the credit obtained over a single spread position. Since there are two spreads involved in the strategy (four options), there is an upper break even and a lower break even. A profit is made if the stock remains above the lower break even point or below the upper break even point. Expectation: The long condor can be a great strategy to use when your feeling on a stock is generally neutral because it's been trading in a narrow range. Like the butterfly, the condor is a limited risk, limited reward strategy that profits in stagnant markets. Situation: Imagine that L&T ltd. is trading at Rs. 240 and has been relatively flat for some time. If you think the situation is unlikely to change, Action Sell 1 240 call @ 20 Sell 1 260 call @ 15 Buy 1 220 call @ 30& buy 1 280 @ 10 call as a hedge in case the market moved against you. Maximum profit: When the stock price is between 240 & 260 Maximum loss: When the stock price is above 280 or below 220 Possible Outcomes at expiry The loss would be of Rs. 5 (initial debit) The profit would be equal to 20-5= Rs.15 The loss would be Rs. 5 (initial debit)

Share Price <220 Stock price 240-260 Stock price>260 Advantages:

The double credit achieved helps lower the potential risk.

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Losses are limited if the stock goes against you one way or the other. If you are facing a large gain or drop in the underlying you could only close one leg of the four legs in the position.

Disadvantages: Commission costs to open the position are higher since there are four trades, might be cost prohibitive to trade iron condors that are low net credits.

14. Calendar Spread Calendar spreads take advantage of the different rates at which time value erodes. Since the time value element of an options premium erodes faster in the near month series than the far month series, a spread opens up between the two. The more rapid erosion in the near month series works to the advantage of the writer and the strategy is therefore particularly appropriate when the near month series is overpriced. Expectation: A calendar spread involves the sale of a near dated call (put) and the purchase of a longer dated call (put) at the same exercise price. Calls are used when market view is moderately bullish and puts are used when market view is moderately bearish. Situation: On 1 May the shares of L&T ltd. are trading at Rs.288 and the May 280 Call is available @ Rs.24 and the Jun Call is available @ Rs. 30 Action: Sell 1 L&T Ltd. May 280 call @ Rs.24. Buy 1 L&T Ltd. Jun 280 call @ Rs.30. Net debit is Rs. 6 Possible Outcomes at expiry The May 280 call expires worthless leaving the position long 1 Jun 280 call at a reduced cost of 6. 98

Share Price <280

Stock price @280

Maximum profit potential is realized. The May 280 call expires worthless but the Jun 280 call will have 1 month time value remaining. Both calls will have intrinsic value, but the true value of the Jun 280 call is likely to be lower.

Stock price >280

A calendar spread using puts could be established in the same way to suit a neutral to moderately bearish strategy. Alternatively, if the May calls were purchased and the Jun calls sold then the risks and rewards would be reversed. This is generally known as a reverse calendar spread.

Advantages Limited loss, i.e. initial debit.

Disadvantages Limited profit. Position may be disrupted by early exercise.

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Chapter 6 Achievements in Future and Options Segment

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ACHIEVEMENTS IN FUTURE AND OPTIONS SEGMENT

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Following is the graphical representation of the above data w.r.t. the Daily Average of Traded Value & Number of Contracts, and Open Interest.

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COMPARATIVE ANALYSIS OF F&O SEGMENT AND CASH SEGMENT

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TOP 5 TRADED SYMBOL IN THE FUTURES SEGMENT FOR THE MONTH OF MAY 2010

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TOP 5 TRADED SYMBOL IN THE OPTIONS SEGMENT FOR THE MONTH OF MAY 2010

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CONCLUSION

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

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Finally, the objective of the study is accomplished and I recommend that one should use the Derivative Instruments, as it is very much applicable in the Indian Stock Market.

SUGGESTIONS AND RECOMMENDATIONS

1. Need to open more branches to be a topper in market because it has alow distri bution network. 2. They should try to make some arrangements to reduce account opening time by verifying documents at branch it selves. 3. Linked as many accounts as client want to its online account. 4. Need to tie up with major banks like SBI,Allahabad bank ,BOB,etc. 5. The company should focus on the customer satisfaction not on just taking money from their pocket. 6. The company would have to make some arrangements to control the branches ane make standardized procedures for all of them for their better control and performance appraisal. 7. Commitment should be equalized for every person. 8. Provide the facility of free demonstration for all. 9. Improvement in opening of Demat. 10. Some promotional activities are required for the awareness of the consumer.

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THE REFERENCE MATERIALS

GLOSSARY
ADJUSTED STRIKE PRICE: Strike price of an option, created as the result of a special event such as stock split or a stock dividend. The adjusted strike price can differ from the regular intervals prescribed for strike prices. AMERICAN STYLE OPTION: A call or put option contract that can be exercised at any time before the expiration of the contract. ARBITRAGE: A trading technique that involves the simultaneous purchase and sale of identical assets or of equivalent assets in two different markets with the intent of profiting by the price discrepancy. ASSIGNMENT: Notification by Stock Exchange Clearing to a clearing member and the writer of an option that an owner of the option has exercised the option and that the terms of settlement must be met. Assignments are made on a random basis by the Stock Exchange Clearing. The writer of a call option is obligated to sell the underlying asset at the strike price of the call option; the writer of a put option is obligated to buy the underlying at the strike price of the put option. AT PRICE: When you enter a prospective trade into a trade parameter, the "At Price" (At. Pr) is automatically computed and displayed. It is the price at which the program expects you can actually execute the trade, taking into account "slippage" and the current Bid/Ask, if available.

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AT-THE-MONEY (ATM): An at-the-money option is one whose strike price is equal to (or, in practice, very close to) the current price of the underlying. AVERAGING DOWN: Buying more of a stock or an option at a lower price than the original purchase so as to reduce the average cost. BACK MONTH: A back month contract is any exchange-traded derivatives contract for a future period beyond the front month contract. Also called FAR MONTH. BEAR, BEARISH: A bear is someone with a pessimistic view on a market or particular asset, e.g. believes that the price will fall. Such views are often described as bearish.

BINOMIAL PRICING MODEL: Methodology employed in some option pricing models which assumes that the price of the underlying can either rise or fall by a certain amount at each predetermined interval until expiration For more information, see COX-ROSS-RUBINSTEIN model. BLACK-SCHOLES PRICING MODEL: A formula used to compute the theoretical value of European-style call and put options from the following inputs: stock price, strike price, interest rates, dividends, time of expiration, and volatiity. It was invented by Fischer Black and Myron Scholes. BOX SPREAD: A four-sided option spread that involves a long call and short put at one strike price as well as a short call and long put at another strike price. In other words, this is a synthetic long stock position at one strike price and a synthetic short stock position at another strike price. BREAK-EVEN POINT: A stock price at option expiration at which an option strategy results in neither a profit or a loss. BULL, BULLISH: A bull is someone with an optimistic view on a market or particular CANCELED ORDER: A buy or sell order that is canceled before it has been executed. In most cases, a limit order can be canceled at any time as long as it has not been executed. (A market 111

order may be canceled if the order is placed after market hours and is then canceled before the market opens the following day). A request for cancel can be made at anytime before execution. CARRYING COST: The interest expense on money borrowed to finance a stock or option position. CASH SETTLEMENT: The process by which the terms of an option contract are fulfilled through the payment or receipt in Rupees of the amount by which the option is in-the-money as opposed to delivering or receiving the underlying stock. CLOSING TRANSACTION: To sell a previously purchased position or to buy back a previously purchased position, effectively canceling out the position. COLLATERAL: This is the legally required amount of cash or securities deposited with a brokerage to insure that an investor can meet all potential obligations. Collateral (or margin) is required on investments with open-ended loss potential such as writing naked options. COMMISSION: This is the charge paid to a broker for transacting the purchase or the sale of stock, options, or any other security. COMMODITY: A raw material or primary product used in manufacturing or industrial processing or consumed in its natural form. CONTRACT SIZE: The number of units of an underlying specified in a contract. In stock options the standard contract size is 100 shares of stock. In futures options the contract size is one futures contract. In index options the contract size is an amount of cash equal to parity times the multiplier. In the case of currency options it varies. COST OF CARRY: This is the interest cost of holding an asset for a period of time. It is either the cost of funds to finance the purchase (real cost), or the loss of income because funds are diverted from one investment to another (opportunity cost).

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DAY ORDER: An order to purchase or sell a security, usually at a specified price, that is good for just the trading session on which it is given. It is automatically cancelled on the close of the session if it is not executed. DAY TRADE: A position that is opened and closed on the same day. DEBIT: The amount you pay for placing a trade. A net outflow of cash from your account as the result of a trade. DIRECTIONAL TRADE: A trade designed to take advantage of an expected movement in price. DISCOUNT: An adjective used to describe an option that is trading below its intrinsic value. DYNAMIC HEDGING: A short-term trading strategy generally using futures contracts to replicate some of the characteristics of option contracts. The strategy takes into account the replicated option's delta and often requires adjusting. EARLY EXERCISE: A feature of American-style options that allows the owner to exercise an option at any time prior to its expiration date. EQUITY OPTION: An option on shares of an individual common stock. Also known as a stock option. EUROPEAN STYLE OPTION: An option that can only be exercised on the expiration date of the contract. EX-DIVIDEND DATE: The day before which an investor must have purchased the stock in order to receive the dividend. On the ex-dividend date, the previous day's closing price is reduced by the amount of the dividend because purchasers of the stock on the ex-dividend date will not receive the dividend payment. EXCHANGE TRADED: The generic term used to describe futures, options and other derivative instruments that are traded on an organized exchange.

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EXERCISE: The act by which the holder of an option takes up his rights to buy or sell the underlying at the strike price. The demand of the owner of a call option that the number of units of the underlying specified in the contract be delivered to him at the specified price. The demand by the owner of a put option contract that the number of units of the underlying asset specified be bought from him at the specified price. EXOTIC OPTIONS: Various over-the-counter options whose terms are very specific, and sometimes unique. Examples include Bermuda options (somewhere between American and European type, this option can be exercised only on certain dates) and look-back options (whose strike price is set at the option's expiration date and varies depending on the level reached by the underlying security). FILL: When an order has been completely executed, it is described as filled. FILL OR KILL (FOK) ORDER: This means do it now if the option (or stock) is available in the crowd or from the specialist, otherwise kill the order altogether. Similar to an all-or-none (AON) order, except it is "killed" immediately if it cannot be completely executed as soon as it is announced. Unlike an AON order, the FOK order cannot be used as part of a GTC order. FLEXIBLE EXCHANGE OPTIONS (FLEX): Customized equity and equity index options. The user can specify, within certain limits, the terms of the options, such as exrcise price, expiration date, exercise type, and settlement calculation. Can only be traded in a minimum size, which makes FLEX an institutional product. FRONT MONTH: The first month of those listed by an exchange - this is usually the most actively traded contract, but liquidity will move from this to the second month contract as the front month nears expiration. Also known as the NEAR MONTH. FRONTRUNNING: An illegal securities transaction based on prior nonpublic knowledge of a forthcoming transaction that will affect the price of a stock.

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FOLLOW-UP ACTION: Term used to describe the trades an investor makes subsequent to implementing a strategy. Through these adjustments, the investor transforms one strategy into a different one in response to price changes in the underlying. GUTS: The purchase (or sale) of both an in-the-money call and in-the-money put. A box spread can be viewed as the combination of an in-the-money strangle and an out-of-the-money strangle. To differentiate between these two strangles, the term guts refer to the in-the-money strangle. See box spread and strangle. HAIRCUT: Similar to margin required of public customers this term refers to the equity required of floor traders on equity option exchanges. Generally, one of the advantages of being a floor trader is that the haircut is less than margin requirements for public customers. HEDGE: A position established with the specific intent of protecting an existing position. Example: an owner of common stock buys a put option to hedge against a possible stock price decline. IMMEDIATE-OR-CANCEL (IOC) ORDER: An option order that gives the trading floor an opportunity to partially or totally execute an order with any remaining balance immediately cancelled. ILLIQUID: An illiquid market is one that cannot be easily traded without even relatively small orders tending to have a disproportionate impact on prices. This is usually due to a low volume of transactions and/or a small number of participants. INDEX: The compilation of stocks and their prices into a single number. E.g. The BSE SENSEX / S&P CNX NSE NIFTY. INDEX OPTION: An option that has an index as the underlying. These are usually cash-settled. IN-THE-MONEY (ITM): Term used when the strike price of an option is less than the price of the underlying for a call option, or greater than the price of the underlying for a put option. In other words, the option has an intrinsic value greater than zero.

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INTRINSIC VALUE: Amount of any favorable difference between the strike price of an option and the current price of the underlying (i.e., the amount by which it is in-the-money). The intrinsic value of an out-of-the-money option is zero. LEAPS: Long-term Equity Anticipation Securities, also known as long-dated options. Calls and puts with expiration as long as 2-5 years. Only about 10% of equities have LEAPs. Currently, equity LEAPS have two series at any time, always with January expirations. Some indexes also have LEAPs. LEGGING: Term used to describe a risky method of implementing or closing out a spread strategy one side ("leg") at a time. Instead of utilizing a "spread order" to insure that both the written and the purchased options are filled simultaneously, an investor gambles a better deal can be obtained on the price of the spread by implementing it as two separate orders. LEVERAGE: A means of increasing return or worth without increasing investment. Using borrowed funds to increase one's investment return, for example buying stocks on margin. Option contracts are leveraged as they provide the prospect of a high return with little investment. MARGIN: The minimum equity required to support an investment position. To buy on margin refers to borrowing part of the purchase price of a security from a brokerage firm. MARKET BASKET: A group of common stocks whose price movement is expected to closely correlate with an index. MARK TO MARKET: The revaluation of a position at its current market price. MARKET MAKER: A trader or institution that plays a leading role in a market by being prepared to quote a two way price (Bid and Ask) on request - or constantly in the case of some screen based markets - during normal market hours. NAKED: An investment in which options sold short are not matched with a long position in either the underlying or another option of the same type that expires at the same time or later than the options sold. The loss potential of naked strategies can be virtually unlimited.

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NET MARGIN REQUIREMENT: The equity required in a margin account to support an option position after deducting the premium received from sold options. NEUTRAL: An adjective describing the belief that a stock or the market in general will neither rise nor decline significantly. ONE-CANCELS-THE-OTHER (OCO) ORDER: Type of order which treats two or more option orders as a package, whereby the execution of any one of the orders causes all the orders to be reduced by the same amount. Can be placed as a day or GTC order. OPTION CHAIN: A list of the options available for a given underlying. OPTIONS CLEARING CORPORATION (OCC): A corporation owned by the exchanges that trade listed stock options; OCC is an intermediary between option buyers and sellers. OCC issues and guarantees all option contracts. OUT-OF-THE-MONEY (OTM): An out-of-the-money option is one whose strike price is unfavorable in comparison to the current price of the underlying. This means when the strike price of a call is greater than the price of the underlying, or the strike price of a put is less than the price of the underlying. An out-of-the-money option has no intrinsic value, only time value. OVERVALUED: An adjective used to describe an option that is trading at a price higher that its theoretical value. It must be remembered that this is a subjective evaluation, because theoretical value depends on one subjective input - the volatility estimate. PARITY: An adjective used to describe the difference between the stock price and the strike price of an in-the-money option. When an option is trading at its intrinsic value, it is said to be trading at parity. PUT/CALL RATIO: This ratio is used by many as a leading indicator. It is computed by dividing the 4-day average of total put VOLUME by the 4-day average of total call VOLUME.

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RATIO CALENDAR COMBINATION: A term used loosely to describe any variation on an investment strategy that involves both puts and calls in unequal quantities and at least two different strike prices and two different expirations. REALIZED GAINS AND LOSSES: The profit or losses received or paid when a closing transaction is made and matched together with an opening transaction. ROLLOVER: Moving a position from one expiration date to another further into the future. As the front month approaches expiration, traders wishing to maintain their positions will often move them to the next contract month. This is accomplished by a simultaneous sale of one and purchase of the other. SCALPER: A trader on the floor of an exchange who hopes to buy on the bid price, sell on the ask price, and profit from moment to moment price movements. Risk is limited by the very short time duration (usually 10 seconds to 3 minutes) of maintaining any one position. SEC: The Securities and Exchange Commission. The SEC is the United States federal government agency that regulates the securities industry. SECTOR INDICES: Indices that measure the performance of a narrow market segment, such as biotechnology or small capitalization stocks. SETTLEMENT PRICE: The official price at the end of a trading session. This price is established by The Options Clearing Corporation and is used to determine changes in account equity, margin requirements, and for other purposes. See mark-to-market. STRIKE PRICE: The price at which the holder of an option has the right to buy or sell the underlying. This is a fixed price per unit and is specified in the option contract. Also known as striking price or exercise price. SYNTHETIC: A strategy that uses options to mimic the underlying asset. Both long and short synthetics are strategies in the Trade Finder. The long synthetic combines a long call and a short put to mimic a long position in the underlying. The short synthetic combines a short call and a long

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

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WASH SALE: When an investor repurchases an asset within 30 days of the sale date and reports the original sale as a tax loss. The Internal Revenue Service prohibits wash sales since no change in ownership takes place. WASTING ASSET: An investment with a finite life, the value of which decreases over time if there is no price fluctuation in the underlying asset.

BIBLIOGRAPHY

Books: Derivatives: Valuation and Risk Management By David A. Dubofsky and Thomas W. Miller, JR., Published by Oxford University Press. Financial Engineering: A Complete Guide to Financial Innovation By John F. Marshall and Vipul K. Bansal, Published by Printice Hall of India. Newspapers: The Times of India The Economic Times

Internet: www.economictimes.com www.moneycontrol.com www.bseindia.com www.nseindia.com

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www.sebi.gov.in www.investors.com www.investopedia.com

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