Perception of derivatives @ smc investment project report

SMC INVESMENT SOLUTIONS & SERVICES

Table of Contents

Sl.no Particulars Page No.
1. Executive Summary 1.
2. Indian Economy Overview 6
3 Company Overview 7
4 Derivatives
4.1 Introduction 10
4.2 Indian Scenario 11
5 Futures Contract 18
5.1 Understanding Index Futures 20
5.2 Hedging 21
5.3 Speculation 24
5.4 Arbitrage 25
5.5 Pricing of Index Futures 26
5.6 Trading Strategies 29
5.7 Settlement Of Futures Contract 36
6 Options
6.1 What is an Option? 41
6.2 Chicago Board of Options Exchange 44
6.3 Regulation and Surveillance 45
6.4 Options Clearing Corporation 45
6.5 Options Market Participants 45
6.6 Call Options 47
6.7 Put Options 49
6.8 Option Styles 52
6.9 Option Class & Series 53
6.10 Pricing of Options 54

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6.11 Options Pricing Factors 54
6.12 Strategies 58
6,13 Key Regulations 75
6.14 Advantages of option trading 80
6.15 Settlement of Options 82
7 Clearing & Settlement 83
8 Analysis 87
9 Findings 105
10 Suggestions 107
11 Conclusion 108
12 Annexure 109
13 Bibliography 111

1. Executive Summary:
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Topic: -

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

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

Need for the study:-
Financial Derivatives are quite new to the Indian Financial Market, but the
derivatives market has shown an immense potential which is visible by the growth it has
achieved in the recent past, In the present changing financial environment and an
increased exposure towards financial risks, It is of immense importance to have a good
working knowledge of Derivatives.
The Derivatives market in Hubli is still in a budding stage, It is necessary to
understand the perception of investors in Hubli city and try to gather information
regarding the behaviour of investors towards Derivatives. So that, the company can
devise certain measures to improve the Derivatives market in Hubli city.

Objectives of the Study:-

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

study of Derivative products.

Sub Objectives:
• To study the trading procedures for Derivative products
• To study the features of Derivatives products such as Futures and Options.
• To study the clearing and settlement procedure of Derivatives products
• To know the awareness and perception of Derivative products in Hubli city.

Methodology:-

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

• Data collection method
Primary data as well as secondary data is used to collect the information.
• Primary data
Information will be gathered through questionnaires and discussion with the
employees of SMC investment solutions & Services Hubli.
• Secondary data

Secondary data will be collected from the various books on

• Derivatives,

• Journals

• Magazines and Internet.

10. FINDINGS:

1. Futures market facilitates for buying and selling futures contracts, which state the
price per unit, type, value, quality and quantity of the commodity in question, as
well as the month the contract expires.
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2. Futures accounts are credited or debited daily depending on profits or losses
incurred. The futures market is also characterized as being highly leveraged due
to its margins; although leverage works as a double-edged sword.
3. “Going long,” “going short,” and “spreads” are the most common strategies used
when trading on the futures market.
4. Investors use options both to speculate and hedge risk.
5. Income is almost evenly distributed among the sample:- 18% less than Rs.1lakh,
27% each Rs.1 lakh-1.5lakhs and upto Rs.2 lakhs and 34% above Rs.2 lakhs.
6. The respondents’ current investments are mainly in FD, Insurance, Mutual Funds
and Shares.
7. 53% of the respondents are aware of derivatives.
8. 44 people falling in the age group of 21-30, only 26 are aware of derivatives i.e.,
43% of them are unaware. As you can see the good awareness level among the
investors of the age 30-40, Rest 43% of the age group 21-30 need to be tapped by
the company and create awareness about derivatives.
9. People above the age of 50 years are unaware of derivatives. They are fond of
traditional investment instruments.
10. People above the age of 50 years are unaware of derivatives. They are fond of
traditional investment instruments.
11. 37 respondents are aware of Futures and 40 are aware of Options.
12. The main factors considered while investing in derivatives are risk[20], return
[24] and volatility [08].

13. Out of 26 people who have invested in derivatives, only 9 of them are considering
the risk factor. This means that they perceive derivatives as less risky.
14. Out of 26 people who have invested their money in derivatives, ALL of them
consider the return factor. This means that derivatives give good returns, as per
their experience.

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15. Out of 26 derivative investors, 17 of them [i.e., 65%] consider the volatility factor
which is the most important influencer in derivative segment in the market. The
investors perceive derivatives as volatile investments.
16. Lot sizes and margins are affecting the investment decisions of the investors to a
large extent. Lot sizes also determine the decisions of the investors to a large
extent.
17. Out of the 100 respondents surveyed, only 52 are willing to invest in derivatives.
And out of them 26 are already the investors. This shows that derivatives are not
known to approximately about 50% of the people in Hubli
18. Awareness of derivatives and investing in is positively correlated. This means that
if there is increase in the number of people being aware of derivatives, the flow of
investments in derivatives will also be more. Awareness is directly associated
with investments in derivatives.
19. The association of risk factor and investing in derivatives is very meager. This
means that increase in risk does not affect investing in derivatives to a greater
extent. Investors perceive derivatives as less risky.
20. Actually derivatives are considered highly volatile. The volatility in the market
directly affects the price of derivatives. The correlation between volatility and
investing in derivatives is 0.393 which is again less but it is positive. This
indicates that an increase in volatility affects the investing in derivatives to some
considerable extent.
21. 60 respondents said that they are interested to invest through SMC Investment
Solutions & Services
SUGGESTIONS

1. The awareness about derivatives among investors should be increased by
conducting various awareness and educational programs.
2. The company can conduct seminars to promote their services along with
educating them about the products they offer. Initially they can start off with
existing demat account holders.
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3. The company can think of tapping the existing demat account holders and provide
them enough information on derivatives and enable them to trade in the same.
This will help the company to increase its earnings of brokerage income.
4. The company has to create and maintain a database of prospective customers from
time to time, to keep track of the people falling in different income levels and
their investing patterns. This is possible if continuous contacts are maintained
with the customers.
5. There is a widespread lack of awareness about the role and technique of futures
trading among the potential beneficiaries. Only traditional players who have been
participating in such trading either in the formal markets or gray markets are
conversant with the intricacies of forward trading. These players are willing to
participate in the trade only in regulated or liberal regulatory environment. The
approach should be first, to bring these traditional players to the formal market
and allow the Derivative markets to garner minimum critical liquidity.

INDIAN ECONOMY OVERVIEW

India's economy is on the fulcrum of an ever-increasing growth curve. With
positive indicators such as a stable 8-9 per cent annual growth, rising foreign exchange
reserves of close to US$ 180 billion, a booming capital market with the popular "Sensex"
index topping the majestic 18,000 mark, the Government estimating FDI flow of US$ 12

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billion in this fiscal, and a more than 35 per cent surge in exports, it is easy to understand
why India is a leading destination for foreign investment.

• The economy has grown by 8.9 per cent for the April-July quarter of ’06-07, the
highest first-quarter growth rate since '00-01.
• The growth rate has been spurred by the manufacturing sector, which has logged
an 11.3 per cent rise in Q1 ’06-07, according to the GDP data released by the
Central Statistical Organization. It was 10.7 per cent in the corresponding period
of the last fiscal year. The GDP numbers come just weeks after the monthly IIP
growth figures have touched 12.4 per cent.
• Other propellers of GDP growth for the first quarter this fiscal have been the
trade, hotels, transport and communications sector which grew by 9.5 per cent and
construction, which grew by 13.2 per cent. In the corresponding period of last
fiscal, these sectors grew by 11.7 per cent and 12.4 per cent, respectively.
• There has been exceptional growth rate in some specific industries, like
commercial vehicles at 36 per cent, telephone connections, by 48.9 per cent and
passenger growth in civil aviation by 32.2 per cent.

With its manufacturing and services sector on a searing growth path, India’s economy
may soon touch the coveted 10 per cent growth figure.

COMPANY OVERVIEW

SMC Global is one of the largest and most reputed Investment Solutions Company
that provides a wide range of services to its substantial and diversified client base.
Founded in 1990, by Mr. Subhash Chand Aggarwal and Mr. Mahesh Chand Gupta, SMC,
is a full financial services firm catering to all classes of investors. The company is having

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its corporate office in New Delhi with regional offices in Mumbai, Kolkata, Chennai,
Ahemdabad, Cochin, Hyderabad, Jaipur plus a growing network of more than 1150
offices across over 300 cities/towns in India and overseas office in Dubai.

SMC acquired membership of the Delhi Stock Exchange in 1990 and later in 1995
became a trading member of NSE. In 2000 the company became a member of BSE and a
depository participant of CDSL India Ltd. In the same year, the company acquired the
Trading & Clearing Membership of NSE Derivatives and the memberships of leading
commodity exchanges i.e. NCDEX and MCX in subsequent years. In 2006, SMC
expanded globally and acquired the Trading & Clearing Membership of Dubai Gold and
Commodity Exchange (DGCX). In the same year, the company also started its Insurance
Broking division, IPO & Mutual Fund Distribution Division and its Merchant Banking
division

PRODUCTS AND SERVICES

Equity & Derivative Trading

SMC Trading Platform offers online equity & derivative trading facilities for investors
who are looking for the ease and convenience and hassle free trading experience. We
provide ODIN Application, which is a high -end, integrated trading application for fast,
efficient and reliable execution of trades. You can now trade in the NSE and BSE
simultaneously from any destination at your convenience. You can access a multitude of
resources like live quotes, charts, research, advice, and online assistance helps you to take
informed decisions. You can also trade through our branch network by registering with us
as our client. You can also trade through us on phone by calling our designated
representatives in the branches where you are registered as a client.

Clearing Services
Being a clearing member in NSE (derivative) segment we are clearing massive volumes
of trades of our trading members in this segment.

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Commodity Trading
SMC is a member of two major national level commodity exchanges, i.e National
Commodity and Derivative Exchange and Multi Commodity Exchange and offers you
trading platform of NCDEX and MCX. You can get Real-Time streaming quotes, place
orders and watch the confirmation, all on a single screen. We use technology using ODIN
application to provide you with live Trading Terminals. In this segment, we have spread
our wings globally by acquiring Membership of Dubai Gold and Commodities Exchange.
We provide trading platform to trade in DGCX and also clear trades of trading members
being a clearing member.

Distribution of Mutual Funds & IPO’s
SMC offers distribution and collection services of various schemes of all Major Fund
houses and IPO’s through its mammoth network of branches across India . We are
registered with AMFI as an approved distributor of Mutual Funds. We assure you a
hassle free and pleasant transaction experience when you invest in mutual funds and
IPO’s through us. We are registered with all major Fund Houses including Fidelity,
Franklyn Templeton etc. We have a distinction of being leading distributors of
IPOs.Shortly we will be providing the facility of online investment in Mutual Funds and
IPO’s

Online back office support
To provide robust back office support backed by excellent accounting standards to our
branches we have ensured connectivity through FTP and Dotnet based Application. To
ensure easy accessibility to back office accounting reports to our clients, we have offered
facilities to view various user-friendly, easily comprehendible back office reports using
the link My SMC Account.

SMC Depository

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We are ISO 9001:2000 certified DP for shares and commodities. We are one of the
leading DP and enjoy the trust of more than 40,000 investors. We offer a quick, secure
and hassle free alternative to holding the securities and commodities in physical form.
We are one of the few Depository Participants offering depository facilities for
commodities. We are empanelled with both NCDEX & MCX.

SMC Research Based Advisory Services
Our massive R&D facility caters to the need of Investors, who are continuously in need
of opportunities for striking rich rewards on their investment. We have one of the most
advanced, hitech in-house R&D wing with some of the best people, process and
technology resources providing complete research solutions on Equity, Commodities,
IPO’s and Mutual Funds. We offer proactive and timely world class research based
advice and guidance to our clients so that they can take informed decisions. Click on
Research to unveil the treasure.

Derivatives
5.1 INTRODUCTION:
BSE created history on June 9, 2000 by launching the first Exchange traded Index
Derivative Contract i.e. futures on the capital market benchmark index - the BSE Sensex.
The inauguration of trading was done by Prof. J.R. Varma, member of SEBI and
chairman of the committee responsible for formulation of risk containment measures for
the Derivatives market. The first historical trade of 5 contracts of June series was done on

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June 9, 2000 at 9:55:03 a.m. between M/s Kaji and Maulik Securities Pvt. Ltd. and M/s
Emkay Share and Stock Brokers Ltd. at the rate of 4755.

In the sequence of product innovation, the exchange commenced trading in Index
Options on Sensex on June 1, 2001. Stock options were introduced on 31 stocks on July
9, 2001 and single stock futures were launched on November 9, 2002.

September 13, 2004 marked another milestone in the history of Indian Capital
Markets, the day on which the Bombay Stock Exchange launched Weekly Options, a
unique product unparallel in derivatives markets, both domestic and international. BSE
permitted trading in weekly contracts in options in the shares of four leading companies
namely Reliance, Satyam, State Bank of India, and Tisco in addition to the flagship
index-Sensex.

Indian scenario
Indian derivatives markets
1. Rise of Derivatives
The global economic order that emerged after World War II was a system where
many less developed countries administered prices and centrally allocated resources.
Even the developed economies operated under the Bretton Woods system of fixed
exchange rates. The system of fixed prices came under stress from the 1970s onwards.
High inflation and unemployment rates made interest rates more volatile. The Bretton
Woods system was dismantled in 1971, freeing exchange rates to fluctuate. Less

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developed countries like India began opening up their economies and allowing prices to
vary with market conditions.
Price fluctuations make it hard for businesses to estimate their future production costs
and revenues. Derivative securities provide them a valuable set of tools for managing this
risk.

2. Definition and Uses of Derivatives
A derivative security is a financial contract whose value is derived from the value
of something else, such as a stock price, a commodity price, an exchange rate, an interest
rate, or even an index of prices. Some simple types of derivatives: forwards, futures,
options and swaps.
Derivatives may be traded for a variety of reasons. A derivative enables a trader
to hedge some preexisting risk by taking positions in derivatives markets that offset
potential losses in the underlying or spot market. In India, most derivatives users describe
themselves as hedgers and Indian laws generally require that derivatives be used for
hedging purposes only. Another motive for derivatives trading is speculation (i.e. taking
positions to profit from anticipated price movements). In practice, it may be difficult to
distinguish whether a particular trade was for hedging or speculation, and active markets
require the participation of both hedgers and speculators. A third type of trader, called
arbitrageurs, profit from discrepancies in the relationship of spot and derivatives prices,
and thereby help to keep markets efficient. Jogani and Fernandes (2003) describe India’s
long history in arbitrage trading, with line operators and traders arbitraging prices
between exchanges located in different cities, and between two exchanges in the same
city. Their study of Indian equity derivatives markets in 2002 indicates that markets were
inefficient at that time. They argue that lack of knowledge, market frictions and
regulatory impediments have led to low levels of capital employed.
Price volatility may reflect changes in the underlying demand and supply
conditions and thereby provide useful information about the market. Thus, economists do
not view volatility as necessarily harmful.

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Speculators face the risk of losing money from their derivatives trades, as they do
with other securities. There have been some well-publicized cases of large losses from
derivatives trading. In some instances, these losses stemmed from fraudulent behavior
that went undetected partly because companies did not have adequate risk management
systems in place. In other cases, users failed to understand why and how they were taking
positions in the derivatives.
Derivatives in arbitrage trading in India. However, more recent evidence suggests
that the efficiency of Indian equity derivatives markets may have improved.

3. Exchange-Traded and Over-the-Counter Derivative Instruments
OTC (over-the-counter) contracts, such as forwards and swaps, are bilaterally
negotiated between two parties. The terms of an OTC contract are flexible, and are often
customized to fit the specific requirements of the user. OTC contracts have substantial
credit risk, which is the risk that the counterparty that owes money defaults on the
payment. In India, OTC derivatives are generally prohibited with some exceptions: those
that are specifically allowed by the Reserve Bank of India (RBI) or, in the case of
commodities (which are regulated by the Forward Markets Commission), those that trade
informally in “havala” or forwards markets.
An exchange-traded contract, such as a futures contract, has a standardized format
that specifies the underlying asset to be delivered, the size of the contract, and the
logistics of delivery. They trade on organized exchanges with prices determined by the
interaction of many buyers and sellers. In India, two exchanges offer derivatives trading:
the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). However,
NSE now accounts for virtually all exchange-traded derivatives in India, accounting for
more than 99% of volume in 2003-2004. Contract performance is guaranteed by a
clearinghouse, which is a wholly owned subsidiary of the NSE. Margin requirements and
daily marking-to-market of futures positions substantially reduce the credit risk of
exchange traded contracts, relative to OTC contracts.

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4. Development of Derivative Markets in India
Derivatives markets have been in existence in India in some form or other for a
long time. In the area of commodities, the Bombay Cotton Trade Association started
futures trading in 1875 and, by the early 1900s India had one of the world’s largest
futures industry. In 1952 the government banned cash settlement and options trading and
derivatives trading shifted to informal forwards markets. In recent years, government
policy has changed, allowing for an increased role for market-based pricing and less
suspicion of derivatives trading. The ban on futures trading of many commodities was
lifted starting in the early 2000s, and national electronic commodity exchanges were
created.
In the equity markets, a system of trading called “badla” involving some elements
of forwards trading had been in existence for decades. However, the system led to a
number of undesirable practices and it was prohibited off and on till the Securities and a
clearinghouse guarantees performance of a contract by becoming buyer to every seller
and seller to every buyer.
Customers post margin (security) deposits with brokers to ensure that they can
cover a specified loss on the position. A futures position is marked-to-market by realizing
any trading losses in cash on the day they occur.
“Badla” allowed investors to trade single stocks on margin and to carry forward
positions to the next settlement cycle. Earlier, it was possible to carry forward a position
indefinitely but later the maximum carry forward period was 90 days. Unlike a futures or
options, however, in a “badla” trade there is no fixed expiration date, and contract terms
and margin requirements are not standardized.
Securities Exchange Board of India (SEBI) banned it for good in 2001. A series
of reforms of the stock market between 1993 and 1996 paved the way for the
development of exchange traded equity derivatives markets in India. In 1993, the
government created the NSE in collaboration with state-owned financial institutions.
NSE improved the efficiency and transparency of the stock markets by offering a fully
automated screen-based trading system and real-time price dissemination. In 1995, a

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prohibition on trading options was lifted. In 1996, the NSE sent a proposal to SEBI for
listing exchange-traded derivatives.
The report of the L. C. Gupta Committee, set up by SEBI, recommended a phased
introduction of derivative products, and bi-level regulation (i.e., self-regulation by
exchanges with SEBI providing a supervisory and advisory role). Another report, by the
J. R. Varma Committee in 1998, worked out various operational details such as the
margining systems. In 1999, the Securities Contracts (Regulation) Act of 1956, or
SC(R)A, was amended so that derivatives could be declared “securities.” This allowed
the regulatory fMr.Xework for trading securities to be extended to derivatives. The Act
considers derivatives to be legal and valid, but only if they are traded on exchanges.
Finally, a 30-year ban on forward trading was also lifted in 1999. The economic
liberalization of the early nineties facilitated the introduction of derivatives based on
interest rates and foreign exchange. A system of market-determined exchange rates was
adopted by India in March 1993. In August 1994, the rupee was made fully convertible
on current account. These reforms allowed increased integration between domestic and
international markets, and created a need to manage currency risk.

5. Derivatives Users in India
The use of derivatives varies by type of institution. Financial institutions, such as
banks, have assets and liabilities of different maturities and in different currencies, and
are exposed to different risks of default from their borrowers. Thus, they are likely to use
derivatives on interest rates and currencies, and derivatives to manage credit risk. Non-
financial institutions are regulated differently from financial institutions, and this affects
their incentives to use derivatives. Indian insurance regulators, for example, are yet to
issue guidelines relating to the use of derivatives by insurance companies.

In India, financial institutions have not been heavy users of exchange-traded
derivatives so far, with their contribution to total value of NSE trades being less than 8%
in October 2005. However, market insiders feel that this may be changing, as indicated

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by the growing share of index derivatives (which are used more by institutions than by
retail investors). In contrast to the exchange-traded markets, domestic financial
institutions and mutual funds have shown great interest in OTC fixed income
instruments. Transactions between banks dominate the market for interest rate
derivatives, while state-owned banks remain a small presence. Corporations are active in
the currency forwards and swaps markets, buying these instruments from banks.

Why do institutions not participate to a greater extent in derivatives markets?
Some institutions such as banks and mutual funds are only allowed to use
derivatives to hedge their existing positions in the spot market, or to rebalance their
existing portfolios. Since banks have little exposure to equity markets due to banking
regulations, they have little incentive to trade equity derivatives. Foreign investors must
register as foreign institutional investors (FII) to trade exchange-traded derivatives, and
be subject to position limits as specified by SEBI. Alternatively, they can incorporate
locally as under RBI directive, banks’ direct or indirect (through mutual funds) exposure
to capital markets instruments is limited to 5% of total outstanding advances as of the
previous year-end. Some banks may have further equity exposure on account of equities
collaterals held against loans in default.
FIIs have a small but increasing presence in the equity derivatives markets. They
have no incentive to trade interest rate derivatives since they have little investments in the
domestic bond markets. It is possible that unregistered foreign investors and hedge funds
trade indirectly, using a local proprietary trader as a front.
Retail investors (including small brokerages trading for themselves) are the major
participants in equity derivatives, accounting for about 60% of turnover in October 2005,
according to NSE. The success of single stock futures in India is unique, as this
instrument has generally failed in most other countries. One reason for this success may
be retail investors’ prior familiarity with “badla” trades which shared some features of
derivatives trading. Another reason may be the small size of the futures contracts,
compared to similar contracts in other countries. Retail investors also dominate the

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markets for commodity derivatives, due in part to their long-standing expertise in trading
in the “havala” or forwards markets.

Why have derivatives?
Derivatives have become very important in the field finance. They are very
important financial instruments for risk management as they allow risks to be separated
and traded. Derivatives are used to shift risk and act as a form of insurance. This shift of
risk means that each party involved in the contract should be able to identify all the risks
involved before the contract is agreed. It is also important to remember that derivatives
are derived from an underlying asset. This means that risks in trading derivatives may
change depending on what happens to the underlying asset.
A derivative is a product whose value is derived from the value of an underlying
asset, index or reference rate. The underlying asset can be equity, forex, commodity or
any other asset. For example, if the settlement price of a derivative is based on the stock
price of a stock for e.g. Infosys, which frequently changes on a daily basis, then the
derivative risks are also changing on a daily basis. This means that derivative risks and
positions must be monitored constantly.

Why Derivatives are preferred?
Retail investors will find the index derivatives useful due to the high correlation of the
index with their portfolio/stock and low cost associated with using index futures for
hedging.

Looking Ahead
Clearly, the nascent derivatives market is heading in the right direction. In terms
of the number of contracts in single stock derivatives, it is probably the largest market
globally. It is no longer a market that can be ignored by any serious participant. With
institutional participation set to increase and a broader product rollout inevitable, the
market can only widen and deepen further.

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How does F&O trading impact the market?
The start of a new derivatives contract pushes up prices in the cash market as
operators take fresh positions in the new month series in the first week of every new
contract. This buying in the derivatives segment pushes up future prices. Higher future
prices are seen as indicators of bullish prices in the days to come. Thus, higher prices
due to new month buying in the derivatives market lead to buying in the physical market.
This lifts prices in the cash market as well.

FUTURES CONTRACT:

A futures contract is similar to a forward contract in terms of its working. The
difference is that contracts are standardized and trading is centralized. Futures markets
are highly liquid and there is no counterparty risk due to the presence of a clearinghouse,
which becomes the counterparty to both sides of each transaction and guarantees the
trade.

What is an Index?

To understand the use and functioning of the index derivatives markets, it is
necessary to understand the underlying index. A stock index represents the change in
value of a set of stocks, which constitute the index. A market index is very important for
the market players as it acts as a barometer for market behavior and as an underlying in
derivative instruments such as index futures.

The Sensex and Nifty

In India the most popular indices have been the BSE Sensex and S&P CNX Nifty.
The BSE Sensex has 30 stocks comprising the index, which are selected based on market
capitalization, industry representation, trading frequency etc. It represents 30 large well-

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established and financially sound companies. The Sensex represents a broad spectrum of
companies in a variety of industries. It represents 14 major industry groups. Then there is
a BSE national index and BSE 200. However, trading in index futures has only
commenced on the BSE Sensex.

While the BSE Sensex was the first stock market index in the country, Nifty was
launched by the National Stock Exchange in April 1996 taking the base of November 3,
1995. The Nifty index consists of shares of 50 companies with each having a market
capitalization of more than Rs 500 crore.

Futures and stock indices

For understanding of stock index futures a thorough knowledge of the
composition of indexes is essential. Choosing the right index is important in choosing the
right contract for speculation or hedging. Since for speculation, the volatility of the index
is important whereas for hedging the choice of index depends upon the relationship
between the stocks being hedged and the characteristics of the index.

Choosing and understanding the right index is important, as the movement of
stock index futures is quite similar to that of the underlying stock index. Volatility of the
futures indexes is generally greater than spot stock indexes.

Every time an investor takes a long or short position on a stock, he also has an
hidden exposure to the Nifty or Sensex. As most often stock values fall in tune with the
entire market sentiment and rise when the market as a whole is rising.

Retail investors will find the index derivatives useful due to the high correlation
of the index with their portfolio/stock and low cost associated with using index futures
for hedging.

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5.1 Understanding index futures

A futures contract is an agreement between two parties to buy or sell an asset at a
certain time in the future at a certain price. Index futures are all futures contracts where
the underlying is the stock index (Nifty or Sensex) and helps a trader to take a view on
the market as a whole.

Index futures permits speculation and if a trader anticipates a major rally in the
market he can simply buy a futures contract and hope for a price rise on the futures
contract when the rally occurs.

In India we have index futures contracts based on S&P CNX Nifty and the BSE
Sensex and near 3 months duration contracts are available at all times. Each contract
expires on the last Thursday of the expiry month and simultaneously a new contract is
introduced for trading after expiry of a contract.

Example: Futures contracts in Nifty in January 2008

Contract month Expiry/settlement
January 2008 January 31
February 2008 February 28
March 2008 March 27

On January 27

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Contract month Expiry/settlement
February 2008 February 28
March 2008 March 27
April 2008 April 24

The permitted lot size is 100 or multiples thereof for the Nifty. That is you buy
one Nifty contract the total deal value will be 100*1100 (Nifty value)= Rs 1,10,000.

In the case of BSE Sensex the market lot is 50. That is you buy one Sensex
futures the total value will be 50*4000 (Sensex value)= Rs 2,00,000.

5.2 Hedging

The other benefit of trading in index futures is to hedge your portfolio
against the risk of trading. In order to understand how one can protect his portfolio
from value erosion let us take an example.

Illustration:

Mr.X enters into a contract with Mr.Y that six months from now he will sell to Y
10 dresses for Rs 4000. The cost of manufacturing for X is only Rs 1000 and he will
make a profit of Rs 3000 if the sale is completed.

Cost (Rs) Selling price Profit
1000 4000 3000

However, X fears that Y may not honour his contract six months from now. So he
inserts a new clause in the contract that if Y fails to honour the contract he will have to
pay a penalty of Rs 1000. And if Y honours the contract X will offer a discount of Rs
1000 as incentive.

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‘Y’ defaults ‘Y’ honours
1000 (Initial Investment) 3000 (Initial profit)
1000 (penalty from Mr.Y) (-1000) discount given to Mr.Y
- (No gain/loss) 2000 (Net gain)

As we see above if Mr.Y defaults Mr.X will get a penalty of Rs 1000 but he will
recover his initial investment. If Mr.Y honours the contract, Mr.X will still make a profit
of Rs 2000. Thus, Mr.X has hedged his risk against default and protected his initial
investment.

The example explains the concept of hedging. Let us try understanding how one
can use hedging in a real life scenario.

Stocks carry two types of risk – company specific and market risk. While
company risk can be minimized by diversifying your portfolio, market risk cannot be
diversified but has to be hedged. So how does one measure the market risk? Market risk
can be known from Beta.

Beta measures the relationship between movement of the index to the movement
of the stock. The beta measures the percentage impact on the stock prices for 1% change
in the index. Therefore, for a portfolio whose value goes down by 11% when the
index goes down by 10%, the beta would be 1.1. When the index increases by 10%,
the value of the portfolio increases 11%. The idea is to make beta of your portfolio
zero to nullify your losses.

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Hedging involves protecting an existing asset position from future adverse
price movements. In order to hedge a position, a market player needs to take an
equal and opposite position in the futures market to the one held in the cash market.
Every portfolio has a hidden exposure to the index, which is denoted by the beta.
Assuming you have a portfolio of Rs 1 million, which has a beta of 1.2, you can factor a
complete hedge by selling Rs 1.2 mn of S&P CNX Nifty futures.

Steps:

1. Determine the beta of the portfolio. If the beta of any stock is not known, it is safe
to assume that it is 1.
2. Short sell the index in such a quantum that the gain on a unit decrease in the index
would offset the losses on the rest of the portfolio. This is achieved by
multiplying the relative volatility of the portfolio by the market value of his
holdings.

Therefore in the above scenario we have to shortsell 1.2 * 1 million = 1.2 million worth
of Nifty.

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

Index up 10% Index down 10%
Gain/(Loss) in Portfolio Rs 120,000 (Rs 120,000)
Gain/(Loss) in Futures (Rs 120,000) Rs 120,000
Net Effect Nil Nil

As we see, that portfolio is completely insulated from any losses arising out of a
fall in market sentiment. But as a cost, one has to forego any gains that arise out of
improvement in the overall sentiment. Then why does one invest in equities if all the
gains will be offset by losses in futures market. The idea is that everyone expects his
portfolio to outperform the market. Irrespective of whether the market goes up or not, his
portfolio value would increase.

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The same methodology can be applied to a single stock by deriving the beta of the
scrip and taking a reverse position in the futures market.

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

5.3 Speculation

Speculators are those who do not have any position on which they enter in futures
and options market. They only have a particular view on the market, stock, commodity
etc. In short, speculators put their money at risk in the hope of profiting from an
anticipated price change. They consider various factors such as demand supply, market
positions, open interests, economic fundamentals and other data to take their positions.

Illustration:

Mr.X is a trader but has no time to track and analyze stocks. However, he fancies
his chances in predicting the market trend. So instead of buying different stocks he buys
Sensex Futures.

On May 1, 2001, he buys 100 Sensex futures @ 3600 on expectations that the
index will rise in future. On June 1, 2001, the Sensex rises to 4000 and at that time he
sells an equal number of contracts to close out his position.

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

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

Net gain Rs.40,000

Mr.X has made a profit of Rs.40,000 by taking a call on the future value of the
Sensex. However, if the Sensex had fallen he would have made a loss. Similarly, if it
would have been bearish he could have sold Sensex futures and made a profit from a
BABASAB PATIL 25


falling profit. In index futures players can have a long-term view of the market up to
atleast 3 months.

5.4 Arbitrage

An arbitrageur is basically risk averse. He enters into those contracts were he can
earn riskless profits. When markets are imperfect, buying in one market and
simultaneously selling in other market gives riskless profit. Arbitrageurs are always in the
look out for such imperfections.

In the futures market one can take advantages of arbitrage opportunities by buying
from lower priced market and selling at the higher priced market. In index futures
arbitrage is possible between the spot market and the futures market (NSE has provided a
special software for buying all 50 Nifty stocks in the spot market.

• Take the case of the NSE Nifty.

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

• The futures price of Nifty futures can be worked out by taking the interest cost of
3 months into account.

• If there is a difference then arbitrage opportunity exists.

Let us take the example of single stock to understand the concept better. If Wipro is
quoted at Rs.1000 per share and the 3 months futures of Wipro is Rs.1070 then one can
purchase Wipro at Rs.1000 in spot by borrowing @ 12% annum for 3 months and sell
Wipro futures for 3 months at Rs 1070.

Sale = 1070

Cost= 1000+30 = 1030

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Arbitrage profit = 40

These kind of imperfections continue to exist in the markets but one has to be alert to the
opportunities as they tend to get exhausted very fast.

5.5 Pricing of Index Futures

The index futures are the most popular futures contracts as they can be used in a
variety of ways by various participants in the market.

How many times have you felt of making risk-less profits by arbitraging between
the underlying and futures markets? If so, you need to know the cost-of-carry model to
understand the dynamics of pricing that constitute the estimation of fair value of futures.

1. The cost of carry model

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

F=S+C

where:

F Futures price

S Spot price

C Holding costs or carry costs

If F < S+C or F > S+C, arbitrage opportunities would exist i.e. whenever the
futures price moves away from the fair value, there would be chances for arbitrage.

If Wipro is quoted at Rs.1000 per share and the 3 months futures of Wipro is
Rs.1070 then one can purchase Wipro at Rs.1000 in spot by borrowing @ 12% annum for
3 months and sell Wipro futures for 3 months at Rs 1070.
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Here F=1000+30=1030 and is less than prevailing futures price and hence there
are chances of arbitrage.

Sale = 1070

Cost= 1000+30 = 1030

Arbitrage profit 40

However, one has to remember that the components of holding cost vary with contracts
on different assets.

2. Futures pricing in case of dividend yield

We have seen how we have to consider the cost of finance to arrive at the futures
index value. However, the cost of finance has to be adjusted for benefits of dividends and
interest income. In the case of equity futures, the holding cost is the cost of financing
minus the dividend returns.

Example:

Suppose a stock portfolio has a value of Rs.100 and has an annual dividend yield
of 3% which is earned throughout the year and finance rate=10% the fair value of the
stock index portfolio after one year will be F= Rs.100 + Rs.100 * (0.10 – 0.03)

Futures price = Rs 107

If the actual futures price of one-year contract is Rs.109. An arbitrageur can buy
the stock at Rs.100, borrowing the fund at the rate of 10% and simultaneously sell futures

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at Rs.109. At the end of the year, the arbitrageur would collect Rs.3 for dividends, deliver
the stock portfolio at Rs.109 and repay the loan of Rs.100 and interest of Rs.10. The net
profit would be Rs 109 + Rs 3 - Rs 100 - Rs 10 = Rs 2. Thus, we can arrive at the fair
value in the case of dividend yield.

5.6 Trading strategies

1. Speculation

We have seen earlier that trading in index futures helps in taking a view of the
market, hedging, speculation and arbitrage. Now we will see how one can trade in index
futures and use forward contracts in each of these instances.

Taking a view of the market

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Have you ever felt that the market would go down on a particular day and feared that
your portfolio value would erode?

There are two options available

Option 1: Sell liquid stocks such as Reliance

Option 2: Sell the entire index portfolio

The problem in both the above cases is that it would be very cumbersome and
costly to sell all the stocks in the index. And in the process one could be vulnerable to
company specific risk. So what is the option? The best thing to do is to sell index futures.

Illustration:

Scenario 1:

On July 13, 2001, ‘X’ feels that the market will rise so he buys 200 Nifties with an expiry
date of July 26 at an index price of 1442 costing Rs 2,88,400 (200*1442).

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

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

Scenario 2:

On July 20, 2001, ‘X’ feels that the market will fall so he sells 200 Nifties with an expiry
date of July 26 at an index price of 1523 costing Rs 3,04,600 (200*1523).

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

‘X’ makes a profit of Rs 13,400 (200*67).
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In the above cases ‘X’ has profited from speculation i.e. he has wagered in the hope of
profiting from an anticipated price change.

2. Hedging

Stock index futures contracts offer investors, portfolio managers, mutual funds etc
several ways to control risk. The total risk is measured by the variance or standard
deviation of its return distribution. A common measure of a stock market risk is the
stock’s Beta. The Beta of stocks are available on the www.nseindia.com.

While hedging the cash position one needs to determine the number of futures
contracts to be entered to reduce the risk to the minimum.

Have you ever felt that a stock was intrinsically undervalued? That the profits and
the quality of the company made it worth a lot more as compared with what the market
thinks?

Have you ever been a ‘stock picker’ and carefully purchased a stock based on a
sense that it was worth more than the market price?

A person who feels like this takes a long position on the cash market. When doing
this, he faces two kinds of risks:

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

b. The entire market moves against him and generates losses even though the underlying
idea was correct.

Everyone has to remember that every buy position on a stock is simultaneously a
buy position on Nifty. A long position is not a focused play on the valuation of a stock. It

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carries a long Nifty position along with it, as incidental baggage i.e. a part long position
of Nifty.

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

‘X’ holds HLL worth Rs 9 lakh at Rs 290 per share on July 01, 2001. Assuming that the
beta of HLL is 1.13. How much Nifty futures does ‘X’ have to sell if the index futures is
ruling at 1527?

To hedge he needs to sell 9 lakh * 1.13 = Rs 1017000 lakh on the index futures i.e. 666
Nifty futures.

On July 19, 2001, the Nifty futures is at 1437 and HLL is at 275. ‘X’ closes both
positions earning Rs 13,389, i.e. his position on HLL drops by Rs 46,551 and his short
position on Nifty gains Rs 59,940 (666*90).

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

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

Suppose you have a portfolio of Rs 10 crore. The beta of the portfolio is 1.19. The
portfolio is to be hedged by using Nifty futures contracts. To find out the number of
contracts in futures market to neutralise risk . If the index is at 1200 * 200 (market lot) =
Rs 2,40,000, The number of contracts to be sold is:

a. 1.19*10 crore = 496 contracts

2,40,000

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

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

3. Margins

The margining system is based on the JR Verma Committee recommendations.
The actual margining happens on a daily basis while online position monitoring is done
on an intra-day basis.

Daily margining is of two types:

1. Initial margins

2. Mark-to-market profit/loss

The computation of initial margin on the futures market is done using the concept
of Value-at-Risk (VaR). The initial margin amount is large enough to cover a one-day
loss that can be encountered on 99% of the days. VaR methodology seeks to measure the
amount of value that a portfolio may stand to lose within a certain horizon time period
(one day for the clearing corporation) due to potential changes in the underlying asset
market price. Initial margin amount computed using VaR is collected up-front. The daily
settlement process called "mark-to-market" provides for collection of losses that have
already occurred (historic losses) whereas initial margin seeks to safeguard against
potential losses on outstanding positions. The mark-to-market settlement is done in cash.

Let us take a hypothetical trading activity of a client of a NSE futures division to
demonstrate the margins payments that would occur.

• A client purchases 200 units of FUTIDX NIFTY 29JUN2001 at Rs 1500.
• The initial margin payable as calculated by VaR is 15%.

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

Initial margin (15%) = Rs 45,000
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Assuming that the contract will close on Day + 3 the mark-to-market position will look as
follows:

Position on Day 1

Close Price Loss Margin released Net cash outflow
1400*200 =2,80,000 20,000 3,000 17,000 (20,000-3000)
(3,00,000-2,80,000) (45,000-42,000)
Payment to be made (17,000)

New position on Day 2

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

Margin = 42,000

Close Price Gain Addn Margin Net cash inflow
1510*200 =3,02,000 22,000 3,300 18,700 (22,000-3300)
(3,02,000-2,80,000) (45,300-42,000)
Payment to be recd 18,700

Position on Day 3

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

Margin = Rs 3,300

Close Price Gain Net cash inflow
1600*200 =3,20,000 18,000 18,000 + 45,300* = 63,300
(3,20,000-3,02,000)
Payment to be recd 63,300

Margin account*

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Initial margin = Rs 45,000

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

Position on Day 2 Rs 42,000

Addn margin = (+) Rs 3,300

Total margin in a/c Rs 45,300*

Net gain/loss

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

Day 2 Gain = Rs 18,700

Day 3 Gain = Rs 18,000

Total Gain = Rs 19,700

The client has made a profit of Rs 19,700 at the end of Day 3 and the total cash inflow at
the close of trade is Rs 63,300.

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5.7 Settlement of futures contracts:

Futures contracts have two types of settlements, the MTM settlement which
happens on a continuous basis at the end of each day, and the final settlement which
happens on the last trading day of the futures contract.

1. MTM settlement:

All futures contracts for each member are marked-to-market(MTM) to the daily
settlement price of the relevant futures contract at the end of each day. The profits/losses
are computed as the difference between:

 The trade price and the day’s settlement price for contracts executed during the
day but not squared up.
 The previous day’s settlement price and the current day’s settlement price for
brought forward contracts.
 The buy price and the sell price for contracts executed during the day and squared
up.

The CMs who have a loss are required to pay the mark-to-market (MTM) loss amount
in cash which is in turn passed on to the CMs who have made a MTM profit. This is
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known as daily mark-to-market settlement. CMs are responsible to collect and settle the
daily MTM profits/losses incurred by the TMs and their clients clearing and settling
through them. Similarly, TMs are responsible to collect/pay losses/ profits from/to their
clients by the next day. The pay-in and pay-out of the mark-to-market settlement are
affected on the day following the trade day. In case a futures contract is not traded on a
day, or not traded during the last half hour, a ‘theoretical settlement price’ is computed.

2. Final settlement for futures
On the expiry day of the futures contracts, after the close of trading hours,
NSCCL marks all positions of a CM to the final settlement price and the resulting
profit/loss is settled in cash. Final settlement loss/profit amount is debited/ credited to the
relevant CM’s clearing bank account on the day following expiry day of the contract.

All trades in the futures market are cash settled on a T+1 basis and all positions
(buy/sell) which are not closed out will be marked-to-market. The closing price of the
index futures will be the daily settlement price and the position will be carried to the
next day at the settlement price.

The most common way of liquidating an open position is to execute an offsetting
futures transaction by which the initial transaction is squared up. The initial buyer
liquidates his long position by selling identical futures contract.

In index futures the other way of settlement is cash settled at the final settlement.
At the end of the contract period the difference between the contract value and closing
index value is paid.

How to read the futures data sheet?

Understanding and deciphering the prices of futures trade is the first challenge for
anyone planning to venture in futures trading. Economic dailies and exchange websites

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www.nseindia.com and www.bseindia.com are some of the sources where one can look
for the daily quotes. Your website has a daily market commentary, which carries end of
day derivatives summary along with the quotes.

The first step is start tracking the end of day prices. Closing prices, Trading
Volumes and Open Interest are the three primary data we carry with Index option quotes.
The most important parameter are the actual prices, the high, low, open, close, last traded
prices and the intra-day prices and to track them one has to have access to real time
prices.

The following table shows how futures data will be generally displayed in the
business papers daily.

Series First High Low Close Volume (No of Value No of Open interest
Trade contracts) (Rs trades (No of
in lakh) contracts)
BSXJUN2000 4755 4820 4740 4783.1 146 348.70 104 51
BSXJUL2000 4900 4900 4800 4830.8 12 28.98 10 2
BSXAUG2000 4800 4870 4800 4835 2 4.84 2 1
Total 160 38252 116 54

Source: BSE

• The first column explains the series that is being traded. For e.g. BSXJUN2000
stands for the June Sensex futures contract.

• The column on volume indicates that (in case of June series) 146 contracts have
been traded in 104 trades.

• One contract is equivalent to 50 times the price of the futures, which are traded.
For e.g. In case of the June series above, the first trade at 4755 represents one
contract valued at 4755 x 50 i.e. Rs.2,37,750/-.

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Open interest indicates the total gross outstanding open positions in the market for
that particular series. For e.g. Open interest in the June series is 51 contracts.

The most useful measure of market activity is Open interest, which is also
published by exchanges and used for technical analysis. Open interest indicates the
liquidity of a market and is the total number of contracts, which are still
outstanding in a futures market for a specified futures contract.

A futures contract is formed when a buyer and a seller take opposite positions in a
transaction. This means that the buyer goes long and the seller goes short. Open interest
is calculated by looking at either the total number of outstanding long or short positions –
not both.

Open interest is therefore a measure of contracts that have not been matched and
closed out. The number of open long contracts must equal exactly the number of open
short contracts.

Action Resulting open interest
New buyer (long) and new seller (short) Rise
Trade to form a new contract.
Existing buyer sells and existing seller buys – Fall
The old contract is closed.
New buyer buys from existing buyer. TheNo change – there is no increase in long
Existing buyer closes his position by sellingcontracts being held
to new buyer.
Existing seller buys from new seller. TheNo change – there is no increase in short
Existing seller closes his position by buyingcontracts being held
from new seller.

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Open interest is also used in conjunction with other technical analysis chart
patterns and indicators to gauge market signals. The following chart may help with these
signals.

Price Open interest Market
Strong
Warning signal
Weak
Warning signal

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

7. OPTIONS

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6.1 What is an Option?
An option is a contract giving the buyer the right, but not the obligation, to buy or
sell an underlying asset (a stock or index) at a specific price on or before a certain date
(listed options are all for 100 shares of the particular underlying asset).
An option is a security, just like a stock or bond, and constitutes a binding
contract with strictly defined terms and properties.
Listed options have been available since 1973, when the Chicago Board Options
Exchange, still the busiest options exchange in the world, first opened.

The World With and Without Options
Prior to the founding of the CBOE, investors had few choices of where to invest
their money; they could either be long or short individual stocks, or they could purchase
treasury securities or other bonds.
Once the CBOE opened, the listed option industry began, and
investors now had a world of investment choices previously unavailable.

Options vs. Stocks

In order to better understand the benefits of trading options, one must first
understand some of the similarities and differences between options and stocks.

Similarities:
Listed Options are securities, just like stocks.
Options trade like stocks, with buyers making bids and sellers making offers.
Options are actively traded in a listed market, just like stocks. They can be bought and
sold just like any other security.

Differences:
Options are derivatives, unlike stocks (i.e, options derive their value from
something else, the underlying security).

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Options have expiration dates, while stocks do not.
There is not a fixed number of options, as there are with stock shares available.
Stockowners have a share of the company, with voting and dividend rights. Options
convey no such rights.
Options Premiums
In this case, XYZ represents the option class while May 30 is the option series.
All options on company XYZ are in the XYZ option class but there will be many
different series.
An option Premium is the price of the option. It is the price you pay to purchase
the option. For example, an XYZ May 30 Call (thus it is an option to buy Company XYZ
stock) may have an option premium of $2. This means that this option costs $200.00.
Why? Because most listed options are for 100 shares of stock, and all equity option prices
are quoted on a per share basis, so they need to be multiplied times 100. More in-depth
pricing concepts will be covered in detail in other sections of the course.

Strike Price
The Strike (or Exercise) Price is the price at which the underlying security (in this
case, XYZ) can be bought or sold as specified in the option contract. For example, with

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the XYZ May 30 Call, the strike price of 30 means the stock can be bought for $30 per
share. Were this the XYZ May 30 Put, it would allow the holder the right to sell the stock
at $30 per share.
The strike price also helps to identify whether an option is In-the-Money, At-the-
Money, or Out-of-the-Money when compared to the price of the underlying security. You
will learn about these terms in another section of the course.

Exercising Options
People who buy options have a Right, and that is the right to Exercise.
For a Call Exercise, Call holders may buy stock at the strike price (from the Call seller).
For a Put Exercise, Put holders may sell stock at the strike price (to the Put seller).
Neither Call holders nor Put holders are obligated to buy or sell; they simply have the
rights to do so, and may choose to Exercise or not to Exercise based upon their own
logic.

6.2 The Chicago Board Options Exchange

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The Chicago Board Options Exchange, or CBOE, was the world's first listed
options exchange, opened in 1973 by members of the Chicago Board of Trade. Almost
half of all listed options trades still occur on CBOE.

NOTE: Options also trade now on several smaller exchanges, including the American
Stock Exchange (AMEX), the Philadelphia Stock Exchange (PHLX), the Pacific Stock
Exchange (PSE) and the International Securities Exchange (ISE).

CBOE: The Competitive Advantage
With over 1500 competing market makers trading more than one million options
contracts per day, the CBOE is the largest and busiest options exchange in the world.

The members of the Exchange have maintained this stature for over 25 years by
constantly providing deep and liquid markets in all options series for all CBOE
customers.

CBOE Facts
The CBOE system works to give you the options you need for your investment
strategy, quickly and easily and at the most efficient price. The CBOE offers investors
the best options markets, the most efficient support network, and the most intensive
insight and most recognized educational division in the industry, the Options Institute.

6.3 Regulation and Surveillance:
Regulation and surveillance are necessary in the options industry in order to
protect customers and firms, and respond to customer complaints.
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CBOE has one of the most technologically advanced and computer-automated
measures for regulation and surveillance, which are unparalleled in the options industry.
CBOE has the premier Regulatory Division, with staff who constantly monitor trading
activity throughout the industry.

The Securities and Exchange Commission (SEC) oversees the entire options
industry to ensure that the markets serve the public interest.

6.4 Options Clearing Corporation:
The formation of the OCC in 1973 as the single, independent, universal clearing
agency for all listed options eliminated the problem of credit risk in options trading.
Every options Exchange and every brokerage firm who offers its customers the ability to
trade options is a member or is associated with a member of the OCC.

The OCC stands in the middle of each trade becoming the buyer for all contracts
that are sold, and the seller for all contracts that are bought. Thus, the OCC is, in fact, the
issuer of all listed options contracts, and is registered as such with the SEC.

6.5 Options Market Participants
Contrary to some beliefs, the single greatest population of CBOE users are not huge
financial institutions, but public investors, just like you. Over 65% of the Exchange's
business comes from them.

However, other participants in the financial marketplace also use options to enhance
their performance, including:
• Mutual Funds
• Pension Plans
• Hedge Funds
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• Endowments
• Corporate Treasurers

Stock markets by their very nature are fickle. While fortunes can be made in a jiffy
more often than not the scenario is the reverse. Investing in stocks has two sides to it –a)
Unlimited profit potential from any upside (remember Infosys, HFCL etc) or b) a
downside which could make you a pauper.

Derivative products are structured precisely for this reason -- to curtail the risk
exposure of an investor. Index futures and stock options are instruments that enable you
to hedge your portfolio or open positions in the market. Option contracts allow you to run
your profits while restricting your downside risk.

Apart from risk containment, options can be used for speculation and investors can
create a wide range of potential profit scenarios.

‘Option’, as the word suggests, is a choice given to the investor to either honour the
contract; or if he chooses not to walk away from the contract.

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

6.6 Call options

Call options give the taker the right, but not the obligation, to buy the underlying
shares at a predetermined price, on or before a predetermined date.

Illustration 1:

Raj purchases 1 Satyam Computer (SATCOM) AUG 150 Call --Premium 8
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This contract allows Raj to buy 100 shares of SATCOM at Rs 150 per share at
any time between the current date and the end of next August. For this privilege, Raj pays
a fee of Rs 800 (Rs eight a share for 100 shares). The buyer of a call has purchased the
right to buy and for that he pays a premium.

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

Sam purchases a December call option at Rs 40 for a premium of Rs 15. That is
he has purchased the right to buy that share for Rs 40 in December. If the stock rises
above Rs 55 (40+15) he will break even and he will start making a profit. Suppose the
stock does not rise and instead falls he will choose not to exercise the option and forego
the premium of Rs 15 and thus limiting his loss to Rs 15.

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

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

Option contract Strike price Call premium
Dec Nifty 1325 Rs.6,000
1345 Rs.2,000

Jan Nifty 1325 Rs.4,500
1345 Rs.5000

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A trader is of the view that the index will go up to 1400 in Jan 2002 but does not
want to take the risk of prices going down. Therefore, he buys 10 options of Jan contracts
at 1345. He pays a premium for buying calls (the right to buy the contract) for 500*10=
Rs.5,000/-.

In Jan 2002 the Nifty index goes up to 1365. He sells the options or exercises the
option and takes the difference in spot index price which is (1365-1345) * 200 (market
lot) = 4000 per contract. Total profit = 40,000/- (4,000*10).

He had paid Rs.5,000/- premium for buying the call option. So he earns by buying
call option is Rs.35,000/- (40,000-5000).

If the index falls below 1345 the trader will not exercise his right and will opt
to forego his premium of Rs.5,000. So, in the event the index falls further his loss is
limited to the premium he paid upfront, but the profit potential is unlimited.

Call Options-Long and Short Positions

When you expect prices to rise, then you take a long position by buying calls.
You are bullish. When you expect prices to fall, then you take a short position by selling
calls. You are bearish.

6.7 Put Options :
A Put Option gives the holder of the right to sell a specific number of shares of
an agreed security at a fixed price for a period of time. eg: Sam purchases 1 INFTEC
(Infosys Technologies) AUG 3500 Put --Premium 200. This contract allows Sam to sell
100 shares INFTEC at Rs 3500 per share at any time between the current date and the
end of August. To have this privilege, Sam pays a premium of Rs 20,000 (Rs 200 a share
for 100 shares).

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

Illustration 2: Raj is of the view that the a stock is overpriced and will fall in future, but
he does not want to take the risk in the event of price rising so purchases a put option at
Rs 70 on ‘X’. By purchasing the put option Raj has the right to sell the stock at Rs 70 but
he has to pay a fee of Rs 15 (premium).

So he will breakeven only after the stock falls below Rs 55 (70-15) and will start
making profit if the stock falls below Rs 55.

Illustration 3:

An investor on Dec 15 is of the view that Wipro is overpriced and will fall in
future but does not want to take the risk in the event the prices rise. So he purchases a Put
option on Wipro.

Quotes are as under:

Spot Rs.1040

Jan Put at 1050 Rs.10

Jan Put at 1070 Rs.30

He purchases 1000 Wipro Put at strike price 1070 at Put price of Rs.30/-. He pays
Rs.30,000/- as Put premium.

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His position in following price position is discussed below.

1. Jan Spot price of Wipro = 1020
2. Jan Spot price of Wipro = 1080

In the first situation the investor is having the right to sell 1000 Wipro shares at
Rs.1,070/- the price of which is Rs.1020/-. By exercising the option he earns Rs.
(1070-1020) = Rs 50 per Put, which totals Rs 50,000/-. His net income is Rs
(50000-30000) = Rs 20,000.

In the second price situation, the price is more in the spot market, so the investor
will not sell at a lower price by exercising the Put. He will have to allow the Put option to
expire unexercised. He looses the premium paid Rs 30,000.

Put Options-Long and Short Positions

When you expect prices to fall, then you take a long position by buying Puts. You
are bearish. When you expect prices to rise, then you take a short position by selling
Puts. You are bullish.

CALL OPTIONS PUT OPTIONS
If you expect a fall in price(Bearish) Short Long
If you expect a rise in price (Bullish) Long Short

SUMMARY:

CALL OPTION BUYER CALL OPTION WRITER (Seller)

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• Pays premium • Receives premium
• Right to exercise and buy the shares • Obligation to sell shares if exercised
• Profits from rising prices • Profits from falling prices or
remaining neutral
• Limited losses, Potentially unlimited
gain • Potentially unlimited losses, limited
gain
PUT OPTION BUYER PUT OPTION WRITER (Seller)
• Pays premium • Receives premium
• Right to exercise and sell shares • Obligation to buy shares if exercised
• Profits from falling prices • Profits from rising prices or
remaining neutral
• Limited losses, Potentially unlimited
gain • Potentially unlimited losses, limited
gain

6.8 Option styles

Settlement of options is based on the expiry date. However, there are three basic
styles of options you will encounter which affect settlement. The styles have
geographical names, which have nothing to do with the location where a contract is
agreed! The styles are:

European: These options give the holder the right, but not the obligation, to buy or sell
the underlying instrument only on the expiry date. This means that the option cannot be
exercised early. Settlement is based on a particular strike price at expiration. Currently,
in India only index options are European in nature.

eg: Sam purchases 1 NIFTY AUG 1110 Call --Premium 20. The exchange will
settle the contract on the last Thursday of August. Since there are no shares for the
underlying, the contract is cash settled.

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American: These options give the holder the right, but not the obligation, to buy or sell
the underlying instrument on or before the expiry date. This means that the option can
be exercised early. Settlement is based on a particular strike price at expiration.

Options in stocks that have been recently launched in the Indian market are
"American Options". eg: Sam purchases 1 ACC SEP 145 Call --Premium 12

Here Sam can close the contract any time from the current date till the expiration
date, which is the last Thursday of September.

American style options tend to be more expensive than European style because
they offer greater flexibility to the buyer.

6.9 Option Class and Series

Generally, for each underlying, there are a number of options available: For this
reason, we have the terms "class" and "series".

An option "class" refers to all options of the same type (call or put) and style
(American or European) that also have the same underlying.

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

An option series refers to all options that are identical: they are the same type,
have the same underlying, the same expiration date and the same exercise price.

Calls Puts
. JUL AUG SEP JUL AUG SEP
Wipro
1300 45 60 75 15 20 28
1400 35 45 65 25 28 35
1500 20 42 48 30 40 55

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

All calls are of the same option type. Similarly, all puts are of the same option
type. Options of the same type that are also in the same class are said to be of the same
class. Options of the same class and with the same exercise price and the same expiration
date are said to be of the same series

6.10 Pricing of options

Options are used as risk management tools and the valuation or pricing of the
instruments is a careful balance of market factors.

There are four major factors affecting the Option premium:

• Price of Underlying
• Time to Expiry
• Exercise Price Time to Maturity
• Volatility of the Underlying

And two less important factors:

• Short-Term Interest Rates
• Dividends

6.11 Review of Options Pricing Factors

1. The Intrinsic Value of an Option

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The intrinsic value of an option is defined as the amount by which an option is in-
the-money, or the immediate exercise value of the option when the underlying position is
marked-to-market.

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

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

The intrinsic value of an option must be positive or zero. It cannot be negative.
For a call option, the strike price must be less than the price of the underlying asset for
the call to have an intrinsic value greater than 0. For a put option, the strike price must be
greater than the underlying asset price for it to have intrinsic value.

Price of underlying

The premium is affected by the price movements in the underlying instrument.
For Call options – the right to buy the underlying at a fixed strike price – as the
underlying price rises so does its premium. As the underlying price falls so does the cost
of the option premium. For Put options – the right to sell the underlying at a fixed strike
price – as the underlying price rises, the premium falls; as the underlying price falls the
premium cost rises.

The following chart summarizes the above for Calls and Puts.

Option Underlying price Premium cost
Call
Put

2. The Time Value of an Option

Generally, the longer the time remaining until an option’s expiration, the higher
its premium will be. This is because the longer an option’s lifetime, greater is the
possibility that the underlying share price might move so as to make the option in-the-
BABASAB PATIL 54


money. All other factors affecting an option’s price remaining the same, the time value
portion of an option’s premium will decrease (or decay) with the passage of time.

Note: This time decay increases rapidly in the last several weeks of an option’s life.
When an option expires in-the-money, it is generally worth only its intrinsic value.

Option Time to expiry Premium cost
Call
Put

3. Volatility

Volatility is the tendency of the underlying security’s market price to fluctuate
either up or down. It reflects a price change’s magnitude; it does not imply a bias toward
price movement in one direction or the other. Thus, it is a major factor in determining an
option’s premium. The higher the volatility of the underlying stock, the higher the
premium because there is a greater possibility that the option will move in-the-money.
Generally, as the volatility of an under-lying stock increases, the premiums of both calls
and puts overlying that stock increase, and vice versa.

Higher volatility=Higher premium

Lower volatility = Lower premium

Option Volatility Premium cost
Call
Put

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4. Interest rates

In general interest rates have the least influence on options and equate
approximately to the cost of carry of a futures contract. If the size of the options contract
is very large, then this factor may take on some importance. All other factors being equal
as interest rates rise, premium costs fall and vice versa. The relationship can be thought
of as an opportunity cost. In order to buy an option, the buyer must either borrow funds
or use funds on deposit. Either way the buyer incurs an interest rate cost. If interest rates
are rising, then the opportunity cost of buying options increases and to compensate the
buyer premium costs fall. Why should the buyer be compensated? Because the option
writer receiving the premium can place the funds on deposit and receive more interest
than was previously anticipated. The situation is reversed when interest rates fall –
premiums rise. This time it is the writer who needs to be compensated.

Option Interest rates Premium cost
Call
Put

6.12 STRATEGIES

1. Bull Market Strategies

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a. Calls in a Bullish Strategy

An investor with a bullish market outlook should buy call options. If you expect
the market price of the underlying asset to rise, then you would rather have the right to
purchase at a specified price and sell later at a higher price than have the obligation to
deliver later at a higher price.

The investor's profit potential of buying a call option is unlimited. The investor's
profit is the market price less the exercise price less the premium. The greater the
increase in price of the underlying, the greater the investor's profit.

The investor's potential loss is limited. Even if the market takes a drastic decline
in price levels, the holder of a call is under no obligation to exercise the option. He may
let the option expire worthless.

The investor breaks even when the market price equals the exercise price
plus the premium.

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An increase in volatility will increase the value of your call and increase your
return. Because of the increased likelihood that the option will become in- the-money, an
increase in the underlying volatility (before expiration), will increase the value of a long
options position. As an option holder, your return will also increase.

A simple example will illustrate the above:

Suppose there is a call option with a strike price of Rs.2000 and the option
premium is Rs.100. The option will be exercised only if the value of the underlying is
greater than Rs.2000 (the strike price). If the buyer exercises the call at Rs.2200 then his
gain will be Rs.200. However, this would not be his actual gain for that he will have to
deduct the Rs.200 (premium) he has paid.

The profit can be derived as follows

Profit = Market price - Exercise price - Premium
Profit = Market price – Strike price – Premium.
2200 – 2000 – 100 = Rs.100

b. Puts in a Bullish Strategy

An investor with a bullish market outlook can also go short on a Put option.
Basically, an investor anticipating a bull market could write Put options. If the market
price increases and puts become out-of-the-money, investors with long put positions will
let their options expire worthless.

By writing Puts, profit potential is limited. A Put writer profits when the price of
the underlying asset increases and the option expires worthless. The maximum profit is
limited to the premium received.

BABASAB PATIL 58


However, the potential loss is unlimited. Because a short put position holder has
an obligation to purchase if exercised. He will be exposed to potentially large losses if the
market moves against his position and declines.

The break-even point occurs when the market price equals the exercise price:
minus the premium. At any price less than the exercise price minus the premium, the
investor loses money on the transaction. At higher prices, his option is profitable.

An increase in volatility will increase the value of your put and decrease your
return. As an option writer, the higher price you will be forced to pay in order to buy back
the option at a later date , lower is the return.

Bullish Call Spread Strategies

A vertical call spread is the simultaneous purchase and sale of identical call
options but with different exercise prices.

To "buy a call spread" is to purchase a call with a lower exercise price and to
write a call with a higher exercise price. The trader pays a net premium for the position.

To "sell a call spread" is the opposite, here the trader buys a call with a higher
exercise price and writes a call with a lower exercise price, receiving a net premium for
the position.

An investor with a bullish market outlook should buy a call spread. The "Bull Call
Spread" allows the investor to participate to a limited extent in a bull market, while at the
same time limiting risk exposure.

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To put on a bull spread, the trader needs to buy the lower strike call and sell the
higher strike call. The combination of these two options will result in a bought spread.
The cost of Putting on this position will be the difference between the premium paid for
the low strike call and the premium received for the high strike call.

The investor's profit potential is limited. When both calls are in-the-money, both
will be exercised and the maximum profit will be realised. The investor delivers on his
short call and receives a higher price than he is paid for receiving delivery on his long
call.

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The investor’s potential loss is limited. At the most, the investor can lose is the
net premium. He pays a higher premium for the lower exercise price call than he receives
for writing the higher exercise price call.

The investor breaks even when the market price equals the lower exercise price
plus the net premium. At the most, an investor can lose is the net premium paid. To
recover the premium, the market price must be as great as the lower exercise price plus
the net premium.

An example of a Bullish call spread:

Let's assume that the cash price of a scrip is Rs.100 and you buy a November call
option with a strike price of Rs.90 and pay a premium of Rs.14. At the same time you sell
another November call option on a scrip with a strike price of Rs.110 and receive a
premium of Rs.4. Here you are buying a lower strike price option and selling a higher
strike price option. This would result in a net outflow of Rs.10 at the time of establishing
the spread.

Now let us look at the fundamental reason for this position. Since this is a bullish
strategy, the first position established in the spread is the long lower strike price call
option with unlimited profit potential. At the same time to reduce the cost of purchase of
the long position a short position at a higher call strike price is established. While this not
only reduces the outflow in terms of premium but his profit potential as well as risk is
limited. Based on the above figures the maximum profit, maximum loss and breakeven
point of this spread would be as follows:

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

= 110 - 90 - 10 = 10

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Maximum Loss = Lower strike premium - Higher strike premium

= 14 - 4 = 10

Breakeven Price = Lower strike price + Net premium paid

= 90 + 10 = 100

Bullish Put Spread Strategies

A vertical Put spread is the simultaneous purchase and sale of identical Put
options but with different exercise prices.

To "buy a put spread" is to purchase a Put with a higher exercise price and to
write a Put with a lower exercise price. The trader pays a net premium for the position.

To "sell a put spread" is the opposite: the trader buys a Put with a lower exercise
price and writes a put with a higher exercise price, receiving a net premium for the
position.

An investor with a bullish market outlook should sell a Put spread. The "vertical
bull put spread" allows the investor to participate to a limited extent in a bull market,
while at the same time limiting risk exposure.

BABASAB PATIL 62

Perception of derivatives @ smc investment project report

Perception of derivatives @ smc investment project report

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