Analysis of Derivatives and Stock Broking at Apollo Sindhoori                             Executive SummaryTitle of the an...
Analysis of Derivatives and Stock Broking at Apollo Sindhoori       Computer share has over 6000 experienced professionals...
Analysis of Derivatives and Stock Broking at Apollo Sindhoori                                Objective of the analysis    ...
Analysis of Derivatives and Stock Broking at Apollo Sindhoori      Introduction to Organization:             ASCI, is a pr...
Analysis of Derivatives and Stock Broking at Apollo Sindhoori       Vision of ASCI:       “To be amongst most trusted powe...
Analysis of Derivatives and Stock Broking at Apollo Sindhoori       Quality policy of ASCI:               To achieve and r...
Analysis of Derivatives and Stock Broking at Apollo SindhooriACTIVITIES CARRIED OUT BY ASCI STOCK BROKING LIMITED   1. Sha...
Analysis of Derivatives and Stock Broking at Apollo Sindhoori       •      Strive to keep all stake-holders (shareholders,...
Analysis of Derivatives and Stock Broking at Apollo Sindhoori                                 DERIVATIVESIntroduction:    ...
Analysis of Derivatives and Stock Broking at Apollo Sindhoori                           Indian derivatives markets   1. Ri...
Analysis of Derivatives and Stock Broking at Apollo Sindhoori       Jogani and Fernandez (2003) describe India’s long hist...
Analysis of Derivatives and Stock Broking at Apollo Sindhoori       Exchange (NSE). However, NSE now accounts for virtuall...
Analysis of Derivatives and Stock Broking at Apollo Sindhoorigovernment created the NSE in collaboration with state-owned ...
Analysis of Derivatives and Stock Broking at Apollo Sindhoori8% in October 2005. However, market insiders feel that this m...
Analysis of Derivatives and Stock Broking at Apollo SindhooriWhy have derivatives?       Derivatives have become very impo...
Analysis of Derivatives and Stock Broking at Apollo Sindhoori       The start of a new derivatives contract pushes up pric...
Analysis of Derivatives and Stock Broking at Apollo Sindhoori        FUTURES CONTRACT:       A futures contract is similar...
Analysis of Derivatives and Stock Broking at Apollo Sindhoori       For understanding of stock index futures a thorough kn...
Analysis of Derivatives and Stock Broking at Apollo SindhooriExample: Futures contracts in Nifty in July 2001             ...
Analysis of Derivatives and Stock Broking at Apollo Sindhoori                             Cost (Rs)       Selling price   ...
Analysis of Derivatives and Stock Broking at Apollo Sindhooriby 10%, the value of the portfolio increases 11%. The idea is...
Analysis of Derivatives and Stock Broking at Apollo Sindhooriexpects his portfolio to outperform the market. Irrespective ...
Analysis of Derivatives and Stock Broking at Apollo Sindhooriwould have been bearish he could have sold Sensex futures and...
Analysis of Derivatives and Stock Broking at Apollo SindhooriThese kind of imperfections continue to exist in the markets ...
Analysis of Derivatives and Stock Broking at Apollo Sindhoori       Here F=1000+30=1030 and is less than prevailing future...
Analysis of Derivatives and Stock Broking at Apollo SindhooriTrading strategies1. Speculation       We have seen earlier t...
Analysis of Derivatives and Stock Broking at Apollo Sindhoori‘X’ makes a profit of Rs 15,600 (200*78)Scenario 2:On July 20...
Analysis of Derivatives and Stock Broking at Apollo Sindhooria. His understanding can be wrong, and the company is really ...
Analysis of Derivatives and Stock Broking at Apollo SindhooriIf you sell more than 496 contracts you are overhedged and se...
Analysis of Derivatives and Stock Broking at Apollo SindhooriInitial margin (15%) = Rs 45,000Assuming that the contract wi...
Analysis of Derivatives and Stock Broking at Apollo SindhooriAddn margin             = (+) Rs 3,300Total margin in a/c    ...
Analysis of Derivatives and Stock Broking at Apollo Sindhoori   The CMs who have a loss are required to pay the mark-to-ma...
Analysis of Derivatives and Stock Broking at Apollo Sindhoori  one can look for the daily quotes. Your website has a daily...
Analysis of Derivatives and Stock Broking at Apollo Sindhoorimarket and is the total number of contracts, which are still ...
Analysis of Derivatives and Stock Broking at Apollo SindhooriWhat is an Option?       An option is a contract giving the b...
Analysis of Derivatives and Stock Broking at Apollo Sindhoori        Stockowners have a share of the company, with voting ...
Analysis of Derivatives and Stock Broking at Apollo SindhooriAssignment of Options          When an option holder chooses ...
Analysis of Derivatives and Stock Broking at Apollo Sindhoori         With over 1500 competing market makers trading more ...
Analysis of Derivatives and Stock Broking at Apollo Sindhoori       The Securities and Exchange Commission (SEC) oversees ...
Analysis of Derivatives and Stock Broking at Apollo Sindhoori   Apart from risk containment, options can be used for specu...
Analysis of Derivatives and Stock Broking at Apollo Sindhoori             Dec Nifty             1325                    Rs...
Analysis of Derivatives and Stock Broking at Apollo Sindhoori        The buyer of a put has purchased a right to sell. The...
Analysis of Derivatives and Stock Broking at Apollo Sindhoori       In the second price situation, the price is more in th...
Analysis of Derivatives and Stock Broking at Apollo Sindhoori                                                             ...
Analysis of Derivatives and Stock Broking at Apollo Sindhoori        Options in stocks that have been recently launched in...
Analysis of Derivatives and Stock Broking at Apollo SindhooriPricing of options       Options are used as risk management ...
Analysis of Derivatives and Stock Broking at Apollo Sindhoori        The premium is affected by the price movements in the...
Analysis of Derivatives and Stock Broking at Apollo Sindhoori       Volatility is the tendency of the underlying security’...
Analysis of Derivatives and Stock Broking at Apollo Sindhooriright to purchase at a specified price and sell later at a hi...
Analysis of Derivatives and Stock Broking at Apollo Sindhoori        An investor with a bullish market outlook can also go...
Analysis of Derivatives and Stock Broking at Apollo Sindhoori        An investor with a bullish market outlook should buy ...
Analysis of Derivatives and Stock Broking at Apollo Sindhooripuchase of the long position a short position at a higher cal...
Analysis of Derivatives and Stock Broking at Apollo Sindhoorihigher strike of either calls or put. The difference between ...
A project on analysis of derivatives and stock broking at apollo sindhoori
A project on analysis of derivatives and stock broking at apollo sindhoori
A project on analysis of derivatives and stock broking at apollo sindhoori
A project on analysis of derivatives and stock broking at apollo sindhoori
A project on analysis of derivatives and stock broking at apollo sindhoori
A project on analysis of derivatives and stock broking at apollo sindhoori
A project on analysis of derivatives and stock broking at apollo sindhoori
A project on analysis of derivatives and stock broking at apollo sindhoori
A project on analysis of derivatives and stock broking at apollo sindhoori
A project on analysis of derivatives and stock broking at apollo sindhoori
A project on analysis of derivatives and stock broking at apollo sindhoori
A project on analysis of derivatives and stock broking at apollo sindhoori
A project on analysis of derivatives and stock broking at apollo sindhoori
A project on analysis of derivatives and stock broking at apollo sindhoori
A project on analysis of derivatives and stock broking at apollo sindhoori
A project on analysis of derivatives and stock broking at apollo sindhoori
A project on analysis of derivatives and stock broking at apollo sindhoori
A project on analysis of derivatives and stock broking at apollo sindhoori
A project on analysis of derivatives and stock broking at apollo sindhoori
A project on analysis of derivatives and stock broking at apollo sindhoori
A project on analysis of derivatives and stock broking at apollo sindhoori
A project on analysis of derivatives and stock broking at apollo sindhoori
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A project on analysis of derivatives and stock broking at apollo sindhoori

  1. 1. Analysis of Derivatives and Stock Broking at Apollo Sindhoori Executive SummaryTitle of the analysis “Analysis of Derivatives and Stock Broking at Apollo Sindhoori capitalInvestment ltd.”The function of the financial market is to facilitate the transfer of funds from surplussectors (lenders) to deficit sector (borrowers) Indian financial system consist of themoney market and capital market. Depository is an organization where the securities of a shareholder are held inthe electronic form at the request of the shareholder through a medium of a depositoryparticipant.To handle the securities in electronic form as per the Depository Act 1996, twoDepositories are registered with SEBI. They are 1. National Securities Depository Ltd (NSDL) 2. Central Depository Services (India) ltd (CSDL)A derivative is a financial instrument that derives its value from an underlying asset.This underlying asset can be stocks, bonds currency, commodities, metals and evenintangible. Like stock indices. There are different types of derivatives like Forwards,Futures, Options, and Swaps. A future is a contract to buy or sell an asset at a specified future date at aspecified price. Options are deferred delivery contracts that give the buyers the right,but not the obligation, to buy or sell a specified underlying at a price on or before aspecified date. ASCI computer share private Ltd. Is a joint venture between computer shareAustralia and ASCI consultant’s Ltd. India in the registry management servicesindustry. Computer share Australia is the world’s largest and only global shareregistry providing financial market services and technology to the global securitiesindustry. ASCI corporate and mutual fund share registry and investor servicesbusiness, India’s No.1Registrar and transfer agent and rated as India’s “most admiredregistrar” for its over all excellence in volume management, quality process andtechnology driven services. BABASAB PATIL PROJECT REPORT ON FINANCE 1
  2. 2. Analysis of Derivatives and Stock Broking at Apollo Sindhoori Computer share has over 6000 experienced professionals; computer shareoperates in five continents, providing services and solutions to listed companies,investors, employees, exchanges and other financial institutions while ASCI hashandled over 675 issues as Registrar to Issues servicing over 16 million investorsfrom multiple locations across India. ASCI Computer share is all geared up to establish a new paradigm in servicedelivery driven by benchmark operations management practices, the highest qualitystandards and state-of –the-art technology to service its clients and the investorcommunity at large. The rapid developments in the Indian securities. This report is delivered in to 2 parts; each part is prepared on the basis of theanalysis carried on in the company, of the first part of the report makes us familiar ofthe company, its quality policy, quality objectives and its plans. The second partcontains the analysis on derivatives, stock broking process and its service offered byASCI to its clients. The objective of the analysis are to analysis of derivativesproducts, trading systems and process, clearing and settlement, to know the process ofstock broking, the calculation of brokerage, how to get registered with ASCI in orderto buy and sell the shares. BABASAB PATIL PROJECT REPORT ON FINANCE 2
  3. 3. Analysis of Derivatives and Stock Broking at Apollo Sindhoori Objective of the analysis  Getting an in-depth knowledge of working of derivatives market with special reference to the stock exchanges.  Understanding the role of stock broking in capital market and derivatives market.  To know the overview of the market, to study about the settlement procedure in the stock exchange.  To analysis about the intermediaries, their functioning and importance of their presence in the capital market and study about the action trading in the stock exchangeNeed for the study Financial Derivatives are quite new to the Indian Financial Market, but thederivatives market has shown an immense potential which is visible by the growth ithas achieved in the recent past, In the present changing financial environment and anincreased exposure towards financial risks, It is of immense importance to have agood working knowledge of Derivatives.Methodology:-Methodology explains the methods used in collecting information to carry out theproject. I have collected the primary data from the internal guide and the clients who usevisit and trade in the ASCI stock broking Ltd. The secondary data about the onlinetrading is collected from the various websites. • Websites • Magazines • News papers The data for the analysis has been collected from NSE websites. BABASAB PATIL PROJECT REPORT ON FINANCE 3
  4. 4. Analysis of Derivatives and Stock Broking at Apollo Sindhoori Introduction to Organization: ASCI, is a premier integrated financial services provider, and ranked among the top five in the country in all its business segments, services over 16 million individual investors in various capacities, and provides investor services to over 300 corporate, comprising the who is who of Corporate India. ASCI covers the entire spectrum of financial services such as Stock broking, Depository Participants, Distribution of financial products - mutual funds, bonds, fixed deposit, equities, Insurance Broking, Commodities Broking, Personal Finance Advisory Services, Merchant Banking & Corporate Finance, placement of equity, IPO’s, among others. ASCI has a professional management team and ranks among the best in technology, operations and research of various industrial segments The birth of ASCI was on a modest scale in 1981. It began with the vision and enterprise of a small group of practicing Chartered Accountants who founded the flagship company …ASCI Consultants Limited. It started with consulting and financial accounting automation, and carved inroads into the field of registry and share accounting by 1985. Since then, they have utilized their experience and superlative expertise to go from strength to strength…to better their services, to provide new ones, to innovate, diversify and in the process, evolved ASCI as one of India’s premier integrated financial service enterprise. Thus over the last 20 years ASCI has traveled the success route, towards building a reputation as an integrated financial services provider, offering a wide spectrum of services. And they have made this journey by taking the route of quality service, path breaking innovations in service, versatility in service and finally…totality in service. Our highly qualified manpower, cutting-edge technology, comprehensive infrastructure and total customer-focus has secured for us the position of an emerging financial services giant enjoying the confidence and support of an enviable clientele across diverse fields in the financial world. BABASAB PATIL PROJECT REPORT ON FINANCE 4
  5. 5. Analysis of Derivatives and Stock Broking at Apollo Sindhoori Vision of ASCI: “To be amongst most trusted power utility company of the country by providing environment friendly power on most cost effective basis, ensuring prosperity for its stakeholders and growth with human face.” Mission of ASCI: • To ensure most cost effective power for sustained growth of India. • To provide clean and green power for secured future of countrymen. • To retain leadership position of the organization in Hydro Power generation, while working with dedication and innovation in every project we undertake. • To maintain continuous pursuit for cost effectiveness enhanced productivity for ensuring financial health of the organization, to take care of stakeholders’ aspirations continuously. • To be a technology driven, transparent organization, ensuring dignity and respect for its team members. • To inculcate value system all cross the organization for ensuring trustworthy relationship with its constituent associates & stakeholders. • To continuously upgrade & update knowledge & skill set of its human resources. • To be socially responsible through community development by leveraging resources and knowledge base. • To achieve excellence in every activity we undertake. BABASAB PATIL PROJECT REPORT ON FINANCE 5
  6. 6. Analysis of Derivatives and Stock Broking at Apollo Sindhoori Quality policy of ASCI: To achieve and retain leadership, ASCI shall aim for complete customer satisfaction, by combining its human and technological resources, to provide superior quality financial services. In the process, ASCI will strive to exceed Customers expectations. Quality Objectives As per the Quality Policy, ASCI will: • Build in-house processes that will ensure transparent and harmonious relationships with its clients and investors to provide high quality of services. • Establish a partner relationship with its investor service agents and vendors that will help in keeping up its commitments to the customers. • Provide high quality of work life for all its employees and equip them with adequate knowledge & skills so as to respond to customers needs. • Continue to uphold the values of honesty & integrity and strive to establish unparalleled standards in business ethics. • Use state-of-the art information technology in developing new and innovative financial products and services to meet the changing needs of investors and clients. • Strive to be a reliable source of value-added financial products and services and constantly guide the individuals and institutions in making a judicious choice of same.Strive to keep all stake-holders (shareholders, clients, investors, employees, suppliersand regulatory authorities) proud and satisfied BABASAB PATIL PROJECT REPORT ON FINANCE 6
  7. 7. Analysis of Derivatives and Stock Broking at Apollo SindhooriACTIVITIES CARRIED OUT BY ASCI STOCK BROKING LIMITED 1. Share Broking. 2. Demat & Remat Services. 3. Mutual Funds. 4. Investments. 5. Personal Tax planning. 6. Insurance Advisory.The explanation for the above –mentioned points are as follows: Services and qualities of ASCI Ltd Quality Objectives As per the Quality Policy, ASCI will: • Build in-house processes that will ensure transparent and harmonious relationships with its clients and investors to provide high quality of services. • Establish a partner relationship with its investor service agents and vendors that will help in keeping up its commitments to the customers. • Provide high quality of work life for all its employees and equip them with adequate knowledge & skills so as to respond to customers needs. • Continue to uphold the values of honesty & integrity and strive to establish unparalleled standards in business ethics. • Use state-of-the art information technology in developing new and innovative financial products and services to meet the changing needs of investors and clients. • Strive to be a reliable source of value-added financial products and services and constantly guide the individuals and institutions in making a judicious choice of same. BABASAB PATIL PROJECT REPORT ON FINANCE 7
  8. 8. Analysis of Derivatives and Stock Broking at Apollo Sindhoori • Strive to keep all stake-holders (shareholders, clients, investors, employees, suppliers and regulatory authorities) proud and satisfied.The services provided by the ASCI:A). my portfolio • Portfolio planner • Risk quotient • Equity portfolio • My net worth B). Planners • Goal planner • Retirement planner • Yield calculator • Risk hedgerC). Publications • The Finapolis • ASCI Bazaar Baatein. BABASAB PATIL PROJECT REPORT ON FINANCE 8
  9. 9. Analysis of Derivatives and Stock Broking at Apollo Sindhoori DERIVATIVESIntroduction: BSE created history on June 9, 2000 by launching the first Exchange tradedIndex Derivative Contract i.e. futures on the capital market benchmark index - theBSE Sensex. The inauguration of trading was done by Prof. J.R. Varma, member ofSEBI and chairman of the committee responsible for formulation of risk containmentmeasures for the Derivatives market. The first historical trade of 5 contracts of Juneseries was done on June 9, 2000 at 9:55:03 a.m. between M/s Kaji and MaulikSecurities 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 inIndex Options on Sensex on June 1, 2001. Stock options were introduced on 31 stockson July 9, 2001 and single stock futures were launched on November 9, 2002. September 13, 2004 marked another milestone in the history of Indian CapitalMarkets, the day on which the Bombay Stock Exchange launched Weekly Options, aunique product unparallel in derivatives markets, both domestic and international.BSE permitted trading in weekly contracts in options in the shares of four leadingcompanies namely Reliance, Satyam, State Bank of India, and Tisco in addition to theflagship index-Sensex. BABASAB PATIL PROJECT REPORT ON FINANCE 9
  10. 10. Analysis of Derivatives and Stock Broking at Apollo Sindhoori Indian derivatives markets 1. Rise of Derivatives The global economic order that emerged after World War II was a system wheremany less developed countries administered prices and centrally allocated resources.Even the developed economies operated under the Bretton Woods system of fixedexchange rates. The system of fixed prices came under stress from the 1970s onwards.High inflation and unemployment rates made interest rates more volatile. The BrettonWoods system was dismantled in 1971, freeing exchange rates to fluctuate. Lessdeveloped countries like India began opening up their economies and allowing pricesto vary with market conditions. Price fluctuations make it hard for businesses to estimate their future productioncosts and revenues. Derivative securities provide them a valuable set of tools formanaging this risk.2. Definition and Uses of Derivatives A derivative security is a financial contract whose value is derived from thevalue 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 atrader to hedge some preexisting risk by taking positions in derivatives markets thatoffset potential losses in the underlying or spot market. In India, most derivativesusers describe themselves as hedgers and Indian laws generally require thatderivatives be used for hedging purposes only. Another motive for derivatives tradingis speculation (i.e. taking positions to profit from anticipated price movements). Inpractice, it may be difficult to distinguish whether a particular trade was for hedgingor speculation, and active markets require the participation of both hedgers andspeculators. A third type of trader, called arbitrageurs, profit from discrepancies in therelationship of spot and derivatives prices, and thereby help to keep markets efficient. BABASAB PATIL PROJECT REPORT ON FINANCE 10
  11. 11. Analysis of Derivatives and Stock Broking at Apollo Sindhoori Jogani and Fernandez (2003) describe India’s long history in arbitrage trading,with line operators and traders arbitraging prices between exchanges located indifferent cities, and between two exchanges in the same city. Their study of Indianequity derivatives markets in 2002 indicates that markets were inefficient at that time.They argue that lack of knowledge, market frictions and regulatory impediments haveled to low levels of capital employed. Price volatility may reflect changes in the underlying demand and supplyconditions and thereby provide useful information about the market. Thus, economistsdo not view volatility as necessarily harmful. Speculators face the risk of losing money from their derivatives trades, as theydo with other securities. There have been some well-publicized cases of large lossesfrom derivatives trading. In some instances, these losses stemmed from fraudulentbehavior that went undetected partly because companies did not have adequate riskmanagement systems in place. In other cases, users failed to understand why and howthey were taking positions in the derivatives. Derivatives in arbitrage trading in India. However, more recent evidencesuggests 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 bilaterallynegotiated between two parties. The terms of an OTC contract are flexible, and areoften customized to fit the specific requirements of the user. OTC contracts havesubstantial credit risk, which is the risk that the counterparty that owes money defaultson the payment. In India, OTC derivatives are generally prohibited with someexceptions: those that are specifically allowed by the Reserve Bank of India (RBI) or,in the case of commodities (which are regulated by the Forward MarketsCommission), those that trade informally in “havala” or forwards markets. An exchange-traded contract, such as a futures contract, has a standardizedformat that specifies the underlying asset to be delivered, the size of the contract, andthe logistics of delivery. They trade on organized exchanges with prices determinedby the interaction of many buyers and sellers. In India, two exchanges offerderivatives trading: the Bombay Stock Exchange (BSE) and the National Stock BABASAB PATIL PROJECT REPORT ON FINANCE 11
  12. 12. Analysis of Derivatives and Stock Broking at Apollo Sindhoori 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 ownedsubsidiary of the NSE. Margin requirements and daily marking-to-market of futurespositions substantially reduce the credit risk of exchange traded contracts, relative toOTC contracts.4. Development of Derivative Markets in India Derivatives markets have been in existence in India in some form or other fora long time. In the area of commodities, the Bombay Cotton Trade Association startedfutures trading in 1875 and, by the early 1900s India had one of the world’s largestfutures industry. In 1952 the government banned cash settlement and options tradingand derivatives trading shifted to informal forwards markets. In recent years,government policy has changed, allowing for an increased role for market-basedpricing and less suspicion of derivatives trading. The ban on futures trading of manycommodities was lifted starting in the early 2000s, and national electronic commodityexchanges were created. In the equity markets, a system of trading called “badla” involving someelements of forwards trading had been in existence for decades. However, the systemled to a number of undesirable practices and it was prohibited off and on till theSecurities and a clearinghouse guarantees performance of a contract by becomingbuyer to every seller and seller to every buyer. Customers post margin (security) deposits with brokers to ensure that they cancover a specified loss on the position. A futures position is marked-to-market byrealizing any trading losses in cash on the day they occur. “Badla” allowed investors to trade single stocks on margin and to carryforward positions to the next settlement cycle. Earlier, it was possible to carry forwarda 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 expirationdate, and contract terms and margin requirements are not standardized. Derivatives Exchange Board of India (SEBI) banned it for good in 2001. Aseries of reforms of the stock market between 1993 and 1996 paved the way for thedevelopment of exchange traded equity derivatives markets in India. In 1993, the BABASAB PATIL PROJECT REPORT ON FINANCE 12
  13. 13. Analysis of Derivatives and Stock Broking at Apollo Sindhoorigovernment created the NSE in collaboration with state-owned financial institutions.NSE improved the efficiency and transparency of the stock markets by offering afully automated screen-based trading system and real-time price dissemination. In1995, a prohibition on trading options was lifted. In 1996, the NSE sent a proposal toSEBI for listing exchange-traded derivatives. The report of the L. C. Gupta Committee, set up by SEBI, recommended aphased 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 variousoperational 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 bedeclared “securities.” This allowed the regulatory fMr.Xework for trading securitiesto be extended to derivatives. The Act considers derivatives to be legal and valid, butonly if they are traded on exchanges. Finally, a 30-year ban on forward trading was also lifted in 1999. Theeconomic liberalization of the early nineties facilitated the introduction of derivativesbased on interest rates and foreign exchange. A system of market-determinedexchange rates was adopted by India in March 1993. In August 1994, the rupee wasmade fully convertible on current account. These reforms allowed increasedintegration between domestic and international markets, and created a need to managecurrency risk.5. Derivatives Users in India The use of derivatives varies by type of institution. Financial institutions, suchas 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 arelikely to use derivatives on interest rates and currencies, and derivatives to managecredit risk. Non-financial institutions are regulated differently from financialinstitutions, and this affects their incentives to use derivatives. Indian insuranceregulators, for example, are yet to issue guidelines relating to the use of derivatives byinsurance companies. In India, financial institutions have not been heavy users of exchange-tradedderivatives so far, with their contribution to total value of NSE trades being less than BABASAB PATIL PROJECT REPORT ON FINANCE 13
  14. 14. Analysis of Derivatives and Stock Broking at Apollo Sindhoori8% in October 2005. However, market insiders feel that this may be changing, asindicated by the growing share of index derivatives (which are used more byinstitutions than by retail investors). In contrast to the exchange-traded markets,domestic financial institutions and mutual funds have shown great interest in OTCfixed income instruments. Transactions between banks dominate the market forinterest rate derivatives, while state-owned banks remain a small presence.Corporations are active in the currency forwards and swaps markets, buying theseinstruments from banks.Why do institutions not participate to a greater extent in derivativesmarkets? Some institutions such as banks and mutual funds are only allowed to usederivatives to hedge their existing positions in the spot market, or to rebalance theirexisting portfolios. Since banks have little exposure to equity markets due to bankingregulations, they have little incentive to trade equity derivatives. Foreign investorsmust register as foreign institutional investors (FII) to trade exchange-tradedderivatives, and be subject to position limits as specified by SEBI. Alternatively, theycan incorporate locally as under RBI directive, banks’ direct or indirect (throughmutual funds) exposure to capital markets instruments is limited to 5% of totaloutstanding advances as of the previous year-end. Some banks may have furtherequity 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 littleinvestments in the domestic bond markets. It is possible that unregistered foreigninvestors and hedge funds trade indirectly, using a local proprietary trader as a front. Retail investors (including small brokerages trading for themselves) are themajor participants in equity derivatives, accounting for about 60% of turnover inOctober 2005, according to NSE. The success of single stock futures in India isunique, as this instrument has generally failed in most other countries. One reason forthis success may be retail investors’ prior familiarity with “badla” trades which sharedsome features of derivatives trading. Another reason may be the small size of thefutures contracts, compared to similar contracts in other countries. Retail investorsalso dominate the markets for commodity derivatives, due in part to their long-standing expertise in trading in the “havala” or forwards markets. BABASAB PATIL PROJECT REPORT ON FINANCE 14
  15. 15. Analysis of Derivatives and Stock Broking at Apollo SindhooriWhy have derivatives? Derivatives have become very important in the field finance. They are veryimportant financial instruments for risk management as they allow risks to beseparated 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 toidentify all the risks involved before the contract is agreed. It is also important toremember that derivatives are derived from an underlying asset. This means that risksin 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 anunderlying 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 isbased on the stock price of a stock for e.g. Infosys, which frequently changes on adaily basis, then the derivative risks are also changing on a daily basis. This meansthat 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 theindex with their portfolio/stock and low cost associated with using index futures forhedging.Looking Ahead Clearly, the nascent derivatives market is heading in the right direction. Interms of the number of contracts in single stock derivatives, it is probably the largestmarket globally. It is no longer a market that can be ignored by any seriousparticipant. With institutional participation set to increase and a broader productrollout inevitable, the market can only widen and deepen further.How does F&O trading impact the market? BABASAB PATIL PROJECT REPORT ON FINANCE 15
  16. 16. Analysis of Derivatives and Stock Broking at Apollo Sindhoori The start of a new derivatives contract pushes up prices in the cash market asoperators take fresh positions in the new month series in the first week of every newcontract. This buying in the derivatives segment pushes up future prices. Higherfuture prices are seen as indicators of bullish prices in the days to come. Thus, higherprices due to new month buying in the derivatives market lead to buying in thephysical market. This lifts prices in the cash market as well. The huge surge in open positions has coincided with the market indexesreaching historic highs. This shows that the two segments are linked. BABASAB PATIL PROJECT REPORT ON FINANCE 16
  17. 17. Analysis of Derivatives and Stock Broking at Apollo Sindhoori FUTURES CONTRACT: A futures contract is similar to a forward contract in terms of its working. Thedifference is that contracts are standardized and trading is centralized. Futures marketsare highly liquid and there is no counterparty risk due to the presence of aclearinghouse, which becomes the counterparty to both sides of each transaction andguarantees the trade.What is an Index? To understand the use and functioning of the index derivatives markets, it isnecessary to understand the underlying index. A stock index represents the change invalue of a set of stocks, which constitute the index. A market index is very importantfor the market players as it acts as a barometer for market behavior and as anunderlying 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 CNXNifty. The BSE Sensex has 30 stocks comprising the index which are selected basedon market capitalization, industry representation, trading frequency etc. It represents30 large well-established and financially sound companies. The Sensex represents abroad spectrum of companies in a variety of industries. It represents 14 major industrygroups. Then there is a BSE national index and BSE 200. However, trading in indexfutures has only commenced on the BSE Sensex. While the BSE Sensex was the first stock market index in the country, Niftywas launched by the National Stock Exchange in April 1996 taking the base ofNovember 3, 1995. The Nifty index consists of shares of 50 companies with eachhaving a market capitalization of more than Rs 500 crore.Futures and stock indices BABASAB PATIL PROJECT REPORT ON FINANCE 17
  18. 18. Analysis of Derivatives and Stock Broking at Apollo Sindhoori For understanding of stock index futures a thorough knowledge of thecomposition of indexes is essential. Choosing the right index is important in choosingthe right contract for speculation or hedging. Since for speculation, the volatility ofthe index is important whereas for hedging the choice of index depends upon therelationship between the stocks being hedged and the characteristics of the index. Choosing and understanding the right index is important as the movement ofstock index futures is quite similar to that of the underlying stock index. Volatility ofthe futures indexes is generally greater than spot stock indexes. Everytime an investor takes a long or short position on a stock, he also has anhidden exposure to the Nifty or Sensex. As most often stock values fall in tune withthe entire market sentiment and rise when the market as a whole is rising. Retail investors will find the index derivatives useful due to the highcorrelation of the index with their portfolio/stock and low cost associated with usingindex futures for hedging6.1 Understanding index futures A futures contract is an agreement between two parties to buy or sell an assetat a certain time in the future at a certain price. Index futures are all futures contractswhere the underlying is the stock index (Nifty or Sensex) and helps a trader to take aview on the market as a whole. Index futures permits speculation and if a trader anticipates a major rally in themarket he can simply buy a futures contract and hope for a price rise on the futurescontract when the rally occurs. In India we have index futures contracts based on S&P CNX Nifty and theBSE Sensex and near 3 months duration contracts are available at all times. Eachcontract expires on the last Thursday of the expiry month and simultaneously anew contract is introduced for trading after expiry of a contract. BABASAB PATIL PROJECT REPORT ON FINANCE 18
  19. 19. Analysis of Derivatives and Stock Broking at Apollo SindhooriExample: Futures contracts in Nifty in July 2001 Contract month Expiry/settlement July 2001 July 26 August 2001 August 30 September 2001 September 27 On July 27 Contract month Expiry/settlement August 2001 August 30 September 2001 September 27 October 2001 October 25 The permitted lot size is 200 or multiples thereof for the Nifty. That is you buyone Nifty contract the total deal value will be 200*1100 (Nifty value)= Rs 2,20,000. In the case of BSE Sensex the market lot is 50. That is you buy one Sensexfutures the total value will be 50*4000 (Sensex value)= Rs 2,00,000.Hedging The other benefit of trading in index futures is to hedge your portfolioagainst the risk of trading. In order to understand how one can protect his portfoliofrom 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 toY 10 dresses for Rs 4000. The cost of manufacturing for X is only Rs 1000 and hewill make a profit of Rs 3000 if the sale is completed. BABASAB PATIL PROJECT REPORT ON FINANCE 19
  20. 20. Analysis of Derivatives and Stock Broking at Apollo Sindhoori Cost (Rs) Selling price Profit 1000 4000 3000 However, X fears that Y may not honour his contract six months from now. Sohe inserts a new clause in the contract that if Y fails to honour the contract he willhave to pay a penalty of Rs 1000. And if Y honours the contract X will offer adiscount of Rs 1000 as incentive. ‘Y’ defaults ‘Y’ honours 1000 (Initial Investment) 3000 (Initial profit) 1000 (penalty from Mr.Y) (-1000) discount given to Mr.Y - (No gain/loss) 2000 (Net gain) As we see above if Mr.Y defaults Mr.X will get a penalty of Rs 1000 but hewill recover his initial investment. If Mr.Y honours the contract, Mr.X will still makea profit of Rs 2000. Thus, Mr.X has hedged his risk against default and protected hisinitial investment. The example explains the concept of hedging. Let us try understanding howone can use hedging in a real life scenario. Stocks carry two types of risk – company specific and market risk. Whilecompany risk can be minimized by diversifying your portfolio, market risk cannotbe 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 themovement of the stock. The beta measures the percentage impact on the stock pricesfor 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 BABASAB PATIL PROJECT REPORT ON FINANCE 20
  21. 21. Analysis of Derivatives and Stock Broking at Apollo Sindhooriby 10%, the value of the portfolio increases 11%. The idea is to make beta of yourportfolio zero to nullify your losses. Hedging involves protecting an existing asset position from future adverseprice movements. In order to hedge a position, a market player needs to take an equaland opposite position in the futures market to the one held in the cash market. Everyportfolio has a hidden exposure to the index, which is denoted by the beta. Assumingyou have a portfolio of Rs 1 million, which has a beta of 1.2, you can factor acomplete hedge by selling Rs 1.2 mn of S&P CNX Nifty futuresSteps: 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 millionworth 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 ofa fall in market sentiment. But as a cost, one has to forego any gains that arise out ofimprovement in the overall sentiment. Then why does one invest in equities if allthe gains will be offset by losses in futures market. The idea is that everyone BABASAB PATIL PROJECT REPORT ON FINANCE 21
  22. 22. Analysis of Derivatives and Stock Broking at Apollo Sindhooriexpects his portfolio to outperform the market. Irrespective of whether the marketgoes up or not, his portfolio value would increase. The same methodology can be applied to a single stock by deriving the beta ofthe scrip and taking a reverse position in the futures market. Thus, we understand how one can use hedging in the futures market to offsetlosses in the cash market.6.3 Speculation Speculators are those who do not have any position on which they enter infutures 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 profitingfrom an anticipated price change. They consider various factors such as demandsupply, market positions, open interests, economic fundamentals and other data totake their positions.Illustration: Mr.X is a trader but has no time to track and analyze stocks. However, hefancies his chances in predicting the market trend. So instead of buying differentstocks he buys Sensex Futures. On May 1, 2001, he buys 100 Sensex futures @ 3600 on expectations that theindex will rise in future. On June 1, 2001, the Sensex rises to 4000 and at that time hesells an equal number of contracts to close out his position.Selling Price : 4000*100 = Rs.4,00,000Less: Purchase Cost: 3600*100 = Rs.3,60,000Net gain Rs.40,000 Mr.X has made a profit of Rs.40,000 by taking a call on the future value of theSensex. However, if the Sensex had fallen he would have made a loss. Similarly, if it BABASAB PATIL PROJECT REPORT ON FINANCE 22
  23. 23. Analysis of Derivatives and Stock Broking at Apollo Sindhooriwould have been bearish he could have sold Sensex futures and made a profit from afalling profit. In index futures players can have a long-term view of the market up toatleast 3 months.6.4 Arbitrage An arbitrageur is basically risk averse. He enters into those contracts were hecan earn riskless profits. When markets are imperfect, buying in one market andsimultaneously selling in other market gives riskless profit. Arbitrageurs are always inthe look out for such imperfections. In the futures market one can take advantages of arbitrage opportunities by buyingfrom lower priced market and selling at the higher priced market. In index futuresarbitrage is possible between the spot market and the futures market (NSE hasprovided 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 isquoted at Rs.1000 per share and the 3 months futures of Wipro is Rs.1070 then onecan purchase Wipro at Rs.1000 in spot by borrowing @ 12% annum for 3 months andsell Wipro futures for 3 months at Rs 1070.Sale = 1070Cost= 1000+30 = 1030Arbitrage profit = 40 BABASAB PATIL PROJECT REPORT ON FINANCE 23
  24. 24. Analysis of Derivatives and Stock Broking at Apollo SindhooriThese kind of imperfections continue to exist in the markets but one has to be alert tothe opportunities as they tend to get exhausted very fast.6.5 Pricing of Index Futures The index futures are the most popular futures contracts as they can be used ina variety of ways by various participants in the market. How many times have you felt of making risk-less profits by arbitragingbetween the underlying and futures markets. If so, you need to know the cost-of-carrymodel to understand the dynamics of pricing that constitute the estimation of fairvalue of futures.1. The cost of carry modelThe cost-of-carry model where the price of the contract is defined as:F=S+Cwhere:F Futures priceS Spot priceC Holding costs or carry costs If F < S+C or F > S+C, arbitrage opportunities would exist i.e. whenever thefutures 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 isRs.1070 then one can purchase Wipro at Rs.1000 in spot by borrowing @ 12% annumfor 3 months and sell Wipro futures for 3 months at Rs 1070. BABASAB PATIL PROJECT REPORT ON FINANCE 24
  25. 25. Analysis of Derivatives and Stock Broking at Apollo Sindhoori Here F=1000+30=1030 and is less than prevailing futures price and hencethere are chances of arbitrage.Sale = 1070Cost= 1000+30 = 1030Arbitrage profit 40However, one has to remember that the components of holding cost vary withcontracts 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 thefutures index value. However, the cost of finance has to be adjusted for benefits ofdividends and interest income. In the case of equity futures, the holding cost is thecost of financing minus the dividend returns.Example: Suppose a stock portfolio has a value of Rs.100 and has an annual dividendyield of 3% which is earned throughout the year and finance rate=10% the fair valueof 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 canbuy the stock at Rs.100, borrowing the fund at the rate of 10% and simultaneously sellfutures at Rs.109. At the end of the year, the arbitrageur would collect Rs.3 fordividends, deliver the stock portfolio at Rs.109 and repay the loan of Rs.100 andinterest 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. BABASAB PATIL PROJECT REPORT ON FINANCE 25
  26. 26. Analysis of Derivatives and Stock Broking at Apollo SindhooriTrading strategies1. Speculation We have seen earlier that trading in index futures helps in taking a view of themarket, hedging, speculation and arbitrage. Now we will see how one can trade inindex futures and use forward contracts in each of these instances.Taking a view of the marketHave you ever felt that the market would go down on a particular day and feared thatyour portfolio value would erode?There are two options availableOption 1: Sell liquid stocks such as RelianceOption 2: Sell the entire index portfolio The problem in both the above cases is that it would be very cumbersome andcostly to sell all the stocks in the index. And in the process one could be vulnerable tocompany specific risk. So what is the option? The best thing to do is to sell indexfutures.Illustration:Scenario 1:On July 13, 2001, ‘X’ feels that the market will rise so he buys 200 Nifties with anexpiry 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. BABASAB PATIL PROJECT REPORT ON FINANCE 26
  27. 27. Analysis of Derivatives and Stock Broking at Apollo Sindhoori‘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 anexpiry date of July 26 at an index price of 1523 costing Rs 3,04,600 (200*1523).On July 21 the Nifty futures falls to 1456 so he squares off his position at 1456.‘X’ makes a profit of Rs 13,400 (200*67).In the above cases ‘X’ has profited from speculation i.e. he has wagered in the hope ofprofiting from an anticipated price change.2. Hedging Stock index futures contracts offer investors, portfolio managers, mutual fundsetc several ways to control risk. The total risk is measured by the variance or standarddeviation of its return distribution. A common measure of a stock market risk is thestock’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 futurescontracts to be entered to reduce the risk to the minimum. Have you ever felt that a stock was intrinsically undervalued? That the profitsand the quality of the company made it worth a lot more as compared with what themarket thinks? Have you ever been a ‘stockpicker’ and carefully purchased a stock based on asense that it was worth more than the market price? A person who feels like this takes a long position on the cash market. Whendoing this, he faces two kinds of risks: BABASAB PATIL PROJECT REPORT ON FINANCE 27
  28. 28. Analysis of Derivatives and Stock Broking at Apollo Sindhooria. His understanding can be wrong, and the company is really not worth more than themarket price orb. The entire market moves against him and generates losses even though theunderlying idea was correct. Everyone has to remember that every buy position on a stock issimultaneously a buy position on Nifty. A long position is not a focused play on thevaluation of a stock. It carries a long Nifty position along with it, as incidentalbaggage i.e. a part long position of Nifty.Let us see how one can hedge positions using index futures:‘X’ holds HLL worth Rs 9 lakh at Rs 290 per share on Jan1 2008asuming that thebeta of HLL is 1.13. How much Nifty futures does ‘X’ have to sell if the index futuresis ruling at 1527?To hedge he needs to sell 9 lakh * 1.13 = Rs 1017000 lakh on the index futures i.e.666 Nifty futures.On Jan , 2008 the Nifty futures is at 1437 and HLL is at 275. ‘X’ closes both positionsearning Rs 13,389, i.e. his position on HLL drops by Rs 46,551 and his short positionon 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. Theportfolio is to be hedged by using Nifty futures contracts. To find out the number ofcontracts 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 BABASAB PATIL PROJECT REPORT ON FINANCE 28
  29. 29. Analysis of Derivatives and Stock Broking at Apollo SindhooriIf you sell more than 496 contracts you are overhedged and sell less than 496contracts you are underhedged.Thus, we have seen how one can hedge their portfolio against market risk.3. Margins The margining system is based on the JR Verma Committeerecommendations. The actual margining happens on a daily basis while onlineposition monitoring is done on an intra-day basis.Daily margining is of two types:1. Initial margins2. Mark-to-market profit/loss The computation of initial margin on the futures market is done using theconcept of Value-at-Risk (VaR). The initial margin amount is large enough to covera one-day loss that can be encountered on 99% of the days. VaR methodology seeksto measure the amount of value that a portfolio may stand to lose within a certainhorizon time period (one day for the clearing corporation) due to potential changes inthe underlying asset market price. Initial margin amount computed using VaR iscollected up-front. The daily settlement process called "mark-to-market" providesfor collection of losses that have already occurred (historic losses) whereas initialmargin 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 todemonstrate 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) BABASAB PATIL PROJECT REPORT ON FINANCE 29
  30. 30. Analysis of Derivatives and Stock Broking at Apollo SindhooriInitial margin (15%) = Rs 45,000Assuming that the contract will close on Day + 3 the mark-to-market position willlook as follows:Position on Day 1 Close Price Loss Margin released Net cash outflow1400*200 =2,80,000 20,000 (3,00,000- 3,000 (45,000- 17,000 (20,000- 2,80,000) 42,000) 3000)Payment to be made (17,000)New position on Day 2Value of new position = 1,400*200= 2,80,000Margin = 42,000 Close Price Gain Addn Margin Net cash inflow1510*200 =3,02,000 22,000 (3,02,000- 3,300 (45,300- 18,700 (22,000- 2,80,000) 42,000) 3300)Payment to be recd 18,700Position on Day 3Value of new position = 1510*200 = Rs 3,02,000Margin = Rs 3,300 Close Price Gain Net cash inflow 1600*200 =3,20,000 18,000 (3,20,000- 18,000 + 45,300* = 63,300 3,02,000) Payment to be recd 63,300Margin account*Initial margin = Rs 45,000Margin released (Day 1) = (-) Rs 3,000Position on Day 2 Rs 42,000 BABASAB PATIL PROJECT REPORT ON FINANCE 30
  31. 31. Analysis of Derivatives and Stock Broking at Apollo SindhooriAddn margin = (+) Rs 3,300Total margin in a/c Rs 45,300*Net gain/lossDay 1 (loss) = (Rs 17,000)Day 2 Gain = Rs 18,700Day 3 Gain = Rs 18,000Total Gain = Rs 19,700The client has made a profit of Rs 19,700 at the end of Day 3 and the total cash inflowat the close of trade is Rs 63,300.Settlement of futures contracts: Futures contracts have two types of settlements, the MTM settlement whichhappens on a continuous basis at the end of each day, and the final settlement whichhappens 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 dailysettlement price of the relevant futures contract at the end of each day. Theprofits/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. BABASAB PATIL PROJECT REPORT ON FINANCE 31
  32. 32. Analysis of Derivatives and Stock Broking at Apollo Sindhoori The CMs who have a loss are required to pay the mark-to-market (MTM) lossamount in cash which is in turn passed on to the CMs who have made a MTM profit.This is known as daily mark-to-market settlement. CMs are responsible to collect andsettle the daily MTM profits/losses incurred by the TMs and their clients clearing andsettling through them. Similarly, TMs are responsible to collect/pay losses/ profitsfrom/to their clients by the next day. The pay-in and pay-out of the mark-to-marketsettlement are effected on the day following the trade day. In case a futures contract isnot traded on a day, or not traded during the last half hour, a ‘theoretical settlementprice’ 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 resultingprofit/loss is settled in cash. Final settlement loss/profit amount is debited/ credited tothe relevant CM’s clearing bank account on the day following expiry day of thecontract. All trades in the futures market are cash settled on a T+1 basis and allpositions (buy/sell) which are not closed out will be marked-to-market. The closingprice of the index futures will be the daily settlement price and the position will becarried to the next day at the settlement price. The most common way of liquidating an open position is to execute anoffsetting futures transaction by which the initial transaction is squared up. The initialbuyer liquidates his long position by selling identical futures contract. In index futures the other way of settlement is cash settled at the finalsettlement. At the end of the contract period the difference between the contract valueand closing index value is paid.How to read the futures data sheet? Understanding and deciphering the prices of futures trade is the first challengefor anyone planning to venture in futures trading. Economic dailies and exchangewebsites www.nseindia.com and www.bseindia.com are some of the sources where BABASAB PATIL PROJECT REPORT ON FINANCE 32
  33. 33. Analysis of Derivatives and Stock Broking at Apollo Sindhoori 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 No of Trade Volume (No of Value trades Open interest contracts) (Rs (No of in lakh) contracts)BSXJUN2000 4755 4820 4740 4783.1 146 348.70 104 51BSXJUL2000 4900 4900 4800 4830.8 12 28.98 10 2BSXAUG2000 4800 4870 4800 4835 2 4.84 2 1 Total 160 38252 116 54 Source: BSE • The first column explains the series that is being traded. For e.g. BSXJUN2000 stands for the June Sensex futures contract. • The column on volume indicates that (in case of June series) 146 contracts have been traded in 104 trades. • One contract is equivalent to 50 times the price of the futures, which are traded. For e.g. In case of the June series above, the first trade at 4755 represents one contract valued at 4755 x 50 i.e. Rs.2,37,750/-. Open interest indicates the total gross outstanding open positions in the market for that particular series. For e.g. Open interest in the June series is 51 contracts. The most useful measure of market activity is Open interest, which is also published by exchanges and used for technical analysis. Open interest indicates the liquidity of a BABASAB PATIL PROJECT REPORT ON FINANCE 33
  34. 34. Analysis of Derivatives and Stock Broking at Apollo Sindhoorimarket and is the total number of contracts, which are still outstanding in afutures market for a specified futures contract. A futures contract is formed when a buyer and a seller take opposite positions in atransaction. This means that the buyer goes long and the seller goes short. Openinterest is calculated by looking at either the total number of outstanding long or shortpositions – not both Open interest is therefore a measure of contracts that have notbeen matched and closed out. The number of open long contracts must equal exactlythe 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. The No 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 buying contracts being held from new seller. Open interest is also used in conjunction with other technical analysis chartpatterns and indicators to gauge market signals. The following chart may help withthese signals. Price Open interest Market Strong Warning signal Weak Warning signalThe warning sign indicates that the Open interest is not supporting the pricedirection. OPTIONS BABASAB PATIL PROJECT REPORT ON FINANCE 34
  35. 35. Analysis of Derivatives and Stock Broking at Apollo SindhooriWhat is an Option? An option is a contract giving the buyer the right, but not the obligation, tobuy or sell an underlying asset (a stock or index) at a specific price on or before acertain 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 bindingcontract with strictly defined terms and properties.Listed options have been available since 1973, when the Chicago Board OptionsExchange, 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 toinvest their money; they could either be long or short individual stocks, or they couldpurchase treasury securities or other bonds. Once the CBOE opened, the listed option industry began, andinvestors now had a world of investment choices previously unavailable.Options vs. Stocks In order to better understand the benefits of trading options, one must firstunderstand some of the similarities and differences between options and stocks.Similarities: Listed Options are securities, just like stocks. Options trade like stocks, with buyers making bids and sellers making offers. Options are actively traded in a listed market, just like stocks. They can be bought and sold just like any other security.Differences: Options are derivatives, unlike stocks (i.e, options derive their value from something else, the underlying security). Options have expiration dates, while stocks do not. There is not a fixed number of options, as there are with stock sharesavailable. BABASAB PATIL PROJECT REPORT ON FINANCE 35
  36. 36. Analysis of Derivatives and Stock Broking at Apollo Sindhoori 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 manydifferent series. An option Premium is the price of the option. It is the price you pay topurchase the option. For example, an XYZ May 30 Call (thus it is an option to buyCompany XYZ stock) may have an option premium of $2. This means that thisoption 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 bemultiplied times 100. More in-depth pricing concepts will be covered in detail in othersections 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. Forexample, with the XYZ May 30 Call, the strike price of 30 means the stock can bebought for $30 per share. Were this the XYZ May 30 Put, it would allow the holderthe 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 underlyingsecurity. 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 Callseller). For a Put Exercise, Put holders may sell stock at the strike price (to the Putseller). Neither Call holders nor Put holders are obligated to buy or sell; they simplyhave the rights to do so, and may choose to Exercise or not to Exercise based upontheir own logic. BABASAB PATIL PROJECT REPORT ON FINANCE 36
  37. 37. Analysis of Derivatives and Stock Broking at Apollo SindhooriAssignment of Options When an option holder chooses to exercise an option, a process begins to finda writer who is short the same kind of option (i.e., class, strike price and option type).Once found, that writer may be Assigned. This means that when buyers exercise,sellers may be chosen to make good on their obligations. For a Call Assignment,Call writers are required to sell stock at the strike price to the Call holder. For a PutAssignment, Put writers are required to buy stock at the strike price from the Putholder.Long Term Investing Given the numerous opportunities that options convey, it is also important toknow that there are options available which can be used to implement longer-termstrategies (not one, two or three months, but those with holding times of one, two ormore years). These are called LEAPS (for Long Term Equity Anticipation Securities), andare yet another alternative that options offer to investors. LEAPS are options withexpiration dates of up to three years from the date they are first listed, and areavailable on a number of individual stocks and indexes. LEAPS have different ticker symbols than short-term options (options withless than nine months until expiration) and, while not available on all stocks, areavailable on most widely held issues and can be traded just like any other options.7.2 The Chicago Board Options Exchange The Chicago Board Options Exchange, or CBOE, was the worlds first listedoptions 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 AmericanStock Exchange (AMEX), the Philadelphia Stock Exchange (PHLX), the PacificStock Exchange (PSE) and the International Securities Exchange (ISE).CBOE: The Competitive Advantage BABASAB PATIL PROJECT REPORT ON FINANCE 37
  38. 38. Analysis of Derivatives and Stock Broking at Apollo Sindhoori With over 1500 competing market makers trading more than one millionoptions contracts per day, the CBOE is the largest and busiest options exchange in theworld. The members of the Exchange have maintained this stature for over 25 yearsby constantly providing deep and liquid markets in all options series for all CBOEcustomers.CBOE Facts The CBOE system works to give you the options you need for yourinvestment strategy, quickly and easily and at the most efficient price. The CBOEoffers investors the best options markets, the most efficient support network, and themost intensive insight and most recognized educational division in the industry, theOptions Institute.CBOE is the market leader in the options industry, with: • Options on more than 1,332 stocks and 41 indices. More than 50,000 series listed • Over $25 billion in contract value traded on a typical day • Over 1 million options contracts changing hands daily • The second largest listed securities market in the U.S., following only the NYSE • Professional instructors teaching options trading to over 10,000 people a year • The premier portal for options information on the Web,7.3 Regulation and Surveillance: Regulation and surveillance are necessary in the options industry in order toprotect customers and firms, and respond to customer complaints. CBOE has one of the most technologically advanced and computer-automatedmeasures for regulation and surveillance, which are unparalleled in the optionsindustry. CBOE has the premier Regulatory Division, with staff who constantlymonitor trading activity throughout the industry. BABASAB PATIL PROJECT REPORT ON FINANCE 38
  39. 39. Analysis of Derivatives and Stock Broking at Apollo Sindhoori The Securities and Exchange Commission (SEC) oversees the entire optionsindustry to ensure that the markets serve the public interest.Options Clearing Corporation: The formation of the OCC in 1973 as the single, independent, universalclearing agency for all listed options eliminated the problem of credit risk in optionstrading. Every options Exchange and every brokerage firm who offers its customersthe 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 allcontracts that are sold, and the seller for all contracts that are bought. Thus, the OCCis, in fact, the issuer of all listed options contracts, and is registered as such with theSEC.7.5 Options Market Participants Contrary to some beliefs, the single greatest population of CBOE users are nothuge financial institutions, but public investors, just like you. Over 65% of theExchanges business comes from them. However, other participants in the financialmarketplace also use options to enhance their performance, including: • Mutual Funds • Pension Plans • Hedge Funds • Endowments • Corporate Treasurers Stock markets by their very nature are fickle. While fortunes can be made in ajiffy more often than not the scenario is the reverse. Investing in stocks has two sidesto it –a) Unlimited profit potential from any upside (remember Infosys, HFCL etc) orb) a downside which could make you a pauper. Derivative products are structured precisely for this reason -- to curtail the riskexposure of an investor. Index futures and stock options are instruments that enableyou to hedge your portfolio or open positions in the market. Option contracts allowyou to run your profits while restricting your downside risk. BABASAB PATIL PROJECT REPORT ON FINANCE 39
  40. 40. Analysis of Derivatives and Stock Broking at Apollo Sindhoori Apart from risk containment, options can be used for speculation and investorscan create a wide range of potential profit scenarios. ‘Option’, as the word suggests, is a choice given to the investor to either honourthe contract; or if he chooses not to walk away from the contract.To begin, there are two kinds of options: Call Options and Put Options.Call options Call options give the taker the right, but not the obligation, to buy theunderlying shares at a predetermined price, on or before a predetermined date.Illustration 1:Raj purchases 1 Satyam Computer (SATCOM) AUG 150 Call --Premium 8 This contract allows Raj to buy 100 shares of SATCOM at Rs 150 per share atany time between the current date and the end of next August. For this privilege, Rajpays a fee of Rs 800 (Rs eight a share for 100 shares). The buyer of a call haspurchased 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. Thatis he has purchased the right to buy that share for Rs 40 in December. If the stockrises 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 theoption 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 theconcept better.Nifty is at 1310. The following are Nifty options traded at following quotes. Option contract Strike price Call premium BABASAB PATIL PROJECT REPORT ON FINANCE 40
  41. 41. Analysis of Derivatives and Stock Broking at Apollo Sindhoori Dec Nifty 1325 Rs.6,000 1345 Rs.2,000 Jan Nifty 1325 Rs.4,500 1345 Rs.5000 A trader is of the view that the index will go up to 1400 in Jan 2008 but doesnot want to take the risk of prices going down. Therefore, he buys 10 options of Jancontracts at 1345. He pays a premium for buying calls (the right to buy the contract)for 500*10= Rs.5,000/-. In Jan 2008 the Nifty index goes up to 1365. He sells the options or exercisesthe 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 bybuying call option is Rs.35,000/- (40,000-5000). If the index falls below 1345 the trader will not exercise his right and will optto forego his premium of Rs.5,000. So, in the event the index falls further his loss islimited 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 byselling calls. You are bearish.Put Options : A Put Option gives the holder of the right to sell a specific number of sharesof an agreed security at a fixed price for a period of time. eg: Sam purchases 1INFTEC (Infosys Technologies) AUG 3500 Put --Premium 200. This contract allowsSam to sell 100 shares INFTEC at Rs 3500 per share at any time between the currentdate and the end of August. To have this privilege, Sam pays a premium of Rs 20,000(Rs 200 a share for 100 shares). BABASAB PATIL PROJECT REPORT ON FINANCE 41
  42. 42. Analysis of Derivatives and Stock Broking at Apollo Sindhoori The buyer of a put has purchased a right to sell. The owner of a put option hasthe 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 putoption at Rs 70 on ‘X’. By purchasing the put option Raj has the right to sell the stockat 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 willstart 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 infuture but does not want to take the risk in the event the prices rise. So he purchases aPut option on Wipro.Quotes are as under:Spot Rs.1040Jan Put at 1050 Rs.10Jan Put at 1070 Rs.30He purchases 1000 Wipro Put at strike price 1070 at Put price of Rs.30/-. He pays Rs.30,000/- as Put premium.His position in following price position is discussed below. 1. Jan Spot price of Wipro = 1020 2. Jan Spot price of Wipro = 1080 In the first situation the investor is having the right to sell 1000 Wipro sharesat 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. BABASAB PATIL PROJECT REPORT ON FINANCE 42
  43. 43. Analysis of Derivatives and Stock Broking at Apollo Sindhoori In the second price situation, the price is more in the spot market, so theinvestor will not sell at a lower price by exercising the Put. He will have to allow thePut 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 byselling 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 ShortSUMMARY: CALL OPTION BUYER CALL OPTION WRITER (Seller) • 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 BABASAB PATIL PROJECT REPORT ON FINANCE 43
  44. 44. Analysis of Derivatives and Stock Broking at Apollo Sindhoori 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 gainOption styles Settlement of options is based on the expiry date. However, there are threebasic styles of options you will encounter which affect settlement. The styles havegeographical names, which have nothing to do with the location where a contract isagreed! The styles are:European: These options give the holder the right, but not the obligation, to buy orsell the underlying instrument only on the expiry date. This means that the optioncannot be exercised early. Settlement is based on a particular strike price atexpiration. Currently, in India only index options are European in nature. eg: Sam purchases 1 NIFTY AUG 1110 Call --Premium 20. The exchangewill settle the contract on the last Thursday of August. Since there are no shares forthe underlying, the contract is cash settled.American: These options give the holder the right, but not the obligation, to buy orsell the underlying instrument on or before the expiry date. This means that theoption can be exercised early. Settlement is based on a particular strike price atexpiration. BABASAB PATIL PROJECT REPORT ON FINANCE 44
  45. 45. Analysis of Derivatives and Stock Broking at Apollo Sindhoori 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 theexpiration date, which is the last Thursday of September. American style options tend to be more expensive than European stylebecause they offer greater flexibility to the buyer.Option Class and Series Generally, for each underlying, there are a number of options available: Forthis reason, we have the terms "class" and "series". An option "class" refers to all options of the same type (call or put) and style(American or European) that also have the same underlying.eg: All Nifty call options are referred to as one class. An option series refers to all options that are identical: they are the same type,have the same underlying, the same expiration date and the same exercise price. Calls Puts . Jan Feb Mar Jan Feb Mar Wipro 1300 45 60 75 15 20 28 1400 35 45 65 25 28 35 1500 20 42 48 30 40 55eg: Wipro JUL 1300 refers to one series and trades take place at differentpremiums All calls are of the same option type. Similarly, all puts are of the same optiontype. Options of the same type that are also in the same class are said to be of thesame class. Options of the same class and with the same exercise price and the sameexpiration date are said to be of the same series BABASAB PATIL PROJECT REPORT ON FINANCE 45
  46. 46. Analysis of Derivatives and Stock Broking at Apollo SindhooriPricing of options Options are used as risk management tools and the valuation or pricing of theinstruments 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 UnderlyingAnd two less important factors: • Short-Term Interest Rates • Dividends7.11 Review of Options Pricing Factors1. The Intrinsic Value of an Option The intrinsic value of an option is defined as the amount by which an option isin-the-money, or the immediate exercise value of the option when the underlyingposition is marked-to-market.For a call option: Intrinsic Value = Spot Price - Strike PriceFor 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 forthe call to have an intrinsic value greater than 0. For a put option, the strike price mustbe greater than the underlying asset price for it to have intrinsic value.Price of underlying BABASAB PATIL PROJECT REPORT ON FINANCE 46
  47. 47. Analysis of Derivatives and Stock Broking at Apollo Sindhoori 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 theunderlying price rises so does its premium. As the underlying price falls so does thecost of the option premium. For Put options – the right to sell the underlying at a fixedstrike price – as the underlying price rises, the premium falls; as the underlying pricefalls the premium cost rises.The following chart summarizes the above for Calls and Puts. Option Underlying price Premium cost Call Put2. The Time Value of an Option Generally, the longer the time remaining until an option’s expiration, thehigher its premium will be. This is because the longer an option’s lifetime, greater isthe possibility that the underlying share price might move so as to make the option in-the-money. All other factors affecting an option’s price remaining the same, the timevalue portion of an option’s premium will decrease (or decay) with the passage oftime.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 Put3. Volatility BABASAB PATIL PROJECT REPORT ON FINANCE 47
  48. 48. Analysis of Derivatives and Stock Broking at Apollo Sindhoori Volatility is the tendency of the underlying security’s market price to fluctuateeither up or down. It reflects a price change’s magnitude; it does not imply a biastoward price movement in one direction or the other. Thus, it is a major factor indetermining 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 movein-the-money. Generally, as the volatility of an under-lying stock increases, thepremiums of both calls and puts overlying that stock increase, and vice versa.Higher volatility=Higher premiumLower volatility = Lower premium4. Interest rates In general interest rates have the least influence on options and equateapproximately to the cost of carry of a futures contract. If the size of the optionscontract is very large, then this factor may take on some importance. All other factorsbeing equal as interest rates rise, premium costs fall and vice versa. The relationshipcan be thought of as an opportunity cost. In order to buy an option, the buyer musteither borrow funds or use funds on deposit. Either way the buyer incurs an interestrate cost. If interest rates are rising, then the opportunity cost of buying optionsincreases and to compensate the buyer premium costs fall. Why should the buyer becompensated? Because the option writer receiving the premium can place the fundson deposit and receive more interest than was previously anticipated. The situation isreversed when interest rates fall – premiums rise. This time it is the writer who needsto be compensated. STRATEGIESBull Market Strategiesa. Calls in a Bullish Strategy An investor with a bullish market outlook should buy call options. If youexpect the market price of the underlying asset to rise, then you would rather have the BABASAB PATIL PROJECT REPORT ON FINANCE 48
  49. 49. Analysis of Derivatives and Stock Broking at Apollo Sindhooriright to purchase at a specified price and sell later at a higher price than have theobligation to deliver later at a higher price. The investors profit potential of buying a call option is unlimited. Theinvestors profit is the market price less the exercise price less the premium. Thegreater the increase in price of the underlying, the greater the investors profit. The investors potential loss is limited. Even if the market takes a drasticdecline in price levels, the holder of a call is under no obligation to exercise theoption. He may let the option expire worthless. The investor breaks even when the market price equals the exercise priceplus the premium. An increase in volatility will increase the value of your call and increase yourreturn. 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 along 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 optionpremium is Rs.100. The option will be exercised only if the value of the underlying isgreater than Rs.2000 (the strike price). If the buyer exercises the call at Rs.2200 thenhis gain will be Rs.200. However, this would not be his actual gain for that he willhave to deduct the Rs.200 (premium) he has paid.The profit can be derived as followsProfit = Market price - Exercise price - PremiumProfit = Market price – Strike price – Premium. 2200 – 2000 – 100 = Rs.100b. Puts in a Bullish Strategy BABASAB PATIL PROJECT REPORT ON FINANCE 49
  50. 50. Analysis of Derivatives and Stock Broking at Apollo Sindhoori 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 marketprice increases and puts become out-of-the-money, investors with long put positionswill let their options expire worthless. By writing Puts, profit potential is limited. A Put writer profits when the priceof the underlying asset increases and the option expires worthless. The maximumprofit is limited to the premium received. However, the potential loss is unlimited. Because a short put position holderhas an obligation to purchase if exercised. He will be exposed to potentially largelosses 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, theinvestor 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 yourreturn. As an option writer, the higher price you will be forced to pay in order to buyback 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 calloptions but with different exercise prices. To "buy a call spread" is to purchase a call with a lower exercise price and towrite a call with a higher exercise price. The trader pays a net premium for theposition. To "sell a call spread" is the opposite, here the trader buys a call with a higherexercise price and writes a call with a lower exercise price, receiving a net premiumfor the position. BABASAB PATIL PROJECT REPORT ON FINANCE 50
  51. 51. Analysis of Derivatives and Stock Broking at Apollo Sindhoori An investor with a bullish market outlook should buy a call spread. The "BullCall Spread" allows the investor to participate to a limited extent in a bull market,while at the same time limiting risk exposure. To put on a bull spread, the trader needs to buy the lower strike call and sellthe higher strike call. The combination of these two options will result in a boughtspread. The cost of Putting on this position will be the difference between thepremium paid for the low strike call and the premium received for the high strike call. The investors profit potential is limited. When both calls are in-the-money,both will be exercised and the maximum profit will be realised. The investor deliverson his short call and receives a higher price than he is paid for receiving delivery onhis long call. The investorss potential loss is limited. At the most, the investor can lose isthe net premium. He pays a higher premium for the lower exercise price call than hereceives for writing the higher exercise price call. The investor breaks even when the market price equals the lower exerciseprice 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 priceplus the net premium.An example of a Bullish call spread: Lets assume that the cash price of a scrip is Rs.100 and you buy a Novembercall option with a strike price of Rs.90 and pay a premium of Rs.14. At the same timeyou sell another November call option on a scrip with a strike price of Rs.110 andreceive a premium of Rs.4. Here you are buying a lower strike price option andselling a higher strike price option. This would result in a net outflow of Rs.10 at thetime of establishing the spread. Now let us look at the fundamental reason for this position. Since this is abullish strategy, the first position established in the spread is the long lower strikeprice call option with unlimited profit potential. At the same time to reduce the cost of BABASAB PATIL PROJECT REPORT ON FINANCE 51
  52. 52. Analysis of Derivatives and Stock Broking at Apollo Sindhooripuchase 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 aswell as risk is limited. Based on the above figures the maximum profit, maximum lossand breakeven point of this spread would be as follows:Maximum profit = Higher strike price - Lower strike price - Net premium paid = 110 - 90 - 10 = 10Maximum Loss = Lower strike premium - Higher strike premium = 14 - 4 = 10Breakeven Price = Lower strike price + Net premium paid = 90 + 10 = 100Bullish Put Spread Strategies A vertical Put spread is the simultaneous purchase and sale of identical Putoptions but with different exercise prices. To "buy a put spread" is to purchase a Put with a higher exercise price and towrite a Put with a lower exercise price. The trader pays a net premium for theposition. To "sell a put spread" is the opposite: the trader buys a Put with a lowerexercise price and writes a put with a higher exercise price, receiving a net premiumfor 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 bullmarket, while at the same time limiting risk exposure. To put on a bull spread, a trader sells the higher strike put and buys the lowerstrikeput. The bull spread can be created by buying the lower strike and selling the BABASAB PATIL PROJECT REPORT ON FINANCE 52
  53. 53. Analysis of Derivatives and Stock Broking at Apollo Sindhoorihigher strike of either calls or put. The difference between the premiums paid andreceived makes up one leg of the spread. The investors profit potential is limited. When the market price reaches orexceeds the higher exercise price, both options will be out-of-the-money and willexpire worthless. The trader will realize his maximum profit, the net premium The investors potential loss is also limited. If the market falls, the options willbe in-the-money. The puts will offset one another, but at different exercise prices. The investor breaks-even when the market price equals the lower exerciseprice less the net premium. The investor achieves maximum profit i.e the premiumreceived, when the market price moves up beyond the higher exercise price (both putsare then worthless).An example of a bullish put spread. Lets us assume that the cash price of the scrip is Rs.100. You now buy aNovember put option on a scrip with a strike price of Rs.90 at a premium of Rs.5 andsell a put option with a strike price of Rs.110 at a premium of Rs.15. The first position is a short put at a higher strike price. This has resulted insome inflow in terms of premium. But here the trader is worried about risk and socaps his risk by buying another put option at the lower strike price. As such, a part ofthe premium received goes off and the ultimate position has limited risk and limitedprofit potential. Based on the above figures the maximum profit, maximum loss andbreakeven point of this spread would be as follows:Maximum profit = Net option premium income or net credit = 15 - 5 = 10Maximum loss = Higher strike price - Lower strike price - Net premium received = 110 - 90 - 10 = 10 BABASAB PATIL PROJECT REPORT ON FINANCE 53

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