SMC INVESMENT SOLUTIONS & SERVICES                         Table of ContentsSl.no                    Particulars          ...
SMC INVESMENT SOLUTIONS & SERVICES      6.11 Options Pricing Factors                 54      6.12 Strategies              ...
SMC INVESMENT SOLUTIONS & SERVICESTopic: -“ Comprehensive Study of Derivative Products and Investors’ Perception ofDerivat...
SMC INVESMENT SOLUTIONS & SERVICESMethodology explains the methods used in collecting         information to carry out the...
SMC INVESMENT SOLUTIONS & SERVICES  2. Futures accounts are credited or debited daily depending on profits or losses     i...
SMC INVESMENT SOLUTIONS & SERVICES  15. Out of 26 derivative investors, 17 of them [i.e., 65%] consider the volatility fac...
SMC INVESMENT SOLUTIONS & SERVICES   3. The company can think of tapping the existing demat account holders and provide   ...
SMC INVESMENT SOLUTIONS & SERVICESbillion in this fiscal, and a more than 35 per cent surge in exports, it is easy to unde...
SMC INVESMENT SOLUTIONS & SERVICESits corporate office in New Delhi with regional offices in Mumbai, Kolkata, Chennai,Ahem...
SMC INVESMENT SOLUTIONS & SERVICESCommodity TradingSMC is a member of two major national level commodity exchanges, i.e Na...
SMC INVESMENT SOLUTIONS & SERVICESWe are ISO 9001:2000 certified DP for shares and commodities. We are one of theleading D...
SMC INVESMENT SOLUTIONS & SERVICESJune 9, 2000 at 9:55:03 a.m. between M/s Kaji and Maulik Securities Pvt. Ltd. and M/sEmk...
SMC INVESMENT SOLUTIONS & SERVICESdeveloped countries like India began opening up their economies and allowing prices tova...
SMC INVESMENT SOLUTIONS & SERVICES       Speculators face the risk of losing money from their derivatives trades, as they ...
SMC INVESMENT SOLUTIONS & SERVICES4. Development of Derivative Markets in India       Derivatives markets have been in exi...
SMC INVESMENT SOLUTIONS & SERVICESprohibition on trading options was lifted. In 1996, the NSE sent a proposal to SEBI forl...
SMC INVESMENT SOLUTIONS & SERVICESby the growing share of index derivatives (which are used more by institutions than byre...
SMC INVESMENT SOLUTIONS & SERVICESmarkets for commodity derivatives, due in part to their long-standing expertise in tradi...
SMC INVESMENT SOLUTIONS & SERVICESHow does F&O trading impact the market?         The start of a new derivatives contract ...
SMC INVESMENT SOLUTIONS & SERVICESestablished and financially sound companies. The Sensex represents a broad spectrum ofco...
SMC INVESMENT SOLUTIONS & SERVICES5.1 Understanding index futures       A futures contract is an agreement between two par...
SMC INVESMENT SOLUTIONS & SERVICES                            Contract month      Expiry/settlement                       ...
SMC INVESMENT SOLUTIONS & SERVICES                          ‘Y’ defaults                   ‘Y’ honours                    ...
SMC INVESMENT SOLUTIONS & SERVICES         Hedging involves protecting an existing asset position from future adverseprice...
SMC INVESMENT SOLUTIONS & SERVICES       The same methodology can be applied to a single stock by deriving the beta of the...
SMC INVESMENT SOLUTIONS & SERVICESfalling profit. In index futures players can have a long-term view of the market up toat...
SMC INVESMENT SOLUTIONS & SERVICESArbitrage profit = 40These kind of imperfections continue to exist in the markets but on...
SMC INVESMENT SOLUTIONS & SERVICES       Here F=1000+30=1030 and is less than prevailing futures price and hence thereare ...
SMC INVESMENT SOLUTIONS & SERVICESat Rs.109. At the end of the year, the arbitrageur would collect Rs.3 for dividends, del...
SMC INVESMENT SOLUTIONS & SERVICESHave you ever felt that the market would go down on a particular day and feared thatyour...
SMC INVESMENT SOLUTIONS & SERVICESIn the above cases ‘X’ has profited from speculation i.e. he has wagered in the hope ofp...
SMC INVESMENT SOLUTIONS & SERVICEScarries a long Nifty position along with it, as incidental baggage i.e. a part long posi...
SMC INVESMENT SOLUTIONS & SERVICESThus, we have seen how one can hedge their portfolio against market risk.3. Margins     ...
SMC INVESMENT SOLUTIONS & SERVICESAssuming that the contract will close on Day + 3 the mark-to-market position will look a...
SMC INVESMENT SOLUTIONS & SERVICESInitial margin             =     Rs 45,000Margin released (Day 1) = (-) Rs 3,000Position...
SMC INVESMENT SOLUTIONS & SERVICES5.7     Settlement of futures contracts:       Futures contracts have two types of settl...
SMC INVESMENT SOLUTIONS & SERVICESknown as daily mark-to-market settlement. CMs are responsible to collect and settle thed...
SMC INVESMENT SOLUTIONS & SERVICES www.nseindia.com and www.bseindia.com are some of the sources where one can look for th...
SMC INVESMENT SOLUTIONS & SERVICES    Open interest indicates the total gross outstanding open positions in the market for...
SMC INVESMENT SOLUTIONS & SERVICES       Open interest is also used in conjunction with other technical analysis chartpatt...
SMC INVESMENT SOLUTIONS & SERVICES6.1 What is an Option?       An option is a contract giving the buyer the right, but not...
SMC INVESMENT SOLUTIONS & SERVICES  Options have expiration dates, while stocks do not.  There is not a fixed number of op...
SMC INVESMENT SOLUTIONS & SERVICESthe XYZ May 30 Call, the strike price of 30 means the stock can be bought for $30 persha...
SMC INVESMENT SOLUTIONS & SERVICES       The Chicago Board Options Exchange, or CBOE, was the worlds first listedoptions e...
SMC INVESMENT SOLUTIONS & SERVICES       CBOE has one of the most technologically advanced and computer-automatedmeasures ...
SMC INVESMENT SOLUTIONS & SERVICES   •   Endowments   •   Corporate Treasurers   Stock markets by their very nature are fi...
SMC INVESMENT SOLUTIONS & SERVICES       This contract allows Raj to buy 100 shares of SATCOM at Rs 150 per share atany ti...
SMC INVESMENT SOLUTIONS & SERVICES       A trader is of the view that the index will go up to 1400 in Jan 2002 but does no...
SMC INVESMENT SOLUTIONS & SERVICES        The buyer of a put has purchased a right to sell. The owner of a put option has ...
SMC INVESMENT SOLUTIONS & SERVICESHis position in following price position is discussed below.   1. Jan Spot price of Wipr...
SMC INVESMENT SOLUTIONS & SERVICES          •   Pays premium                               •   Receives premium          •...
SMC INVESMENT SOLUTIONS & SERVICESAmerican: These options give the holder the right, but not the obligation, to buy or sel...
SMC INVESMENT SOLUTIONS & SERVICESeg: Wipro JUL 1300 refers to one series and trades take place at differentpremiums      ...
SMC INVESMENT SOLUTIONS & SERVICES       The intrinsic value of an option is defined as the amount by which an option is i...
SMC INVESMENT SOLUTIONS & SERVICESmoney. All other factors affecting an option’s price remaining the same, the time valuep...
SMC INVESMENT SOLUTIONS & SERVICES4. Interest rates        In general interest rates have the least influence on options a...
SMC INVESMENT SOLUTIONS & SERVICESa. Calls in a Bullish Strategy        An investor with a bullish market outlook should b...
SMC INVESMENT SOLUTIONS & SERVICES         An increase in volatility will increase the value of your call and increase you...
SMC INVESMENT SOLUTIONS & SERVICES        However, the potential loss is unlimited. Because a short put position holder ha...
SMC INVESMENT SOLUTIONS & SERVICES        To put on a bull spread, the trader needs to buy the lower strike call and sell ...
SMC INVESMENT SOLUTIONS & SERVICES       The investor’s potential loss is limited. At the most, the investor can lose is t...
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
Perception of derivatives @ smc investment project report
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  1. 1. SMC INVESMENT SOLUTIONS & SERVICES Table of ContentsSl.no Particulars Page No. 1. Executive Summary 1. 2. Indian Economy Overview 6 3 Company Overview 7 4 Derivatives 4.1 Introduction 10 4.2 Indian Scenario 11 5 Futures Contract 18 5.1 Understanding Index Futures 20 5.2 Hedging 21 5.3 Speculation 24 5.4 Arbitrage 25 5.5 Pricing of Index Futures 26 5.6 Trading Strategies 29 5.7 Settlement Of Futures Contract 36 6 Options 6.1 What is an Option? 41 6.2 Chicago Board of Options Exchange 44 6.3 Regulation and Surveillance 45 6.4 Options Clearing Corporation 45 6.5 Options Market Participants 45 6.6 Call Options 47 6.7 Put Options 49 6.8 Option Styles 52 6.9 Option Class & Series 53 6.10 Pricing of Options 54BABASAB PATIL 1
  2. 2. SMC INVESMENT SOLUTIONS & SERVICES 6.11 Options Pricing Factors 54 6.12 Strategies 58 6,13 Key Regulations 75 6.14 Advantages of option trading 80 6.15 Settlement of Options 827 Clearing & Settlement 838 Analysis 879 Findings 10510 Suggestions 10711 Conclusion 10812 Annexure 10913 Bibliography 111 1. Executive Summary:BABASAB PATIL 2
  3. 3. SMC INVESMENT SOLUTIONS & SERVICESTopic: -“ Comprehensive Study of Derivative Products and Investors’ Perception ofDerivative products in Hubli City ”Name of the Organization:- SMC Investment Solutions & Services, HubliNeed 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 it hasachieved in the recent past, In the present changing financial environment and anincreased exposure towards financial risks, It is of immense importance to have a goodworking knowledge of Derivatives. The Derivatives market in Hubli is still in a budding stage, It is necessary tounderstand the perception of investors in Hubli city and try to gather informationregarding the behaviour of investors towards Derivatives. So that, the company candevise certain measures to improve the Derivatives market in Hubli city.Objectives of the Study:-To study the Investors perception of Derivatives products in Hubli city, and a detailedstudy of Derivative products.Sub Objectives: • To study the trading procedures for Derivative products • To study the features of Derivatives products such as Futures and Options. • To study the clearing and settlement procedure of Derivatives products • To know the awareness and perception of Derivative products in Hubli city.Methodology:-BABASAB PATIL 3
  4. 4. SMC INVESMENT SOLUTIONS & SERVICESMethodology explains the methods used in collecting information to carry out theproject. • Data collection method Primary data as well as secondary data is used to collect the information. • Primary data Information will be gathered through questionnaires and discussion with the employees of SMC investment solutions & Services Hubli. • Secondary data Secondary data will be collected from the various books on • Derivatives, • Journals • Magazines and Internet. 10. FINDINGS: 1. Futures market facilitates for buying and selling futures contracts, which state the price per unit, type, value, quality and quantity of the commodity in question, as well as the month the contract expires.BABASAB PATIL 4
  5. 5. SMC INVESMENT SOLUTIONS & SERVICES 2. Futures accounts are credited or debited daily depending on profits or losses incurred. The futures market is also characterized as being highly leveraged due to its margins; although leverage works as a double-edged sword. 3. “Going long,” “going short,” and “spreads” are the most common strategies used when trading on the futures market. 4. Investors use options both to speculate and hedge risk. 5. Income is almost evenly distributed among the sample:- 18% less than Rs.1lakh, 27% each Rs.1 lakh-1.5lakhs and upto Rs.2 lakhs and 34% above Rs.2 lakhs. 6. The respondents’ current investments are mainly in FD, Insurance, Mutual Funds and Shares. 7. 53% of the respondents are aware of derivatives. 8. 44 people falling in the age group of 21-30, only 26 are aware of derivatives i.e., 43% of them are unaware. As you can see the good awareness level among the investors of the age 30-40, Rest 43% of the age group 21-30 need to be tapped by the company and create awareness about derivatives. 9. People above the age of 50 years are unaware of derivatives. They are fond of traditional investment instruments. 10. People above the age of 50 years are unaware of derivatives. They are fond of traditional investment instruments. 11. 37 respondents are aware of Futures and 40 are aware of Options. 12. The main factors considered while investing in derivatives are risk[20], return [24] and volatility [08]. 13. Out of 26 people who have invested in derivatives, only 9 of them are considering the risk factor. This means that they perceive derivatives as less risky. 14. Out of 26 people who have invested their money in derivatives, ALL of them consider the return factor. This means that derivatives give good returns, as per their experience.BABASAB PATIL 5
  6. 6. SMC INVESMENT SOLUTIONS & SERVICES 15. Out of 26 derivative investors, 17 of them [i.e., 65%] consider the volatility factor which is the most important influencer in derivative segment in the market. The investors perceive derivatives as volatile investments. 16. Lot sizes and margins are affecting the investment decisions of the investors to a large extent. Lot sizes also determine the decisions of the investors to a large extent. 17. Out of the 100 respondents surveyed, only 52 are willing to invest in derivatives. And out of them 26 are already the investors. This shows that derivatives are not known to approximately about 50% of the people in Hubli 18. Awareness of derivatives and investing in is positively correlated. This means that if there is increase in the number of people being aware of derivatives, the flow of investments in derivatives will also be more. Awareness is directly associated with investments in derivatives. 19. The association of risk factor and investing in derivatives is very meager. This means that increase in risk does not affect investing in derivatives to a greater extent. Investors perceive derivatives as less risky. 20. Actually derivatives are considered highly volatile. The volatility in the market directly affects the price of derivatives. The correlation between volatility and investing in derivatives is 0.393 which is again less but it is positive. This indicates that an increase in volatility affects the investing in derivatives to some considerable extent. 21. 60 respondents said that they are interested to invest through SMC Investment Solutions & Services SUGGESTIONS 1. The awareness about derivatives among investors should be increased by conducting various awareness and educational programs. 2. The company can conduct seminars to promote their services along with educating them about the products they offer. Initially they can start off with existing demat account holders.BABASAB PATIL 6
  7. 7. SMC INVESMENT SOLUTIONS & SERVICES 3. The company can think of tapping the existing demat account holders and provide them enough information on derivatives and enable them to trade in the same. This will help the company to increase its earnings of brokerage income. 4. The company has to create and maintain a database of prospective customers from time to time, to keep track of the people falling in different income levels and their investing patterns. This is possible if continuous contacts are maintained with the customers. 5. There is a widespread lack of awareness about the role and technique of futures trading among the potential beneficiaries. Only traditional players who have been participating in such trading either in the formal markets or gray markets are conversant with the intricacies of forward trading. These players are willing to participate in the trade only in regulated or liberal regulatory environment. The approach should be first, to bring these traditional players to the formal market and allow the Derivative markets to garner minimum critical liquidity. INDIAN ECONOMY OVERVIEW Indias economy is on the fulcrum of an ever-increasing growth curve. Withpositive indicators such as a stable 8-9 per cent annual growth, rising foreign exchangereserves of close to US$ 180 billion, a booming capital market with the popular "Sensex"index topping the majestic 18,000 mark, the Government estimating FDI flow of US$ 12BABASAB PATIL 7
  8. 8. SMC INVESMENT SOLUTIONS & SERVICESbillion in this fiscal, and a more than 35 per cent surge in exports, it is easy to understandwhy India is a leading destination for foreign investment. • The economy has grown by 8.9 per cent for the April-July quarter of ’06-07, the highest first-quarter growth rate since 00-01. • The growth rate has been spurred by the manufacturing sector, which has logged an 11.3 per cent rise in Q1 ’06-07, according to the GDP data released by the Central Statistical Organization. It was 10.7 per cent in the corresponding period of the last fiscal year. The GDP numbers come just weeks after the monthly IIP growth figures have touched 12.4 per cent. • Other propellers of GDP growth for the first quarter this fiscal have been the trade, hotels, transport and communications sector which grew by 9.5 per cent and construction, which grew by 13.2 per cent. In the corresponding period of last fiscal, these sectors grew by 11.7 per cent and 12.4 per cent, respectively. • There has been exceptional growth rate in some specific industries, like commercial vehicles at 36 per cent, telephone connections, by 48.9 per cent and passenger growth in civil aviation by 32.2 per cent. With its manufacturing and services sector on a searing growth path, India’s economymay soon touch the coveted 10 per cent growth figure. COMPANY OVERVIEW SMC Global is one of the largest and most reputed Investment Solutions Companythat provides a wide range of services to its substantial and diversified client base.Founded in 1990, by Mr. Subhash Chand Aggarwal and Mr. Mahesh Chand Gupta, SMC,is a full financial services firm catering to all classes of investors. The company is havingBABASAB PATIL 8
  9. 9. SMC INVESMENT SOLUTIONS & SERVICESits corporate office in New Delhi with regional offices in Mumbai, Kolkata, Chennai,Ahemdabad, Cochin, Hyderabad, Jaipur plus a growing network of more than 1150offices across over 300 cities/towns in India and overseas office in Dubai. SMC acquired membership of the Delhi Stock Exchange in 1990 and later in 1995became a trading member of NSE. In 2000 the company became a member of BSE and adepository participant of CDSL India Ltd. In the same year, the company acquired theTrading & Clearing Membership of NSE Derivatives and the memberships of leadingcommodity exchanges i.e. NCDEX and MCX in subsequent years. In 2006, SMCexpanded globally and acquired the Trading & Clearing Membership of Dubai Gold andCommodity Exchange (DGCX). In the same year, the company also started its InsuranceBroking division, IPO & Mutual Fund Distribution Division and its Merchant BankingdivisionPRODUCTS AND SERVICESEquity & Derivative TradingSMC Trading Platform offers online equity & derivative trading facilities for investorswho are looking for the ease and convenience and hassle free trading experience. Weprovide ODIN Application, which is a high -end, integrated trading application for fast,efficient and reliable execution of trades. You can now trade in the NSE and BSEsimultaneously from any destination at your convenience. You can access a multitude ofresources like live quotes, charts, research, advice, and online assistance helps you to takeinformed decisions. You can also trade through our branch network by registering with usas our client. You can also trade through us on phone by calling our designatedrepresentatives in the branches where you are registered as a client.Clearing ServicesBeing a clearing member in NSE (derivative) segment we are clearing massive volumesof trades of our trading members in this segment.BABASAB PATIL 9
  10. 10. SMC INVESMENT SOLUTIONS & SERVICESCommodity TradingSMC is a member of two major national level commodity exchanges, i.e NationalCommodity and Derivative Exchange and Multi Commodity Exchange and offers youtrading platform of NCDEX and MCX. You can get Real-Time streaming quotes, placeorders and watch the confirmation, all on a single screen. We use technology using ODINapplication to provide you with live Trading Terminals. In this segment, we have spreadour wings globally by acquiring Membership of Dubai Gold and Commodities Exchange.We provide trading platform to trade in DGCX and also clear trades of trading membersbeing a clearing member.Distribution of Mutual Funds & IPO’sSMC offers distribution and collection services of various schemes of all Major Fundhouses and IPO’s through its mammoth network of branches across India . We areregistered with AMFI as an approved distributor of Mutual Funds. We assure you ahassle free and pleasant transaction experience when you invest in mutual funds andIPO’s through us. We are registered with all major Fund Houses including Fidelity,Franklyn Templeton etc. We have a distinction of being leading distributors ofIPOs.Shortly we will be providing the facility of online investment in Mutual Funds andIPO’sOnline back office supportTo provide robust back office support backed by excellent accounting standards to ourbranches we have ensured connectivity through FTP and Dotnet based Application. Toensure easy accessibility to back office accounting reports to our clients, we have offeredfacilities to view various user-friendly, easily comprehendible back office reports usingthe link My SMC Account.SMC DepositoryBABASAB PATIL 10
  11. 11. SMC INVESMENT SOLUTIONS & SERVICESWe are ISO 9001:2000 certified DP for shares and commodities. We are one of theleading DP and enjoy the trust of more than 40,000 investors. We offer a quick, secureand hassle free alternative to holding the securities and commodities in physical form.We are one of the few Depository Participants offering depository facilities forcommodities. We are empanelled with both NCDEX & MCX.SMC Research Based Advisory ServicesOur massive R&D facility caters to the need of Investors, who are continuously in needof opportunities for striking rich rewards on their investment. We have one of the mostadvanced, hitech in-house R&D wing with some of the best people, process andtechnology resources providing complete research solutions on Equity, Commodities,IPO’s and Mutual Funds. We offer proactive and timely world class research basedadvice and guidance to our clients so that they can take informed decisions. Click onResearch to unveil the treasure. Derivatives5.1 INTRODUCTION: BSE created history on June 9, 2000 by launching the first Exchange traded IndexDerivative Contract i.e. futures on the capital market benchmark index - the BSE Sensex.The inauguration of trading was done by Prof. J.R. Varma, member of SEBI andchairman of the committee responsible for formulation of risk containment measures forthe Derivatives market. The first historical trade of 5 contracts of June series was done onBABASAB PATIL 11
  12. 12. SMC INVESMENT SOLUTIONS & SERVICESJune 9, 2000 at 9:55:03 a.m. between M/s Kaji and Maulik Securities Pvt. Ltd. and M/sEmkay Share and Stock Brokers Ltd. at the rate of 4755. In the sequence of product innovation, the exchange commenced trading in IndexOptions on Sensex on June 1, 2001. Stock options were introduced on 31 stocks on July9, 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. BSEpermitted trading in weekly contracts in options in the shares of four leading companiesnamely Reliance, Satyam, State Bank of India, and Tisco in addition to the flagshipindex-Sensex.Indian scenario 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. LessBABASAB PATIL 12
  13. 13. SMC INVESMENT SOLUTIONS & SERVICESdeveloped countries like India began opening up their economies and allowing prices tovary with market conditions. Price fluctuations make it hard for businesses to estimate their future production costsand revenues. Derivative securities provide them a valuable set of tools for managing thisrisk.2. Definition and Uses of Derivatives A derivative security is a financial contract whose value is derived from the valueof something else, such as a stock price, a commodity price, an exchange rate, an interestrate, or even an index of prices. Some simple types of derivatives: forwards, futures,options and swaps. Derivatives may be traded for a variety of reasons. A derivative enables a traderto hedge some preexisting risk by taking positions in derivatives markets that offsetpotential losses in the underlying or spot market. In India, most derivatives users describethemselves as hedgers and Indian laws generally require that derivatives be used forhedging purposes only. Another motive for derivatives trading is speculation (i.e. takingpositions to profit from anticipated price movements). In practice, it may be difficult todistinguish whether a particular trade was for hedging or speculation, and active marketsrequire the participation of both hedgers and speculators. A third type of trader, calledarbitrageurs, profit from discrepancies in the relationship of spot and derivatives prices,and thereby help to keep markets efficient. Jogani and Fernandes (2003) describe India’slong history in arbitrage trading, with line operators and traders arbitraging pricesbetween exchanges located in different cities, and between two exchanges in the samecity. Their study of Indian equity derivatives markets in 2002 indicates that markets wereinefficient at that time. They argue that lack of knowledge, market frictions andregulatory impediments have led 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, economists donot view volatility as necessarily harmful.BABASAB PATIL 13
  14. 14. SMC INVESMENT SOLUTIONS & SERVICES Speculators face the risk of losing money from their derivatives trades, as they dowith other securities. There have been some well-publicized cases of large losses fromderivatives trading. In some instances, these losses stemmed from fraudulent behaviorthat went undetected partly because companies did not have adequate risk managementsystems in place. In other cases, users failed to understand why and how they were takingpositions in the derivatives. Derivatives in arbitrage trading in India. However, more recent evidence suggeststhat 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 are oftencustomized to fit the specific requirements of the user. OTC contracts have substantialcredit risk, which is the risk that the counterparty that owes money defaults on thepayment. In India, OTC derivatives are generally prohibited with some exceptions: thosethat are specifically allowed by the Reserve Bank of India (RBI) or, in the case ofcommodities (which are regulated by the Forward Markets Commission), those that tradeinformally in “havala” or forwards markets. An exchange-traded contract, such as a futures contract, has a standardized formatthat specifies the underlying asset to be delivered, the size of the contract, and thelogistics of delivery. They trade on organized exchanges with prices determined by theinteraction of many buyers and sellers. In India, two exchanges offer derivatives trading:the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). However,NSE now accounts for virtually all exchange-traded derivatives in India, accounting formore than 99% of volume in 2003-2004. Contract performance is guaranteed by aclearinghouse, which is a wholly owned subsidiary of the NSE. Margin requirements anddaily marking-to-market of futures positions substantially reduce the credit risk ofexchange traded contracts, relative to OTC contracts.BABASAB PATIL 14
  15. 15. SMC INVESMENT SOLUTIONS & SERVICES4. Development of Derivative Markets in India Derivatives markets have been in existence in India in some form or other for along 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 trading andderivatives trading shifted to informal forwards markets. In recent years, governmentpolicy has changed, allowing for an increased role for market-based pricing and lesssuspicion of derivatives trading. The ban on futures trading of many commodities waslifted starting in the early 2000s, and national electronic commodity exchanges werecreated. In the equity markets, a system of trading called “badla” involving some elementsof forwards trading had been in existence for decades. However, the system led to anumber of undesirable practices and it was prohibited off and on till the Securities and aclearinghouse guarantees performance of a contract by becoming buyer to every sellerand 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 by realizingany trading losses in cash on the day they occur. “Badla” allowed investors to trade single stocks on margin and to carry forwardpositions to the next settlement cycle. Earlier, it was possible to carry forward a positionindefinitely but later the maximum carry forward period was 90 days. Unlike a futures oroptions, however, in a “badla” trade there is no fixed expiration date, and contract termsand margin requirements are not standardized. Securities Exchange Board of India (SEBI) banned it for good in 2001. A seriesof reforms of the stock market between 1993 and 1996 paved the way for thedevelopment of exchange traded equity derivatives markets in India. In 1993, thegovernment created the NSE in collaboration with state-owned financial institutions.NSE improved the efficiency and transparency of the stock markets by offering a fullyautomated screen-based trading system and real-time price dissemination. In 1995, aBABASAB PATIL 15
  16. 16. SMC INVESMENT SOLUTIONS & SERVICESprohibition on trading options was lifted. In 1996, the NSE sent a proposal to SEBI forlisting exchange-traded derivatives. The report of the L. C. Gupta Committee, set up by SEBI, recommended a phasedintroduction of derivative products, and bi-level regulation (i.e., self-regulation byexchanges with SEBI providing a supervisory and advisory role). Another report, by theJ. R. Varma Committee in 1998, worked out various operational details such as themargining systems. In 1999, the Securities Contracts (Regulation) Act of 1956, orSC(R)A, was amended so that derivatives could be declared “securities.” This allowedthe regulatory fMr.Xework for trading securities to be extended to derivatives. The Actconsiders derivatives to be legal and valid, but only if they are traded on exchanges. Finally, a 30-year ban on forward trading was also lifted in 1999. The economicliberalization of the early nineties facilitated the introduction of derivatives based oninterest rates and foreign exchange. A system of market-determined exchange rates wasadopted by India in March 1993. In August 1994, the rupee was made fully convertibleon current account. These reforms allowed increased integration between domestic andinternational markets, and created a need to manage currency risk.5. Derivatives Users in India The use of derivatives varies by type of institution. Financial institutions, such asbanks, have assets and liabilities of different maturities and in different currencies, andare exposed to different risks of default from their borrowers. Thus, they are likely to usederivatives on interest rates and currencies, and derivatives to manage credit risk. Non-financial institutions are regulated differently from financial institutions, and this affectstheir incentives to use derivatives. Indian insurance regulators, for example, are yet toissue guidelines relating to the use of derivatives by insurance 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 8%in October 2005. However, market insiders feel that this may be changing, as indicatedBABASAB PATIL 16
  17. 17. SMC INVESMENT SOLUTIONS & SERVICESby the growing share of index derivatives (which are used more by institutions than byretail investors). In contrast to the exchange-traded markets, domestic financialinstitutions and mutual funds have shown great interest in OTC fixed incomeinstruments. Transactions between banks dominate the market for interest ratederivatives, while state-owned banks remain a small presence. Corporations are active inthe currency forwards and swaps markets, buying these instruments from banks.Why do institutions not participate to a greater extent in derivatives markets? Some institutions such as banks and mutual funds are only allowed to 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 investors mustregister as foreign institutional investors (FII) to trade exchange-traded derivatives, andbe subject to position limits as specified by SEBI. Alternatively, they can incorporatelocally as under RBI directive, banks’ direct or indirect (through mutual funds) exposureto capital markets instruments is limited to 5% of total outstanding advances as of theprevious year-end. Some banks may have further equity exposure on account of equitiescollaterals held against loans in default. FIIs have a small but increasing presence in the equity derivatives markets. Theyhave no incentive to trade interest rate derivatives since they have little investments in thedomestic bond markets. It is possible that unregistered foreign investors and hedge fundstrade indirectly, using a local proprietary trader as a front. Retail investors (including small brokerages trading for themselves) are the majorparticipants in equity derivatives, accounting for about 60% of turnover in October 2005,according to NSE. The success of single stock futures in India is unique, as thisinstrument has generally failed in most other countries. One reason for this success maybe retail investors’ prior familiarity with “badla” trades which shared some features ofderivatives trading. Another reason may be the small size of the futures contracts,compared to similar contracts in other countries. Retail investors also dominate theBABASAB PATIL 17
  18. 18. SMC INVESMENT SOLUTIONS & SERVICESmarkets for commodity derivatives, due in part to their long-standing expertise in tradingin the “havala” or forwards markets.Why have derivatives? Derivatives have become very important in the field finance. They are veryimportant financial instruments for risk management as they allow risks to be separatedand traded. Derivatives are used to shift risk and act as a form of insurance. This shift ofrisk means that each party involved in the contract should be able to identify all the risksinvolved before the contract is agreed. It is also important to remember that derivativesare derived from an underlying asset. This means that risks in trading derivatives maychange depending on what happens to the underlying asset. A derivative is a product whose value is derived from the value of an underlyingasset, index or reference rate. The underlying asset can be equity, forex, commodity orany other asset. For example, if the settlement price of a derivative is based on the stockprice of a stock for e.g. Infosys, which frequently changes on a daily basis, then thederivative risks are also changing on a daily basis. This means that derivative risks andpositions 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. In termsof the number of contracts in single stock derivatives, it is probably the largest marketglobally. It is no longer a market that can be ignored by any serious participant. Withinstitutional participation set to increase and a broader product rollout inevitable, themarket can only widen and deepen further.BABASAB PATIL 18
  19. 19. SMC INVESMENT SOLUTIONS & SERVICESHow does F&O trading impact the market? 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. Higher futureprices are seen as indicators of bullish prices in the days to come. Thus, higher pricesdue to new month buying in the derivatives market lead to buying in the physical market.This lifts prices in the cash market as well. FUTURES CONTRACT: A futures contract is similar to a forward contract in terms of its working. 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 a clearinghouse,which becomes the counterparty to both sides of each transaction and guarantees thetrade.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 important forthe market players as it acts as a barometer for market behavior and as an underlying inderivative instruments such as index futures.The Sensex and Nifty In India the most popular indices have been the BSE Sensex and S&P CNX Nifty.The BSE Sensex has 30 stocks comprising the index, which are selected based on marketcapitalization, industry representation, trading frequency etc. It represents 30 large well-BABASAB PATIL 19
  20. 20. SMC INVESMENT SOLUTIONS & SERVICESestablished and financially sound companies. The Sensex represents a broad spectrum ofcompanies in a variety of industries. It represents 14 major industry groups. Then there isa BSE national index and BSE 200. However, trading in index futures has onlycommenced on the BSE Sensex. While the BSE Sensex was the first stock market index in the country, Nifty waslaunched by the National Stock Exchange in April 1996 taking the base of November 3,1995. The Nifty index consists of shares of 50 companies with each having a marketcapitalization of more than Rs 500 crore.Futures and stock indices For understanding of stock index futures a thorough knowledge of thecomposition of indexes is essential. Choosing the right index is important in choosing theright contract for speculation or hedging. Since for speculation, the volatility of the indexis important whereas for hedging the choice of index depends upon the relationshipbetween 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 of thefutures indexes is generally greater than spot stock indexes. Every time 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 with theentire market sentiment and rise when the market as a whole is rising. Retail investors will find the index derivatives useful due to the high correlationof the index with their portfolio/stock and low cost associated with using index futuresfor hedging.BABASAB PATIL 20
  21. 21. SMC INVESMENT SOLUTIONS & SERVICES5.1 Understanding index futures A futures contract is an agreement between two parties to buy or sell an asset at acertain time in the future at a certain price. Index futures are all futures contracts wherethe underlying is the stock index (Nifty or Sensex) and helps a trader to take a view onthe 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 the BSESensex and near 3 months duration contracts are available at all times. Each contractexpires on the last Thursday of the expiry month and simultaneously a new contract isintroduced for trading after expiry of a contract.Example: Futures contracts in Nifty in January 2008 Contract month Expiry/settlement January 2008 January 31 February 2008 February 28 March 2008 March 27 On January 27BABASAB PATIL 21
  22. 22. SMC INVESMENT SOLUTIONS & SERVICES Contract month Expiry/settlement February 2008 February 28 March 2008 March 27 April 2008 April 24 The permitted lot size is 100 or multiples thereof for the Nifty. That is you buyone Nifty contract the total deal value will be 100*1100 (Nifty value)= Rs 1,10,000. In the case of BSE Sensex the market lot is 50. That is you buy one Sensexfutures the total value will be 50*4000 (Sensex value)= Rs 2,00,000.5.2 Hedging The other benefit of trading in index futures is to hedge your 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 to Y10 dresses for Rs 4000. The cost of manufacturing for X is only Rs 1000 and he willmake a profit of Rs 3000 if the sale is completed. Cost (Rs) Selling price Profit 1000 4000 3000 However, X fears that Y may not honour his contract six months from now. So heinserts a new clause in the contract that if Y fails to honour the contract he will have topay a penalty of Rs 1000. And if Y honours the contract X will offer a discount of Rs1000 as incentive.BABASAB PATIL 22
  23. 23. SMC INVESMENT SOLUTIONS & SERVICES ‘Y’ defaults ‘Y’ honours 1000 (Initial Investment) 3000 (Initial profit) 1000 (penalty from Mr.Y) (-1000) discount given to Mr.Y - (No gain/loss) 2000 (Net gain) As we see above if Mr.Y defaults Mr.X will get a penalty of Rs 1000 but he willrecover his initial investment. If Mr.Y honours the contract, Mr.X will still make a profitof Rs 2000. Thus, Mr.X has hedged his risk against default and protected his initialinvestment. The example explains the concept of hedging. Let us try understanding how onecan 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 cannot bediversified but has to be hedged. So how does one measure the market risk? Market riskcan be known from Beta. Beta measures the relationship between movement of the index to the movementof the stock. The beta measures the percentage impact on the stock prices for 1% changein the index. Therefore, for a portfolio whose value goes down by 11% when theindex goes down by 10%, the beta would be 1.1. When the index increases by 10%,the value of the portfolio increases 11%. The idea is to make beta of your portfoliozero to nullify your losses.BABASAB PATIL 23
  24. 24. SMC INVESMENT SOLUTIONS & SERVICES Hedging involves protecting an existing asset position from future adverseprice movements. In order to hedge a position, a market player needs to take anequal and opposite position in the futures market to the one held in the cash market.Every portfolio has a hidden exposure to the index, which is denoted by the beta.Assuming you have a portfolio of Rs 1 million, which has a beta of 1.2, you can factor acomplete hedge by selling Rs 1.2 mn of S&P CNX Nifty futures.Steps: 1. Determine the beta of the portfolio. If the beta of any stock is not known, it is safe to assume that it is 1. 2. Short sell the index in such a quantum that the gain on a unit decrease in the index would offset the losses on the rest of the portfolio. This is achieved by multiplying the relative volatility of the portfolio by the market value of his holdings.Therefore in the above scenario we have to shortsell 1.2 * 1 million = 1.2 million worthof Nifty.Now let us see the impact on the overall gain/loss that accrues: Index up 10% Index down 10% Gain/(Loss) in Portfolio Rs 120,000 (Rs 120,000) Gain/(Loss) in Futures (Rs 120,000) Rs 120,000 Net Effect Nil Nil As we see, that portfolio is completely insulated from any losses arising out of afall 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 all thegains will be offset by losses in futures market. The idea is that everyone expects hisportfolio to outperform the market. Irrespective of whether the market goes up or not, hisportfolio value would increase.BABASAB PATIL 24
  25. 25. SMC INVESMENT SOLUTIONS & SERVICES The same methodology can be applied to a single stock by deriving the beta of thescrip 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.5.3 Speculation Speculators are those who do not have any position on which they enter in futuresand options market. They only have a particular view on the market, stock, commodityetc. In short, speculators put their money at risk in the hope of profiting from ananticipated price change. They consider various factors such as demand supply, marketpositions, open interests, economic fundamentals and other data to take their positions.Illustration: Mr.X is a trader but has no time to track and analyze stocks. However, he fancieshis chances in predicting the market trend. So instead of buying different stocks he buysSensex 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 itwould have been bearish he could have sold Sensex futures and made a profit from aBABASAB PATIL 25
  26. 26. SMC INVESMENT SOLUTIONS & SERVICESfalling profit. In index futures players can have a long-term view of the market up toatleast 3 months.5.4 Arbitrage An arbitrageur is basically risk averse. He enters into those contracts were he canearn riskless profits. When markets are imperfect, buying in one market andsimultaneously selling in other market gives riskless profit. Arbitrageurs are always in thelook 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 has provided aspecial 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 one canpurchase Wipro at Rs.1000 in spot by borrowing @ 12% annum for 3 months and sellWipro futures for 3 months at Rs 1070.Sale = 1070Cost= 1000+30 = 1030BABASAB PATIL 26
  27. 27. SMC INVESMENT SOLUTIONS & SERVICESArbitrage profit = 40These kind of imperfections continue to exist in the markets but one has to be alert to theopportunities as they tend to get exhausted very fast.5.5 Pricing of Index Futures The index futures are the most popular futures contracts as they can be used in avariety of ways by various participants in the market. How many times have you felt of making risk-less profits by arbitraging betweenthe underlying and futures markets? If so, you need to know the cost-of-carry model tounderstand the dynamics of pricing that constitute the estimation of fair value 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% annum for3 months and sell Wipro futures for 3 months at Rs 1070.BABASAB PATIL 27
  28. 28. SMC INVESMENT SOLUTIONS & SERVICES Here F=1000+30=1030 and is less than prevailing futures price and hence thereare chances of arbitrage.Sale = 1070Cost= 1000+30 = 1030Arbitrage profit 40However, one has to remember that the components of holding cost vary with contractson different assets.2. Futures pricing in case of dividend yield We have seen how we have to consider the cost of finance to arrive at the futuresindex value. However, the cost of finance has to be adjusted for benefits of dividends andinterest income. In the case of equity futures, the holding cost is the cost of financingminus the dividend returns.Example: Suppose a stock portfolio has a value of Rs.100 and has an annual dividend yieldof 3% which is earned throughout the year and finance rate=10% the fair value of thestock index portfolio after one year will be F= Rs.100 + Rs.100 * (0.10 – 0.03)Futures price = Rs 107 If the actual futures price of one-year contract is Rs.109. An arbitrageur can buythe stock at Rs.100, borrowing the fund at the rate of 10% and simultaneously sell futuresBABASAB PATIL 28
  29. 29. SMC INVESMENT SOLUTIONS & SERVICESat Rs.109. At the end of the year, the arbitrageur would collect Rs.3 for dividends, deliverthe stock portfolio at Rs.109 and repay the loan of Rs.100 and interest of Rs.10. The netprofit would be Rs 109 + Rs 3 - Rs 100 - Rs 10 = Rs 2. Thus, we can arrive at the fairvalue in the case of dividend yield.5.6 Trading 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 in indexfutures and use forward contracts in each of these instances.Taking a view of the marketBABASAB PATIL 29
  30. 30. SMC INVESMENT SOLUTIONS & SERVICESHave 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 index futures.Illustration:Scenario 1:On July 13, 2001, ‘X’ feels that the market will rise so he buys 200 Nifties with an expirydate of July 26 at an index price of 1442 costing Rs 2,88,400 (200*1442).On July 21 the Nifty futures have risen to 1520 so he squares off his position at 1520.‘X’ makes a profit of Rs 15,600 (200*78)Scenario 2:On July 20, 2001, ‘X’ feels that the market will fall so he sells 200 Nifties with an expirydate 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).BABASAB PATIL 30
  31. 31. SMC INVESMENT SOLUTIONS & SERVICESIn 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 funds etcseveral 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 profits andthe quality of the company made it worth a lot more as compared with what the marketthinks? Have you ever been a ‘stock picker’ 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. When doingthis, he faces two kinds of risks:a. 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 the underlyingidea was correct. Everyone has to remember that every buy position on a stock is simultaneously abuy position on Nifty. A long position is not a focused play on the valuation of a stock. ItBABASAB PATIL 31
  32. 32. SMC INVESMENT SOLUTIONS & SERVICEScarries a long Nifty position along with it, as incidental baggage i.e. a part long positionof Nifty.Let us see how one can hedge positions using index futures:‘X’ holds HLL worth Rs 9 lakh at Rs 290 per share on July 01, 2001. Assuming that thebeta of HLL is 1.13. How much Nifty futures does ‘X’ have to sell if the index futures isruling at 1527?To hedge he needs to sell 9 lakh * 1.13 = Rs 1017000 lakh on the index futures i.e. 666Nifty futures.On July 19, 2001, the Nifty futures is at 1437 and HLL is at 275. ‘X’ closes bothpositions earning Rs 13,389, i.e. his position on HLL drops by Rs 46,551 and his shortposition on Nifty gains Rs 59,940 (666*90).Therefore, the net gain is 59940-46551 = Rs 13,389.Let us take another example when one has a portfolio of stocks:Suppose you have a portfolio of Rs 10 crore. The beta of the portfolio is 1.19. 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 2,40,000If you sell more than 496 contracts you are overhedged and sell less than 496 contractsyou are underhedged.BABASAB PATIL 32
  33. 33. SMC INVESMENT SOLUTIONS & SERVICESThus, we have seen how one can hedge their portfolio against market risk.3. Margins The margining system is based on the JR Verma Committee recommendations.The actual margining happens on a daily basis while online position monitoring is doneon 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 the conceptof Value-at-Risk (VaR). The initial margin amount is large enough to cover a one-dayloss that can be encountered on 99% of the days. VaR methodology seeks to measure theamount of value that a portfolio may stand to lose within a certain horizon time period(one day for the clearing corporation) due to potential changes in the underlying assetmarket price. Initial margin amount computed using VaR is collected up-front. The dailysettlement process called "mark-to-market" provides for collection of losses that havealready occurred (historic losses) whereas initial margin seeks to safeguard againstpotential 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)Initial margin (15%) = Rs 45,000BABASAB PATIL 33
  34. 34. SMC INVESMENT SOLUTIONS & SERVICESAssuming that the contract will close on Day + 3 the mark-to-market position will look asfollows:Position on Day 1 Close Price Loss Margin released Net cash outflow 1400*200 =2,80,000 20,000 3,000 17,000 (20,000-3000) (3,00,000-2,80,000) (45,000-42,000) Payment to be made (17,000)New position on Day 2Value of new position = 1,400*200= 2,80,000Margin = 42,000 Close Price Gain Addn Margin Net cash inflow 1510*200 =3,02,000 22,000 3,300 18,700 (22,000-3300) (3,02,000-2,80,000) (45,300-42,000) Payment to be recd 18,700Position 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 18,000 + 45,300* = 63,300 (3,20,000-3,02,000) Payment to be recd 63,300Margin account*BABASAB PATIL 34
  35. 35. SMC INVESMENT SOLUTIONS & SERVICESInitial margin = Rs 45,000Margin released (Day 1) = (-) Rs 3,000Position on Day 2 Rs 42,000Addn 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 inflow atthe close of trade is Rs 63,300.BABASAB PATIL 35
  36. 36. SMC INVESMENT SOLUTIONS & SERVICES5.7 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. The profits/lossesare computed as the difference between:  The trade price and the day’s settlement price for contracts executed during the day but not squared up.  The previous day’s settlement price and the current day’s settlement price for brought forward contracts.  The buy price and the sell price for contracts executed during the day and squared up. The CMs who have a loss are required to pay the mark-to-market (MTM) loss amountin cash which is in turn passed on to the CMs who have made a MTM profit. This isBABASAB PATIL 36
  37. 37. SMC INVESMENT SOLUTIONS & SERVICESknown as daily mark-to-market settlement. CMs are responsible to collect and settle thedaily MTM profits/losses incurred by the TMs and their clients clearing and settlingthrough them. Similarly, TMs are responsible to collect/pay losses/ profits from/to theirclients by the next day. The pay-in and pay-out of the mark-to-market settlement areaffected on the day following the trade day. In case a futures contract is not traded on aday, or not traded during the last half hour, a ‘theoretical settlement price’ is computed.2. Final settlement for futures On the expiry day of the futures contracts, after the close of trading hours,NSCCL marks all positions of a CM to the final settlement price and the resultingprofit/loss is settled in cash. Final settlement loss/profit amount is debited/ credited to therelevant CM’s clearing bank account on the day following expiry day of the contract. All trades in the futures market are cash settled on a T+1 basis and all positions(buy/sell) which are not closed out will be marked-to-market. The closing price of theindex futures will be the daily settlement price and the position will be carried to thenext day at the settlement price. The most common way of liquidating an open position is to execute an offsettingfutures transaction by which the initial transaction is squared up. The initial buyerliquidates his long position by selling identical futures contract. In index futures the other way of settlement is cash settled at the final settlement.At the end of the contract period the difference between the contract value and closingindex value is paid.How to read the futures data sheet? Understanding and deciphering the prices of futures trade is the first challenge foranyone planning to venture in futures trading. Economic dailies and exchange websitesBABASAB PATIL 37
  38. 38. SMC INVESMENT SOLUTIONS & SERVICES www.nseindia.com and www.bseindia.com are some of the sources where one can look for the daily quotes. Your website has a daily market commentary, which carries end of day derivatives summary along with the quotes. The first step is start tracking the end of day prices. Closing prices, Trading Volumes and Open Interest are the three primary data we carry with Index option quotes. The most important parameter are the actual prices, the high, low, open, close, last traded prices and the intra-day prices and to track them one has to have access to real time prices. The following table shows how futures data will be generally displayed in the business papers daily. Series First High Low Close Volume (No of Value No of Open interest Trade contracts) (Rs trades (No of in lakh) contracts)BSXJUN2000 4755 4820 4740 4783.1 146 348.70 104 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/-. BABASAB PATIL 38
  39. 39. SMC INVESMENT SOLUTIONS & SERVICES Open interest indicates the total gross outstanding open positions in the market forthat 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 alsopublished by exchanges and used for technical analysis. Open interest indicates theliquidity of a market and is the total number of contracts, which are stilloutstanding in a futures 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. Open interestis calculated by looking at either the total number of outstanding long or short positions –not both. Open interest is therefore a measure of contracts that have not been matched andclosed out. The number of open long contracts must equal exactly the number of openshort contracts. Action Resulting open interest New buyer (long) and new seller (short) Rise Trade to form a new contract. Existing buyer sells and existing seller buys – Fall The old contract is closed. New buyer buys from existing buyer. TheNo change – there is no increase in long Existing buyer closes his position by sellingcontracts being held to new buyer. Existing seller buys from new seller. TheNo change – there is no increase in short Existing seller closes his position by buyingcontracts being held from new seller.BABASAB PATIL 39
  40. 40. SMC INVESMENT SOLUTIONS & SERVICES Open interest is also used in conjunction with other technical analysis chartpatterns and indicators to gauge market signals. The following chart may help with thesesignals. Price Open interest Market Strong Warning signal Weak Warning signalThe warning sign indicates that the Open interest is not supporting the price direction. 7. OPTIONSBABASAB PATIL 40
  41. 41. SMC INVESMENT SOLUTIONS & SERVICES6.1 What is an Option? An option is a contract giving the buyer the right, but not the obligation, to buy orsell an underlying asset (a stock or index) at a specific price on or before a certain date(listed options are all for 100 shares of the particular underlying asset). An option is a security, just like a stock or bond, and constitutes a 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 to investtheir money; they could either be long or short individual stocks, or they could purchasetreasury 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).BABASAB PATIL 41
  42. 42. SMC INVESMENT SOLUTIONS & SERVICES Options have expiration dates, while stocks do not. There is not a fixed number of options, as there are with stock shares available. Stockowners have a share of the company, with voting and dividend rights. Options convey no such rights.Options Premiums In this case, XYZ represents the option class while May 30 is the option series.All options on company XYZ are in the XYZ option class but there will be manydifferent series. An option Premium is the price of the option. It is the price you pay to purchasethe option. For example, an XYZ May 30 Call (thus it is an option to buy Company XYZstock) may have an option premium of $2. This means that this option costs $200.00.Why? Because most listed options are for 100 shares of stock, and all equity option pricesare quoted on a per share basis, so they need to be multiplied times 100. More in-depthpricing concepts will be covered in detail in other sections of the course.Strike Price The Strike (or Exercise) Price is the price at which the underlying security (in thiscase, XYZ) can be bought or sold as specified in the option contract. For example, withBABASAB PATIL 42
  43. 43. SMC INVESMENT SOLUTIONS & SERVICESthe XYZ May 30 Call, the strike price of 30 means the stock can be bought for $30 pershare. Were this the XYZ May 30 Put, it would allow the holder the right to sell the stockat $30 per share. The strike price also helps to identify whether an option is In-the-Money, At-the-Money, or Out-of-the-Money when compared to the price of the underlying security. Youwill learn about these terms in another section of the course.Exercising Options People who buy options have a Right, and that is the right to Exercise.For a Call Exercise, Call holders may buy stock at the strike price (from the Call seller).For a Put Exercise, Put holders may sell stock at the strike price (to the Put seller).Neither Call holders nor Put holders are obligated to buy or sell; they simply have therights to do so, and may choose to Exercise or not to Exercise based upon their ownlogic.6.2 The Chicago Board Options ExchangeBABASAB PATIL 43
  44. 44. SMC INVESMENT SOLUTIONS & SERVICES The Chicago Board Options Exchange, or CBOE, was the worlds first listedoptions exchange, opened in 1973 by members of the Chicago Board of Trade. Almosthalf 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 Pacific StockExchange (PSE) and the International Securities Exchange (ISE).CBOE: The Competitive Advantage With over 1500 competing market makers trading more than one million optionscontracts per day, the CBOE is the largest and busiest options exchange in the world. The members of the Exchange have maintained this stature for over 25 years byconstantly 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 your investmentstrategy, quickly and easily and at the most efficient price. The CBOE offers investorsthe best options markets, the most efficient support network, and the most intensiveinsight and most recognized educational division in the industry, the Options Institute.6.3 Regulation and Surveillance: Regulation and surveillance are necessary in the options industry in order toprotect customers and firms, and respond to customer complaints.BABASAB PATIL 44
  45. 45. SMC INVESMENT SOLUTIONS & SERVICES CBOE has one of the most technologically advanced and computer-automatedmeasures for regulation and surveillance, which are unparalleled in the options industry.CBOE has the premier Regulatory Division, with staff who constantly monitor tradingactivity throughout the industry. The Securities and Exchange Commission (SEC) oversees the entire optionsindustry to ensure that the markets serve the public interest.6.4 Options Clearing Corporation: The formation of the OCC in 1973 as the single, independent, universal clearingagency for all listed options eliminated the problem of credit risk in options trading.Every options Exchange and every brokerage firm who offers its customers the ability totrade options is a member or is associated with a member of the OCC. The OCC stands in the middle of each trade becoming the buyer for all contractsthat are sold, and the seller for all contracts that are bought. Thus, the OCC is, in fact, theissuer of all listed options contracts, and is registered as such with the SEC.6.5 Options Market Participants Contrary to some beliefs, the single greatest population of CBOE users are not hugefinancial institutions, but public investors, just like you. Over 65% of the Exchangesbusiness comes from them. However, other participants in the financial marketplace also use options to enhancetheir performance, including: • Mutual Funds • Pension Plans • Hedge FundsBABASAB PATIL 45
  46. 46. SMC INVESMENT SOLUTIONS & SERVICES • Endowments • Corporate Treasurers Stock markets by their very nature are fickle. While fortunes can be made in a jiffymore often than not the scenario is the reverse. Investing in stocks has two sides to it –a)Unlimited profit potential from any upside (remember Infosys, HFCL etc) or b) adownside 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 enable youto hedge your portfolio or open positions in the market. Option contracts allow you to runyour profits while restricting your downside risk. Apart from risk containment, options can be used for speculation and investors cancreate a wide range of potential profit scenarios. ‘Option’, as the word suggests, is a choice given to the investor to either honour thecontract; or if he chooses not to walk away from the contract.To begin, there are two kinds of options: Call Options and Put Options.6.6 Call options Call options give the taker the right, but not the obligation, to buy the underlyingshares at a predetermined price, on or before a predetermined date.Illustration 1:Raj purchases 1 Satyam Computer (SATCOM) AUG 150 Call --Premium 8BABASAB PATIL 46
  47. 47. SMC INVESMENT SOLUTIONS & SERVICES 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, Raj paysa fee of Rs 800 (Rs eight a share for 100 shares). The buyer of a call has purchased theright to buy and for that he pays a premium.Now let us see how one can profit from buying an option. Sam purchases a December call option at Rs 40 for a premium of Rs 15. That ishe has purchased the right to buy that share for Rs 40 in December. If the stock risesabove Rs 55 (40+15) he will break even and he will start making a profit. Suppose thestock does not rise and instead falls he will choose not to exercise the option and foregothe 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 Dec Nifty 1325 Rs.6,000 1345 Rs.2,000 Jan Nifty 1325 Rs.4,500 1345 Rs.5000BABASAB PATIL 47
  48. 48. SMC INVESMENT SOLUTIONS & SERVICES A trader is of the view that the index will go up to 1400 in Jan 2002 but does notwant to take the risk of prices going down. Therefore, he buys 10 options of Jan contractsat 1345. He pays a premium for buying calls (the right to buy the contract) for 500*10=Rs.5,000/-. In Jan 2002 the Nifty index goes up to 1365. He sells the options or exercises theoption and takes the difference in spot index price which is (1365-1345) * 200 (marketlot) = 4000 per contract. Total profit = 40,000/- (4,000*10). He had paid Rs.5,000/- premium for buying the call option. So he earns by buyingcall 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 by sellingcalls. You are bearish.6.7 Put Options : A Put Option gives the holder of the right to sell a specific number of shares ofan agreed security at a fixed price for a period of time. eg: Sam purchases 1 INFTEC(Infosys Technologies) AUG 3500 Put --Premium 200. This contract allows Sam to sell100 shares INFTEC at Rs 3500 per share at any time between the current date and theend of August. To have this privilege, Sam pays a premium of Rs 20,000 (Rs 200 a sharefor 100 shares).BABASAB PATIL 48
  49. 49. SMC INVESMENT SOLUTIONS & SERVICES The buyer of a put has purchased a right to sell. The owner of a put option has theright to sell.Illustration 2: Raj is of the view that the a stock is overpriced and will fall in future, buthe does not want to take the risk in the event of price rising so purchases a put option atRs 70 on ‘X’. By purchasing the put option Raj has the right to sell the stock at Rs 70 buthe has to pay a fee of Rs 15 (premium). So he will breakeven only after the stock falls below Rs 55 (70-15) and will startmaking 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 a Putoption 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 paysRs.30,000/- as Put premium.BABASAB PATIL 49
  50. 50. SMC INVESMENT SOLUTIONS & SERVICESHis position in following price position is discussed below. 1. Jan Spot price of Wipro = 1020 2. Jan Spot price of Wipro = 1080 In the first situation the investor is having the right to sell 1000 Wipro shares atRs.1,070/- the price of which is Rs.1020/-. By exercising the option he earns Rs.(1070-1020) = Rs 50 per Put, which totals Rs 50,000/-. His net income is Rs(50000-30000) = Rs 20,000. In the second price situation, the price is more in the spot market, so the investorwill not sell at a lower price by exercising the Put. He will have to allow the Put option toexpire 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. Youare bearish. When you expect prices to rise, then you take a short position by sellingPuts. 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)BABASAB PATIL 50
  51. 51. SMC INVESMENT SOLUTIONS & SERVICES • Pays premium • Receives premium • Right to exercise and buy the shares • Obligation to sell shares if exercised • Profits from rising prices • Profits from falling prices or remaining neutral • Limited losses, Potentially unlimited gain • Potentially unlimited losses, limited gain PUT OPTION BUYER PUT OPTION WRITER (Seller) • Pays premium • Receives premium • Right to exercise and sell shares • Obligation to buy shares if exercised • Profits from falling prices • Profits from rising prices or remaining neutral • Limited losses, Potentially unlimited gain • Potentially unlimited losses, limited gain6.8 Option styles Settlement of options is based on the expiry date. However, there are three basicstyles 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 or sellthe underlying instrument only on the expiry date. This means that the option cannot beexercised early. Settlement is based on a particular strike price at expiration. Currently,in India only index options are European in nature. eg: Sam purchases 1 NIFTY AUG 1110 Call --Premium 20. The exchange willsettle the contract on the last Thursday of August. Since there are no shares for theunderlying, the contract is cash settled.BABASAB PATIL 51
  52. 52. SMC INVESMENT SOLUTIONS & SERVICESAmerican: These options give the holder the right, but not the obligation, to buy or sellthe underlying instrument on or before the expiry date. This means that the option canbe exercised early. Settlement is based on a particular strike price at expiration. Options in stocks that have been recently launched in the Indian market are"American Options". eg: Sam purchases 1 ACC SEP 145 Call --Premium 12 Here Sam can close the contract any time from the current date till the expirationdate, which is the last Thursday of September. American style options tend to be more expensive than European style becausethey offer greater flexibility to the buyer.6.9 Option Class and Series Generally, for each underlying, there are a number of options available: For thisreason, we have the terms "class" and "series". An option "class" refers to all options of the same type (call or put) and style(American or European) that also have the same underlying.eg: All Nifty call options are referred to as one class. An option series refers to all options that are identical: they are the same type,have the same underlying, the same expiration date and the same exercise price. Calls Puts . JUL AUG SEP JUL AUG SEP Wipro 1300 45 60 75 15 20 28 1400 35 45 65 25 28 35 1500 20 42 48 30 40 55BABASAB PATIL 52
  53. 53. SMC INVESMENT SOLUTIONS & SERVICESeg: 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 the sameclass. Options of the same class and with the same exercise price and the same expirationdate are said to be of the same series6.10 Pricing 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 • Dividends6.11 Review of Options Pricing Factors1. The Intrinsic Value of an OptionBABASAB PATIL 53
  54. 54. SMC INVESMENT SOLUTIONS & SERVICES The intrinsic value of an option is defined as the amount by which an option is in-the-money, or the immediate exercise value of the option when the underlying position ismarked-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 must begreater than the underlying asset price for it to have intrinsic value.Price of underlying The premium is affected by the price movements in the underlying instrument.For Call options – the right to buy the underlying at a fixed strike price – as theunderlying price rises so does its premium. As the underlying price falls so does the costof the option premium. For Put options – the right to sell the underlying at a fixed strikeprice – as the underlying price rises, the premium falls; as the underlying price falls thepremium 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, the higherits premium will be. This is because the longer an option’s lifetime, greater is thepossibility that the underlying share price might move so as to make the option in-the-BABASAB PATIL 54
  55. 55. SMC INVESMENT SOLUTIONS & SERVICESmoney. All other factors affecting an option’s price remaining the same, the time valueportion of an option’s premium will decrease (or decay) with the passage of time.Note: This time decay increases rapidly in the last several weeks of an option’s life.When an option expires in-the-money, it is generally worth only its intrinsic value. Option Time to expiry Premium cost Call Put3. Volatility 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 bias towardprice movement in one direction or the other. Thus, it is a major factor in determining anoption’s premium. The higher the volatility of the underlying stock, the higher thepremium because there is a greater possibility that the option will move in-the-money.Generally, as the volatility of an under-lying stock increases, the premiums of both callsand puts overlying that stock increase, and vice versa.Higher volatility=Higher premiumLower volatility = Lower premium Option Volatility Premium cost Call PutBABASAB PATIL 55
  56. 56. SMC INVESMENT SOLUTIONS & SERVICES4. 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 options contractis very large, then this factor may take on some importance. All other factors being equalas interest rates rise, premium costs fall and vice versa. The relationship can be thoughtof as an opportunity cost. In order to buy an option, the buyer must either borrow fundsor use funds on deposit. Either way the buyer incurs an interest rate cost. If interest ratesare rising, then the opportunity cost of buying options increases and to compensate thebuyer premium costs fall. Why should the buyer be compensated? Because the optionwriter receiving the premium can place the funds on deposit and receive more interestthan was previously anticipated. The situation is reversed when interest rates fall –premiums rise. This time it is the writer who needs to be compensated. Option Interest rates Premium cost Call Put6.12 STRATEGIES1. Bull Market StrategiesBABASAB PATIL 56
  57. 57. SMC INVESMENT SOLUTIONS & SERVICESa. Calls in a Bullish Strategy An investor with a bullish market outlook should buy call options. If you expectthe market price of the underlying asset to rise, then you would rather have the right topurchase at a specified price and sell later at a higher price than have the obligation todeliver later at a higher price. The investors profit potential of buying a call option is unlimited. The investorsprofit is the market price less the exercise price less the premium. The greater theincrease in price of the underlying, the greater the investors profit. The investors potential loss is limited. Even if the market takes a drastic declinein price levels, the holder of a call is under no obligation to exercise the option. He maylet the option expire worthless. The investor breaks even when the market price equals the exercise priceplus the premium.BABASAB PATIL 57
  58. 58. SMC INVESMENT SOLUTIONS & SERVICES 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, anincrease in the underlying volatility (before expiration), will increase the value of a longoptions 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 then hisgain will be Rs.200. However, this would not be his actual gain for that he will have todeduct 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 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 positions willlet their options expire worthless. By writing Puts, profit potential is limited. A Put writer profits when the price ofthe underlying asset increases and the option expires worthless. The maximum profit islimited to the premium received.BABASAB PATIL 58
  59. 59. SMC INVESMENT SOLUTIONS & SERVICES However, the potential loss is unlimited. Because a short put position holder hasan obligation to purchase if exercised. He will be exposed to potentially large losses if themarket 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 buy backthe 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 the position. 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 premium forthe position. An investor with a bullish market outlook should buy a call spread. The "Bull CallSpread" allows the investor to participate to a limited extent in a bull market, while at thesame time limiting risk exposure.BABASAB PATIL 59
  60. 60. SMC INVESMENT SOLUTIONS & SERVICES To put on a bull spread, the trader needs to buy the lower strike call and sell thehigher strike call. The combination of these two options will result in a bought spread.The cost of Putting on this position will be the difference between the premium paid forthe 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, bothwill be exercised and the maximum profit will be realised. The investor delivers on hisshort call and receives a higher price than he is paid for receiving delivery on his longcall.BABASAB PATIL 60
  61. 61. SMC INVESMENT SOLUTIONS & SERVICES The investor’s potential loss is limited. At the most, the investor can lose is thenet premium. He pays a higher premium for the lower exercise price call than he receivesfor writing the higher exercise price call. The investor breaks even when the market price equals the lower exercise priceplus the net premium. At the most, an investor can lose is the net premium paid. Torecover the premium, the market price must be as great as the lower exercise price plusthe 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 November calloption with a strike price of Rs.90 and pay a premium of Rs.14. At the same time you sellanother November call option on a scrip with a strike price of Rs.110 and receive apremium of Rs.4. Here you are buying a lower strike price option and selling a higherstrike price option. This would result in a net outflow of Rs.10 at the time of establishingthe spread. Now let us look at the fundamental reason for this position. Since this is a bullishstrategy, the first position established in the spread is the long lower strike price calloption with unlimited profit potential. At the same time to reduce the cost of purchase ofthe long position a short position at a higher call strike price is established. While this notonly reduces the outflow in terms of premium but his profit potential as well as risk islimited. Based on the above figures the maximum profit, maximum loss and breakevenpoint of this spread would be as follows:Maximum profit = Higher strike price - Lower strike price - Net premium paid = 110 - 90 - 10 = 10BABASAB PATIL 61

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