DERIVATIVES

Introduction:
Derivative is a Contract or Product whose value is derived from value of some other assets
known as underlying. The underlying assets could include Financial Assets such as Shares,
Bonds, Currencies, and Metals such as Gold, Silver, Aluminium, Copper, Lead, Zinc, and
Agro Commodities such as Cotton, Wheat, Pulses, and Sugar etc.
Derivative itself is contract between two or more parties based upon the assets. Its value is
determined by the fluctuations in the underlying assets.
History of Derivatives:
In Japan, 17th Century futures market in rice was developed to protect rice producers from bad
weather conditions which were a significant development in the evolution of derivatives
market.
In 19th Century, Chicago Board of Trade (CBOT) introduced the trading of Forward Contracts
on various commodities and Future Contracts in the US.
In 20th Century, Chicago Mercantile Exchange created International Monetary Market for
trading in Currency futures, in 1982 they introduced the first Euro Dollar futures Contract.
In the mean time, CBOT introduced Interest rate futures in 1975, Treasury Bond futures
contract in 1975
In India, Securities and Exchange Board of India (SEBI) setup a 24 member committee under
the Chairmanship of Dr.L.C.Gupta on 1996 as an initial step towards the introduction of
derivative trading in India. They developed the regulatory frameworks for the same. Also
SEBI setup a committee under the chairmanship of Prof.J.R.Verma in 1998 to recommend the
measures for risk containment in derivative markets in India.
In 1999, Indian Government amended the Security Contract Regulation Act (SCRA) to
include DERIVATIVES within the domain of SECURITIES and regulatory framework
was developed for governing derivatives trading in India.
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Following these developments, SEBI permitted NSE & BSE to deal in Equity Derivative
Segment Trading in June 2000, initially SEBI approved trading in Index futures contracts on
namely Nifty-50 and Sensex-30 index. Trading in Index options was Commenced on June
2001, Stock options commenced on July 2001. Future Contracts on individual stocks started in
November 2001.Recently in 2012, SEBI has given permission to Metropolitan Stock
Exchange of India (MCX-SX) to deal in equity derivatives.
Derivative Market Types
In the modern world, there is a huge variety of derivative products available. They
are either traded on organized exchanges (called exchange traded derivatives) or agreed
directly between the contracting counterparties over the telephone or through electronic media
called Over-the-counter (OTC) derivatives. Few complex products are constructed on simple
building blocks like forwards, futures, options and swaps to cater to the specific requirements
of customers.
Over-the-counter market is not a physical marketplace but a collection of brokerdealers scattered across the country. Main idea of the market is more a way of doing business
than a place. Buying and Selling of contracts is matched through negotiated bidding process
over a network of telephonic or electronic media that link thousands of intermediaries. OTC
derivative markets have witnessed a substantial growth over the past few years, very much
contributed by the recent developments in information technology. The OTC derivative
markets have banks, financial institutions and sophisticated market participants like hedge
funds, corporations and high net-worth individuals. OTC derivative market is less regulated
market because these transactions occur in private among qualified counterparties, who are
supposed to be capable enough to take care of themselves.
The OTC derivative markets transactions among the dealing counterparties, have following
features compared to exchange traded derivatives:

Contracts are tailor made to fit in the specific requirements of dealing counterparties.
The management of counter-party (credit) risk is decentralized and located within
individual institutions.
2

There are no formal centralized limits on individual positions, leverage or margining.

There are no formal rules or mechanisms for risk management to ensure market
stability and integrity, and for safeguarding the collective interest of market

participants.
Transactions are private with little or no disclosure to the entire market.

On the contrary, Exchange-Traded contracts are standardized, traded on organized

exchanges with prices determined by the interaction of buyers and sellers through
anonymous auction platform. A clearing house/ clearing corporation, guarantees contract
performance (Settlement of transactions).
Functions of Derivatives Market
1. Derivative markets helps in improving price discovery based on actual valuations and
expectations.
2. Derivative markets helps in transfer of various risks from those who are exposed to
risk but have low risk appetite to participants with high risk appetite. Hedgers will
transfer the risk to Speculators.
3. Derivative markets helps shift of speculative trades from unorganized market to
organized market. Risk management mechanism and surveillance of activities of
various participants provide stability to the financial system.
Major Products in Derivatives Market
1. Forwards
Forwards is a Contractual agreement between two parties to buy/sell an underlying
asset at a future date for a particular price that is pre-decided on the date of contract.
Both the contracting parties are committed and are obliged to honor the transaction
irrespective of price of the underlying asset at the time of delivery. Here, the Terms and
Conditions of the contracts are customized. These are called OTC contracts.

2. Futures

Future Contract is similar to forwards, except that the deal is made through an
organized and regulated exchange rather than being negotiated directly between two
parties. Futures can also be called as Forward Contracts traded on exchange.
3. Options
An Option is a contract that gives the right, but not an obligation to buy or sell the
underlying on or before a started date and at stated price. While buyer of option pays
premium and buys the right, Seller of option receives the premium with obligation to
sell/buy the underlying asset, if the buyer exercises his right.
4. Swaps
Swap is an agreement made between two parties to exchange cash flows in the future
according to a prearranged formula. Swaps are a series of forwards contracts. Swaps
help market participants manage risk associated with volatile interest rates, Currency
exchange rates and commodity prices.
5. Credit
Credit derivative is a loan sold to a speculator at a discount to its true value. Though
the original lender is selling the loan at a reduced price and will therefore see a lower
return, in selling the loan the lender will regain most of the capital from the loan and
can then use that money to issue a new and more profitable loan. Credit derivatives
exchange modest returns for lower risk and greater liquidity.
Factors influencing the growth of Derivative Market Globally
Over the last three decades, derivatives market has seen a phenomenal growth. Many
derivative contracts were launched at exchanges across the world. Some of the factors driving
the growth of financial derivatives are:
1. Increased fluctuations in underlying asset prices in financial markets.
2. Integration of financial markets globally.
3. Use of latest technology in communications has helped in reduction of transaction
costs.
4. Enhanced understanding of market participants on sophisticated risk management
tools to manage risk.
5. Frequent Innovations in derivatives market and newer applications of products.
Participants in Derivatives Market
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Broadly three types of participants in the derivative markets are Hedgers, Traders and
Arbitrageurs.
1. Hedgers
Hedgers face risk associated with the prices of underlying assets and use derivatives to
reduce their risk. Corporations, Investing institutions and Banks use derivative
products to hedge or reduce their exposure to markets.
2. Speculators
Speculators try to predict the future movements in prices of the underlying assets and
based on their views, take positions in the derivative contracts. Here the transaction
cost is lower than the underlying and are faster to execute in size as they are traded in
Lots.
3. Arbitrageurs
Arbitrage produces profit by exploiting a price difference in a product in two different
markets. This situation arises when a trades purchase an asset cheaply in one location
and simultaneously arranges to sell it at a higher price in another location.
Various risk faced by participants in Derivatives
Market Participants must understand that derivates, being leveraged instruments have
risks like counterparty risk (default by counterparty), price risk (loss on position
because of price move), liquidity risk (inability to exit from a position), legal or
regulatory risk (enforceability of contracts), operational risk (fraud, inadequate
documentation, improper execution, etc.) and may not be an appropriate avenue for
someone of limited resources, trading experience and low risk tolerance. A market
participant should therefore carefully consider whether such trading is suitable for
him/her based on these parameters. Market Participants, who trade in derivatives, are
advised to carefully read the Model Risk Disclosure Document, given by the broker to
his clients at the time of signing agreement.
Mode Risk Disclosure Document is issued by the members of Exchanges and contains
information on trading in Equities and Future & Options segments of exchanges. All
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prospective participants should read this document before trading on Capital

Market/Cash Segment or Future & Option segment of the Exchanges.

PROBLEM DEFINITION
Derivatives have been in existence for more than a decade in India, however
proper utilization of the same is missing. From a Retail Investor & Trader to a High
Net worth Individuals, Derivatives have been viewed as a Tool of Destruction rather
than a Risk Management Tool & an Income Generator. Lot of wealth destruction has
been happened in the times of Bear Markets in 2000, 2008 & early 2016 in Indian
Markets. This has changed the lives of thousands of people across India.
Once Investors burnt their fingers in Capital Markets, next time its obvious
they will feel reluctant to invest again in Markets. Old memories continue to haunt
them. The longstanding impact is that Investors will stay away from markets and Old
Companies as well as new companies looking to raise funds will find difficult to do the
same. As a result of this, Scarcity of funds arises, companies will find it hard to start
new projects, expansion projects etc. Profitability of the companies will continue to
decline / remain stagnant and Employment generation will also decrease drastically.
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Taxes such as Service Tax, Security Transaction Tax are levied on Investors
&Traders while they enter into a transaction, which adds sizeable Revenue to the
Indian Government. Derivative Traders play a significant role in this. Once they incur
huge losses, Revenue to the Indian Government reduces which further worsens the
Fiscal Deficit.
To avoid these adverse scenarios, Investors/Traders need Protection and
Profit Generation, which makes them safe and continue to invest in markets.
Derivatives play a vital role in safeguarding the Investors & Traders and also to make
profit from the same if used properly with adequate knowledge and practice.

OBJECTIVE AND SCOPE

The Objective of this Project is to address the major issues faced by Investors & Traders in the
Capital Markets and providing practically applicable solutions to them using Derivatives.
They are mentioned below.
1.
2.
3.
4.

Capital Protection
Generating Risk Free Annualized Profits
Generating Monthly Income
Exponential Profits

Various methodologies used to achieve the above mentioned objectives are explained in detail
as we go ahead. All the techniques are practically tested in real time with the Market
Participants and statistical data is provided at the required areas.
Capital Protection will be more effective if a portfolio is formulated carefully, for this
Portfolio Formulation Strategy is touched upon to achieve the objective.
Technical Analysis (TA) is used to achieve Objectives 3 & 4, which are beyond the scope of
this project as it is a separate subject of matter. However, Clear and Concise explanation about

TA is given at appropriate places which will ensure the Investors & Traders to achieve the
objective.
As we progress in the coming years, more and more new class of people will begin to
participate in Derivative Markets, New Innovative Customized solutions can be provided
to them rather than providing a standardized solution. Evolution of this project will also help
to achieve this.
Portfolio Formulation Strategy and Technical Analysis have been explained with the
help of Security Analysis and Portfolio Management subject and with the guidance
of the experienced Professional Traders.

Figure 1: Shows the four key objectives of the project

THEORETICAL PROSPECTIVE
Objectives are clearly defined. Next step is to explain the theoretical prospective,
Methodology & Procedure of work and Analysis of Data. Here 4 objectives are explained one
by one in the order mentioned.
1. Capital Protection
Investors once invested in Capital Markets tend only to think of making huge profits
and forget the important factor called Risk, which is the other side of the coin. When they are
in profit, they feel comfortable and happy. But once things tend to reverse they dont know
9

how to react and in panic will incur huge losses. To avoid these mishaps, Investors need to
know their Beta of the Portfolio and weightage of the individual stocks they have invested.
Here the Investors Capital is protected with the help of Index based Derivatives called Nifty.
Now, the theoretical part of the Calculating Beta of the portfolio and Weightage of the
individual stocks are explained.
What is Beta?
Beta is a measure of systematic risk of security that cannot be avoided through
diversification*. It measures the Sensitivity of a scrip or portfolio vis--vis index movement
over a period of time, on the basis of historical prices.
For example, A Stock has a Beta of 1.5, this means that historically this stock has
moved 15% when the index moved 10%, which indicates the stock is more volatile (more
fluctuating) than the index.
In another case, Let us say a Stock has a Beta of 0.5, this means that historically this
stock has moved 5% when the index moved 10%, which indicates the stocks is less volatile
than the index.
*Diversification: It is the process of allocating capital in a way that reduces the exposure to
any one particular asset or risk. Common way of diversification is to reduce risk or volatility
by investing in a variety of assets.
For Simplification, Beta of future index is taken as one.
Scrips / Portfolio having beta more than 1 are called Aggressive Portfolio.
Scrips / Portfolio having beta less than 1 are called Conservative Portfolio.
In order to calculate the Beta of a portfolio, betas of individual scrips are used. It is calculated
as weighted average of betas of individual scrips in the portfolio based on their investment
proportion. For example, if there are 3 scrips in a portfolio with betas x, y, z having
weightages a%, b% and c% respectively, then the beta of this portfolio would be
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x*a% + y*b% + z*c% respectively.

Generalized formula for Beta portfolio can be written as
W1 1 + W2 2 + W3 3 +. + Wn n = p
Where, W1 is weight of scrip 1, 1 is the Beta of Scrip, Wn is the weight of scrip n, n is the
Beta of scrip n and p is the Beta of the portfolio.
Beta of individual scrips is readily available in financial newspapers like Economic times,
magazines like Dalal Street, Information vending networks like Bloomberg,Reuters and on
www.nseindia.com or www.moneycontrol.com websites.
Here, once an Investor is uncomfortable of the market scenario they used to sell the entire
portfolio of stocks and stay away from the market. Instead of doing this, if an option is
available for them where they can make profit in Index Derivatives if the market falls and
make profit when the market arises again.
To do this we are using Derivatives efficiently as a tool to manage the risk.

How to do this?
Investors need to do a perfect Hedge for their portfolio. Now again the question arises what
is Hedging. Hedge is an investment to reduce the risk of adverse price movements in an asset.
Hedge consists of taking an offsetting position related to a security, such as Index Futures or
Stock futures contract.
Now we need to find out how to hedge and how many contracts to hedge a portfolio. To find
this Hedge Ratio is calculated.
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Hedge Ratio = (Vp) / Mi

Vp = Value of the Portfolio
Mi = Margin required to buy/sell one index futures contract
Single lot size of Nifty is 75.
Now, next section of the project is explained.
METHODOLOGY & PROCEDURE OF WORK
In the Case study conducted in Viyan Financial Services, an Investor has agreed to invest INR
500000 in equity markets on 15th Jan 2016.
Time frame for this case study is 1 month.
After one month, the value of the portfolio and the impact of Derivatives used as a hedge are
explained.
He was recommended to choose 5 Nifty 50 stocks to invest. They are:
1. Reliance Industries
2. Infosys
3. State Bank of India
4. Tata Steel
5. Maruti Suzuki Ltd.
Here the capital invested in each scrip:
1,50,000 in Reliance Industries; 1,25,000 in Infosys; 1,00,000 in State Bank of India; 75,000
in Tata Steel; 50,000 in Maruti Suzuki Ltd.
Price of the above scrips after the markets close on 15.01.2016 is:
Reliance Industries: 1073
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Infosys: 1140
State Bank of India: 184.3
Tata Steel: 229.7
Maruti Suzuki Ltd: 4273
No of shares bought will be:
Reliance Industries = 140 (150000/1073 = 140); Infosys = 110; State Bank of India = 543
Tata Steel = 327; Maruti Suzuki Ltd = 12
Here the weightage of each scrip in the portfolio need to be calculated.
Step:1
Weightage Calculation:
Weightage = (Total Portfolio Value) / (Total Amount Invested in each scrip)
For Reliance Industries,
Weightage = (500000) / (150000)
W1 = 0.3 for Reliance industries
Similarly for all the other stocks weightage is calculated and are as follows.
Infosys, W2 = 0.25; State Bank of India, W3 = 0.2; Tata Steel, W4 = 0.15;
Maruti Suzuki, W5 = 0.1
Step:2
Calculation of Beta of a Portfolio
Beta of each scrip is taken from www.nseindia.com and are as follows.
Reliance Industries 1: 1.23; Infosys 2: 0.68; State Bank of India 3: 1.08
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Tata Steel 4: 1.46; Maruti Suzuki Ltd 5: 0.67

As explained in the previous section, Formula for calculation of Beta is:
W1 1 + W2 2 + W3 3 +. + Wn n = p
Now, of this portfolio is,
Here, = (0.3*1.23) + (0.25*0.68) + (0.2*1.08) + (0.15*1.46) + (0.1*0.67)
Beta, = 1.041
From the value of Beta, we can infer that the portfolio is neither aggressive nor conservative.
Portfolio constructed here varies directly proportional to the changes in the benchmark
indices, Nifty.
Step:3
Calculation of Hedge Ratio
Hedge Ratio = (Vp) / Mi
In our case study, Value of the portfolio, Vp = 500000
Margin required to Sell one index futures contract, Mi = 50000 (as on 15th Jan 2016)
Hedge Ratio = (500000) / (50000)
Hedge Ratio = 10
So the investor needs to sell 10 lots of Index Derivative Nifty Future Contract for protecting
his capital from unexpected fall in markets. Index derivative Nifty is sold here as this will be a
hedge to the bought INR 500000 portfolio shares.
One lot of Nifty Derivative Contract = 75
10 Lots of Nifty Derivative Contract = 750 Indices

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Now the investor has invested INR 500000 in 5 scrips & sold 10 lots of Nifty derivative
contracts to hedge his portfolio.
Now the impact of this is explained in the next section

ANALYSIS OF DATA
Now the Capital has been invested and proper hedge has been taken.
Lets us see the impact of this portfolio after 1month i.e. on 15th Feb 2016
The value of the 5 scrips is as under:
1.
2.
3.
4.

Reliance Industries : 946.75

Infosys : 1092
State Bank of India : 167.85
Tata Steel : 246.7
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5. Maruti Suzuki Ltd : 3711

Now the portfolio has suffered a loss of 30.46% in one month, which is equivalent to INR
1,52,300 which is massive destruction of wealth.
Table 1: Shares price change in one month
Sl.No.

Scrip Name

Price on

Price on

% change in

1
2
3
4
5

Reliance Industries
Infosys
State Bank of India
Tata Steel
Maruti Suzuki Ltd

15.01.2016
1073
1140
184.3
229.7
4273

15.02.2016
946.75
1092
167.85
246.7
3711

value
-11.76
-4.2
-8.9
+7.4
-13

But, as the investor has taken a proper hedge all of this loss has been neutralized by the Sell
position in Index Derivative Nifty Futures Contract.

Table 2: Nifty price change in one month

Price of Index Derivative Nifty on 15.01.2016
Price of Index Derivative Nifty on 15.02.2016
Points gained by Short Selling

7441.25
7161.25
280

Investor has sold 10 lots of Index derivative Nifty, which is equivalent to 750 indices.
Profit from this position = 750 * 280
Total Profit = 210000
Even though the portfolio has suffered a loss of INR 152300, hedge position has given him a
profit of INR 210000
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Total Value of the Portfolio = 500000 152300 + 210000

Vp = 557700
Even after the major crash in the Markets, Investor is safe and his portfolio has actually gained
a return of 11.54% in a month.
Proper use of Derivatives has saved this Investor in turbulent times and kept his portfolio
profitable.

LIMITATIONS
1. It is a slightly expensive strategy as an investor needs to invest some more capital apart
from his investments, which is required for hedging.
2. Closing the hedging position and continuing with the investment requires basic
understanding of Technical Analysis*.
3. Lack of Awareness among investors in tier -2 &3 cities makes it difficult to convince
and gain their confidence. Investors need to be educated and this is painstaking & time
consuming task.

*Technical Analysis: It is a method of analyzing securities thereby forecasting the

direction of prices through the study of past statistical market data namely Price and
Volume.
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THEORETICAL PERSPECTIVE
Risk free Annualized Profits
Whenever an Investor/Trader come across the term risk free profits, it tends to generate
interest in the market participants mind to know How is it possible in Markets? & What
is the complex strategy we need to learn to grab this? The answer to the above question is
it is possible and simple. All one need to understand is It is possible only by using
Derivatives. This opportunity arises in the beginning of every new trading month i.e. after
the expiry of a particular month derivative contract.
Whenever there is plethora of opportunities are available, an investor/ trader likes that
situation and make good profits. But markets are not the same forever. There will be times
where there will be confusion, volatility and participants need to stay out of markets &
keep their cash idle. Now the problem arises, which is the impatience to stay idle with the
cash available. So an average market participant tends to do something out of nothing in
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these sorts of markets. Finally, they will end up making losses. To avoid these kind of
psychological challenges also Derivatives can be effectively used.
Now let us get into the details of how to do this every month and make a sizeable
annualized risk free profit.
In Indian markets, last Thursday of every month, derivative contract of Indices &
Stocks expires and a new contract is released by the exchange. These contracts are
available for the next three months. Important point to note here is out of 200 stocks
available in the Derivative segments, 80% of the stocks are always available at a
premium in the beginning of the expiry. It is here, an investor as well as trader can make
use of this opportunity to make nice risk free annualized profits. This is also called as Cash
and Futures Arbitrage.
It has been observed in the beginning of every month, there are few stocks in derivatives
which will be at a premium to the cash market price. Because,
One month future price of a Stock = Cash Price of the Stock + The cost of carry for a
period of one month.
Cost of carry refers to costs incurred as a result of an investment position. These costs
include financial costs such as interest cost, interest expenses on margin accounts and
interest on loans used to purchase a security and Economic costs such as opportunity
costs associated with taking the initial position.
How to make profit out of this?
A particular share in cash market will be available at a price say X. The same stock is
available in derivative market at a price of X + Y.
The difference between the cash market price and future market price can be utilized to
make an annualized profit of 5 20% per annum.
It is pertinent to explain about the Cash and Carry Model for Future Fair price
calculation method before delving into the practical application and analysis of this strategy.
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Because this strategy has to be used only when there is a mispricing between the cash price
and future price of the shares. Difference between the prices in two segments is going to yield
profit.
Cash and Carry model is also known as non-arbitrage model. This model assumes that
in an efficient market, arbitrage opportunities cannot exist. In other words, the moment
there is an opportunity to make money in the market due to mispricing in the asset price
and its replicas, market participants will start trading to profit from these mispricing and
thereby eliminating these opportunities. This trading continues until the prices are aligned
across the products/markets for replicating assets.
This position can be created in the following manners:
1. Enter into a forward/futures contract, or
2. Create a synthetic forward/futures position by buying in the cash market and
carrying the asset to future date
Price of acquiring the asset as on future date in both the cases should be same
i.e. cost of synthetic forward/futures contract (spot price + cost of carrying the
asset from today to the future date) should be equivalent to the price of the present
forward/ futures contract. If prices are not same then it will trigger the arbitrage
and will continue until price in both the markets are aligned.
The cost of creating a synthetic futures position is a fair price of futures
contract. Fair price of futures contract is nothing but addition of spot price of
underlying asset and cost of carrying the asset from today until delivery. Cost of
carrying a financial asset from today to the future date would entail different costs
like transaction cost, custodial charges, financing cost etc whereas for commodities, it
would also include costs like warehousing cost, insurance cost etc.
Similarly, if futures prices are less than the future fair price of asset / synthetic
futures price, it will trigger reverse cash and carry arbitrage.
Cost of transaction and non-arbitrage bound
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Cost components of futures transaction like margins, transaction costs

(commissions), taxes etc. create distortion and take markets away from equilibrium.
In fact, these cost components create a non-arbitrage bound in the market i.e if the
futures price is within that bound around the fair value/ synthetic futures value,
arbitrage will not take place. In other words, because of the frictions in the market, for
arbitrage to get triggered, it is important for the futures price to fall beyond the non
arbitrage bound in either direction for the arbitragers to make profit from the arbitrage
opportunities.
Practically, every component of carrying cost contributes towards widening
this non-arbitrage bound. Here, we should appreciate that wider the non-arbitrage
bound, farther the markets are from the equilibrium. In other words, for markets to be
efficient, different costs of operating in the markets should be as low as possible.
Lower costs would narrow down the non-arbitrage bound, which in-turn would
ensure the efficient price alignment across the markets.
Application of cash & carry model to the assets generating returns
Cash and Carry model is extended by adding the inflows during the holding
period of underlying assets. For instance, underlying asset like securities (equity or
bonds) may have certain inflows, like dividend on equity and interest on debt
instruments, during the holding period. Thus, modified formula of future fair price or
synthetic futures price is:
Fair price = Spot price + Cost of carry Inflows
In mathematical terms, F = S (1+r-q) ^T
Where F is fair price of the futures contract, S is the Spot price of the underlying
asset, q is expected return during holding period T (in years) and r is cost of carry.
If we use the continuous compounding, we may rewrite the formula as:
F = Se^(r-q)*T
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General assumption here is, Cost of financing is 12% and the return on index is
45% per annum (spread uniformly across the year). Given this statistics, fair price of
index three months down the line should be:
Fair Price = Spot Price (1+cost of financing holding period return) ^ (time to
expiration/365)
Important point to note here is Cost of borrowing of funds and securities, return
expectations on the held asset etc. are different for the different market participants.
The number of fair values of futures can be equal to the number of market
participants in the market. Perhaps the difference among their fair values of futures
contracts and non-arbitrage bound for different market participants is what makes the
market on continuous basis.
Cash and Carry model of futures pricing works under certain assumptions.
Important assumptions are stated below:
1.
2.
3.
4.
5.
6.
7.

Underlying asset is available in abundance in cash market.

Demand and Supply in the underlying asset is not seasonal.
Holding and maintaining of underlying asset is easy and feasible.
Underlying asset can be sold short.
No transaction cost
No taxes.
No margin requirements.
However in the case study conducted point no: 5&6 namely transaction cost and

taxes have been considered and taken into account.

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METHODOLOGY AND PROCEDURE OF WORK

In the case study conducted in Viyan Financial Services Pvt. Ltd., this Cash and Futures
Arbitrage strategy has been tested practically in a trader account. The details of the same
are explained here.
On 28th January 2016 which is the last Thursday of the month, January month contract
gets expired. Here the price difference between the stocks in cash market and February
month derivative stock future contract has existed in number of stocks. Out of 200 stocks
available in derivatives, 8 stocks have provided decent risk free annualized profits. Hence
the trader was advised to follow this cash and future arbitrage strategy on these stocks.
Stocks where the opportunity existed are:
1.
2.
3.
4.
5.
6.
7.

Tata Communications
Pidilite Industries
IndiaBulls Housing Finance Limited
Apollo Hospitals
Havells
Mcleod Russell
CEAT Tyre
23

8. Bharat Earth Movers Limited (BEML)

Cash Market Price and Derivatives - Future Market price of the above stocks as on 28th
January 2016 are as follows:
Table:3 Cash & Futures price comparison
Sl.No.
1.
2.
3.
4.
5.
6.
7.
8.

Stock Name
Tata Communications
Pidilite Industries
India Bulls Housing Finance Ltd.
Apollo Hospitals
Havells
Mcleod Russell
CEAT Tyres
BEML

Cash Market Price

401
555
692
1409
295.45
149.8
917
1063

Feb. Futures Price

407
560
697
1419
297.45
150.85
923
1069

Risk free annualized profits available between the above stocks as on 28th January 2016 is as
follows:
Table 4: Profit potential realized
Sl.No.
1.
2.
3.
4.
5.
6.
7.
8.

Stock Name
Tata Communications
Pidilite Industries
India Bulls Housing Finance Ltd.
Apollo Hospitals
Havells
Mcleod Russell
CEAT Tyres
BEML

Profit (%)
17.95
10.81
8.67
8.5
8.12
8.01
7.85
6.77

How this strategy is executed?

Before executing this strategy, it is better to confirm it using cash and carry arbitrage model.
24

Theoretical value should match with the practical value with reasonable accuracy.
As explained in the theoretical section, formula for calculating this is:
F = Se^(r-q)*T
In this case study, Tata Communication has been identified as a share with high potential
among the list of opportunities available.
S, Closing Cash Price of Tata Communication as of 28.01.2016 = 401
28.01.2016 is chosen because this strategy has been executed on the last Thursday of the
expiry of every month.
R, Cost of financing = 12%
Q, Return on Index = 4%
T, Time to expiration = Number of days left for expiry / 365
= 28/365
Number of days left for expiry is 28, because this strategy has been executed on the last
Thursday of expiry of every month which is January in this case study. This position remains
open till the last Thursday of expiry of the month of February.
So No. of days between 28.01.2016 to 25.02.2016 = 28 days
Applying all these data in the formula, we get
F = 401 * e^ (0.12-0.04)*28/365
F = 403.45
But the February future contract price of Tata Communication as on 28.01.2016 is 407,
which clearly indicates there is an excellent opportunity to execute this strategy and make
Risk-Free Annualized profits.
The lot size of each stock need to be known for executing this strategy. They are:
25

Table 5: Lot sizes of shares taken for case study

Sl.No.
1
2
3
4
5
6
7
8

Stock Name
Tata Communications
Pidilite Industries
IndiaBulls Housing Finance
Apollo Hospitals
Havells
Mcleod Russell
CEAT Tyres
BEML

Lot Size
1100
1000
800
400
2000
2200
700
500

On 28th January 2016, a Trader is advised to Buy 1100 shares of Tata Communication in Cash
Market and Sell one lot of Tata Communication in Futures Market.
1100 shares is chosen because one lot size of Tata Communication is 1100, Lot sizes are
decided by the stock exchanges.
On 28th January 2016, Tata Communication Share Prices are:
Cash Market Price: 401
Future Market Price: 407
On the expiry of February Month Contract, i.e. on 25th February 2016, Tata Communication
Share Prices are:
Cash Market Price: 330.2
Future Market Price: 330.7

26

Since the Traders has bought in cash market and sold in futures market, he was able to exploit
the price difference between the two which was 1.49% on a monthly basis which is 17.95% on
an annual basis.
ANALYSIS OF DATA
In this section, what has happened in the traders account for this one month has been
explained.
In cash market, 1100 shares of Tata Communication was bought at a price of 401
Investment required was 1100 * 401 = 441100
In futures market, 1 lot i.e. 1100 shares of Tata Communication was sold at a price of 407
Since it is a derivative trade, investment required was just INR 58000 which is 13% of the
contract value. This amount is called margin required to trade one contract which was decided
by the stock exchanges.
At the end of February month contract, the scenario is:
Cash Market Price: 330.2
Trader has lost INR 77880
Future Market Price: 330.7
Trader has gained INR 83930
Net Profit in this Cash and Future Arbitrage Strategy is: 6050
Here the trader was able to get a return of 1.37% in just one month, which is 16.44% on an
annualized basis without taking any risk irrespective of market conditions.
There is a difference in value on annualized return between the data shown on the table 4 &
actual return generated. Since the markets are not ideal, there will be always a minor price
difference while practically executing this strategy.
27

If opportunity arises, a trader need not wait for one month to take this profit. If the price
between cash market and futures market shrinks at any point of time before the expiry of the
February contract, he can quickly cash in to lock the profits.
Similarly, for all the stocks a trader was guided to exploit the price difference between
cash market and future market. Risk free annualized profits objective was achieved and
practically proven with the data available.
Without the knowledge of Derivatives, a Trader would have suffered a major loss or would
have stayed out of the market with fear & kept his cash idle. Here, a Trader was able to
make a risk free profit and enjoy the benefit irrespective of market condition either up or
down.

28

Advantages of this Strategy are:

1. Reasonable returns can be generated when the trader is in confusion, as he needs to spot
only the price difference between the stocks between on two segments.
2. Idle cash which is lying around can be utilized here and returns are generated without
taking any risk.
3. Whether the market is up or down or sideways or volatile, a trader can spot these kinds
of opportunity and profit from the same.
LIMITATIONS
1. Brokerages and Various taxes levied will reduce the profit of a trader by a certain
percentage, which cannot be eliminated completely but can be reduced by negotiating
with the concerned broker to reduce the brokerages charged by him.
2. Here the price difference between the cash market and the future market will exist only
for a shorter period of time. To grab this, Trader need to spend full time in markets and it
requires tremendous concentration and professional advice from an expert.

29

THEORETICAL PERSPECTIVE
Exponential Profits
The third objective of this project is to explain practically how to generate Exponential
profits in markets using Derivatives effectively. An Investor/Trader entering into capital
market expects to generate a return which should be minimum twice the return which he/she
will be getting by investing in Fixed Deposits. Also, Profit eaten up by Inflation has also to be
considered. This is because as everyone knows, an individual or a corporate likes to generate a
return equivalent to the risk taken. Making an annualized return of 8-10% by investing in
Capital Markets doesnt attract Investors/Traders for the risk they are taking, instead they can
invest in Fixed Deposit and be relaxed.
To achieve Exponential profits in Capital Markets irrespective of the prevailing trend
either up or down, it is necessary to integrate Derivatives with Technical Analysis. A brief
introduction about Technical Analysis will guide in achieving the objective.
What is Technical Analysis?
Technical Analysis is a method of analyzing securities thereby forecasting the direction
of prices through the study of past statistical market data namely Price and Volume.
In other words, Technical Analysis studies the supply and demand in a market in an
attempt to determine what direction or trend will continue in the future. Also it attempts to
understand the emotions in the market by studying the market itself, as opposed to its
components. Once the benefits and limitation of technical analysis is properly understood,
one can devise a new set of strategies to become an Intelligent Investor / Trader.
Various techniques have been used to predict the securities future price movements.
They are:
1. Chart Patterns
2. Technical Indicators
30

3.
4.
5.
6.
7.
8.
9.

Technical Oscillators
Fibonacci Retracement Levels & Ratios
Moving Averages
Dow Theory
Elliott Wave Theory
Gann Theory
Gartley Chart Pattern

Among the various tools available, majority of the technical analysts use chart patterns
along with Indicators and Oscillators to predict the future movement of the securities.
Technical Analysis is based on three assumptions:
1. The market discounts everything.
One of the major criticism about technical analysis is it considers only the price
movements, ignoring the fundamental factors. But the fact is all the Macro Micro
economic factors, fundamental news which could affect the company are already
priced in to the stock price because all the Critical factors are known to the Insiders,
so all these factors are already priced in, which leaves only the analysis of price
movements to the analysts.
2. Price moves in trends.
Price movements are believed to follow trends, which mean that after a trend has
been established, future price movement is likely to be in the same direction as the
trend than to be against it.
3. History tends to repeat itself.
History tends to repeat itself mainly in terms of price movement. The repetitive
nature of price movements is attributed to market psychology, in other words, market
participants tend to provide a consistent reaction to similar market stimuli over time.
Technical analysis uses chart patterns to analyze market movements and understand
trends.

Use of Trend:

31

Trend is really nothing more than the general direction in which a security or
market is headed. There are basically 3 types of trends. They are:
1. Uptrend
2. Down Trend
3. Sideways/Horizontal trend.
The first two types of trends, as the name indicates are easy to understand. When
each successive peak and trough is higher, it is referred to as an upward trend. If the peaks and
troughs are getting lower, its a downtrend. When there is a little movement up or down in the
peaks and troughs, it is sideways or horizontal trend.
Figure 2: Example of Uptrend and Downtrend

Above figure is an example of up trending and down trending stock.

Figure 3: Example of Sideways trend

32

Above figure is an example of a sideways stock.

CHARTS CHART PATTERNS - VOLUMES
Charts are a pictorial representation of price movement of a security over a period to time.
Time is plotted along the X-Axis and Price is plotted along the Y-Axis. There are various types
of charts used in Technical Analysis. They are:
1.
2.
3.
4.

Line Charts
Bar Charts
Candle Stick Charts
Point and Figure Charts

Most popular candle stick chart have been extensively used in the analysis.
Various Chart Patterns are available, among them most reliable pattern is taken for study,
which is called Head and Shoulder Top & Head and Shoulder Bottom which was also
explained in the Security Analysis and Portfolio Management Subject.
Here, Volume is an important factor to be considered in Technical Analysis.
Volume is the number of shares or contracts that trade over a given period of time, usually
a day. It depends on the time frame used. Time frame may vary from one minute to one year.
33

Higher the volume, more active the security. To determine the movement of the volume, up or
down, Technical Analysts look at the volume bars that can be usually found at the bottom of
the any chart. Volume bars illustrate how many shares have traded per period and show trends
in the same way that prices do.
Volume is an important aspect of technical analysis as it is used to confirm trends and
chart patterns. Any price movement up or down with relatively high volume is sees as a
stronger, more relevant move than a similar move with low volume.
Volume should move with the trend. If the prices are moving in an upward trend, volume
should increase and vice versa. If the previous relationship between volume and price
movements starts to deteriorate, it is usually a sign of weakness in trend. For example, if the
stock is in an uptrend but the up trending days are marked with lower volume, it is a sign that
the trend is starting to lose its legs and may soon end.
When volume indicates a different thing, it is a case of divergence which refers to a
contradiction between two different indicators. Simple example of divergence is clear upward
trend with declining volumes.
HEAD & SHOULDER PATTERN FORMATION
Head and Shoulder is one of the reliable chart patterns that occur at both market tops and
bottoms. It is a potential reversal pattern. Market Tops are formed in bull phase and Market
Bottoms are formed in bear phase.
In a bull phase, potential reversal occurs by the Head and Shoulder Top pattern in which a
stocks price
1. Rallies to a peak with high volumes and subsequently declines which is called the
Left Shoulder of the pattern.
2. Then, the price rises above the former peak which is the left shoulder with declining
volume than the previous peak and again declines. This is called the Head of the
pattern.
3. Finally, price rallies again with drastic reduction in volume but not to the height of the
second peak and declines once more. This is called the Right Shoulder of the pattern.
34

Figure 4: Head & Shoulder Pattern

Above figure is a pictorial example of a Head and Shoulder Top pattern in a bull phase.
How to achieve Exponential Profit using this pattern?
Once a market participant identifies this pattern, they can sell short the particular stock
or indices on Derivatives Market and buy back the same once the target is achieved as
mentioned in the figure.

Where to Sell the Stock or Indices?

After identifying the pattern a trader has to sell short the stock or indices once the Neck
Line is broken with huge volumes. Neck Line is a horizontal line connecting the Left
shoulder, head and Right Shoulder of the pattern.
35

METHODOLOGY AND PROCEDURE OF WORK

In a case study conducted in Viyan Financial Services Pvt. Ltd., the above mentioned
Reversal Pattern Head and Shoulders Top was found in the Stock called Arvind Limited on
03.02.2016
Once all the criteria of the pattern was satisfied, a Trader was advised to sell short the
stock and follow the procedures as explained above.
Figure 5: Head & Shoulder Top pattern on Arvind Limited

As explained in the theoretical part, similar pattern was formed and in the case study a
trader was advised to sell short the stock and the result was pictorially visible in the
candlestick chart as shown above.
Trader has to sell this stock one and only when the neck line was broken, which is at 300
in this stock, which can be seen in the above figure.
Here the trade has been entered, now the next question is when to exit. This has been a
major issue right from a retail trader to professionals as well as corporate. Here the target
measurement technique has been used to address this issue.
36

Target Measurement:
The height of the pattern is measured by the distance between the head, which is the top
of the pattern and the Neck Line. Here the head is 365, Neck Line point is 292; subtracting
both of these, we will get 365 296 = 69
These 73 points must be subtracted from the Breakout Point to arrive at the target which
is shown as Neckline broken on 03.02.2016 on the figure.
Breakout Point is: 300
Target is: 300 69 = 231
Stock Price of Arvind Limited reached to a level of 237 on 29.02.2016 which was close
to the target point and the trader was advised to book profits on the same.
ANALYSIS OF DATA
Here, Derivatives and Technical Analysis has been integrated to achieve Exponential
profits. This can be understood much clearly when the data was analyzed in this section.
Since a trader can sell short only in Derivatives market, he can do so in lot size
mentioned by the exchanges. One Lot size of Arvind Limited is 1700
In the case study, one lot of Arvind Limited was sold at a price of 300
Total Capital required: 300 * 1700 = 510000
Since the exchanges charge only 15% of the total capital required in derivative segment,
here the requirement is only 76500
What happened after this?
Trader has sold 1700 shares which is one lot of Arvind Limited at 300 and bought back
the same at a price of 237 on 29.02.2016

37

Total Profit = 1700 * (300 237)

= 107100
Total Profit of 107100 have been achieved by integrating Derivatives with Technical
Analysis which equates to a Return on Investment of 140 % in just 26 days which can be
termed as Exponential Profits.
By using Derivatives and Technical Analysis wisely, an Investor and Trader can amass
huge wealth from markets. All the data provided with example are from 2016
LIMITATIONS
1. To achieve this objective, Technical Analysis has been extensively used which requires
lot of expertise and practice to determine the trend of the stock, without which it will
be very difficult for a market participant to achieve these kind of return from markets.
2. The basic limitation of Integrating Derivatives and Technical Analysis is Success ratio
of Technical Analysis in any world market is between 70 75%, so a market
participant should also be prepared to take losses in the remaining time. However,
overall a market participant will be at Gain.

THEORETICAL PERSPECTIVE
Generating Monthly Income
The final objective of this project has been explained in this section. Second objective
Risk Free Annualized Profits was also able to achieve this, but the difference between Risk
38

free Annualized profits and Monthly Income Generation is in the name itself. Here the
chance of making profit is 70% this strategy works well in the quite markets, which
constitutes about 70% in a financial year. The need of this strategy is as explained in the
previous section, an investor/trader needs to spend full time in markets to identify and grab
that opportunity which is practically not possible and a common retail investor is reluctant to
pay for a professional advice.
In this strategy, once an investor/trader understands the basics of Technical Analysis and
Derivatives, he will be able to execute this strategy with ease for a life time and get regular
monthly income without spending much of his time concentrating on markets. This is one of
the major problems faced by working professionals who are unable to concentrate full time
on markets. By closely observing the market conditions and regular practice the success rate
of this strategy can be easily increased.
In this strategy, one of the Derivative tools called OPTION is used.
An Option is a contract that gives the right, but not an obligation, to buy or sell the
underlying asset on or before a stated date/day, at a stated price, for a price. The party taking
a long position i.e. buying the option is called buyer/holder of the option and the party taking
a short position i.e. selling the option is called the seller/writer of the option.
The option buyer has the right but no obligation with regards to buying or selling the
underlying asset, while the option writer has the obligation in the contract. Therefore, option
buyer/holder will exercise his option only when the situation is favorable to him, but, when
he decides to exercise, option writer would be legally bound to honor the contract.

Options are categorized into two main types:

1. Call Options
2. Put Options
Option which gives buyer a right to buy the underlying asset is called Call Option and the
Option which gives buyer a right to sell the underlying asset is called a Put Option.
39

Before delving into this strategy, brief introduction about Option is required as this will
bring further clarity on how this objective can be achieved.
Terms used in Options
Index Option: These options have index as a underlying asset. Example: Nifty, Sensex.
Stock Option: These options have individual stocks as the underlying asset. Example: TCS,
DLF.
Buyer of an option: The buyer of an option is one who has a right but not the obligation in the
contract. For owning his right, he pays a price to the seller of this right called Option
Premium to the option seller.
Writer of an option: The writer of an option is one who receives the option premium and is
thereby obliged to sell/buy the asset if the buyer of option exercises his right.
American Option: The owner of such option can exercise his right at any time on or before the
expiry date/day of the contract.
European Option: The owner of such option can exercise his right only on the expiry date/day
of the contract. In India, Index options are European.
Option Price/Premium: It is the price which the option buyer pays to the option seller. For
example if the price of one lot of a call/ put option of Nifty is 50. This 50 is called Option
Premium. To find the total value, we need to multiply this with lot size.
Lot Size: Lot size is the number of units of underlying asset in a contract. Lot size of Nifty
option contracts is 75. So the Total Premium is 50 * 75 = 3750
Expiration Day: The day on which a derivative contract ceases to exist. This is the last trading
date/day of the contract, which is usually last Thursday of the month.
Spot Price: It is the price at which the underlying asset trades in the spot market. This is also
called as Cash Market Price.

40

Strike Price or Exercise Price: Strike price is the price per share for which the underlying
security may be purchased or sold by the option holder.
In the Money (ITM) option: This option would give holder a positive cash flow, if it were
exercised immediately. A call option is said to be ITM, when spot price is higher than strike
price. A put option is said to be ITM, when spot price is lower than strike price.
At the Money (ATM) option: At the money lead to zero cash flow if it were exercised
immediately. Therefore, for both call and put ATM options, Strike price is equal to spot
price.
Out of the Money (OTM) option: OTM option is one where strike price worse than the spot
price for the holder of option. In other words, this option would give the holder a negative
cash flow if it were exercised immediately. A call option is said to be OTM when spot price
is higher than strike price. In our examples, put option is out of money.
Intrinsic Value: Option Premium consists of two components Intrinsic value and Time
Value.
For an option, Intrinsic value refers to the amount by which option is in the money i.e. the
amount an option buyer will realize, before adjusting for premium paid, if he exercises the
option instantly. Therefore, only in-the-money options have intrinsic value whereas at-themoney and out-of-the money option have zero intrinsic value. The intrinsic value of an
option can never be negative.
Thus, for call option which us in the money, intrinsic value is the excess of spot price over
the exercise price. Thus, intrinsic value of call option can be calculated as Spot Price minus
Exercise Price, with minimum possible value as zero because no one would like to exercise
his right under no advantage condition.
For put option which is in-the-money, intrinsic value is the excess of exercise price over
the spot price. Thus, intrinsic value of put option can be calculated as Strike price Spot
price, with minimum value possible as zero.
41

Time Value: It is the difference between premium and intrinsic value, if any, of an option. ATM
and OTM options will have only time values because the intrinsic value of such option is zero.
Open Interest: Open Interest is the total number of option contracts outstanding for an
underlying asset.
Exercise of Options
In case of American Options, buyers can exercise their option any time before the maturity of
contract. All these options are exercise with respect to the settlement value/closing price of the
stock on the day of exercise of option.
Assignment of Options
Assignment of options means the allocation of exercised options to one or more option sellers.
The issue of assignment of options arises only in case of American options because a buyer
can exercise his options at any point of time.
Importance of time in Options Derivatives
As far as option is concerned, time is an important factor in using this valuable
Derivative tool. Various Factors which affects price of an option / option premium are:
1.
2.
3.
4.
5.

Spot price of the underlying asset

Strike price of the option
Volatility of the underlying assets price
Time to expiration
Interest rates.

These factors affect the premium / price of options, both American and European
options in several ways.
Spot price of the underlying asset
The option premium is affected by the price movements in the underlying instrument.
If the price of the underlying asset goes up the value of the call option increases while the

42

value of the put option decreases. Similarly if the price of the underlying asset fails, the value
of the call option decreases while the value of the put option increases.
Strike Price
If all the other factors remain constant but the strike price of option increases, intrinsic
value of the call option will decrease and hence its value will also decrease. On the other hand,
with all the other factors remain constant, increase in strike price of option increases the
intrinsic value of the put option which in turn increases its option value.
Volatility
It is the magnitude of movement in the underlying assets price, either up or down. It
affects both call and put options in the same way. Higher the volatility of the underlying stock,
higher the premium because there is a greater possibility that the option will move in-themoney during the life of the contract.
Higher Volatility = Higher premium
Lower Volatility = Lower Premium
Above point is applicable for both call and put options.

Time to expiration
The effect of time to expiration on both call and put options is similar to that of
volatility on option premiums. Generally, longer the maturity of the option greater is the
uncertainty and hence the higher premiums. If all the other factors affecting an options price
remain same, the time value portion of an options premium will decrease with the passage of
time. This is also known as time decay. Options are known as Wasting assets, due to this
property where the time value gradually falls to zero.
It is also interesting to note that two of the two component of option pricing (time
value and intrinsic value), one component is inherently biased towards reducing in value, that
43

is time value. So, if all things remain constant throughout the contract period, the option price
will always fall in price by expiry. Thus option sellers are at a fundamental advantage as
compared top option buyers as there is an inherent tendency in the price to go down.
Interest Rates
Interest rates are slightly complicated because they affect different options differently.
For example, interest rates have a greater impact on options with individual stocks and indices
compared top options on futures. To put it in simpler way high interest rates will result in an
increase in the value of a call option and a decrease in the value of a put option.
Pricing of options
One of the effective tools of Derivative called OPTION is misunderstood and viewed as a
dangerous tool because of the hidden factors in the pricing of an option. So it is a must to
understand the calculation of Option Pricing. There are various option pricing models which
traders use to arrive at the right value of the option. Most popular model is:
1. Binomial Pricing Model
2. The Black & Scholes Model

The Binomial Pricing Model

The binomial option pricing model was developed by William Sharpe in 1978. It has
proved over the time to be the most flexible, intuitive and popular approach to option pricing.
The binomial model represents the price evolution of the options underlying asset as the
binomial tree of all possible prices at equally-spaced time steps from today under the
assumption that at each step, the price can only move up and down at fixed rates and with
respective simulated probabilities.
This is a very accurate model as it is iterative, but also very lengthy and time consuming.
44

The Black & Scholes Model

The Black & Scholes model was published in 1973 by Fisher Black and Myron Scholes.
It is one of the most popular, relatively simple and fast modes of calculation. Unlike the
Binomial model, it does not rely on calculation by iteration.
This model is used to calculate a theoretical call price (ignoring the dividends paid
during the life of the option) using the five key determinants of an options price; stock price,
strike price, volatility, time to expiration and short term risk free interest rate.
The original formula for calculating the theoretical Options Price (OP) is:
OP = SN (d1) - XertN (d2)
Where,
D1 = [ln(s/n) + (r+ (v2/2) t]/ v (t) 1/2
D2 = d1 v (t)
And the variables are
1.
2.
3.
4.
5.

S = Stock Price
X = Strike Price
T = time remaining until expiration, expressed in years
r = current continuously compounded risk-free interest rate
v = annual volatility of stock price (the standard deviation of the short-term

returns over one year)

6. ln = Natural Logarithm
7. N(x) = Standard normal cumulative distributive function
8. E = the exponential function
Option Greeks
Option premiums change with changes in the factors that determine option pricing
that is factors such as strike price, volatility, term to maturity etc. The sensitivities most
45

commonly tracked in the market are known collectively as Greeks represented by Delta,
Gamma, Theta, Vega and Rho.
Delta
The most important of the Greeks is the options Delta. This measures the sensitivity
of the option value to a given small change in the price of the underlying asset. It may also be
seen as the speed with which an option moves with respect to price of the underlying asset.
Delta = Change in option premium / Unit change in price of the underlying asset.
Delta for call option buyer is positive. This means that the value of the contract increases
as the share price rises. To that extent it is rather like a long or bull position in the underlying
asset. Delta for call option seller will be same in magnitude but with the opposite sign
(negative).
Delta for put option buyer is negative. The value of the contract increases as the share
price falls. This is similar to a short or bear position in the underlying asset. Delta for put
option seller will be same in magnitude but with the opposite sign (positive).
Therefore, delta is the degree to which an option price will move given a change in the
underlying stock or index price, all else being equal.
The knowledge of delta is of vital importance for option traders because this parameter
is heavily used in margining and risk management strategies. The delta is often called the
Hedge Ratio, this hedge ratio is created using the derivative tool option, If you have a
portfolio of nshares of a stock then n divided by the delta gives you the number of calls you
would need to be short, which is also called writing, to create a hedge. In such a delta neutral
portfolio, any gain in the value of the shares held due to rise in the share price would be
exactly offset by a loss on the value of the calls written, and vice versa.
Gamma
It measures the change in delta with respect to change in price of the underlying asset.
This is called a second derivative option with regard to price of the underlying asset. It is
46

calculated as the ration of change in delta for a unit change in market price of the underlying
asset.
Gamma = Change in an option delta / Unit change in price of underlying asset
Gamma works as an acceleration of the delta, i.e. it signifies the speed with which an
option will go either in-the-money or out-of the-money due to a change in price of the
underlying asset.
Theta
It is a measure of an options sensitivity to time decay. This is the change in option price
given a one day decrease in time to expiration. It is a measure of time decay. Theta is
generally used to gain an idea of how time decay is affecting your option positions.
Theta = Change in an option premium / Change in time to expiry
Usually theta is negative for a long position, whether it is a call or a put. Other things
being equal, options tend to lose time value each day throughout their life. This is due to the
fact that the uncertainty element in the price decreases.
Vega
This is a measure of the sensitivity of an option price to changes in market volatility. It is
the change of an option premium for a given change (typically 1%) in the underlying
volatility.
Vega = Change in an option premium / Change in volatility
Vega is positive for a long call and a long put. An increase in the assumed volatility of
the underlying increases the expected payout from a buy option, whether it is a call or a put.
Rho
Rho is the change in option price given a one percentage point change in the risk-free
interest rate. Rho measures the change in an options price per unit increase in the cost of
funding the underlying.
47

Rho = Change in an option premium / Change in cost of funding the underlying

How this strategy works?
The concept of covered call writing strategy is used.
Covered Call writing is buying a stock in futures and at the same time writing/selling the
nearest at-the-money call option. Aggressive investors can sell one strike further out-of-the
money; Conservative investors can sell one strike further in-the-money.
Number of ways this covered call seller benefits:
1. If the options volatility reduces, a trader makes the difference of the volatility
premium.
2. As the time to expiry reduces, money is made on the time value.

48

Figure 6: Pictorial representation of Covered Call

49

3. If at expiry the price is below the strike price, entire premium is made as profit.
History repeats in market, past 15 years data shows markets trend 20 - 30% of the
time, remaining 70% market remains in a sideways trend to consolidation/correction. This data
makes this strategy attractive to achieve a monthly income on a regular basis. What happens
here is the volatility of an option premium decreases with the time, since the trader has sold an
option he will benefit from it and at the same time the price of the stock future, even if it
remains stagnant the sold call will give him a monthly return on his investment.
METHODOLOGY AND PROCEDURE OF WORK
In the case of a Stock ACC which was trading in the price range between 130 180, an
investor would have gained nothing in this period as circled in the graph. As the cement sector
did nothing exciting when the markets have rallied 50% it would have disappointed the
investor.
An investor who was long 1500 ACC shares at 180 and held on till 220 for 3 years would have
made profit of INR 60000. But by writing a covered call which yields 3% per month, which is
about 8100 per month, (1500 * 220 = 270000 ; 3% * 270000 = 8100) annually which gives a
profit of 97200. For four years together, it gave a profit of 388800. Entire investment of
270000 is back plus stock holding plus covered call profit is achieved here.
Figure 7: Daily chart of ACC Limited

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Here the important thing to note here is investors dont have to watch the markets closely
and continuously as explained in the previous objective. For the 70% of the time, market as
well as the stock has moved sideways which resulted in nice profits.
ANALYSIS OF DATA
ACC shares have traded between 120 180 and an investor has made a sizeable profit
even as the stock remained sideways in a tight range. Here the analysis of various scenarios of
what have happened if the stock moved out of this range has been explained.
Here ACC has moved out of this range and was trading at 215; Covered Call strategy is
selling a 220 Call Options at INR 15. Strike 220 is taken here because nearest at-the-money
call option is a best strategy in these sideways markets as already explained in the theoretical
section.
In this scenario, covered call performs better than just holding a long stock at all points
other than above 235. Money is made if the ACC trades above 200. This is because the stock
price is 215, upfront premium received is 15 and breakeven point is 200. This is because Stock
price minus premium paid is the breakeven point.

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Scenario1: When ACC closes below 220

If the stock closes below 220 at the end of a particular expiry, for example at 210, entire
premium of 15 is profit. As far as the stock doesnt close below 200, there is no problem as
there is a hedge against this fall. Here the hedge is 50 paise to every rupee loss in the stock. If
the stock goes down to 200, option will go down to 7.5
Scenario 2: When ACC closes above 220
If the stock closes above 220, 5 points is made as profit in stock appreciation and 15
points in option premium. So effective return for the month is about 10%; Even is the stock
closes at 230 at the end of the month, 15 points is made as profit in stock appreciation , but the
call has been exercised against us, so it ended like keeping only 5 points and 10 points paid
out. Above 220, return remains constant at 20 (5 in option premium; 15 in stock futures).
LIMITATIONS
1. This strategy works well only in quite markets, once news affecting the markets,
sectors or a particular stock came, then suddenly the Covered Call Strategy will run
into losses. Proper attention has to be paid on Macro Factors and understanding
interpreting reacting to the same is important.
2. Out of 100s of stocks available in the derivative segment, proper selection of stock,
proper selection of which strike price to enter is one of the limitations.
3. Timely Entry & Exit is an important factor in this strategy which needs extra care.

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FINDINGS, INFERENCES & RECOMMENDATIONS:

Findings:
With respect to the project title Derivatives following points were the findings in Viyan
Financial Services
1. Even though Derivatives has been in existence for more than 15 years in India, there
was a lacuna in understanding the theoretical part and Practical application of the
same.
2. Derivative has been viewed as a tool of destruction by a retail investor to sophisticated
HNIs rather than viewing it as a Risk Management tool.
3. There was a misconception among the market participants that Derivatives is an easy
way to make quick and huge bucks.
4. Keeping the above point in mind, many market participants try their luck in derivatives
segment especially Options, by buying huge quantity of Call / Put options simply for
the reason they are available at INR 5 or 10, theses kind of unplanned gambling like
strategy has led to the wash out of the accounts.
5. Some of the market participants are applying their theoretical knowledge of
Derivatives in their Investment & Trading activities. But still the problem persists
which is the theoretical part has to be adapted to the current market scenario to utilize
the available derivative strategies effectively, which is very much lacking.
6. Small retail investors having a Capital of less than INR 25000 are taking a huge risk by
participating in derivative market. They are doing it so by getting exposure from their
respective brokerage firms which is detrimental to their financial health and also to the
growth of Derivative markets. Brokerage firms are giving exposures ranging from 10
to 50 times of the capital, which shows their narrow mindset of generating brokerage
for the short term to achieve their monthly targets.
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7. Without proper knowledge and practice, 95% of the market participants are repeatedly
losing their hard earned money in derivative markets. After their threshold limit is
reached, they are deciding to quit and completely stay away from their markets which
leads to lot of inactive demat accounts in the firm. This also affects the profitability of
the brokerage firm to a large extent and in the long run the growth of derivative
market.

Inferences & Recommendations

1. All the market participants ranging from retail to a HNI, everybody needs to be
given a proper training before allowing them to participate in Derivative segment.
Training has to be given by an experienced person having a proven track record in
Derivative Markets. Initially, it will incur expenses for the brokerage firm, but in
the long run it will be highly profitable for both the firm and market participants.
2. Once this is done, Market participants view about Derivative Markets will change
and they will view Derivative purely as a Risk Management tool & also if properly
used with practice can generate exponential returns.
3. Once the market participants are trained and they begin to practice it, they will
realize this is not an easy and quick money making ways rather it is a long term
sustainable income & wealth generating process.
54

4. Various market scenarios from the past and the application of Derivative strategies
at those times have to be studied. This will help the market participants to use those
strategies if same kind of market scenario prevails.
5. Customized strategies using Derivatives have to be developed for market
participants ranging from retail to HNI as per their risk taking ability and capital
invested. The four objectives of this project have been suggested to categorize the
customers according to their need. They are Capital Protection, Risk free
annualized profits, Generating Monthly Income and Exponential Profits.
6. Instead of giving huge exposures to market participants, Brokerage firms have to
be broader in their mindset. Train their customers, categorize them and look for
long term mutual & beneficial relationship.

CONCLUSION AND SUGGESTIONS FOR IMPROVEMENT IN THE

ORGANISATION
Following 12 steps have been suggested in the organization.
1. Classification of customers based on their Trading style
(a) Day Trader
(b) Swing Trader
(c) Positional Trader
(d) Short Term Investor
(e) Medium Term Investor
(f) Long Term Investor
Classification of customers based on the Capital Invested
(a) Retail
(b) HNI
One more General classification of Investors
(a) Active Investors
(b) Passive Investors
(c) Retirement Investors
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2. Identifying the personal needs of the customers. Why they are investing/ trading?
What kind of returns they are exactly expecting from the markets?
3. Comparing and Cross checking whether the customers requirement can be met or
not. A Feasibility check. Because most of the market participants are entering into
markets with the view of becoming crorepathi in one year by investing one lakh.
4. Customers requirement is brought under the four objectives of this project.
5. Once the customers need is identified and the feasibility check is done, next step is
training them by experienced person. Training can be given on weekends & public
holiday so that the normal functioning of the firm remains unaffected. Since the
customers cant spend time on training, practicing and application, firms
employees are given training so that they can monitor, get trained & execute the
strategies learned on behalf of customers after obtaining proper consent from them.
There can be a separate agreement between the Firm and Customers.
6. After the training is completed, employees are advised to practically implement
what they have learnt in their training. Practical application can be done using very
small amount of capital.
7. Employees who are performing well are selected and move to the next hierarchy of
the suggestion.
8. Employees who are lacking in performance are trained once again and allowed to
concentrate more on their area of weakness.
9. Once the employees are performing well, they are monitored and stabilized. This is
an important phase which is called Stabilization.
10. Strategies executed by the employees are continuously monitored. This leads to
continuous improvement in the performance.
11. Since the firm is taking time and pain for the welfare of their customers, final step
is sharing of profits between Firm and Customers, for which both of them are
striving for.
12. Above steps are repeatedly followed and the profitable process continues.

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CONCLUSION
Viyan Financial Services has started to execute the suggestions from 24.03.2016.
Presently first 5 steps of the suggestions are completed and they are in search of a qualified
person for training their employees. Initially to start with, 6 customers have been identified
and they are explained about the future processes. All of the six customers objectives have
been brought under the 4 objectives of this project. The Process goes on.
Along with me, Firms Managing Partners are continuously working on this and they
have shown great amount of confidence on the Derivative Strategies as they are practically
implemented on their Customers account. Soon it is expected that all of the customers will
return into profitable path.
Also, it is the right time to thank the managing partners of Viyan Financial Services for
showing enormous confidence in this project and most importantly allowing the Derivative
strategies to be executed in customers account.

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SUMMARY OF THE PROJECT REPORT

Project titled Derivatives starts with the theoretical explanation of the
Derivatives followed by Problem Definition, Objective and Scope of the project.
Theoretical explanation contains the following topics as given below.
1. Introduction
2. History of Derivatives
3. Evolution of Derivatives globally and in India
4. Various types
5. Functions
6. Major Products
7. Various Market Participants
Various Problems faced by Market Participants are explained in brief.
Solutions to the problems are explained in the following hierarchy as given
below
1. Theoretical Perspective
2. Methodology and Procedure of Work
3. Analysis of Real time Data
4. Limitation of the solutions provided
This project Derivatives involves addressing the key problems faced by
Investors & Traders in Indian Capital Markets.
Major problems faced by market participants are:
(i)
Minimizing the risk involved in Investing & Trading in Capital Markets
(ii)
Protecting their Capital in turbulent market conditions
(iii)
Making Risk Free Annualized Profits
(iv)
Generating handsome Return on Investment which should beat Indian
Inflation Rate. To benchmark the ROI, returns obtained should be at
least twice the rate offered by Banks for Fixed Deposits.

Solutions provided to the Market Participants:

All the solutions provided will help the market participants to
minimize the risk involved simultaneously. Minimization of Risk is
given due importance as this is the major hindrance to the growth of
Capital Markets in India.
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Capital Protection
In this key problem, Market Participant is initially advised to
find out the following.
1. Beta of the Portfolio
2. Weightage of the Portfolio
3. Finding whether the Portfolio is Aggressive or Conservation or
Neutral
4. Diversification
5. Calculation of Hedge Ratio
6. Required Hedge for the Portfolio
Step by Step explanations are explicitly given in the project
along with the calculation of the above concepts and how an
Investors capital was protected was explained in detail with real
time example on a customers demat account.
Risk Free Annualized Profits
Here the solution provided is short and simple. Even a new
comer to the market can easily observe the share price
difference between cash & derivative segment and profit from
the same.
All one needs to do is calculate the theoretical future price of
the stock using cash price of the stock plus the cost of carry for
a period of 1 month. Explanation the same is explained with a
real time example.
Generating Handsome Returns from Market
Solution to this problem is provided using two methods
1. Generating Monthly Income using Options
2. Generating Exponential Profits using Technical
Analysis
Generating Monthly Income using Options

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Option is one of the important tools in Derivatives.

Following points are explained in this section so as to give clarity
to this segment before explaining the strategy. They are:
1. Introduction
An Option is a contract that gives the right, but not an
obligation, to buy or sell the underlying asset on or before a stated
date/day, at a stated price, for a price. The party taking a long
position i.e. buying the option is called buyer/holder of the option
and the party taking a short position i.e. selling the option is called
the seller/writer of the option.
2. Types of Option
3. Terms used in Options
4. Finally, Strategy used to generate Monthly Income.
Here, Covered Call strategy is used and explained with
example on how to generate Monthly Income.
Covered Call writing is buying a stock in futures and at the
same time writing/selling the nearest at-the-money call option.
Aggressive investors can sell one strike further out-of-the money;
Conservative investors can sell one strike further in-the-money.

Generating Exponential Profits using Technical Analysis

Technical Analysis is a method of analyzing securities thereby forecasting
the direction of prices through the study of past statistical market data
namely price and volume.
Here, the brief explanation about basics of Technical
Analysis is given as this is the subject matter of prime importance. They
are:
1.
2.
3.
4.

Various methods of Technical Analysis

Assumptions
Trends
Chart Chart Patterns Volumes

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In addition to this, Real time example of using Technical

Analysis and how exponential return was generated in a customers
account was explained in detail.
Solutions provided to the above mentioned problems are
clearly explained in this project with real time case study conducted in
Viyan Financial Services. Investments and Trades are conducted in their
customers demat account and the benefits of using Derivatives can be
clearly understood by observing the results.
Also, in addition to the above problems addressed, Market
participants are advised with some of the advanced strategies using
Technical Analysis. By religiously practicing and following this they
will be able to make Exponential Returns. Real Time example of this
strategy is also explained.
Introduction, Problems Identified and Solutions provided
are explained in brief.
However, in spite of the various methodologies,
techniques, strategies and solutions provided, there always exists a limitation,
which is explained under each section of the solutions provided.
It is pertinent to point out some of the key findings, Inferences and
Recommendations provided to the organization at this point of time.
Some of the Key Findings are:
1. Even though Derivatives has been in existence for more than 15 years in India,
there was a lacuna in understanding the theoretical part and Practical application
of the same.
2. Derivative has been viewed as a tool of destruction by a retail investor to
sophisticated HNIs rather than viewing it as a Risk Management tool.

61

3. There was a misconception among the market participants that Derivatives is an

easy way to make quick and huge bucks.
Some of the Key Inferences and Recommendations provided are:
1.

All the market participants ranging from retail to a HNI, everybody needs
to be given a proper training before allowing them to participate in Derivative
segment. Training has to be given by an experienced person having a proven
track record in Derivative Markets. Initially, it will incur expenses for the
brokerage firm, but in the long run it will be highly profitable for both the firm
and market participants.

2.

Once this is done, Market participants view about Derivative Markets will
change and they will view Derivative purely as a Risk Management tool & also

if properly used with practice can generate exponential returns.

3.
Once the market participants are trained and they begin to practice it, they
will realize this is not an easy and quick money making ways rather it is a long
term sustainable income & wealth generating process.
In addition to the above points, 12 step suggestions have been provided for
improvement in the organization and they are in the implementation of the fifth step
of the same.

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References
1. Managing risk in the Derivative Markets by Heinz Reihl
2. Investing in Derivatives by Alan Northcott
3. Mastering Derivatives Markets by Francesca Taylor
4. Derivative and Risk Management by Rajiv Srivastava
5. National Institute of Securities Markets

List of Figures
1.
2.
3.
4.
5.
6.
7.

Four Key Objectives of the Project 9

Example of Uptrend and Downtrend 33
Example of Sideways trend 34
Head and Shoulder Pattern 36
Head and Shoulder Top on Arvind Limited 37
Pictorial representation of Covered Call 50
Daily chart of ACC limited 52

List of Tables
1.
2.
3.
4.

Shares price change in one month 16

Nifty price change in one month 17
Cash and Futures comparison 24
Profit potential realized 25
5. Lot sizes of shares taken for case study 27

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