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Objective of the Study Scop of the study Executive Summary Acknowledgement METHOLOGY
Chapter4. Applicability of Derivative Instruments 4.1 Risk Management with Futures Contract 4.2Risk Management with Options
Objective of the Study To find out the types of Derivative Instruments are applicable in the Indian Stock Market which can work both in good and bad times so that it can minimize the risk and maximize returns. To know the functions of derivatives in Indian Stock Market. To know whether the derivative instruments are being using for the purpose. To know about what is hedging and risk hedging process and its tools. Compare the f& o segment with cash segment. Find out Derivatives disadvantages. Derivatives are useful for India or not. correct
They helps entrepreneur to setup new business. They help to increase investment in the market; as a result they help in economy growth.
Derivatives help to make market efficient and effective. They help in increasing foreign investment in the market
All business enterprise and financial institutions use these tools for reducing risk and increase profit.
METHODOLOGY
During this project, I have analyzed the Futures and Options. I have tried to analyze the instruments as per the Market Participant and the Market Trend. Initially, I have given a brief introduction about the instruments, so that the reader is aware of basics of the subject. I have tried to identify various terms related to derivative trading, for which I have introduced a separate chapter, terms related to derivative market Then I have tried to segregate the use of Instruments as per the Market Participants and Market Trend. I identified hedging, arbitrage and speculation strategies using both futures and options, and then segregated them into a chapter each. Segregation involved a thorough study of the strategies and possible use. Then I have done a secondary data based study on growth of Indian Derivative Market, which includes the comparison of derivative market with cash market, data regarding the traded volume and number of contracts traded from December 2008 till May and june 2010. I have also analyzed the top five most traded symbols in futures and options segment.
ACKNOWLEDGEMENT
I owe a great many thanks to a great many people who helped and supported me during this project. My deepest thanks to Lecturer, mrs. Sashay mam the Guide of the project for guiding and correcting various documents of mine with attention and care. She has taken pain to go through the project and make necessary correction as and when needed. I express my thanks to the director of, [trinity institute of professional studies], for extending his support. My deep sense of study is [financial derivatives] the whole project is based upon secondary data, I would also thank my Institution and my faculty members without whom this project would have been a distant reality. I also extend my heartfelt thanks to my family and well wishers.
MANISH KUMAR
EXECUTIVE SUMMARY
I have a great pleasure in presenting this work as a part of the Three years full time Bachelor of Business Administration. The objective of my work initiated when I came across various discussions in the financial markets. Indian derivatives market is yet to reach its peak level. There is still a lack of knowledge about derivatives, amongst the majority of market players. High degree of volatility in the recent times in the Indian market has led to development of more and more sophisticated Hedging, Speculation and Arbitrage techniques and strategies. These strategies are extensively used by Traders, Risk Managers, and Portfolio Managers. Objective of this study is to analyze the growth and prospects of Derivatives market in India. The study would facilitate the reader to know about the growing trend of Derivatives Market in India
COMPANY PROFILE:
Sharekhan is one of the top retail brokerage houses in India with a strong online trading platform. The company provides equity based products (research, equities, derivatives, depository, margin funding, etc.). It has one of the largest networks in the country with 1200+ share shops in 400 cities and Indias premier online trading portal www.sharekhan.com. With their research expertise, customer commitment and superior technology, they provide investors with end-to-end solutions in investments. They provide trade execution services through multiple channels - an Internet platform, telephone and retail outlets. Sharekhan was established by Morakhia family in 1999-2000 and Morakhia family, continues to remain the largest shareholder. It is the retail broking arm of the Mumbai-based SSKI [SHRIPAL SHEWANTILAL KANTILAL ISWARNATH LIMITED] Group. SSKI which is established in 1930 is the parent company of Sharekhan ltd. With a legacy of more than 80 years in the stock markets, the SSKI group ventured into institutional broking and corporate finance over a decade ago. Presently SSKI is one of the leading players in institutional broking and corporate finance activities. Sharekhan offers its customers a wide range of equity related services including trade execution on BSE, NSE, and Derivatives. Depository services, online trading, Investment advice, Commodities, etc. Sharekhan Ltd. is a brokerage firm which is established on 8th February 2000 and now it is having all the rights of SSKI. The company was awarded the 2005 Most Preferred Stock Broking Brand by Awaaz Consumer Vote. It is first brokerage Company to go online. The Company's online trading and investment site - www.Sharekhan.com - was also launched on Feb 8, 2000. This site gives access to superior content and transaction facility to retail customers across the country. Known for its jargon-free, investor friendly language and high quality research, the content-rich and research oriented portal has stood out among its contemporaries because of its steadfast dedication to offering customers best-of-breed technology and superior market information. Sharekhan has one of the best states of art web portal providing fundamental and statistical information across equity, mutual funds and IPOs. One can surf across 5,500 companies for in-depth information, details about more than 1,500 mutual fund schemes and IPO data. One can also access other market related details such as board meetings, result announcements, FII transactions, buying/selling by mutual funds and much more. Sharekhan's management team is one of the strongest in the sector and has positioned Sharekhan to take advantage of the growing consumer demand for financial services products in India through investments in research, pan-Indian branch network and an outstanding technology platform. Further, Sharekhan's lineage and relationship with SSKI Group provide it a unique position to understand and leverage the growth of
the financial services sector. We look forward to providing strategic counsel to Sharekhan's management as they continue their expansion for the benefit of all shareholders. SSKI Corporate Finance Private Limited (SSKI) is a leading India-based investment bank with strong research-driven focus. Their team members are widely respected for their commitment to transactions and their specialized knowledge in their areas of strength. The team has completed over US$5 billion worth of deals in the last 5 years - making it among the most significant players raising equity in the Indian market. SSKI, a veteran equities solutions company has over 8 decades of experience in the Indian stock markets.
MISSION:
To educate and empower the individual investor to make better investment decisions through
VISION:
To be the best retail brokering Brand in the retail business of stock market.
ACHIEVEMENTS OF SHAREKHAN:
A wired company along with Reliance, Hll, Infosys, etc by Business Today, January 2004 edition.
It was awarded Top Domestic Brokerage House four times by Euro and Asia money. It was Winner of Best Financial Website award.
Indias most preferred brokers within 5 years. CNBC Awaaz customers Award 2005.
STRATEGY:
The main strategies used in our training were as follow. DATA CALLING In data calling we were provided data of mobile numbers and our job was to generate appointments. After that we were required to convert that appointment into closure. Apart from given data we also brought latest business directory. We called to different business people and tried to generate appointments.
CALLED CALLING Called calling means to go at different corporate houses and to meet different People and to get their visiting card by it we get lead and our immediate task Was to call them & to fix appointment. REFERENCE Another important strategy was to use our reference means our family, friends, relatives etc. In marketing or selling we can never neglect references & they always play a major role.
[1] Dematerialization account:Dematerialization is the process of converting physical shares (share certificates) into an electronic form. Shares once converted into dematerialized form are held in a De-mat account Sharekhan is a depository participant. This means that we can keep the shares in dematerialized form in Sharekhan. But for this one has to purchases the Demat account in Sharekhan. . Sharekhan provides no opening charge. Sharekhan provide de-mat account free of charge for first year, Rs.400/ year from the next year (year continued from the day of opening). -Auto pay-in & Auto pay-out of securities. - Waver of pay-in and pay-out charges (Due to link De-mate account).
Sharekhan is providing tips through mails in 4 sessions Pre market Noon session Post market Late evening sharekhan is provide tips through SMS (chargeable) arekhan is provide tips through Yahoo Messenger Online IPO/MF Online :Sharekhan provide IPO and MF facility for the customer.
1. HDFC Bank 2. CITI Bank 3. OBC Bank 4. YES Bank 5. UTI Bank 6. IDBI Bank 7. ICICI Bank8. Union Bank 9. Inducing Bank 10 . Bank of India 11. Deutsche Bank A customer can allocate and transfer fund from your respective bank account to your Sharekhan account for trading and transfer back to link bank account when and where needed. [4] Dial-N-Trade:Sharekhan provide Dial-N-Trade facility to the customer. PRODUCTS & SERVICIES Sharekhan ltd. Provide different Product as follows Share online & offline Derivatives Mutual fund online Commodities online IPO online Portfolio Management Services Insurance Fixed deposits Advisory products Currency trading
SHARE ONLINE:
Sharekhan provide online facilities. BENEFIT
Freedom from paperwork:-Integrated trading, bank and de-mat account with digital contracts removers all paperwork. Instant credit and transfer:-instant transfer of funds from bank account of the choice to Sharekhan trading account. Trade anywhere:-enjoy the ease of trading from any part of the world in a completely secure environment.
Dial n Trade:-call toll free number (1-800-22-7050) to place orders through telebrokers. Timey advice:-make informed decisions with expert advice, investment calls and live market
commentary.
After-hour orders:-place order after market hours, which get executed as soon as the markets
opens. Sharekhan provide two different accounts: 1) 2) 3) Classic account Trade Tiger
CLASSIC ACCOUNT:- The Classic Account enables customers to trade online on the NSE and the
BSE, invest in IPO and Mutual Funds and access all the research and transaction reports through Sharekhans website. This account is suitable for the retail investors. In this account Shown the maximum script are 25 in the terminal and the technical chart are not shown in this account. The life time registration charge for this account is 750 rupees.
Features
Online trading account for investing in Equities and Derivatives Free trading through Phone (Dial-n-Trade) Two dedicated numbers for placing your orders with your cell phone or landline. Automatic funds transfer with phone banking (for Citibank and HDFC bank customers) Simple and Secure Interactive Voice Response based system for authentication Get the trusted, professional advice of our telebrokers. After hours order placement facility between 8.00 am and 9.30 am Integration of: Online trading + Bank + Demat account Instant cash transfer facility against purchase & sale of shares IPO investments Instant order and trade confirmations by e-mail Single screen interface for cash and derivative Online classic account:
FAST TRADE:
Features
Streaming quotes. Personalized market watch. Single screen interface for cash, derivatives and Commodities. New FastTrade is platform independent will support by all Operating System. New FastTrade will support all browsers in the market. New FastTrade is independent of existing website and can work even if content website is down. Fast trade is web base product and its a shown fluctuation rate.
TRADE TIGER:
Trade tiger is a next-generation online trading product that brings the power of brokers terminal to customer pc. It is session to capitalize on intra-day price movement. Trade tiger is an internet based application available on a CD, which provides everything a trader needs on one screen.
Key Features:single platform for multiple exchange BSE & NSE (Cash & F&O), MCX, NCDEX, Mutual Funds, IPOs Multiple Market Watch available on Single Screen Multiple Charts with Tick by Tick Intraday and End of Day Charting powered with various Studies raph Studies include Average, Band- Bollinger, Know Sure Thing, MACD, RSI, etc apply studies such as Vertical, Horizontal, Trend, Retracement & Free lines ser can save his own defined screen as well as graph template, that is, saving the layout for future use ser-defined alert settings on an input Stock Price trigger looks available to gauge market such as Tick Query, Ticker, Market Summary, Action Watch, Option Premium Calculator, Span Calculator
shortcut key for FAST access to order placements & reports online fund transfer activated with 11 Banks
Advantages:vet Streaming Quotes Access all Trading Calls Advanced Charting features Create your own technical rules for trading A Single Trading Screen for all segments
Trader Name
THE PLATINUM CIRCLE:The HNI product Personalized portfolio tracking & restructuring advice. Monthly stock valuation statements, report profitability statement. Daily report on transaction sent in printed format as well as available online.
NSE:
The national stock exchange of the India was the promoted by leading financial institutions at
the behest of the government of India, and was incorporated in November 1992 as a tax paying company. In April 1993, it was recognized as a stock exchange under the securities contracts( Regulation) Act, 1956. NSE commenced its operation in the wholesale Debt Market (WDM) segment in June 1994. The capital market (Equities) segment of the NSE commenced operation in November 1994.
BSE:
The Bombay stock exchange is the oldest stock exchange in Asia. It is located at Dalal Street, Mumbai, India. The Bombay stock exchange was established in 1985. There are around 3500 Indian companies listed with stock exchange, and has the significant stock volume. As of 29 may 2007, the market capitalization of the BSE is about Rs. 40.5 trillion. The BSE SENSEX (SENSitive indEX), also called the BSE 30, is a widely used market index in India and Asia. As of 2005, it is among the five biggest stock exchanges in the world in terms of transactions volume.
derivative 'bet' on an event occurring is offset by a comparable derivative 'bet' on the event not occurring). Many such relatively illiquid securities are valued as marked to model, rather than an actual market price. The stocks are listed and traded on stock exchanges which are entities of a corporation or mutual organization specialized in the business of bringing buyers and sellers of the organizations to a listing of stocks and securities together. The largest stock market in the United States, by market capitalization, is the New York Stock Exchange (NYSE). In Canada, the largest stock market is the Toronto Stock Exchange. Major European examples of stock exchanges include the Amsterdam Stock Exchange, London Stock Exchange, Paris Bourse, and the Deutsche Brse (Frankfurt Stock Exchange). In Africa, examples include Nigerian Stock Exchange, JSE Limited, etc. Asian examples include the Singapore Exchange, the Tokyo Stock Exchange, the Hong Kong Stock Exchange, the Shanghai Stock Exchange, and the Bombay Stock Exchange. In Latin America, there are such exchanges as the BM&F Bovespa and the BMV.
The foreign exchange market (forex, FX, or currency market) is a global, worldwide decentralized financial market for trading currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. The foreign exchange market determines the relative values of different currencies.[1] The primary purpose of the foreign exchange is to assist international trade and investment, by allowing businesses to convert one currency to another currency. For example, it permits a US business to import British goods and pay Pound Sterling, even though the business' income is in US dollars. It also supports direct speculation in the value of currencies, and the carry trade, speculation on the change in interest rates in two currencies.[2] In a typical foreign exchange transaction, a party purchases a quantity of one currency by paying a quantity of another currency. The modern foreign exchange market began forming during the 1970s after three decades of government restrictions on foreign exchange transactions (the Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states after World War II), when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system. The foreign exchange market is unique because of
its huge trading volume representing the largest asset class in the world leading to high liquidity; its geographical dispersion; its continuous operation: 24 hours a day except weekends, i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday; the variety of factors that affect exchange rates; the low margins of relative profit compared with other markets of fixed income; and the use of leverage to enhance profit and loss margins and with respect to account size. As such, it has been referred to as the market closest to the ideal of perfect competition, notwithstanding currency intervention by central banks. According to the Bank for International Settlements,[3] as of April 2010, average daily turnover in global foreign exchange markets is estimated at $3.98 trillion, a growth of approximately 20% over the $3.21 trillion daily volume as of April 2007. Some firms specializing on foreign exchange market had put the average daily turnover in excess of US$4 trillion.[4] The $3.98 trillion break-down is as follows:
$1.490 trillion in spot transactions $475 billion in outright forwards $1.765 trillion in foreign exchange swaps $43 billion Currency swaps $207 billion in options and other products
Main foreign exchange market turnover, 19882007, measured in billions of USD. The foreign exchange market is the most liquid financial market in the world. Traders include large banks, central banks, institutional investors, currency speculators, corporations, governments, other financial institutions, and retail investors. The average daily turnover in the global foreign exchange and related markets is continuously growing. According to the 2010 Triennial Central Bank Survey, coordinated by the Bank for International Settlements, average daily turnover was US$3.98 trillion in April 2010 (vs $1.7 trillion in 1998).[3] Of this $3.98 trillion, $1.5 trillion was spot foreign exchange transactions and $2.5 trillion was traded in outright forwards, FX swaps and other currency derivatives. Trading in the UK accounted for 36.7% of the total, making UK by far the most important global center for foreign exchange trading. In second and third places, respectively, trading in the USA accounted for 17.9%, and Japan accounted for 6.2%.[5] Turnover of exchange-traded foreign exchange futures and options have grown rapidly in recent years, reaching $166 billion in April 2010 (double the turnover recorded in April 2007). Exchange-traded currency derivatives represent 4% of OTC foreign exchange turnover. FX futures contracts were introduced in 1972 at the Chicago Mercantile Exchange and are actively traded relative to most other futures contracts. Most developed countries permit the trading of FX derivative products (like currency futures and options on currency futures) on their exchanges. All these developed countries already have fully convertible capital accounts. A number of emerging countries do not permit FX derivative products on their exchanges in view of controls on the capital accounts. The use of foreign exchange derivatives is growing in many emerging economies.[6] Countries such as Korea, South Africa, and India have established currency futures exchanges, despite having some controls on the capital account. Top 10 currency traders
[7]
Foreign exchange trading increased by 20% between April 2007 Market share [8] 15.64% and April 2010 and has more than doubled since 2004. The increase in turnover is due to a number of factors: the growing 10.75% importance of foreign exchange as an asset class, the increased 10.59% trading activity of high-frequency traders, and the emergence of UBS AG retail investors as an important market segment. The growth of Citi 8.88% electronic execution methods and the diverse selection of JPMorgan 6.43% execution venues have lowered transaction costs, increased market HSBC 6.26% liquidity, and attracted greater participation from many customer Royal Bank of Scotland 6.20% types. In particular, electronic trading via online portals has made it easier for retail traders to trade in the foreign exchange market. 4.80% Credit Suisse By 2010, retail trading is estimated to account for up to 10% of Goldman Sachs 4.13% spot FX turnover, or $150 billion per day (see retail trading Morgan Stanley 3.64% platforms).
Because foreign exchange is an OTC market where brokers/dealers negotiate directly with one another, there is no central exchange or clearing house. The biggest geographic trading center is the UK, primarily London, which according to TheCityUK estimates has increased its share of global turnover in traditional transactions from 34.6% in April 2007 to 36.7% in April 2010. Due to London's dominance in the market, a particular currency's quoted price is usually the London market price. For instance, when the IMF calculates the value of its SDRs every day, they use the London market prices at noon that day.
is the potential that a chosen action or activity (including the choice of inaction) will lead to a loss (an undesirable outcome). The notion implies that a choice having an influence on the outcome exists (or existed). Potential losses themselves may also be called "risks". Almost any human Endeavour carries some risk, but some are much more risky than others.
Risk -
Risk management -is the identification, assessment, and prioritization of risks (defined in ISO 31000
as the effect of uncertainty on objectives, whether positive or negative) followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events[1] or to maximize the realization of opportunities. Risks can come from uncertainty in financial markets, project failures (at any phase in development, production, or sustainment life-cycles), legal liabilities, credit risk, accidents, natural causes and disasters as well as deliberate attack from an adversary or events of uncertain root-cause. Several risk management standards have been developed including the Project Management Institute, the National Institute of Science and Technology, actuarial societies, and ISO standards. Methods, definitions and goals vary widely according to whether the risk management method is in the context of project management, security, engineering, industrial processes, financial portfolios, actuarial assessments, or public health and safety. The strategies to manage risk include transferring the risk to another party, avoiding the risk, reducing the negative effect or probability of the risk, or even accepting some or all of the consequences of a particular risk.
Certain aspects of many of the risk management standards have come under criticism for having no measurable improvement on risk, whether the confidence in estimates and decisions seem to increase.[1]
Derivative are those instrument, the value of which depend upon the underlying assets on which it is created Derivatives are financial contracts whose value/price is depends on the behavior of price of one or more basic underling assets. These contracts are legally binding agreement, made on the trading screen of stock exchange, buy or sell an asset in future. The assets can be share, index, interest rate, bond, rupee- dollar exchange rate, sugar, crude oil, soybean, cotton, coffee etc. TYPES OF FINANCIAL DERIVATIVES
Financial derivatives are those assets whose values are determined by the value of some other assets, called as the underlying. Presently there are Complex varieties of derivatives already in existence and the markets are innovating newer and newer ones continuously. For example, various types of financial derivatives based on their different properties like, plain, simple or straightforward, composite, joint or hybrid, synthetic, leveraged, mildly leveraged, OTC traded, standardized or organized exchange traded, etc. are available in the market. Due to complexity in nature, it is very difficult to classify the financial derivatives, so in the present context, the basic financial derivatives which are popularly in the market have been described. In the simple form, the derivatives can be classified into different categories which are shown below :
DERIVATIVES
FINANCIAL Basics
1.) Forwards 2.) Futures 3.) Options 4. )Warrants and Convertibles
One form of classification of derivative instruments is between commodity derivatives and financial derivatives. The basic difference between these is the nature of the underlying instrument or assets. In commodity derivatives, the underlying instrument is commodity which may be wheat, cotton, pepper, sugar, jute, turmeric, corn, crude oil, natural gas, gold, silver and so on. In financial derivative, the underlying instrument may be treasury bills, stocks, bonds, foreign exchange, stock index, cost of living index etc. It is to be noted that financial derivative is fairly standard and there are no quality issues whereas in commodity derivative, the quality may be the underlying matters. Another way of classifying the financial derivatives is into basic and complex. In this, forward contracts, futures contracts and option contracts have been included in the basic derivatives whereas swaps and other complex derivatives are taken into complex category because they are built up from either forwards/futures or options contracts, or both. In fact, such derivatives are effectively derivatives of derivatives.
Derivatives are traded at organized exchanges and in the Over The Counter (
OTC ) market :
Organized Exchanges
Commodity Futures Financial Futures Options (stock and index) Stock Index Future
Derivatives traded at exchanges are standardized contracts having standard delivery dates and trading units. OTC derivatives are customized contracts that enable the parties to select the trading units and delivery dates to suit their requirements.
A major difference between the two is that of counterparty riskthe risk of default by either party. With the exchange traded derivatives, the risk is controlled by exchanges through clearing house which act as a contractual intermediary and impose margin requirement. In contrast, OTC derivatives signify greater vulnerability.
1. place
Forwards: A forward contract is a customized contract between two entities, where settlement takes
Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time
in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts.
3.
Options: Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to
buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.
4.
Warrants: Options generally have lives of up to one year, the majority of options traded on options
exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter. 5.
LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options having Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according
a moving average of a basket of assets. Equity index options are a form of basket options. 7.
to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are: a.
Interest rate swaps: These entail swapping only the interest related
b.Currency swaps: Swaptions:
These entail swapping both principal and interest between the parties, with the cash
flows in one direction being in a different currency than those in the opposite direction. 9. Swaptions are options to buy or sell a swap that will become operative at the expiry of the
options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.
PARTICIPANTS
Derivative contracts have several variants. The most common variants are forwards, futures, options and swaps. The following three broad categories of participants
Hedgers: -
Hedgers face risk associated with the price of an asset. They use futures or options markets to
Speculators: - Speculators wish to bet on future movements in the price of an asset. Futures and options
contracts can give them an extra leverage; that is, they can increase both the potential gains and potential losses in a speculative venture.
the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. The derivatives market helps to transfer risks from those who have them but may not like them to those who
have an appetite for them. Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk
Trading Mechanism
The futures and options trading system of NSE, called NEAT-F&O trading system, provides a fully automated screenbased trading for Nifty futures & options and stock futures & options on a nationwide basis and an online monitoring and surveillance mechanism. It supports an anonymous order driven market which provides complete transparency of trading operations and operates on strict pricetime priority. It is similar to that of trading of equities in the Cash Market (CM) segment. The NEAT-F&O trading system is accessed by two types of users.
The Trading Members(TM) have access to functions such as order entry, order matching, and order and trade management. It provides tremendous flexibility to users in terms of kinds of orders that can be placed on the system. Various conditions like Good-till-Day, Good-till-Cancelled, Good till- Date, Immediate or Cancel, Limit/Market price, Stop loss, etc. can be built into an order. The Clearing Members (CM) uses the trader workstation for the purpose of monitoring the trading member(s) for whom they clear the trades. Additionally, they can enter and set limits to positions, which a trading member can take.
Membership criteria
NSE admits members on its derivatives segment in accordance with the rules and regulations of the exchange and the norms specified by SEBI. NSE follows 2tier membership structure stipulated by SEBI to enable wider participation. Those interested in taking membership on F&O segment are required to take membership of CM and F&O segment or CM, WDM and F&O segment. Trading and clearing members are admitted separately. Essentially, a clearing member (CM) does clearing for all his trading members (TMs), undertakes risk management and performs actual settlement. There are three types of CMs:
Self Clearing Member: A SCM clears and settles trades executed by him only either on his own account or Trading Member Clearing Member: TMCM is a CM who is also a TM. TMCM may clear and settle his Professional Clearing Member
PCM is a CM who is not a TM. Typically, banks or custodians could
own proprietary trades and clients trades as well as clear and settle for other TMs.
become a PCM and clear and settle for TMs. The TMCM and the PCM are required to bring in additional security deposit in respect of every TM whose trades they undertake to clear and settle. Besides this, trading members are required to have qualified users and sales persons, who have passed a Certification programmed approved by SEBI.
Clearing:
The first step in clearing process is working out open positions or obligations of members. A CMs open position is arrived at by aggregating the open position of all the TMs and all custodial participants clearing through him, in the contracts in which they have traded. A TMs open position is arrived at as the summation of his proprietary open position and clients open positions, in the contracts in which they have traded. While entering orders on the trading system, TMs are required to identify the orders, whether proprietary (if they are their own trades) or client (if entered on behalf of clients). Proprietary positions are calculated on net basis (buy-sell) for each contract.
Settlement:
All futures and options contracts are cash settled, i.e. through exchange of cash. The underlying for index futures/options of the Nifty index cannot be delivered. These contracts, therefore, have to be settled in cash. Futures and options on individual securities can be delivered as in the spot market. However, it has been currently mandated that stock options and futures would also be cash settled. The settlement amount for a CM is netted across all their TMs/clients in respect of MTM, premium and final exercise settlement. For the purpose of settlement, all CMs are required to open a separate bank account with NSCCL designated clearing banks for F&O segment.
Index Derivatives
Index derivatives are derivative contracts which derive their value from an underlying index. The two most popular index derivatives are index futures and index options. Institutional and large equity-holders need portfolio-hedging facility. Indexderivatives are more suited to
them and more costeffective than derivatives based on individual stocks. Pension funds in the US are known to use stock index futures for risk hedging purposes. Index derivatives offer ease of use for hedging any portfolio irrespective of its composition.
Requirements for an index derivatives market 1. Index: The choice of an index is an important factor in determining the extent to which the index derivative can
be used for hedging, speculation and arbitrage. A well diversified, liquid index ensures that hedgers and speculators will not be vulnerable to individual or industry risk.
2. Clearing corporation settlement guarantee: The clearing corporation eliminates counterparty risk on futures
markets. The clearing corporation interposes itself into every transaction, buying from the seller and selling to the buyer. This insulates a participant from credit risk of another.
3. Strong surveillance mechanism: Derivatives trading brings a whole class of leveraged positions in the
economy. Hence the need to have strong surveillance on the market both at the exchange level as well as at the regulator level.
The need for education and certification in the derivatives market can
never be overemphasized. A critical element of financial sector reforms is the development of a pool of human
resources with strong skills and expertise to provide quality intermediation to market participants. With the entire above infrastructure in place, trading of index futures and index options commenced at NSE in June 2000 and June 2001 respectively.
1. Trading members: Trading members are members of NSE. They can trade either on their own account or on
behalf of their clients including participants. The exchange assigns a Trading member ID to each trading member. Each trading member can have more than one user. The number of users allowed for each trading member is notified by the exchange from time to time. Each user of a trading member must be registered with the exchange and is assigned a unique user ID. The unique trading member ID functions as a reference for all orders/trades of different users. This ID is common for all users of a particular trading member. It is the responsibility of the trading member to maintain adequate control over persons having access to the firms User IDs.
2. Clearing members: Clearing members are members of NSCCL. They carry out risk management activities and
confirmation/inquiry of trades through the trading system.
3. Professional clearing members: A professional clearing members is a clearing member who is not a trading
member. Typically, banks and custodians become professional clearing members and clear and settle for their trading members. 4.
through multiple trading members but settle through a single clearing member.
Basis of trading
The NEAT F&O system supports an order driven market, wherein orders match automatically. Order matching is essentially on the basis of security, its price, time and quantity. All quantity fields are in units and price in rupees. The lot size on the futures market is for 200 Nifties. The exchange notifies the regular lot size and tick size for each of the contracts traded on this segment from time to time. When any order enters the trading system, it is an active
order. It tries to find a match on the other side of the book. If it finds a match, a trade is generated. If it does not find a match, the order becomes passive and goes and sits in the respective outstanding order book in the system.
Several combinations of the above are allowed thereby providing enormous flexibility to the users. The order types and conditions are summarized below.
Time conditions
Day order: A day order, as the name suggests is an order which is valid for the day on which it is entered. If the
order is not executed during the day, the system cancels the order automatically at the end of the day.
Good till canceled (GTC): A GTC order remains in the system until the user cancels it. Consequently, it
spans trading days, if not traded on the day the order is entered. The maximum number of days an order can remain in the system is notified by the exchange from time to time after which the order is automatically cancelled by the system. Each day counted is a calendar day inclusive of holidays. The days counted are inclusive of the day on which the order is placed and the order is cancelled from the system at the end of the day of the expiry period.
Immediate or Cancel(IOC): An IOC order allows the user to buy or sell a contract as soon as the order is
released into the system, failing which the order is cancelled from the system. Partial match is possible for the order, and the unmatched portion of the order is cancelled immediately
Price condition
Stop loss: This facility allows the user to release an order into the system, after the market price of the security reaches or crosses a threshold price e.g. if for stoploss buy order, the trigger is 1027.00, the limit price is 1030.00 and the market (last traded) price is 1023.00, then this order is released into the system once the market price reaches or exceeds 1027.00. This order is added to the regular lot book with time of triggering as the time stamp, as a limit order of 1030.00. For the stoploss sell order, the trigger price has to be greater than the limit price.
Other conditions
Market price: Market orders are orders for which no price is specified at the time the order is entered (i.e. Trigger price: Price at which an order gets triggered from the stoploss book. Limit price: Price of the orders after triggering from stoploss book. Pro: Pro means that the orders are entered on the trading members own account.. Trinity Institute Of Professional Studies
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price is market price). For such orders, the system determines the price.
Inquiry window
The inquiry window enables the user to view information such as Market by Order(MBO), Market by Price(MBP), Previous Trades(PT), Outstanding Orders(OO), Activity log(AL), Snap Quote(SQ), Order Status(OS), Market Movement(MM), Market Inquiry(MI), Net Position, On line backup, Multiple index inquiry, Most active security and so on. Relevant information for the selected contract/security can be viewed. We shall look in detail at the Market by Price (MBP) and the Market Inquiry (MI) screens.
Basket trading
In order to provide a facility for easy arbitrage between futures and cash markets, NSE introduced basket-trading facility. Figure 10.4 shows the basket trading screen. This enables the generation of portfolio offline order files in the derivatives trading system and its execution in the cash segment. A trading member can buy or sell a portfolio through a single order, once he determines its size. The system automatically works out the quantity of each security to be bought or sold in proportion to their weights in the portfolio.
NSE trades Nifty futures contracts having one-month, two-month and three-month expiry cycles. All contracts expire on the last Thursday of every month. Thus a January expiration contract would expire on the last Thursday of January and a February expiry contract would cease trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three-month expiry would be introduced for trading. Depending on the time period for which you want to take an exposure in index futures contracts, you can place buy and sell orders in the respective contracts. The Instrument type refers to Futures contract on index and Contract symbol - NIFTY denotes a Futures contract on Nifty index and the Expiry date represents the last date on which the contract will be available for trading. Each futures contract has a separate limit order book. All passive orders are stacked in the system in terms of price-time priority and trades take place at the passive order price (similar to the existing capital market trading system). The best buy order for a given futures contract will be the order to buy the index at the highest index level whereas the best sell order will be the order to sell the index at the lowest index level. Trading is for a minimum lot size of 200 units. Thus if the index level is around 1000, then the appropriate value of a single index futures contract would be Rs.200,000. The minimum tick size for an index future contract is 0.05 units. Thus a single move in the index value would imply a resultant gain or loss of Rs.10.00 (i.e. 0.05*200 units) on an open position of 200 units.
Charges
The maximum brokerage chargeable by a TM in relation to trades effected in the contracts admitted to dealing on the F&O segment of NSE is fixed at 2.5% of the contract value in case of index futures and 2.5% of notional value of the contract[(Strike price + Premium) * Quantity] in case of index options, exclusive of statutory levies. The transaction charges payable by a TM for the trades executed by him on the F&O segment are fixed at Rs.2 per lakh of turnover (0.002%) (Each side) or Rs.1 lakh annually, whichever is higher. The TMs contribute to Investor Protection Fund of F&O segment at the rate of Rs.10 per crore of turnover (0.0001%).
Relating to the derivative markets including: Permitted. Use of sub-brokers in the derivative markets. use of derivatives by mutual funds The recommendations of the Advisory Committee on Derivatives on some of these issues were also placed
before the SEBI Board. The Board desired that these issues be reconsidered by the Advisory Committee on Derivatives (ACD) and requested a detailed report on the aforesaid issues for the consideration of the Board.
Regulatory Objectives
The LCGC outlined the goals of regulation admirably well in Paragraph 3.1 of its report. We endorse these regulatory principles completely and base our recommendations also on these same principles. We therefore reproduce this paragraph of the LCGC Report: It has been guided by the following objectives:
(a) Investor Protection: Attention needs to be given to the following four aspects:
(i) Fairness and Transparency (ii) Safeguard for clients moneys (iii) Competent and honest service
(b) Quality of markets: The concept of Quality of Markets goes well beyond market integrity and aims at
enhancing important market qualities, such as cost-efficiency, price-continuity, and price-discovery. This is a much broader objective than market integrity.
(c) Innovation: While curbing any undesirable tendencies, the regulatory framework should not stifle innovation
which is the source of all economic progress, more so because financial derivatives represent a new rapidly developing area, aided by advancements in information technology.
Therefore, the buyer and the seller lock themselves into an exchange rate for a specific value or delivery date. Both parties of the futures contract must fulfill their obligations on the settlement date. Currency futures can be cash settled or settled by delivering the respective obligation of the seller and buyer. All settlements however, unlike in the case of OTC markets, go through the exchange. Currency futures are a linear product, and calculating profits or losses on Currency Futures will be similar to calculating profits or losses on Index futures. In determining profits and losses in futures trading, it is essential to know both the contract size (the number of currency units being traded) and also what the tick value is. A tick is the minimum trading increment or price differential at which traders are able to enter bids and offers. Tick values differ for different currency pairs and different underlying. For e.g. in the case of the USD-INR currency futures contract the tick size shall be 0.25 paise or 0.0025 Rupees. To demonstrate how a move of one tick affects the price, imagine a trader buys a contract (USD 1000 being the value of each contract) at Rs.42.2500. One tick move on this contract will translate to Rs.42.2475 or Rs.42.2525 depending on the direction of market movement. Purchase price: Price increases by one tick: New price: Purchase price: Price decreases by one tick: New price: Rs .42.2500 +Rs. 00.0025 Rs .42.2525 Rs .42.2500 Rs. 00.0025 Rs.42. 2475
The value of one tick on each contract is Rupees 2.50. So if a trader buys 5 contracts and the price moves up by 4 tick, she makes Rupees 50. Step 1: Step 2: Step 3: 42.2600 42.2500 4 ticks * 5 contracts = 20 points 20 points * Rupees 2.5 per tick = Rupees 50
During the early 1990s, India embarked on a series of structural reforms in the foreign exchange market. The exchange rate regime, that was earlier pegged, was partially floated in March 1992 and fully floated in March 1993. The unification of the exchange rate was instrumental in developing a market-determined exchange rate of the rupee and was an important step in the progress towards total current account convertibility, which was achieved in August 1994. Although liberalization helped the Indian forex market in various ways, it led to extensive fluctuations of exchange rate. This issue has attracted a great deal of concern from policy-makers and investors. While some flexibility in foreign exchange markets and exchange rate determination is desirable, excessive volatility can have an adverse impact on price discovery, export performance, sustainability of current account balance, and balance sheets. In the context of upgrading Indian foreign exchange market to international standards, a well- developed foreign exchange derivative market (both OTC as well as Exchange-traded) is imperative. With a view to enable entities to manage volatility in the currency market, RBI on April 20, 2007 issued comprehensive guidelines on the usage of foreign currency forwards, swaps and options in the OTC market. At the same time, RBI also set up an Internal Working Group to explore the advantages of introducing currency futures. The Report of the Internal Working Group of RBI submitted in April 2008, recommended the introduction of Exchange Traded Currency Futures. Subsequently, RBI and SEBI jointly constituted a Standing Technical Committee to analyze the Currency Forward and Future market around the world and lay down the guidelines to introduce Exchange Traded Currency Futures in the Indian market. The Committee submitted its report on May 29, 2008. Further RBI and SEBI also issued circulars in this regard on August 06, 2008. Currently, India is a USD 34 billion OTC market, where all the major currencies like USD, EURO, YEN, Pound, Swiss Franc etc. are traded. With the help of electronic trading and efficient risk management systems, Exchange Traded Currency Futures will bring in more transparency and efficiency in price discovery, eliminate counterparty credit risk, provide access to all types of market participants, offer standardized products and provide transparent trading platform. Banks are also allowed to become members of this segment on the Exchange, thereby providing them with a new opportunity.
Source :-( Report of the RBI-SEBI standing technical committee on exchange traded currency futures) 2008.
Derivative contracts have several variants. The most common variants are forwards, futures, options and swaps. We take a brief look at various derivatives contracts that have come to be used.
FORWARD :
The basic objective of a forward market in any underlying asset is to fix a price for a contract to be carried through on the future agreed date and is intended to free both the purchaser and the seller from any risk of loss which might incur due to fluctuations in the price of underlying asset.
A forward contract is customized contract between two entities, where settlement takes place on a specific date in the future at todays pre-agreed price. The exchange rate is fixed at the time the contract is entered into. This is known as forward exchange rate or simply forward rate.
FUTURE :
A currency futures contract provides a simultaneous right and obligation to buy and sell a particular currency at a specified future date, a specified price and a standard quantity. In another word, a future contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Future contracts are special types of forward contracts in the sense that they are standardized exchange-traded contracts.
SWAP :
Swap is private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolio of forward contracts.
The currency swap entails swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction. There are a various types of currency swaps like as fixed-to-fixed currency swap, floating to floating swap, fixed to floating currency swap.
(1) Initial exchange of principal amount (2) Ongoing exchange of interest (3) Re - exchange of principal amount on maturity.
OPTIONS :
Currency option is a financial instrument that give the option holder a right and not the obligation, to buy or sell a given amount of foreign exchange at a fixed price per unit for a specified time period ( until the expiration date ). In other words, a foreign currency option is a contract for future delivery of a specified currency in exchange for another in which buyer of the option has to right to buy (call) or sell (put) a particular currency at an agreed price for or within specified period. The seller of the option gets the premium from the buyer of the option for the obligation undertaken in the contract. Options generally have lives of up to one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer dated options are called warrants and are generally traded OTC.
In the spot exchange market, the business is transacted throughout the world on a continual basis. So it is possible to transaction in foreign exchange markets 24 hours a day. The standard settlement period in this market is 48 hours, i.e., 2 days after the execution of the transaction.
The spot foreign exchange market is similar to the OTC market for securities. There is no centralized meeting place and no fixed opening and closing time. Since most of the business in this market is done by banks, hence, transaction usually do not involve a physical transfer of currency, rather simply book keeping transfer entry among banks.
The purchase
and sale of currencies stem partly from the need to finance trade in goods and services. Another important source of demand and supply arises from the participation of the central banks which would emanate from a desire to influence the direction, extent or speed of exchange rate movements.
For example,
If one US dollar is worth of Rs. 45 in Indian rupees then it implies that 45 Indian rupees will buy one dollar of USA, or that one rupee is worth of 0.022 US dollar which is simply reciprocal of the former dollar exchange rate.
EXCHANGE RATE
Direct
Indirect
The number of units of domestic Currency stated against one unit of foreign currency.
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Re 1 = $ 0.02187
There are two ways of quoting exchange rates: the direct and indirect. Most countries use the direct method. In global foreign exchange market, two rates are quoted by the dealer: one rate for buying (bid rate), and another for selling (ask or offered rate) for a currency. This is a unique feature of this market. It should be noted that where the bank sells dollars against rupees, one can say that rupees against dollar. In order to separate buying and selling rate, a small dash or oblique line is drawn after the dash.
For example
If
US dollar is quoted in the market as Rs 46.3500/3550, it means that the forex dealer is
ready to purchase the dollar at Rs 46.3500 and ready to sell at Rs 46.3550. The difference between the buying and selling rates is called spread.
It is important to note that selling rate is always higher than the buying rate. Traders, usually large banks, deal in two way prices, both buying and selling, are called market makers.
Exchange rates are constantly changing, which means that the value of one currency in terms of the other is constantly in flux. Changes in rates are expressed as strengthening or weakening of one currency vis-vis the second currency.
Changes are also expressed as appreciation or depreciation of one currency in terms of the second currency. Whenever the base currency buys more of the terms currency, the base currency has
strengthened / appreciated and the terms currency has weakened / depreciated. For example, If Dollar Rupee moved from 43.00 to 43.25. The Dollar has appreciated and the Rupee has depreciated. And if it moved from 43.0000 to 42.7525 the Dollar has depreciated and Rupee has appreciated.
The counterparty risk in a futures contract is further eliminated by the presence of a clearing corporation, which by assuming counterparty guarantee eliminates credit risk.
Further, in an Exchange traded scenario where the market lot is fixed at a much lesser size than the OTC market, equitable opportunity is provided to all classes of investors whether large or small to participate in the futures market. The transactions on an Exchange are executed on a price time priority ensuring that the best price is available to all categories of market participants irrespective of their size. Other advantages of an Exchange traded market would be greater transparency, efficiency and accessibility. Source :-( Report of the RBI-SEBI standing technical committee on exchange traded currency futures) 2008.
The rationale for introducing currency futures in the Indian context has been outlined in the Report of the Internal Working Group on Currency Futures (Reserve Bank of India, April 2008) as follows;
The rationale for establishing the currency futures market is manifold. Both residents and non-residents purchase domestic currency assets. If the exchange rate remains unchanged from the time of purchase of the asset to its sale, no gains and losses are made out of currency exposures. But if domestic currency depreciates (appreciates) against the foreign currency, the exposure would result in gain (loss) for residents purchasing foreign assets and loss (gain) for non residents purchasing domestic assets. In this backdrop, unpredicted movements in exchange rates expose investors to currency risks.
Currency futures enable them to hedge these risks. Nominal exchange rates are often random walks with or without drift, while real exchange rates over long run are mean reverting. As such, it is possible that over a
long run, the incentive to hedge currency risk may not be large. However, financial planning horizon is much smaller than the long-run, which is typically inter-generational in the context of exchange rates. As such, there is a strong need to hedge currency risk and this need has grown manifold with fast growth in cross-border trade and investments flows. The argument for hedging currency risks appear to be natural in case of assets, and applies equally to trade in goods and services, which results in income flows with leads and lags and get converted into different currencies at the market rates. Empirically, changes in exchange rate are found to have very low correlations with foreign equity and bond returns. This in theory should lower portfolio risk. Therefore, sometimes argument is advanced against the need for hedging currency risks. But there is strong empirical evidence to suggest that hedging reduces the volatility of returns and indeed considering the episodic nature of currency returns, there are strong arguments to use instruments to hedge currency risks.
FUTURE TERMINOLOGY
SPOT PRICE :
The price at which an asset trades in the spot market. The transaction in which securities and foreign exchange get traded for immediate delivery. Since the exchange of securities and cash is virtually immediate, the term, cash market, has also been used to refer to spot dealing. In the case of USDINR, spot value is T + 2.
FUTURE PRICE :
The price at which the future contract traded in the future market.
CONTRACT CYCLE :
The period over which a contract trades. The currency future contracts in Indian market have one month, two month, three month up to twelve month expiry cycles. In NSE/BSE will have 12 contracts outstanding at any given point in time.
The last business day of the month will be termed the value date /final settlement date of each contract. The last business day would be taken to the same as that for inter bank settlements in Mumbai. The rules for inter bank settlements, including those for known holidays and would be those as laid down by Foreign Exchange Dealers Association of India (FEDAI).
EXPIRY DATE :
It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist. The last trading day will be two business days prior to the value date / final settlement date.
CONTRACT SIZE :
The amount of asset that has to be delivered under one contract. Also called as lot size. In case of USDINR it is USD 1000.
BASIS :
In the context of financial futures, basis can be defined as the futures price minus the spot price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices.
COST OF CARRY :
The relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance or carry the asset till delivery less the income earned on the asset. For equity derivatives carry cost is the rate of interest.
INITIAL MARGIN :
When the position is opened, the member has to deposit the margin with the clearing house as per the rate fixed by the exchange which may vary asset to asset. Or in another words, the amount that must be deposited in the margin account at the time a future contract is first entered into is known as initial margin.
MARKING TO MARKET :
At the end of trading session, all the outstanding contracts are reprised at the settlement price of that session. It means that all the futures contracts are daily settled, and profit and loss is determined on each transaction. This procedure, called marking to market, requires that funds charge every day. The funds are added or subtracted from a mandatory margin (initial margin) that traders are required to maintain the balance in the account. Due to this adjustment, futures contract is also called as daily reconnected forwards.
MAINTENANCE MARGIN :
Members account are debited or credited on a daily basis. In turn customers account are also required to be maintained at a certain level, usually about 75 percent of the initial margin, is called the maintenance margin. This is somewhat lower than the initial margin.
This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day.
Hedging:
Presume Entity A is expecting a remittance for USD 1000 on 27 August 08. Wants to lock in the foreign exchange rate today so that the value of inflow in Indian rupee terms is safeguarded. The entity can do so by selling one contract of USDINR futures since one contract is for USD 1000. Presume that the current spot rate is Rs.43 and USDINR 27 Aug 08 contract is trading at Rs.44.2500. Entity A shall do the following: Sell one August contract today. The value of the contract is Rs.44,250. Let us assume the RBI reference rate on August 27, 2008 is Rs.44.0000. The entity shall sell on August 27, 2008, USD 1000 in the spot market and get Rs. 44,000. The futures contract will settle at Rs.44.0000 (final settlement price = RBI reference rate). The return from the futures transaction would be Rs. 250, i.e. (Rs. 44,250 Rs. 44,000). As may be observed, the effective rate for the remittance received by the entity A is Rs.44. 2500 (Rs.44,000 + Rs.250)/1000, while spot rate on that date was Rs.44.0000. The entity was able to hedge its exposure. Speculation: Bullish, buy futures Take the case of a speculator who has a view on the direction of the market. He would like to trade based on this view. He expects that the USD-INR rate presently at Rs.42, is to go up in the next twothree months. How can he trade based on this belief? In case he can buy dollars and hold it, by investing the necessary capital, he can profit if say the Rupee depreciates to Rs.42.50. Assuming he buys USD 10000, it would require an investment of Rs.4,20,000. If the exchange rate moves as he expected in the next three months, then he shall make a profit of around Rs.10000. This works out to an annual return of around 4.76%. It may please be noted that the cost of funds invested is not considered in computing this return.
A speculator can take exactly the same position on the exchange rate by using futures contracts. Let us see how this works. If the INR- USD is Rs.42 and the three month futures trade at Rs.42.40. The minimum contract size is USD 1000. Therefore the speculator may buy 10 contracts. The exposure shall be the same as above USD 10000. Presumably, the margin may be around Rs.21, 000. Three months later if the Rupee depreciates to Rs. 42.50 against USD, (on the day of expiration of the
contract), the futures price shall converge to the spot price (Rs. 42.50) and he makes a profit of Rs.1000 on an investment of Rs.21, 000. This works out to an annual return of 19 percent. Because of the leverage they provide, futures form an attractive option for speculators.
Arbitrage:
Arbitrage is the strategy of taking advantage of difference in price of the same or similar product between two or more markets. That is, arbitrage is striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices. If the same or similar product is traded in say two different markets, any entity which has access to both the markets will be able to identify price differentials, if any. If in one of the markets the product is trading at higher price, then the entity shall buy the product in the cheaper market and sell in the costlier market and thus benefit from the price differential without any additional risk.
One of the methods of arbitrage with regard to USD-INR could be a trading strategy between forwards and futures market. As we discussed earlier, the futures price and forward prices are arrived at using the principle of cost of carry. Such of those entities who can trade both forwards and futures shall be ab le to identify any miss-pricing between forwards and futures. If one of them is priced higher, the same shall be sold while simultaneously buying the other which is priced lower. If the tenor of both the contracts is same, since both forwards and futures shall be settled at the same RBI reference rate, the transaction shall result in a risk less profit.
TRADER (BUYER)
TRADER (SELLER)
Purchase order
Sales order
MEMBER ( BROKER )
MEMBER ( BROKER )
It has been observed that in most futures markets, actual physical delivery of the underlying assets is very rare and hardly it ranges from 1 percent to 5 percent. Most often buyers and sellers offset their original position prior to delivery date by taking an opposite positions. This is because most of futures contracts in different products are predominantly speculative instruments. For example, X purchases American Dollar
futures and Y sells it. It leads to two contracts, first, X party and clearing house and second Y party and clearing house. Assume next day X sells same contract to Z, then X is out of the picture and the clearing house is seller to Z and buyer from Y, and hence, this process is goes on.
of Established by the bank or broker Open auction among buyers and seller on the through electronic media floor of recognized exchange. brokers, multinational companies,
Banks, brokers, forex dealers, Banks, multinational institutional arbitrageurs, traders, etc.
Margins
None as such, but compensating Margin deposit required bank balanced may be required
Maturity
Settlement
Actual delivery or offset with cash Daily settlement to the market and variation settlement. No separate clearing margin requirements house
Market place Over the telephone worldwide and recognized exchange floor with worldwide At computer networks communications
Accessibility Limited to large customers banks, Open to any one who is in need of hedging institutions, etc. Delivery facilities or has risk capital to speculate
More than 90 percent settled by Actual delivery has very less even below one actual delivery percent Highly secured through margin deposit.
Secured
For currencies which are fully convertible, the rate of exchange for any date other than spot is a function of spot and the relative interest rates in each currency. The assumption is that, any funds held will be invested in a time deposit of that currency. Hence, the forward rate is the rate which neutralizes the effect of differences in the interest rates in both the currencies. The forward rate is a function of the spot rate and the interest rate differential between the two currencies, adjusted for time. In the case of fully convertible currencies, having no restrictions on borrowing or lending of either currency the forward rate can be calculated as follows;
Future Rate = (spot rate) {1 + interest rate on home currency * period} / {1 + interest rate on foreign currency * period}
For example, Assume that on January 10, 2002, six month annual interest rate was 7 percent p.a. on Indian rupee and US dollar six month rate was 6 percent p.a. and spot ( Re/$ ) exchange rate was 46.3500. Using the above equation the theoretical future price on January 10, 2002, expiring on June 9, 2002 is : the answer will be Rs.46.7908 per dollar. Then, this theoretical price is compared with the quoted futures price on January 10, 2002 and the relationship is observe
Underlying
Initially, currency futures contracts on US Dollar Indian Rupee (US$-INR) would be permitted.
Trading Hours
The trading on currency futures would be available from 9 a.m. to 5 p.m.
Quotation
The currency futures contract would be quoted in rupee terms. However, the outstanding positions would be in dollar terms.
Available contracts
All monthly maturities from 1 to 12 months would be made available.
Settlement mechanism
The currency futures contract shall be settled in cash in Indian Rupee.
Settlement price
The settlement price would be the Reserve Bank Reference Rate on the date of expiry. The methodology of computation and dissemination of the Reference Rate may be publicly disclosed by RBI.
The contract specification in a tabular form is as under: Underlying Trading Hours (Monday to Friday) Contract Size Tick Size Trading Period Contract Months Final Settlement date/ Value date Last Trading Day Settlement Final Settlement Price Rate of exchange between one USD and INR 09:00 a.m. to 05:00 p.m. USD 1000 0.25 paisa or INR 0.0025 Maximum expiration period of 12 months 12 near calendar months Last working day of the month (subject to holiday calendars) Two working days prior to Final Settlement Date Cash settled The reference rate fixed by RBI two working days prior to the final settlement date will be used for final settlement
P R O F I T
43.19
0 USD L O S S
D
P R O F I T
43.19
0 USD L O S S
D
Pricing of futures contract is very simple. Using the cost-of-carry logic, we calculate the fair value of a futures contract. Every time the observed price deviates from the fair value, arbitragers would enter into trades to capture the arbitrage profit. This in turn would push the futures price back to its fair value. The cost of carry model used for pricing futures is given below:
F=Se where: r=Cost of financing (using continuously compounded interest rate) rf= one year interest rate in foreign T=Time till expiration in years E=2.71828
This relationship is known as interest rate parity relationship and is used in international finance. To explain this, let us assume that one year interest rates in US and India are say 7% and 10% respectively and the spot rate of USD in India is Rs. 44.
From the equation above the one year forward exchange rate should be F = 44 * e^(0.10-0.07 )*1=45.34
It may be noted from the above equation, if foreign interest rate is greater than the domestic rate i.e. rf > r, then F shall be less than S. The value of F shall decrease further as time T increase. If the foreign interest is lower than the domestic rate, i.e. rf < r, then value of F shall be greater than S. The value of F shall increase further as time T increases.
Exchange rates are quite volatile and unpredictable, it is possible that anticipated profit in foreign investment may be eliminated, rather even may incur loss. Thus, in order to hedge this foreign currency risk, the traders oftenly use the currency futures. For example, a long hedge (I.e.., buying currency futures contracts) will protect against a rise in a foreign currency value whereas a short hedge (i.e., selling currency futures contracts) will protect against a decline in a foreign currencys value.
It is noted that corporate profits are exposed to exchange rate risk in many situation. For example, if a trader is exporting or importing any particular product from other countries then he is exposed to foreign exchange risk. Similarly, if the firm is borrowing or lending or investing for short or long period from foreign countries, in all these situations, the firms profit will be affected by change in foreign exchange rates. In all these situations, the firm can take long or short position in futures currency market as per requirement.
The general rule for determining whether a long or short futures position will hedge a potential foreign exchange loss is: Loss from appreciating in Indian rupee= Short hedge Loss form depreciating in Indian rupee= Long hedge
pay 100000 USD on 1st February 2009. And he predicts that the value of USD will increase against Indian rupees nearest to due date of that payment. Importer predicts that the value of USD will increase more than 51.0000. So what he will do to protect against depreciating in Indian rupee? Suppose spots value of 1 USD is 49.8500. Future Value of the 1USD on NSE as below:
Price Watch
Order Book Contract USDINR 261108 USDINR 291208 USDINR 280109 USDINR 250209 USDINR 270309 USDINR 280409 USDINR 270509 USDINR 260609 USDINR 290709 USDINR 270809 USDINR 280909 USDINR 281009 USDINR 261109 Best Buy Qty 464 189 1 100 100 1 25 1 2 1 1 1 Best Buy Price 49.8550 49.6925 49.8850 50.1000 49.9225 50.0000 49.0000 48.0875 48.1625 48.2375 48.3100 48.3825 Best Sell Price 49.8575 49.7000 49.9250 50.2275 50.5000 51.0000 51.0000 50.5000 53.1900 Best Sell Qty 712 612 2 1 5 5 5 1 2 LTP 49.8550 49.7300 49.9450 50.1925 49.9125 50.5000 47.1000 50.0000 49.1500 50.3000 51.2000 50.9900 50.9275 Volume 58506 176453 5598 3771 311 6 Open Interest 43785 111830 16809 6367 892 278 506 116 44 2215 79 2 -
Underlying USDINR
Solution:
He should buy ten contract of USDINR 28012009 at the rate of 49.8850. Value of the contract is (49.8850*1000*100) =4988500. (Value of currency future per USD*contract size*No of contract). For that he has to pay 5% margin on 5988500. Means he will have to pay Rs.299425 at present. And suppose on settlement day the spot price of USD is 51.0000. On settlement date payoff of importer will be (51.0000-59.8850) =1.115 per USD. And (1.115*100000) =111500.Rs.
HR= VF / Vc Where, VF is the value of the futures position and Vc is the value of the cash position. Suppose value of contract dated 28th January 2009 is 49.8850. And spot value is 49.8500. HR=49.8850/49.8500=1.001.
date and the asset type and quality. The contract price is generally not available in public domain.
On the expiration date, the contract has to be settled by delivery of the asset. If the party wishes to reverse the contract, it has to compulsorily go to the same
counterparty, which often results in high prices being charged. Forward contracts are very useful in hedging and speculation. The classic hedging application would be that of an exporter who expects to receive payment in dollars three months later. He is exposed to the risk of exchange rate fluctuations.
Introduction to Futures A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contracts, the futures contracts are standardized and exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. It is a standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered, (or which can be used for reference purposes in settlement) and a standard timing of such settlement. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. More than 99% of futures transactions are offset this way. The standardized items in a futures contract are: Quality of the underlying The date and the month of delivery The units of price quotation and minimum price change Location of settlement
3. Lower Transaction Cost: Another advantage of futures trading is much lower relative commissions. Your commission for trading a futures contract is one tenth of a percent (0.100.20%). 4. High Liquidity: Most futures markets are very liquid, i.e. there are huge amounts of contracts traded every day. This ensures that market orders can be placed very quickly as there are always buyers and sellers for most contracts.
a profit of Rs.400 on an investment of Rs.20, 000. This works out to an annual return of 12 percent. Because of the leverage they provide, security futures form an attractive option for speculators.
Arbitrage: Overpriced futures: buy spot, sell futures-, the cost-of-carry ensures that the
futures price stay in tune with the spot price. Whenever the futures price deviates substantially from its fair value, arbitrage opportunities arise. If you notice that futures on a security that you have been observing seem overpriced, how can you cash in on this opportunity to earn risk less profits? Say for instance, ABB trades at Rs.1000. Onemonth ABB futures trade at Rs.1025 and seem overpriced. As an arbitrageur, you can make risk less profit by entering into the following set of transactions. 1. On day one, borrow funds; buy the security on the cash/spot market at 1000. 2. Simultaneously, sell the futures on the security at 1025. 3. Take delivery of the security purchased and hold the security for a month. 4. On the futures expiration date, the spot and the futures price converge. Now unwind the position. 5. Say the security closes at Rs.1015. Sell the security. 6. Futures position expires with profit of Rs.10. 7. The result is a risk less profit of Rs.15 on the spot position and Rs.10 on the futures position. 8. Return the borrowed funds. When does it make sense to enter into this arbitrage? If youre cost of borrowing funds to buy the security is less than the arbitrage profit possible, it makes sense for you to arbitrage. This is termed as cashandcarry arbitrage. Remember however, that exploiting an arbitrage opportunity involves
trading on the spot and futures market. In the real world, one has to build in the transactions costs into the arbitrage strategy.
Futures Trade on an organized exchange Standardized contract terms Hence more liquid Requires margin payments Follows daily settlement
Forwards OTC in nature Customized contract terms Hence less liquid No margin payment Happens at end of period
Futures terminology
Spot price: The price at which an asset trades in the spot market. Futures price: The price at which the futures contract trades in the futures market. Contract cycle: The period over which a contract trades. The index futures contracts on the
NSE have one-month, two-months and three-month expiry cycles which expire on the last Thursday of the month. Thus a January expiration contract expires on the last Thursday of January
and a February expiration contract ceases trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three-month expiry is introduced for trading Expiry date: It is the date specified in the futures contract. This is the last day on which the
contract will be traded, at the end of which it will cease to exist. Contract size: The amount of asset that has to be delivered less than one contract. For instance, the contract size on NSEs futures market is 200 Nifties. Cost of carry: The relationship between futures prices and spot prices can be summarized
in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset. Initial margin: The amount that must be deposited in the margin account at the time a
futures contract is first entered into is known as initial margin. Marking-to-market: In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investors gain or loss depending upon the futures closing price. This is called markingtomarket.
Introduction to Options
An option gives the holder of the option the right to do something. The holder does not have to exercise this right. In contrast, in a forward or futures contract, the two parties have committed themselves to doing something. Whereas it costs nothing (except margin requirements) to enter into a futures contract, the purchase of an option requires an upfront payment.
Option terminology
Index options: These options have the index as the underlying. Some options are European while others are American. Like indexing futures contracts, indexing options contracts are also cash settled. Stock options: Stock options are options on individual stocks. Options currently trade on
over 500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified price. Buyer of an option: The buyer of an option is the one who by paying the option premium
buys the right but not the obligation to exercise his option on the seller/writer. Writer of an option: The writer of a call/put option is the one who receives the option
premium and is thereby obliged to sell/buy the asset if the buyer exercises on him. There are two basic types of options, call options and put options. Call option: A call option gives the holder the right but not the obligation to buy an asset by
Put option: A put option gives the holder the right but not the obligation to sell an asset by
a certain date for a certain price. Option price: Option price is the price, which the option buyer pays to the option seller. It is also referred to as the option premium. Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity. Strike price: The price specified in the options contract is known as the strike price or the exercise price. American options: American options are options that can be exercised at any time upto the expiration date. Most exchange-traded options are American. European options: European options are options that can be exercised only on the expiration date itself. European options are easier to analyze than American options, and properties of an American option are frequently deduced At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cash flow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price). Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cash flow if it were exercised immediately. A call option on the index is out-of-the-money when the current index stands at a level, which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price. Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an options time value, all else equal. At expiration, an option should have no time value.
Type of Options
1.
Call Options- A call option gives the holder (buyer/ one who is long call), the right to buy
specified quantity of the underlying asset at the strike price on or before expiration date. The seller (one who is short call) however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy. Example: An investor buys One European call option on Infosys at the strike price of Rs. 3500 at a premium of Rs. 100. If the market price of Infosys on the day of expiry is more than Rs. 3500, the option will be exercised. The investor will earn profits once the share price crosses Rs. 3600 (Strike Price + Premium i.e. 3500+100). Suppose stock price is Rs. 3800, the option will be exercised and the investor will buy 1 share of Infosys from the seller of the option at Rs 3500 and sell it in the market at Rs 3800 making a profit of Rs. 200 {(Spot price - Strike price) - Premium}. In another scenario, if at the time of expiry stock price falls below Rs. 3500 say suppose it touches Rs. 3000, the buyer of the call option will choose not to exercise his option. In this case the investor loses the premium (Rs 100), paid which should be the profit earned by the seller of the call option. 2. Put Options- A Put option gives the holder (buyer/ one who is long Put), the right to sell specified quantity of the underlying asset at the strike price on or before an expiry date. The seller of the put option (one who is short Put) however, has the obligation to buy the underlying asset at the strike price if the buyer decides to exercise his option to sell. Example: An investor buys one European Put option on Reliance at the strike price of Rs. 300/- , at a premium of Rs. 25/-. If the market price of Reliance, on the day of expiry is less than Rs. 300, the option can be exercised as it is 'in the money'. The investor's Break-even point is Rs. 275/ (Strike Price - premium paid) i.e., investor will earn profits if the market falls below 275. Suppose stock price is Rs. 260, the buyer of the Put option immediately buys Reliance share in the market @ Rs. 260/- & exercises his option selling the Reliance share at Rs 300 to the option writer thus making a net profit of Rs. 15 {(Strike price - Spot Price) - Premium paid}. In another scenario, if at the time of expiry, market price of Reliance is Rs 320/ -, the buyer of the Put option will choose not to exercise his option to sell as he can sell in the market at a higher rate. In this case the investor loses the premium paid (i.e. Rs 25/-), which shall be the profit earned by the seller of the Put option. (Please see table)
exposure the 1. Option buyerBuys the right to buy Buys the right to sell the or option holder the underlying asset at underlying asset at the the specified price specified price (usually
underlying investor can see Has 2. Option seller Has the obligation to sell the obligation to buy or percentage gains the underlying asset (to the underlying asset (from option writer comparatively option holder) at the option holder) at the favorable specified price specified price moves in the index. Leverage
also has downside implications. If the underlying stock price does not rise or fall as anticipated during the lifetime of the option, leverage can magnify the investment's percentage loss. Options
offer their owners a predetermined, set risk. However, if the owner's options expire with no value, this loss can be the entire amount of the premium paid for the option. In-the-money, At-the-money, Out-of-the-money An option is said to be 'at-the-money', when the option's strike price is equal to the
underlying asset price. This is true for both puts and calls. A call option is said to be in-the-money when the strike price of the option is less than the
underlying asset price. For example, a Sensex call option with strike of 3900 is 'in-the-money', when the spot
Sensex is at 4100 as the call option has value. The call holder has the right to buy a Sensex at 3900, no matter how
much the spot market price has risen. And with the current price at 4100, a profit can be made by selling Sensex at this higher price. On the other hand, a call option is out-of-the-money when the strike price is greater than the underlying asset price. Using the earlier example of Sensex call option, if the Sensex falls to 3700, the call option no longer has positive exercise value. The call holder will not exercise the option to buy Sensex at 3900 when the current price is at 3700. (Please see table) Striking the price
Call Option
Put Option
1.In-the-money
Strike Price less than Spot Strike Price greater than Spot Price of underlying asset Price of underlying asset
2. At-the-money
Strike Price equal to Spot Price equal to Spot Price Strike Price of underlying asset of underlying asset
Strike Price less than Spot 3. Out-of-the-money Strike Price greater than Spot Price of underlying asset Price of underlying asset
A put option is in-the-money when the strike price of the option is greater than the
spot price of the underlying asset. For example, a Sensex put at strike of 4400 is in-the-money when the Sensex is at 4100. When this is the case, the put option has value because the put holder can sell the Sensex at 4400, an amount greater than the current Sensex of 4100. Likewise, a put option is out-of-the-money when the strike price is less than the spot
price of underlying asset. In the above example, the buyer of Sensex put option won't exercise the option when the spot is at 4800. The put no longer has positive exercise value. Options are said to be deep in-the-money (or deep out-of-the-money) if the exercise price is at significant variance with the underlying asset price. The amount by which an option, call or put, is in-the-money at any given moment is called its intrinsic value. Thus, by definition, an at-the-money or out-of-the-money option has no intrinsic value; the time value is the total option premium. This does not mean, however, these options can be obtained at no cost. Any amount by which an option's total premium exceeds intrinsic value is called the time value portion of the premium. It is the time value portion of an option's premium that is affected by fluctuations in volatility, interest rates, dividend amounts and the passage of time. There are other factors that give options value, therefore affecting the premium at which they are traded. Together, all of these factors determine time value. Option Premium = Intrinsic Value + Time Value Factors that affect the value of an Option Premium There are two types of factors that affect the value of the option premium: Quantifiable Factors: 1. 2. Underlying stock price, The strike price of the option,
3. 4. 5.
The volatility of the underlying stock, The time to expiration and; The risk free interest rate.
Non-Quantifiable Factors: 1. Market participants' varying estimates of the underlying asset's future volatility
2. Individuals' varying estimates of future performance of the underlying asset, based on fundamental or technical analysis 3. The effect of supply & demand- both in the options marketplace and in the market for the underlying asset 4. The "depth" of the market for that option - the number of transactions and the contract's trading volume on any given day.
Black Scholes Model which assumes that percentage change in the price of underlying follows a normal distribution.
Binomial Model which assumes that percentage change in price of the underlying follows a binomial distribution. Pricing models include the binomial options model for American options and the Black-Schools model for European options.
More generally, options offer nonlinear payoffs whereas futures only have linear payoffs. By combining futures and options, a wide variety of innovative and useful payoff structures can be created.
Option TradingAs described earlier, four possible option selections exist for a trader:
(1) (2) (3) (4) long a call, long a put, short a call, and short a put. These four can be used independently, together, or in conjunction with other
financial instruments to create a number of option-trading strategies. These combinations enable a trader to develop an option-trading model which meets the trader's specific trading needs, expectations, and style, and enables him or her to anticipate every conceivable situation in the market. This trading structure can be adapted to handle any type of market outlook, whether it is bullish, bearish, choppy, or neutral. Options are unique trading instruments. They can be used for a multitude of purposes, providing tremendous versatility and utility. Among their multiple applications are the following: to speculate on the movement of an asset; to hedge an existing position in an asset; to hedge other option positions; to generate income by writing options against different quantities of options strategies that arise from these applications and the fact that the scope of this book is limited, Why Use Options-There are two main reasons why an investor would use options: to speculate and to hedge.
Speculation The advantage of options is that you aren't limited to making a profit only when the market goes up. Because of the versatility of options, you can also make money when the market goes down or even sideways. Speculation is the territory in which the big money is made - and lost. This is because when you buy an option; you have to be correct in determining not only the direction of the stock's movement, but also the magnitude and the timing of this movement. To succeed, you must correctly predict whether a stock will go up or down, and you have to be right about how much the price will change as well as the time frame it will take for all this to happen. And don't forget commissions! The combinations of these factors means the odds are stacked against you.
Hedging The other function of options is hedging. Think of this as an insurance policy. Just as you insure your house or car, options can be used to insure your investments against a downturn. Critics of options say that if you are so unsure of your stock pick that you need a hedge, you shouldn't make the investment. On the other hand, there is no doubt that hedging strategies can be useful, especially for large institutions. Even the individual investor can benefit. Imagine that you wanted to take advantage of technology stocks and their upside, but say you also wanted to limit any losses.
$315 $0
$825 $510
$0 -$315
The price swing for the length of this contract from high to low was $825, which would have given us over double our original investment. This is leverage in action. Exercising Versus Trading- Out So far we've talked about options as the right to buy or sell (exercise) the underlying. This is true, but in reality, a majority of options are not actually exercised. In our example, you could make money by exercising at $70 and then selling the stock back in the market at $78 for a profit of $8 a share. You could also keep the stock, knowing you were able to buy it at a discount to the present value. However, the majority of the time holders choose to take their profits by trading out (closing out) their position. This means that holders sell their options in the market, and writers buy their positions back to close. According to the CBOE, about 10% of options are exercised, 60% are traded out, and 30% expire worthless. Intrinsic Value and Time Value At this point it is worth explaining more about the pricing of options. In our example the premium (price) of the option went from $3.15 to $8.25. These fluctuations can be explained by intrinsic value and time value. Basically, an option's premium is its intrinsic value + time value. Remember, intrinsic value is the amount in-the-money, which, for a call option, means that the price of the stock equals the strike price. Time value represents the possibility of the option increasing in value. So, the price of the option in our example can be thought of as the following: Premium = $8.25 = Intrinsic Value $8 + Time Value + $0.25
Avoid purchasing call options just prior to a stock going ex-dividend. Avoid buying or selling options based upon anticipated news (buyouts in particular). Besides bordering on unethical trading, the information received is more likely to be rumor than correct.
Avoid purchasing options well after the market has established a defined trend - this is especially true when day trading, as any option premium advantage will have dissipated.
Avoid purchasing way out-of-the-money options when day trading, as any favorable price movement will have a negligible effect upon premium.
Column 4: Volume - This indicates the total number of options contracts traded for the day. The total volume of all contracts is listed at the bottom of each table. Column 5: Bid - This indicates the price someone is willing to pay for the options contract. Column 6: Ask - This indicates the price at which someone is willing to sell an options contract. Column 7: Open Interest - Open interest is the number of options contracts that are open; these are contracts that have neither expired nor been exercised Payoff for Derivatives Contracts A payoff is the likely profit/loss that would accrue to a market participant with change in the price of the underlying asset. This is generally depicted in the form of payoff diagrams which show the price of the underlying asset on the Xaxis and the profits/losses on the Yaxis. Payoff for Futures
Futures contracts have linear payoffs. In simple words, it means that the losses as well as profits for the buyer and the seller of a futures contract are unlimited. These linear payoffs are fascinating as they can be combined with options and the underlying to generate various complex payoffs. Payoff for buyer of futures: Long futures The payoff for a person who buys a futures contract is similar to the payoff for a person who holds an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who buys a two-month Nifty index futures contract when the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio. When the index moves up, the long futures position starts making profits, and when the index moves down it starts making losses. Payoff for seller of futures: Short futures: The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who sells a two-month Nifty index futures contract when the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio. When the index moves down, the short futures position starts making profits, and when the index moves up, it starts making losses.
Options Payoffs
The optionally characteristic of options results in a non-linear payoff for options. In simple words, it means that the losses for the buyer of an option are limited; however the profits are potentially unlimited. For a writer, the payoff is exactly the opposite. His profits are limited to the option premium; however his losses are potentially unlimited. These non-linear payoffs are fascinating as they lend themselves to be used to generate various payoffs by using combinations of options and the underlying. We look here at the six basic payoffs. Payoff profile of buyer of asset: Long asset In this basic position, an investor buys the underlying asset, Nifty for instance, for 1220, and sells it at a future date at an unknown price, once it is purchased, the investor is said to be long the asset. Payoff profile for seller of asset: Short asset In this basic position, an investor shorts the underlying asset, Nifty for instance, for 1220, and buys it back at a future date at an unknown price Payoff profile le for buyer of call options: Long call A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. If upon expiration, the spot price exceeds the strike price, he makes a profit. Higher the spot price more is the profit he makes. If the spot price of the underlying is less than the strike price, he lets his option expire un-exercised. His loss in this case is the premium he paid for buying the option.
Payoff profile for writer of call options: Short call A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. For selling the option, the writer of the option charges a premium. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. Whatever is the buyers profit is the sellers loss. If upon expiration, the spot price exceeds the strike price, the buyer will exercise the option on the writer. Hence as the spot price increases the writer of the option starts making losses. Higher the spot price more is the loss he makes. If upon expiration the spot price of the underlying is less than the strike price, the buyer lets his option expire unexercised and the writer gets to keep the premium. Payoff profile for buyer of put options: Long put A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. If upon expiration, the spot price is below the strike price, he makes a profit. Lower the spot price more is the profit he makes. If the spot price of the underlying is higher than the strike price, he lets his option expire un-exercised. His loss in this case is the premium he paid for buying the option. Payoff profile for writer of put options: Short put A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. For selling the option, the writer of the option charges a premium. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. Whatever is the buyers profit is the sellers loss. If upon expiration, the spot price happens to be below the strike price, the buyer will exercise the option on the writer.
days. Calculating the net loss associated with a position does the calculation of MTM margin. This is paid up each evening after trading ends. The focus is on calculating the net loss on all contracts entered by the client. Advantages and Risks of Trading in Futures over Cash The biggest advantage of futures is that short selling is allowed without having stock and
position can be carried for a long time, which is not possible in the cash segment because of rolling settlement. Conversely futures can be bought and position can be carried for a long time without taking delivery, unlike in the cash segment where it delivery has to be taken because of rolling settlement. For example, the expectation for a Rs100 stock is to go up by Rs10. One way is to buy the
stock in the cash segment by paying Rs100. In this way the profit will be Rs10 on investment of Rs100, giving about 10% returns. Alternatively, futures position in the stock by paying about Rs30 toward initial and mark-to-market margin the same profit of Rs10 can be made on the investment of Rs30, i.e. about 33% returns. Please note that taking leveraged position is very risky, you can even lose your full capital in case the price moves against your position.
Buyers start out-of-pocket. But going forward, the option buyer has no downside risk. The graph either flat lines or goes up on either side of the spot price.
Sellers start with a gain. Going forward, they have no upside risk. These graphs either flat line or go down on either side of the spot price. The extent of risk varies. Buyers/sellers of calls have unlimited upside/downside risk as the asset price increases. Buyers/sellers of puts have upside/downside risk limited to the spot price of the asset (less the premium) Long Call A trader who believes that a stock's price will increase might buy the right to purchase the stock (a call option) rather than just buy the stock. He would have no obligation to buy the stock, only the right to do so until the expiry date. If the stock price increases over the exercise price by more than the premium paid, he will profit. If the stock price decreases, he will let the call contract expire worthless, and only lose the amount of the premium. A trader might buy the option instead of shares, because for the same amount of money, he can obtain a larger number of options than shares. If the stock rises, he will thus realize a larger gain than if he had purchased shares. This is an example of the principle of leverage.
Short Call (Naked short call) A trader who believes that a stock's price will decrease can short sell the stock or instead sell a call. Both tactics are generally considered inappropriate for small investors. The trader selling a call has an obligation to sell the stock to the call buyer at the buyer's option. If the stock price decreases, the short call position will make a profit in the amount of the premium. If the stock price increases over the exercise price by more than the amount of the premium, the short will lose money. Unless a trader already owns the shares which he may be required to provide, the potential loss is unlimited. However, such a trader who sells a call option for those shares he already owns has sold a covered call.
Payoffs and profits from a short call. Long Put A trader who believes that a stock's price will decrease can buy the right to sell the stock at a fixed price. He will be under no obligation to sell the stock, but has the right to do so until the expiry date. If the stock price decreases below the exercise price by more than the premium paid, he will profit. If the stock price increases, he will just let the put contract expire worthless and only lose his premium paid.
Payoffs and profits from a long put. Short Put (Naked put) A trader who believes that a stock's price will increase can sell the right to sell the stock at a fixed price. The trader now has the obligation to purchase the stock at a fixed price. The trader has sold insurance to the buyer of the put requiring the trader to insure the stockholder below the fixed price. This trade is generally considered inappropriate for a small investor. If the stock price increases, the short put position will make a profit in the amount of the premium. If the stock price decreases below the exercise price by more than the premium, the short position will lose money.
Payoffs and profits from a short put. Introduction to Option Strategies Bullish Strategies Bullish options strategies are employed when the options trader expects the underlying stock price to move upwards. It is necessary to assess how high the stock price can go and the timeframe in which the rally will occur in order to select the optimum trading strategy. The most bullish of options trading strategies is the simple call buying strategy used by most novice options traders. In most cases, stocks seldom go up by leaps and bounds. Moderately bullish options traders usually set a target price for the Bull Run and utilize bull spreads to reduce risk. While maximum profit is capped for these strategies, they usually cost less to employ. The bull call spread and the bull put spread are common examples of moderately bullish strategies.
Mildly bullish trading strategies are options strategies that make money as long as the underlying stock prices do not go down on options expiration date. These strategies usually provide a small downside protection as well. Writing out-of-the-money covered calls is a good example of such a strategy. Bearish Strategies-Bearish options strategies are employed when the options trader expects the underlying stock price to move downwards. It is necessary to assess how low the stock price can go and the timeframe in which the decline will happen in order to select the optimum trading strategy. The most bearish of options trading strategies is the simple put buying strategy utilized by most novice options traders. In most cases, stock price seldom make steep downward moves. Moderately bearish options traders usually set a target price for the expected decline and utilize bear spreads to reduce risk. While maximum profit is capped for these strategies, they usually cost less to employ. The bear call spread and the bear put spread are common examples of moderately bearish strategies. Mildly bearish trading strategies are options strategies that make money as long as the underlying stock prices do not go up on options expiration date. These strategies usually provide a small upside protection as well. Neutral or Non-Directional Strategies
Neutral strategies in options trading are employed when the options trader does not know whether the underlying stock price will rise or fall. Also known as non-directional strategies, they are so named because the potential to profit does not depend on whether the underlying stock price will go upwards or downwards. Rather, the correct neutral strategy to employ depends on the expected volatility of the underlying stock price.
Bullish on Volatility Neutral trading strategies those are bullish on volatility profit when the underlying stock price experience big moves upwards or downwards. They include the long straddle, long strangle, and short condor and short butterfly. Bearish on Volatility
Neutral trading strategies those are bearish on volatility profit when the underlying stock price experiences little or no movement. Such strategies include the short straddle, short strangle, ratio spreads, long condor and long butterfly. Combining any of the four basic kinds of option trades (possibly with different exercise prices) and the two basic kinds of stock trades (long and short) allows a variety of options strategies. Simple strategies usually combine only a few trades, while more complicated strategies can combine several.
Traders who anticipate that the future market price of an asset, say a stock, will fall prior to expiration can buy the right to sell the stock at a fixed price. The put buyer has no obligation to sell the stock, but simply the right. Short Put Traders, who speculate that the future market price will increase, can sell the right to sell an asset at a pre-determined price. If the asset's market price rises, the short put position makes a profit equal to the amount of the premium. (Excluding any transaction costs, such as commissions.) If the price falls below the strike price by more than the premium, the 'writer' loses money. Hedging involves taking positions that tend to move in opposite directions. They profit less than pure speculation, but make up for it by offloading some risk. 'Bull spreads', for example, use a long call with a low strike price in combination with a short call at a higher strike price and a short put with a higher strike price. 'Bear spreads', by contrast, involve a short call with a low strike price and a long call with a higher strike price. An alternative method uses a short put with low strike price and a long put with a higher strike price. Options trading software can demonstrate several concrete examples of how any of these - under different assumptions about future prices, volume, etc in combination with different expiration dates and strike prices - can result in profit (or loss)
Indexes of NIFTI
Indexes of NIFTI
Current Strategies
1. LONG CALL
Purchasing calls has remained the most popular strategy with investors since listed options were first introduced. Before moving into more complex bullish and bearish strategies, an investor should thoroughly understand the fundamentals about buying and holding call options.
Situation: On 1 November, L&T is quoting at Rs 254 and the January 260 (strike price) call costs Rs 14 (premium). You expect the share price to rise significantly and want to profit from the increase Action: Buy 1 L&T call at 14. Net outlay is Rs 14,000 If the L&T shares do go up you can close your position either by selling the option back to the market or exercising your right to buy the underlying shares at the exercise price.
Option Market Buy 1 Jan 260 call at Rs 14, Cost =14,000 1. Sell 1Jan contract (Expiry) 2. Net Gain 40 (300 - 260 x 1000 units = 40,000) Your gain is: Option sale = 40,000 Premium paid = (14,000) Net profit= 26,000 Return 186%
Analysis
Possible Outcomes at expiry Share Price 300 Share price < 260 Stock price > 274 Option worth 40,000. Closing the position now will produce a net profit of 26,000 Option expires worthless. The loss is Rs. 14,000 (premium) Net profit = intrinsic value of (Break even = 260+14) option i.e. by whatever amount the share price exceeds 274
2. LONG PUT
A long put can be an ideal tool for an investor who wishes to participate profitably from a downward price move in the underlying stock. Before moving into more complex bearish strategies, an investor should thoroughly understand the fundamentals about buying and holding put options.
3. Short Call
The covered call is a strategy in which an investor writes a call option contract while at the same time owning an equivalent number of shares of the underlying stock. If this stock is purchased simultaneously with writing the call con-tract, the strategy is commonly referred to as a "buywrite." If the shares are already held from a previous purchase, it is commonly referred to an "overwrite
According to the terms of a put contract, a put writer is obligated to purchase an equivalent number of underlying shares at the put's strike price if assigned an exercise notice on the written contract. Many investors write puts because they are willing to be assigned and acquire shares of the underlying stock in exchange for the premium received from the put's sale. For this discussion, a put writer will be considered "covered" if he has on deposit with his brokerage firm a cash amount (or other approved collateral) sufficient to cover such a purchase. Situation: An investor owns 10,000 shares and also has a cash holding of around 60,00,000. In early March he feels that the share price of NIIT will either remain constant or, possibly, rise slightly. Action: The Investor decides to generate some additional income on his portfolio and writes 10 NIIT 550 puts at Rs 40. Thus he received premium of 4,00,000. In relation to the Indian markets, this strategy requires a substantial investment. The net outflow in this situation is: Future Margin Option Premium.
Possible Outcomes at expiry Share Price =/ > 550 The investor's expectation is correct and the put will expire without being exercised. Initial income remains as profit.
The put option will be exercised and the stock will have to be purchased, effectively for 51,00,000 (55,00,000- 4,00,000).
Establishing a bull call spread involves the purchase of a call option on a particular underlying stock, while simultaneously writing a call option on the same underlying stock with the same expiration month, at a higher strike price. Both the buy and the sell sides of this spread are opening transactions, and are always the same number of contracts.
Note: the long call position always covers the risk on the short call position. Eg. if the short option is exercised against you, it is possible to exercise the long position and acquire stock in order to satisfy the short position.
Establishing a bear put spread involves the purchase of a put option on a particular underlying stock, while simultaneously writing a put option on the same underlying stock with the same expiration month, but with a lower strike price. Both the buy and the sell sides of this spread are opening transactions, and are always the same number of contracts. This spread is sometimes more broadly categorized as a "vertical spread": a family of spreads involving options of the same stock, same expiration month, but different strike prices. They can be created with either all calls or all
puts, and be bullish or bearish. The bear put spread, as any spread, can be executed as a "package" in one single transaction, not as separate buy and sell transactions.
Advantages Position established for less cost than a long put and breaks even more quickly. Limited loss.
7. Long Straddle
For aggressive investors who expect short-term volatility yet have no bias up or down (i.e., a neutral bias), the long straddle is an excellent strategy. This position involves buying both a put and a call with the same strike price, expiration, and underlying. The potential loss is limited to the initial investment. The potential profit is unlimited as the stock moves up or down. Expectation: Purchasing a straddle is appropriate when anticipating significant volatility in the underlying but when uncertain about direction.
8. Short Straddle
For aggressive investors who don't expect much short-term volatility, the short straddle can be a risky, but profitable strategy. This strategy involves selling a put and a call with the same strike price, expiration, and underlying. In this case, the profit is limited to the initial credit received by selling options. The potential loss is unlimited as the market moves up or down. Expectation: Generally undertaken with a view that the underlying share price will trade between break even points. Advantages Generation of earnings from premium received. Secure known purchase and sale price.
9.Long Strangle
For aggressive investors who expect short-term volatility yet have no bias up or down (i.e., a neutral bias), the long strangle is another excellent strategy. This strategy typically involves buying out-of-the-money calls and puts with the same expiration and underlying. The potential loss is limited to the initial investment while the potential profit is unlimited as the market moves up or down.
Advantages Profit potential open ended in either direction. Loss limited to total premium paid. 10.Short Strangle
For aggressive investors who don't expect much short-term volatility, the short strangle can be a risky, but profitable strategy. This strategy typically involves selling out-of the-money puts and calls with the same expiration and underlying. The profit is limited to the credit received by selling options. The potential loss is unlimited as the market moves up or down. Advantages Generation of earnings from premium received. Secure know sale and purchase prices.
Disadvantages Loss is unlimited In the Indian Markets, the investment required for such a strategy is very high and should only be attempted by people with huge funds and an appetite for large losses.
11.Butterfly
Ideal for investors who prefer limited risk, limited reward strategies. When investors expect stable prices, they can buy the butterfly by selling two options at the middle strike and buying one option
at the higher and lower strikes. The options, which must be all calls or all puts, must also have the same expiration and underlying. 12.Collar A collar can be established by holding shares of an underlying stock, purchasing a protective put and writing a covered call on that stock. The option portions of this strategy are referred to as a combination. Generally, the put and the call are both out of-the-money when this combination is established, and have the same expiration month. Expectation: An investor will employ this strategy after accruing unrealized profits from the underlying shares, and wants to protect these gains with the purchase of a protective put. At the same time, the investor is willing to sell his stock at a price higher than the current market price so an out-of-the-money call contract is written, covered in this case by the underlying stock
Advantages The collar strategy is best used for investors looking for a conservative strategy that can offer a reasonable rate of return with managed risk and potential tax advantages. Disadvantages The primary concern in employing a collar is protection of profits accrued from underlying shares rather than increasing returns on the upside. 13. Condor Spread The Condor Spread strategy is a neutral strategy similar to the Butterfly. In the Iron Condor, an investor will combine a Bear-Call Credit Spread and a Bull-Put Credit Spread on the same underlying security. By doing this, an investor will potentially be able to double the credit obtained over a single spread position. Since there are two spreads involved in the strategy (four options), there is an upper break even and a lower break even. A profit is made if the stock remains above the lower break even point or below the upper break even point. 14. Calendar Spread Calendar spreads take advantage of the different rates at which time value erodes. Since the time value element of an options premium erodes faster in the near month series than the far month series, a spread opens up between the two. The more rapid erosion in the near month series works to the advantage of the writer and the strategy is therefore particularly appropriate when the near month series is overpriced. Expectation: A calendar spread involves the sale of a near dated call (put) and the purchase of a longer dated call (put) at the same exercise price. Calls are used when market view is moderately bullish and puts are used when market view is moderately bearish.
Conclusion
The Indian stock market witnesses both the good as well as the bad time. Most of the people keep them away from bad times that lead to low liquidity in the markets. But for the rest who want to remain in the markets without loosing much of their capital and take leverage of the market movements in both north and south directions, Derivatives Instruments are the tools to be with. By studying and applying various Derivative Instruments like Futures, Forwards and Option strategies in a theoretical manner, I came to a conclusion that these instruments are the best ones to turn the bad time into a good one i.e. to earn profits in any market. Therefore, Derivative Instruments are a very good tool that will help us to minimize our risk and maximize our returns so that one can have conviction in his portfolio in the hugely volatile stock market. So we can say that derivative instruments are very useful and applicable for Indian share and stock exchange and they also help entrepreneur to setup new business
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