A project on analysis of derivatives and stock broking at apollo sindhoori

Analysis of Derivatives and Stock Broking at Apollo Sindhoori

Executive Summary
Title of the analysis
“Analysis of Derivatives and Stock Broking at Apollo Sindhoori capital
Investment ltd.”
The function of the financial market is to facilitate the transfer of funds from surplus
sectors (lenders) to deficit sector (borrowers) Indian financial system consist of the
money market and capital market.
Depository is an organization where the securities of a shareholder are held in
the electronic form at the request of the shareholder through a medium of a depository
participant.
To handle the securities in electronic form as per the Depository Act 1996, two
Depositories are registered with SEBI. They are
1. National Securities Depository Ltd (NSDL)
2. Central Depository Services (India) ltd (CSDL)
A derivative is a financial instrument that derives its value from an underlying asset.
This underlying asset can be stocks, bonds currency, commodities, metals and even
intangible. Like stock indices. There are different types of derivatives like Forwards,
Futures, Options, and Swaps.
A future is a contract to buy or sell an asset at a specified future date at a
specified price. Options are deferred delivery contracts that give the buyers the right,
but not the obligation, to buy or sell a specified underlying at a price on or before a
specified date.
ASCI computer share private Ltd. Is a joint venture between computer share
Australia and ASCI consultant’s Ltd. India in the registry management services
industry. Computer share Australia is the world’s largest and only global share
registry providing financial market services and technology to the global securities
industry. ASCI corporate and mutual fund share registry and investor services
business, India’s No.1Registrar and transfer agent and rated as India’s “most admired
registrar” for its over all excellence in volume management, quality process and
technology driven services.

BABASAB PATIL PROJECT REPORT ON FINANCE 1


Computer share has over 6000 experienced professionals; computer share
operates in five continents, providing services and solutions to listed companies,
investors, employees, exchanges and other financial institutions while ASCI has
handled over 675 issues as Registrar to Issues servicing over 16 million investors
from multiple locations across India.
ASCI Computer share is all geared up to establish a new paradigm in service
delivery driven by benchmark operations management practices, the highest quality
standards and state-of –the-art technology to service its clients and the investor
community at large. The rapid developments in the Indian securities.
This report is delivered in to 2 parts; each part is prepared on the basis of the
analysis carried on in the company, of the first part of the report makes us familiar of
the company, its quality policy, quality objectives and its plans. The second part
contains the analysis on derivatives, stock broking process and its service offered by
ASCI to its clients. The objective of the analysis are to analysis of derivatives
products, trading systems and process, clearing and settlement, to know the process of
stock broking, the calculation of brokerage, how to get registered with ASCI in order
to buy and sell the shares.



Objective of the analysis

 Getting an in-depth knowledge of working of derivatives market with
special reference to the stock exchanges.

 Understanding the role of stock broking in capital market and derivatives
market.

 To know the overview of the market, to study about the settlement
procedure in the stock exchange.

 To analysis about the intermediaries, their functioning and importance of
their presence in the capital market and study about the action trading in
the stock exchange

Need for the study
Financial Derivatives are quite new to the Indian Financial Market, but the
derivatives market has shown an immense potential which is visible by the growth it
has achieved in the recent past, In the present changing financial environment and an
increased exposure towards financial risks, It is of immense importance to have a
good working knowledge of Derivatives.

Methodology:-

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

I have collected the primary data from the internal guide and the clients who use
visit and trade in the ASCI stock broking Ltd. The secondary data about the online
trading is collected from the various websites.

• Websites
• Magazines
• News papers

The data for the analysis has been collected from NSE websites.



Introduction to Organization:

ASCI, is a premier integrated financial services provider, and ranked
among the top five in the country in all its business segments, services over 16
million individual investors in various capacities, and provides investor
services to over 300 corporate, comprising the who is who of Corporate India.
ASCI covers the entire spectrum of financial services such as Stock broking,
Depository Participants, Distribution of financial products - mutual funds,
bonds, fixed deposit, equities, Insurance Broking, Commodities Broking,
Personal Finance Advisory Services, Merchant Banking & Corporate Finance,
placement of equity, IPO’s, among others. ASCI has a professional
management team and ranks among the best in technology, operations and
research of various industrial segments

The birth of ASCI was on a modest scale in 1981. It began with the
vision and enterprise of a small group of practicing Chartered Accountants
who founded the flagship company …ASCI Consultants Limited. It started
with consulting and financial accounting automation, and carved inroads into
the field of registry and share accounting by 1985. Since then, they have
utilized their experience and superlative expertise to go from strength to
strength…to better their services, to provide new ones, to innovate, diversify
and in the process, evolved ASCI as one of India’s premier integrated
financial service enterprise.

Thus over the last 20 years ASCI has traveled the success route,
towards building a reputation as an integrated financial services provider,
offering a wide spectrum of services. And they have made this journey by
taking the route of quality service, path breaking innovations in service,
versatility in service and finally…totality in service.

Our highly qualified manpower, cutting-edge technology,
comprehensive infrastructure and total customer-focus has secured for us the
position of an emerging financial services giant enjoying the confidence and
support of an enviable clientele across diverse fields in the financial world.



Vision of ASCI:

“To be amongst most trusted power utility company of the country by
providing environment friendly power on most cost effective basis, ensuring
prosperity for its stakeholders and growth with human face.”

Mission of ASCI:

• To ensure most cost effective power for sustained growth of India.
• To provide clean and green power for secured future of countrymen.
• To retain leadership position of the organization in Hydro Power generation,
while working with dedication and innovation in every project we undertake.
• To maintain continuous pursuit for cost effectiveness enhanced productivity
for ensuring financial health of the organization, to take care of stakeholders’
aspirations continuously.
• To be a technology driven, transparent organization, ensuring dignity and
respect for its team members.
• To inculcate value system all cross the organization for ensuring trustworthy
relationship with its constituent associates & stakeholders.
• To continuously upgrade & update knowledge & skill set of its human
resources.
• To be socially responsible through community development by leveraging
resources and knowledge base.
• To achieve excellence in every activity we undertake.



Quality policy of ASCI:

To achieve and retain leadership, ASCI shall aim for complete
customer satisfaction, by combining its human and technological resources, to
provide superior quality financial services. In the process, ASCI will strive to
exceed Customer's expectations.

Quality Objectives

As per the Quality Policy, ASCI will:

• Build in-house processes that will ensure transparent and harmonious
relationships with its clients and investors to provide high quality of
services.
• Establish a partner relationship with its investor service agents and
vendors that will help in keeping up its commitments to the customers.
• Provide high quality of work life for all its employees and equip them
with adequate knowledge & skills so as to respond to customer's needs.
• Continue to uphold the values of honesty & integrity and strive to
establish unparalleled standards in business ethics.
• Use state-of-the art information technology in developing new and
innovative financial products and services to meet the changing needs
of investors and clients.
• Strive to be a reliable source of value-added financial products and
services and constantly guide the individuals and institutions in making
a judicious choice of same.

Strive to keep all stake-holders (shareholders, clients, investors, employees, suppliers
and regulatory authorities) proud and satisfied



ACTIVITIES CARRIED OUT BY ASCI STOCK BROKING LIMITED

1. Share Broking.
2. Demat & Remat Services.
3. Mutual Funds.
4. Investments.
5. Personal Tax planning.
6. Insurance Advisory.
The explanation for the above –mentioned points are as follows:

Services and qualities of ASCI Ltd

Quality Objectives

As per the Quality Policy, ASCI will:

• Build in-house processes that will ensure transparent and harmonious
relationships with its clients and investors to provide high quality of
services.
• Establish a partner relationship with its investor service agents and
vendors that will help in keeping up its commitments to the customers.
• Provide high quality of work life for all its employees and equip them
with adequate knowledge & skills so as to respond to customer's needs.
• Continue to uphold the values of honesty & integrity and strive to
establish unparalleled standards in business ethics.
• Use state-of-the art information technology in developing new and
innovative financial products and services to meet the changing needs
of investors and clients.
• Strive to be a reliable source of value-added financial products and
services and constantly guide the individuals and institutions in making
a judicious choice of same.



• Strive to keep all stake-holders (shareholders, clients, investors,
employees, suppliers and regulatory authorities) proud and satisfied.

The services provided by the ASCI:

A). my portfolio
• Portfolio planner
• Risk quotient
• Equity portfolio
• My net worth
B). Planners
• Goal planner
• Retirement planner
• Yield calculator
• Risk hedger

C). Publications

• The Finapolis
• ASCI Bazaar Baatein.



DERIVATIVES
Introduction:
BSE created history on June 9, 2000 by launching the first Exchange traded
Index Derivative Contract i.e. futures on the capital market benchmark index - the
BSE Sensex. The inauguration of trading was done by Prof. J.R. Varma, member of
SEBI and chairman of the committee responsible for formulation of risk containment
measures for the Derivatives market. The first historical trade of 5 contracts of June
series was done on June 9, 2000 at 9:55:03 a.m. between M/s Kaji and Maulik
Securities Pvt. Ltd. and M/s Emkay Share and Stock Brokers Ltd. at the rate of 4755.

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

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



Indian derivatives markets
1. Rise of Derivatives
The global economic order that emerged after World War II was a system where
many less developed countries administered prices and centrally allocated resources.
Even the developed economies operated under the Bretton Woods system of fixed
exchange rates. The system of fixed prices came under stress from the 1970s onwards.
High inflation and unemployment rates made interest rates more volatile. The Bretton
Woods system was dismantled in 1971, freeing exchange rates to fluctuate. Less
developed countries like India began opening up their economies and allowing prices
to vary with market conditions.
Price fluctuations make it hard for businesses to estimate their future production
costs and revenues. Derivative securities provide them a valuable set of tools for
managing this risk.

2. Definition and Uses of Derivatives
A derivative security is a financial contract whose value is derived from the
value of something else, such as a stock price, a commodity price, an exchange rate,
an interest rate, or even an index of prices. Some simple types of derivatives:
forwards, futures, options and swaps.
Derivatives may be traded for a variety of reasons. A derivative enables a
trader to hedge some preexisting risk by taking positions in derivatives markets that
offset potential losses in the underlying or spot market. In India, most derivatives
users describe themselves as hedgers and Indian laws generally require that
derivatives be used for hedging purposes only. Another motive for derivatives trading
is speculation (i.e. taking positions to profit from anticipated price movements). In
practice, it may be difficult to distinguish whether a particular trade was for hedging
or speculation, and active markets require the participation of both hedgers and
speculators. A third type of trader, called arbitrageurs, profit from discrepancies in the
relationship of spot and derivatives prices, and thereby help to keep markets efficient.



Jogani and Fernandez (2003) describe India’s long history in arbitrage trading,
with line operators and traders arbitraging prices between exchanges located in
different cities, and between two exchanges in the same city. Their study of Indian
equity derivatives markets in 2002 indicates that markets were inefficient at that time.
They argue that lack of knowledge, market frictions and regulatory impediments have
led to low levels of capital employed.
Price volatility may reflect changes in the underlying demand and supply
conditions and thereby provide useful information about the market. Thus, economists
do not view volatility as necessarily harmful.
Speculators face the risk of losing money from their derivatives trades, as they
do with other securities. There have been some well-publicized cases of large losses
from derivatives trading. In some instances, these losses stemmed from fraudulent
behavior that went undetected partly because companies did not have adequate risk
management systems in place. In other cases, users failed to understand why and how
they were taking positions in the derivatives.
Derivatives in arbitrage trading in India. However, more recent evidence
suggests that the efficiency of Indian equity derivatives markets may have improved.

3. Exchange-Traded and Over-the-Counter Derivative Instruments
OTC (over-the-counter) contracts, such as forwards and swaps, are bilaterally
negotiated between two parties. The terms of an OTC contract are flexible, and are
often customized to fit the specific requirements of the user. OTC contracts have
substantial credit risk, which is the risk that the counterparty that owes money defaults
on the payment. In India, OTC derivatives are generally prohibited with some
exceptions: those that are specifically allowed by the Reserve Bank of India (RBI) or,
in the case of commodities (which are regulated by the Forward Markets
Commission), those that trade informally in “havala” or forwards markets.
An exchange-traded contract, such as a futures contract, has a standardized
format that specifies the underlying asset to be delivered, the size of the contract, and
the logistics of delivery. They trade on organized exchanges with prices determined
by the interaction of many buyers and sellers. In India, two exchanges offer
derivatives trading: the Bombay Stock Exchange (BSE) and the National Stock



Exchange (NSE). However, NSE now accounts for virtually all exchange-
traded derivatives in India, accounting for more than 99% of volume in 2003-2004.
Contract performance is guaranteed by a clearinghouse, which is a wholly owned
subsidiary of the NSE. Margin requirements and daily marking-to-market of futures
positions substantially reduce the credit risk of exchange traded contracts, relative to
OTC contracts.

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



government created the NSE in collaboration with state-owned financial institutions.
NSE improved the efficiency and transparency of the stock markets by offering a
fully automated screen-based trading system and real-time price dissemination. In
1995, a prohibition on trading options was lifted. In 1996, the NSE sent a proposal to
SEBI for listing exchange-traded derivatives.
The report of the L. C. Gupta Committee, set up by SEBI, recommended a
phased introduction of derivative products, and bi-level regulation (i.e., self-
regulation by exchanges with SEBI providing a supervisory and advisory role).
Another report, by the J. R. Varma Committee in 1998, worked out various
operational details such as the margining systems. In 1999, the Securities Contracts
(Regulation) Act of 1956, or SC(R)A, was amended so that derivatives could be
declared “securities.” This allowed the regulatory fMr.Xework for trading securities
to be extended to derivatives. The Act considers derivatives to be legal and valid, but
only if they are traded on exchanges.
Finally, a 30-year ban on forward trading was also lifted in 1999. The
economic liberalization of the early nineties facilitated the introduction of derivatives
based on interest rates and foreign exchange. A system of market-determined
exchange rates was adopted by India in March 1993. In August 1994, the rupee was
made fully convertible on current account. These reforms allowed increased
integration between domestic and international markets, and created a need to manage
currency risk.

5. Derivatives Users in India
The use of derivatives varies by type of institution. Financial institutions, such
as banks, have assets and liabilities of different maturities and in different currencies,
and are exposed to different risks of default from their borrowers. Thus, they are
likely to use derivatives on interest rates and currencies, and derivatives to manage
credit risk. Non-financial institutions are regulated differently from financial
institutions, and this affects their incentives to use derivatives. Indian insurance
regulators, for example, are yet to issue guidelines relating to the use of derivatives by
insurance companies.
In India, financial institutions have not been heavy users of exchange-traded
derivatives so far, with their contribution to total value of NSE trades being less than



8% in October 2005. However, market insiders feel that this may be changing, as
indicated by the growing share of index derivatives (which are used more by
institutions than by retail investors). In contrast to the exchange-traded markets,
domestic financial institutions and mutual funds have shown great interest in OTC
fixed income instruments. Transactions between banks dominate the market for
interest rate derivatives, while state-owned banks remain a small presence.
Corporations are active in the currency forwards and swaps markets, buying these
instruments from banks.
Why do institutions not participate to a greater extent in derivatives
markets?
Some institutions such as banks and mutual funds are only allowed to use
derivatives to hedge their existing positions in the spot market, or to rebalance their
existing portfolios. Since banks have little exposure to equity markets due to banking
regulations, they have little incentive to trade equity derivatives. Foreign investors
must register as foreign institutional investors (FII) to trade exchange-traded
derivatives, and be subject to position limits as specified by SEBI. Alternatively, they
can incorporate locally as under RBI directive, banks’ direct or indirect (through
mutual funds) exposure to capital markets instruments is limited to 5% of total
outstanding advances as of the previous year-end. Some banks may have further
equity exposure on account of equities collaterals held against loans in default.
FIIs have a small but increasing presence in the equity derivatives markets.
They have no incentive to trade interest rate derivatives since they have little
investments in the domestic bond markets. It is possible that unregistered foreign
investors and hedge funds trade indirectly, using a local proprietary trader as a front.
Retail investors (including small brokerages trading for themselves) are the
major participants in equity derivatives, accounting for about 60% of turnover in
October 2005, according to NSE. The success of single stock futures in India is
unique, as this instrument has generally failed in most other countries. One reason for
this success may be retail investors’ prior familiarity with “badla” trades which shared
some features of derivatives trading. Another reason may be the small size of the
futures contracts, compared to similar contracts in other countries. Retail investors
also dominate the markets for commodity derivatives, due in part to their long-
standing expertise in trading in the “havala” or forwards markets.



Why have derivatives?

Derivatives have become very important in the field finance. They are very
important financial instruments for risk management as they allow risks to be
separated and traded. Derivatives are used to shift risk and act as a form of insurance.
This shift of risk means that each party involved in the contract should be able to
identify all the risks involved before the contract is agreed. It is also important to
remember that derivatives are derived from an underlying asset. This means that risks
in trading derivatives may change depending on what happens to the underlying asset.

A derivative is a product whose value is derived from the value of an
underlying asset, index or reference rate. The underlying asset can be equity, forex,
commodity or any other asset. For example, if the settlement price of a derivative is
based on the stock price of a stock for e.g. Infosys, which frequently changes on a
daily basis, then the derivative risks are also changing on a daily basis. This means
that derivative risks and positions must be monitored constantly.

Why Derivatives are preferred?

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

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

How does F&O trading impact the market?



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

The huge surge in open positions has coincided with the market indexes
reaching historic highs. This shows that the two segments are linked.



FUTURES CONTRACT:

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

What is an Index?

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

The Sensex and Nifty

In India the most popular indices have been the BSE Sensex and S&P CNX
Nifty. The BSE Sensex has 30 stocks comprising the index which are selected based
on market capitalization, industry representation, trading frequency etc. It represents
30 large well-established and financially sound companies. The Sensex represents a
broad spectrum of companies in a variety of industries. It represents 14 major industry
groups. Then there is a BSE national index and BSE 200. However, trading in index
futures has only commenced on the BSE Sensex.

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

Futures and stock indices



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

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

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

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

6.1 Understanding index futures

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

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

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



Example: Futures contracts in Nifty in July 2001

Contract month Expiry/settlement
July 2001 July 26
August 2001 August 30
September 2001 September 27

On July 27

Contract month Expiry/settlement
August 2001 August 30
September 2001 September 27
October 2001 October 25

The permitted lot size is 200 or multiples thereof for the Nifty. That is you buy
one Nifty contract the total deal value will be 200*1100 (Nifty value)= Rs 2,20,000.

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

Hedging

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

Illustration:

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



Cost (Rs) Selling price Profit

1000 4000 3000

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

‘Y’ defaults ‘Y’ honours

1000 (Initial Investment) 3000 (Initial profit)

1000 (penalty from Mr.Y) (-1000) discount given to Mr.Y

- (No gain/loss) 2000 (Net gain)

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

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

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

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



by 10%, the value of the portfolio increases 11%. The idea is to make beta of your
portfolio zero to nullify your losses.

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

Steps:

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

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

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

Index up 10% Index down 10%

Gain/(Loss) in Portfolio
Rs 120,000 (Rs 120,000)

Gain/(Loss) in Futures
(Rs 120,000) Rs 120,000

Net Effect
Nil Nil

As we see, that portfolio is completely insulated from any losses arising out of
a fall in market sentiment. But as a cost, one has to forego any gains that arise out of
improvement in the overall sentiment. Then why does one invest in equities if all
the gains will be offset by losses in futures market. The idea is that everyone



expects his portfolio to outperform the market. Irrespective of whether the market
goes up or not, his portfolio value would increase.

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

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

6.3 Speculation

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

Illustration:

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

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

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

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

Net gain Rs.40,000

Mr.X has made a profit of Rs.40,000 by taking a call on the future value of the
Sensex. However, if the Sensex had fallen he would have made a loss. Similarly, if it



would have been bearish he could have sold Sensex futures and made a profit from a
falling profit. In index futures players can have a long-term view of the market up to
atleast 3 months.

6.4 Arbitrage

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

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

• Take the case of the NSE Nifty.

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

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

• If there is a difference then arbitrage opportunity exists.

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

Sale = 1070

Cost= 1000+30 = 1030

Arbitrage profit = 40



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

6.5 Pricing of Index Futures

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

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

1. The cost of carry model

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

F=S+C

where:

F Futures price

S Spot price

C Holding costs or carry costs

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

If Wipro is quoted at Rs.1000 per share and the 3 months futures of Wipro is
Rs.1070 then one can purchase Wipro at Rs.1000 in spot by borrowing @ 12% annum
for 3 months and sell Wipro futures for 3 months at Rs 1070.



Here F=1000+30=1030 and is less than prevailing futures price and hence
there are chances of arbitrage.

Sale = 1070

Cost= 1000+30 = 1030

Arbitrage profit 40

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

2. Futures pricing in case of dividend yield

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

Example:

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

Futures price = Rs 107

If the actual futures price of one-year contract is Rs.109. An arbitrageur can
buy the stock at Rs.100, borrowing the fund at the rate of 10% and simultaneously sell
futures at Rs.109. At the end of the year, the arbitrageur would collect Rs.3 for
dividends, deliver the stock portfolio at Rs.109 and repay the loan of Rs.100 and
interest of Rs.10. The net profit would be Rs 109 + Rs 3 - Rs 100 - Rs 10 = Rs 2.
Thus, we can arrive at the fair value in the case of dividend yield.



Trading strategies

1. Speculation

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

Taking a view of the market

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

There are two options available

Option 1: Sell liquid stocks such as Reliance

Option 2: Sell the entire index portfolio

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

Illustration:

Scenario 1:

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

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



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

Scenario 2:

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

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

‘X’ makes a profit of Rs 13,400 (200*67).

In the above cases ‘X’ has profited from speculation i.e. he has wagered in the hope of
profiting from an anticipated price change.

2. Hedging

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

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

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

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

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



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

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

Everyone has to remember that every buy position on a stock is
simultaneously a buy position on Nifty. A long position is not a focused play on the
valuation of a stock. It carries a long Nifty position along with it, as incidental
baggage i.e. a part long position of Nifty.

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

‘X’ holds HLL worth Rs 9 lakh at Rs 290 per share on Jan1 2008asuming that the
beta of HLL is 1.13. How much Nifty futures does ‘X’ have to sell if the index futures
is ruling at 1527?

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

On Jan , 2008 the Nifty futures is at 1437 and HLL is at 275. ‘X’ closes both positions
earning Rs 13,389, i.e. his position on HLL drops by Rs 46,551 and his short position
on Nifty gains Rs 59,940 (666*90).

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

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

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

a. 1.19*10 crore = 496 contracts

2,40,000



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

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

3. Margins

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

Daily margining is of two types:

1. Initial margins

2. Mark-to-market profit/loss

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

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

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

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



Initial margin (15%) = Rs 45,000

Assuming that the contract will close on Day + 3 the mark-to-market position will
look as follows:

Position on Day 1

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

New position on Day 2

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

Margin = 42,000

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

Position on Day 3

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

Margin = Rs 3,300

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

Margin account*

Initial margin = Rs 45,000

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

Position on Day 2 Rs 42,000



Addn margin = (+) Rs 3,300

Total margin in a/c Rs 45,300*

Net gain/loss

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

Day 2 Gain = Rs 18,700

Day 3 Gain = Rs 18,000

Total Gain = Rs 19,700

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

Settlement of futures contracts:

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

1. MTM settlement:

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

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



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

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

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

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

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

How to read the futures data sheet?

Understanding and deciphering the prices of futures trade is the first challenge
for anyone planning to venture in futures trading. Economic dailies and exchange
websites www.nseindia.com and www.bseindia.com are some of the sources where



one can look for the daily quotes. Your website has a daily market commentary,
which carries end of day derivatives summary along with the quotes.

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

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

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

Source: BSE

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

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

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

Open interest indicates the total gross outstanding open positions in the market for
that particular series. For e.g. Open interest in the June series is 51 contracts. The
most useful measure of market activity is Open interest, which is also published by
exchanges and used for technical analysis. Open interest indicates the liquidity of a



market and is the total number of contracts, which are still outstanding in a
futures market for a specified futures contract.

A futures contract is formed when a buyer and a seller take opposite positions in a
transaction. This means that the buyer goes long and the seller goes short. Open
interest is calculated by looking at either the total number of outstanding long or short
positions – not both Open interest is therefore a measure of contracts that have not
been matched and closed out. The number of open long contracts must equal exactly
the number of open short contracts.

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

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

Price
Open interest Market
Strong

Warning signal

Weak

Warning signal

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

OPTIONS



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

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

Options vs. Stocks

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

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

Differences:
Options are derivatives, unlike stocks (i.e, options derive their value from
something else, the underlying security).
Options have expiration dates, while stocks do not.
There is not a fixed number of options, as there are with stock shares
available.



Stockowners have a share of the company, with voting and dividend rights.
Options
convey no such rights.

Options Premiums
In this case, XYZ represents the option class while May 30 is the option series.
All options on company XYZ are in the XYZ option class but there will be many
different series.
An option Premium is the price of the option. It is the price you pay to
purchase the option. For example, an XYZ May 30 Call (thus it is an option to buy
Company XYZ stock) may have an option premium of $2. This means that this
option costs $200.00. Why? Because most listed options are for 100 shares of stock,
and all equity option prices are quoted on a per share basis, so they need to be
multiplied times 100. More in-depth pricing concepts will be covered in detail in other
sections of the course.
Strike Price
The Strike (or Exercise) Price is the price at which the underlying security
(in this case, XYZ) can be bought or sold as specified in the option contract. For
example, with the XYZ May 30 Call, the strike price of 30 means the stock can be
bought for $30 per share. Were this the XYZ May 30 Put, it would allow the holder
the right to sell the stock at $30 per share.
The strike price also helps to identify whether an option is In-the-Money, At-
the-Money, or Out-of-the-Money when compared to the price of the underlying
security. You will learn about these terms in another section of the course.

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



Assignment of Options
When an option holder chooses to exercise an option, a process begins to find
a writer who is short the same kind of option (i.e., class, strike price and option type).
Once found, that writer may be Assigned. This means that when buyers exercise,
sellers may be chosen to make good on their obligations. For a Call Assignment,
Call writers are required to sell stock at the strike price to the Call holder. For a Put
Assignment, Put writers are required to buy stock at the strike price from the Put
holder.
Long Term Investing
Given the numerous opportunities that options convey, it is also important to
know that there are options available which can be used to implement longer-term
strategies (not one, two or three months, but those with holding times of one, two or
more years).
These are called LEAPS (for Long Term Equity Anticipation Securities), and
are yet another alternative that options offer to investors. LEAPS are options with
expiration dates of up to three years from the date they are first listed, and are
available on a number of individual stocks and indexes.
LEAPS have different ticker symbols than short-term options (options with
less than nine months until expiration) and, while not available on all stocks, are
available on most widely held issues and can be traded just like any other options.

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

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

CBOE: The Competitive Advantage



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

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

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

CBOE is the market leader in the options industry, with:
• Options on more than 1,332 stocks and 41 indices. More than 50,000 series
listed
• Over $25 billion in contract value traded on a typical day
• Over 1 million options contracts changing hands daily
• The second largest listed securities market in the U.S., following only the
NYSE
• Professional instructors teaching options trading to over 10,000 people a year
• The premier portal for options information on the Web,

7.3 Regulation and Surveillance:
Regulation and surveillance are necessary in the options industry in order to
protect customers and firms, and respond to customer complaints.

CBOE has one of the most technologically advanced and computer-automated
measures for regulation and surveillance, which are unparalleled in the options
industry. CBOE has the premier Regulatory Division, with staff who constantly
monitor trading activity throughout the industry.



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

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

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

7.5 Options Market Participants
Contrary to some beliefs, the single greatest population of CBOE users are not
huge financial institutions, but public investors, just like you. Over 65% of the
Exchange's business comes from them. However, other participants in the financial
marketplace also use options to enhance their performance, including:
• Mutual Funds
• Pension Plans
• Hedge Funds
• Endowments
• Corporate Treasurers

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

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



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

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

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

Call options

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

Illustration 1:

Raj purchases 1 Satyam Computer (SATCOM) AUG 150 Call --Premium 8

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

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

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

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

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

Option contract Strike price Call premium



Dec Nifty 1325 Rs.6,000
1345 Rs.2,000

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

A trader is of the view that the index will go up to 1400 in Jan 2008 but does
not want to take the risk of prices going down. Therefore, he buys 10 options of Jan
contracts at 1345. He pays a premium for buying calls (the right to buy the contract)
for 500*10= Rs.5,000/-.

In Jan 2008 the Nifty index goes up to 1365. He sells the options or exercises
the option and takes the difference in spot index price which is (1365-1345) * 200
(market lot) = 4000 per contract. Total profit = 40,000/- (4,000*10).

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

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

Call Options-Long and Short Positions

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

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



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

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

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

Illustration 3:

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

Quotes are as under:

Spot Rs.1040

Jan Put at 1050 Rs.10

Jan Put at 1070 Rs.30

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

His position in following price position is discussed below.

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

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



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

Put Options-Long and Short Positions

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

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

SUMMARY:

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



gain

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

Option styles

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

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

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

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



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

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

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

Option Class and Series

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

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

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

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

Calls Puts
.
Jan Feb Mar Jan Feb Mar
Wipro
1300 45 60 75 15 20 28
1400 35 45 65 25 28 35
1500 20 42 48 30 40 55

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

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



Pricing of options

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

There are four major factors affecting the Option premium:

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

And two less important factors:

• Short-Term Interest Rates
• Dividends

7.11 Review of Options Pricing Factors

1. The Intrinsic Value of an Option

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

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

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

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

Price of underlying



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

The following chart summarizes the above for Calls and Puts.

Option Underlying price Premium cost
Call

Put

2. The Time Value of an Option

Generally, the longer the time remaining until an option’s expiration, the
higher its premium will be. This is because the longer an option’s lifetime, greater is
the possibility that the underlying share price might move so as to make the option in-
the-money. All other factors affecting an option’s price remaining the same, the time
value portion of an option’s premium will decrease (or decay) with the passage of
time.

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

Option Time to expiry Premium cost
Call

Put

3. Volatility



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

Higher volatility=Higher premium

Lower volatility = Lower premium

4. Interest rates

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

STRATEGIES

Bull Market Strategies

a. Calls in a Bullish Strategy

An investor with a bullish market outlook should buy call options. If you
expect the market price of the underlying asset to rise, then you would rather have the



right to purchase at a specified price and sell later at a higher price than have the
obligation to deliver later at a higher price.

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

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

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

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

A simple example will illustrate the above:

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

The profit can be derived as follows

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

b. Puts in a Bullish Strategy



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

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

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

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

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

Bullish Call Spread Strategies

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

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

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



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

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

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

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

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

An example of a Bullish call spread:

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

Now let us look at the fundamental reason for this position. Since this is a
bullish strategy, the first position established in the spread is the long lower strike
price call option with unlimited profit potential. At the same time to reduce the cost of



puchase of the long position a short position at a higher call strike price is established.
While this not only reduces the outflow in terms of premium but his profit potential as
well as risk is limited. Based on the above figures the maximum profit, maximum loss
and breakeven point of this spread would be as follows:

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

= 110 - 90 - 10 = 10

Maximum Loss = Lower strike premium - Higher strike premium

= 14 - 4 = 10

Breakeven Price = Lower strike price + Net premium paid

= 90 + 10 = 100

Bullish Put Spread Strategies

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

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

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

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

To put on a bull spread, a trader sells the higher strike put and buys the lower
strikeput. The bull spread can be created by buying the lower strike and selling the



higher strike of either calls or put. The difference between the premiums paid and
received makes up one leg of the spread.

The investor's profit potential is limited. When the market price reaches or
exceeds the higher exercise price, both options will be out-of-the-money and will
expire worthless. The trader will realize his maximum profit, the net premium

The investor's potential loss is also limited. If the market falls, the options will
be in-the-money. The puts will offset one another, but at different exercise prices.

The investor breaks-even when the market price equals the lower exercise
price less the net premium. The investor achieves maximum profit i.e the premium
received, when the market price moves up beyond the higher exercise price (both puts
are then worthless).

An example of a bullish put spread.

Lets us assume that the cash price of the scrip is Rs.100. You now buy a
November put option on a scrip with a strike price of Rs.90 at a premium of Rs.5 and
sell a put option with a strike price of Rs.110 at a premium of Rs.15.

The first position is a short put at a higher strike price. This has resulted in
some inflow in terms of premium. But here the trader is worried about risk and so
caps his risk by buying another put option at the lower strike price. As such, a part of
the premium received goes off and the ultimate position has limited risk and limited
profit potential. Based on the above figures the maximum profit, maximum loss and
breakeven point of this spread would be as follows:

Maximum profit = Net option premium income or net credit

= 15 - 5 = 10

Maximum loss = Higher strike price - Lower strike price - Net premium received

= 110 - 90 - 10 = 10



Breakeven Price = Higher Strike price - Net premium income

= 110 - 10 = 100

2. Bear Market Strategies

a. Puts in a Bearish Strategy: When you purchase a put you are long and want the
market to fall. A put option is a bearish position. It will increase in value if the
market falls. An investor with a bearish market outlook shall buy put options.
By purchasing put options, the trader has the right to choose whether to sell
the underlying asset at the exercise price. In a falling market, this choice is
preferable to being obligated to buy the underlying at a price higher.

An investor's profit potential is practically unlimited. The higher the fall in
price of the underlying asset, higher the profits.

The investor's potential loss is limited. If the price of the underlying asset rises
instead of falling as the investor has anticipated, he may let the option expire
worthless. At the most, he may lose the premium for the option.

The trader's breakeven point is the exercise price minus the premium. To
profit, the market price must be below the exercise price. Since the trader has paid a
premium he must recover the premium he paid for the option.

An increase in volatility will increase the value of your put and increase your
return. An increase in volatility will make it more likely that the price of the
underlying instrument will move. This increases the value of the option.

b. Calls in a Bearish Strategy: Another option for a bearish investor is to go short on
a call with the intent to purchase it back in the future. By selling a call, you have a net
short position and needs to be bought back before expiration and cancel out your
position.

For this an investor needs to write a call option. If the market price falls, long
call holders will let their out-of-the-money options expire worthless, because they
could purchase the underlying asset at the lower market price.


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