A Project Report on

DERIVATIVES

AT

INDIA INFOLINE

Project submitted in partial fulfillment for the award of the degree of

MASTER OF BUSINESS ADMINISTRATION

By

MD.SIDDIQUE

HALL TICKET NO – 052060128

    

                                                       

MESCO INSTITUTE OF MANAGEMENT AND COMPUTER SCIENCE

 

(Affiliated to Osmania University) 

MUSTAIDPURA, KARWAN 

HYDERABAD – 500006 

(2006-2008)  

DECLARATION  

I, Siddique, here by declare that this project report titled   

“DERIVATIVES ”   has been carried out by me for INDIA  

INFOLINE under the guidance of  Mr.B. Srinivas Rao from  

INDIA INFOLINE submitted by me to the  department of

management  MESCO INSTITUTE OF MANAGEMENT        

AND COMPUTER SCIENCE   is a bonafide work undertaken  

by me and it is not submitted to any other university or  

institution for the award of any degree diploma/certificate or  

published any time before.   

        

Name of the student                                                    Signature     

Date: 

ACKNOWLEDGEMENT

 

The euphoria of the competition of the project will be  nothing without mentioning the persons who have helped me in doing so.   

I am extremely thankful to INDIA INFOLINE for giving me this opportunity to conduct project on “DERIVATIVES”  

I take this opportunity to thank Mr.B. Srinivas Rao of INDIA INFOLINE for his valuable guidance and arranging helpful consultancy sessions.   

I extend my thanks to my project guide Ms. Narjis  of Mesco Institute of Management And Computer Science for his valuable help.             

  

INTRODUCTION 

      The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very high degree of volatility. Through the use of derivative Products, it is possible to partially or fully transfer price risks by locking–in asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors. 

      While forward contracts and exchange traded in futures has grown by leaps and bound, Indian stock markets have been largely slow to these global changes. However, in the last few years, there has been substantial improvement in the functioning of the securities market. Requirements of adequate capitalization for market intermediaries, margining and establishment of clearing corporations have reduced market and credit risks. However, there were inadequate advanced risk management tools. And after the ICE (Information, Communication, Entertainment) meltdown the market regulator felt that in order to deepen and strengthen the cash market trading of derivatives like futures and options was imperative.

NATIONAL STOCK EXCHANGE

 

      The National Stock Exchange of India Limited has genesis in the report of the High Powered Study Group on Establishment of New Stock Exchanges, which recommended promotion of a National Stock Exchange by financial institutions  to provide access to investors from all across the country on an equal footing. Based on the recommendations, NSE was promoted by leading Financial Institutions at the behest of the Government of India and was incorporated in November 1992 as a tax-paying company unlike other stock exchanges in the country.    

         

      On its recognition as a stock exchange under the Securities Contracts (Regulation) Act, 1956 in April 1993, NSE commenced operations in the Wholesale Debt Market (WDM) segment in June 1994. The Capital Market (Equities) segment commenced operations in November 1994 and operations in Derivatives segment commenced in June 2000.

Our Mission

 

   NSE's mission is setting the agenda for change in the securities markets in India. The NSE was set-up with the main objectives of: 

Establishing a nation-wide trading facility for equities, debt instruments and hybrids,

  Ensuring equal access to investors all over the country through an

appropriate communication network, Providing a fair, efficient and transparent securities market to investors

using electronic trading systems,

  Enabling shorter settlement cycles and book entry settlements systems,

and meeting the current international standards of securities markets.

The standards set by NSE in terms of market practices and technology have become industry benchmarks and are being emulated by other market participants. NSE is more than a mere market facilitator. It's that force which is guiding the industry towards new horizons and greater opportunities.

Corporate Structure

 

      NSE is one of the first de-mutualised stock exchanges in the country, where the ownership and management of the Exchange is completely divorced from the right to trade on it. Though the impetus for its establishment came from policy makers in the country, it has been set up as a public limited company, owned by the leading institutional investors in the country. 

      From day one, NSE has adopted the form of a demutualised exchange - the ownership, management and trading is in the hands of three different sets of people. NSE is owned by a set of leading financial institutions, banks, insurance companies and other financial intermediaries and is managed by professionals, who do not directly or indirectly trade on the Exchange. This has completely eliminated any conflict of interest and helped NSE in aggressively pursuing policies and practices within a public interest framework. 

      The NSE model however, does not preclude, but in fact accommodates involvement, support and contribution of trading members in a variety of ways. Its Board comprises of senior executives from promoter institutions, eminent professionals in the fields of law, economics, accountancy, finance, taxation, etc, public representatives, nominees of SEBI and one full time executive of the Exchange. 

      While the Board deals with broad policy issues, decisions relating to market operations are delegated by the Board to various committees constituted by it. Such committee includes representatives from trading members, professionals, the public and the management. The day-to-day management of the Exchange is delegated to the Managing Director who is supported by a team of professional staff.

BOMBAY STOCK EXCHANGE

 

INTRODUCTION

 

      Bombay Stock Exchange Limited is the oldest stock exchange in Asia with a rich heritage. Popularly known as "BSE", it was established as "The Native Share & Stock Brokers Association" in 1875. It is the first stock exchange in the country to obtain permanent recognition in 1956 from the Government of India under the Securities Contracts (Regulation) Act, 1956.The Exchange's pivotal and pre-eminent role in the development of the Indian capital market is widely recognized and its index, SENSEX, is tracked worldwide. Earlier an Association of Persons (AOP), the Exchange is now a demutualised and corporatised entity incorporated under the provisions of the Companies Act, 1956, pursuant to the BSE(Corporatisation and Demutualization) Scheme, 2005 notified by the Securities and Exchange Board of India (SEBI). 

      With demutualization, the trading rights and ownership rights have been de-linked effectively addressing concerns regarding perceived and real conflicts of interest. The Exchange is professionally managed under the overall direction of the Board of Directors. The Board comprises eminent professionals, representatives of Trading Members and the Managing Director of the Exchange. The Board is inclusive and is designed to benefit from the participation of market intermediaries.     

   

      In terms of organization structure, the Board formulates larger policy issues and exercises over-all control. The committees constituted by the Board are broad-based. The day-to-day operations of the Exchange are managed by the Managing Director and a management team of professionals. 

      The Exchange has a nation-wide reach with a presence in 417 cities and towns of India. The systems and processes of the Exchange are designed to safeguard market integrity and enhance transparency in operations. During the year 2004-2005, the trading volumes on the Exchange showed robust growth. 

      The Exchange provides an efficient and transparent market for trading in equity, debt instruments and derivatives. The BSE's On Line Trading System (BOLT) is a proprietary system of the Exchange and is BS 7799-2-2002 certified. The surveillance and clearing & settlement functions of the Exchange are ISO 9001:2000 certified. 

OBJECTIVES OF THE STUDY   

o To analyze the present situation of derivatives in Indian market and suggest for any improvements thereafter.

 o To study in detail the role of futures and options.

 

o To find out option holder and option writer

 o To study the bullish trends in derivatives market

NEED FOR THE STUDY

 

      The study is undertaken to analyze the bullish trends practices with special reference to derivatives as tool of risk management techniques.  

SCOPE OF THE STUDY 

      The study is confined to bullish trends in stock exchange with special reference to NSE. 

LIMITATIONS OF THE STUDY 

The study is limited to bull market trends in “Derivatives “with reference to futures and options in the Indian context. The study can’t say as totally perfect, any alteration may come.

  The study is not based on the international perspective of derivatives

markets, which exists in NASDAQ & NYSE. Etc.

METHODOLOGY

 

      To achieve the object of studying the bullish trends in derivatives market in stock market data can been collected.

    

   Research methodology carried for this study can be two types

             

Primary

 

Secondary    

 

PRIMARY 

      The primary data, which is being collected for this project from “BLESSO SOFTWARE OF INDIA”, guide of the project.    

SECONDARY DATA 

      Data has been collected from various books & websites which are mentioned below.

COMPANY PROFILE 

                                                                                                                       

         

About India Infoline  

India Infoline is a one-stop financial services shop, most respected for quality of its advice, personalised service and cutting-edge technology. 

It’s Vision : 

It’s VISION  IS TO BE THE MOST RESPECTED COMPANY IN THE FINANCIAL SERVICES SPACE. 

India Infoline Group : 

The India Infoline group, comprising the holding company, India Infoline Limited and its wholly-owned subsidiaries, straddle the entire financial services space with offerings ranging from Equity research, Equities and derivatives trading, Commodities trading, Portfolio Management Services, Mutual Funds, Life Insurance, Fixed deposits, GoI bonds and other small savings instruments to loan products and Investment banking. India Infoline also owns and manages the websites www.indiainfoline.com and www.5paisa.com  

The company has a network of 596 branches spread across 345 cities and towns. It has more than 500,000 customers. 

India Infoline Ltd 

India Infoline Limited is listed on both the leading stock exchanges in India, viz. the Stock Exchange, Mumbai (BSE) and the National Stock Exchange (NSE) and is also a member of both the exchanges. It is engaged in the businesses of Equities broking, Wealth Advisory Services and Portfolio Management Services. It offers broking services in the Cash and Derivatives segments of the NSE as well as the Cash segment of the BSE. It is registered with NSDL as well as CDSL as a depository participant, providing a one-stop solution for clients trading in the equities market. It hasrecently launched its Investment banking and Institutional Broking business.

 

A SEBI authorized Portfolio Manager; it offers Portfolio Management Services to clients. These services are offered to clients as different schemes, which are based on differing investment strategies made to reflect the varied risk-return preferences of clients.  

India Infoline Media and Research Services Limited : 

The content services represent a strong support that drives the broking, commodities, mutual fund and portfolio management services businesses. Revenue generation is through the sale of content to financial and media houses, Indian as well as global. 

It undertakes equities research which is acknowledged by none other than Forbes as 'Best of the Web' and '…a must read for investors in Asia'. India Infoline's research is available not just over the internet but also on international wire services like Bloomberg (Code: IILL), Thomson First Call and Internet Securities where India Infoline is amongst the most read Indian brokers 

India Infoline Commodities Limited : 

India Infoline Commodities Pvt Limited is engaged in the business of commodities broking. Our experience in securities broking empowered us with the requisite skills and technologies to allow us offer commodities broking as a contra-cyclical alternative to equities broking. We enjoy memberships with the MCX and NCDEX, two leading Indian commodities exchanges, and recently acquired membership of DGCX. We have a multi-channel delivery model, making it among the select few to offer online as well as offline trading facilities. 

India Infoline Marketing & Services : 

India Infoline Marketing and Services Limited is the holding company of India Infoline Insurance Services Limited and India Infoline Insurance Brokers Limited.  

(a) India Infoline Insurance Services Limited is a registered Corporate Agent with the Insurance Regulatory and Development Authority (IRDA). It is the largest Corporate Agent for ICICI Prudential Life Insurance Co Limited, which is India's largest private Life Insurance Company. India Infoline was the first corporate agent to get licensed by IRDA in early 2001.  

(b) India Infoline Insurance Brokers Limited India Infoline Insurance Brokers Limited is a newly formed subsidiary which will carry out the business of Insurance broking. We have applied to IRDA for the insurance broking licence and the clearance for the same is awaited. Post the grant of license, we propose to also commence the general insurance distribution business.  

India Infoline Investment Services Limited : 

Consolidated shareholdings of all the subsidiary companies engaged in loans and financing activities under one subsidiary. Recently, Orient Global, a Singapore-based investment institution invested USD 76.7 million for a 22.5% stake in India Infoline Investment Services. This will help focused expansion and capital raising in the said subsidiaries for various lending businesses like loans against securities, SME financing, distribution of retail loan products, consumer finance business and housing finance business. India Infoline Investment Services Private Limited consists of the following step-down subsidiaries.  

(a) India Infoline Distribution Company Limited (distribution of retail loan products)  

(b) Moneyline Credit Limited (consumer finance) 

(c) India Infoline Housing Finance Limited (housing finance)  

IIFL (Asia) Private Limited : 

IIFL (Asia) Private Limited is wholly owned subsidiary which has been incorporated in Singapore to pursue financial sector activities in other Asian markets. Further to obtaining the necessary regulatory approvals, the company has been initially capitalized at 1 million Singapore dollars.           

An Overview of NCFM

      A critical element of the financial sector reforms is the development of a pool of human resources having right skills and expertise in each segment of the industry to provide quality intermediation to market participants.

In order to dispense quality intermediation, personnel working in the industry need to

i. follow a certain code of conduct usually achieved through regulations and

(ii)            Possess requisite skills and knowledge acquired through a system of   testing and certification.

      As intermediation involves human expertise more than technological support, it is important that a person providing intermediation in the industry

has a proper understanding of the business and the skills to help it remain competitive. In order to ensure this, it has become an accepted international practice for personnel working for market intermediaries to be adequately certified.

      Such testing and certification has assumed significance in India as there is no formal education or training on financial markets, especially in the area of operations, while at the same time the market has undergone a complete transformation in the recent years.

      A variety of new functions that need different levels and nature of specialization and orientation have emerged. The industry has a large work force with varying levels of professional qualifications, skills and experience that do not necessarily match their work responsibilities.  

      Taking into account international experience and the needs of the Indian financial markets, with a view for protecting interests of investors in financial markets and more importantly, for minimizing risks of losses arising out of deficient understanding of markets and instruments, National Stock Exchange introduced in 1998 a facility for testing and certification by launching NSE's Certification in Financial Markets (NCFM).

The NCFM Program

      NCFM is an online testing system, a revolutionary concept in administration of examinations and the only one of its kind today in the country. It tests the practical knowledge and skills required to operate in the financial markets in a secure and unbiased manner and awards certificates based on relative merits thus ensuring that the caliber of persons entering this field is kept high in the best interests of a mature and vibrant market.

      The entire process of testing, assessing, scores reporting and invigilation in the NCFM is fully automated. The system is operated through an intranet facility by using a central World Wide Web server with terminals located at each of the designated test centers to be used as an examination front end. Communication between the central server and the test centers is achieved through VSAT/leased line network.

      The Test is also offered through the Internet to enable candidates outside the designated test centers to take tests at their convenience. This allows flexibility in terms of testing centers, dates and timing and provides easy accessibility and convenience to candidates.

      The easy accessibility as well as flexibility involved in the NCFM programme has resulted in its wider acceptance among market intermediaries, students and regulators.

NCFM Modules

   NCFM currently tests expertise in the following modules:

1. Financial Markets: A Beginners' Module 2. Derivatives Market (Dealers) Module 3. Capital Market (Dealers) Module 4. Securities Market (Basic) Module 5. FIMMDA-NSE Debt Market (Basic) Module 6. Surveillance in Stock Exchanges Module 7. NSDL - Depository Operations Module 8. Commodities Market Module 9. AMFI - Mutual Fund (Basic) Module 10.AMFI - Mutual Fund (Advisors) Module 11.Corporate Governance Module 12. Modules of Financial Planning Standards Board India

            

Training at India Info Line 

i. Online Exam Registration ii. Online Mock Tests

iii. Practical Training iv. Doubt Sessions v. Market Analysis

vi. Training Certificate vii. Career Counseling

viii. Job Assistance ix. Course Kit

Benefits of NCFM

 i. Real-time exposure to the Finance market

ii. Industry Analysis will be an easy task in any finance related domain iii. Job assurance is 100% as this certification is a mandate by SEBI iv. Students and investors shall be greatly benefited in applying for jobs as

well as in investment procedures respectively

          

           INTRODUCTION TO DERIVATIVES

      Derivatives have become very important in the field of 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, also have an impact on the derivative risks which also changes simultaneously on a daily basis. This means that derivative risks and positions must be monitored constantly.

Derivatives defined

 

      Derivative is a product whose value is derived from the value of one or more basic variables, Called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the “underlying”.

      In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R) A) defines 

“Derivative” to include  

a. A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security.

 b. A contract which derives its value from the prices, or index of

prices, of underlying securities.

 c. Derivatives are securities under the SC(R) A and hence the

trading of derivatives is governed by the regulatory framework under the SC(R)A

 

Types of derivatives 

      The most commonly used derivatives contracts are forwards, futures and options which we shall discuss in detail later. Here we take a brief look at various derivatives contracts that have come to be used. 

Forwards:

           A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today’s pre-agreed price.   

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. 

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. 

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. 

Leaps:

      The acronym LEAPS means Long-Term Equity Anticipation Security Years. These are options having a maturity of up to three  

Baskets:

      Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average of a basket of assets. Equity index options are a form of basket options.  

Swaps:

      Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are: 

Interest rate swaps:

      These entail swapping only the interest related cash flows between the parties in the same currency. 

Currency swaps:

      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. 

Swaptions:

      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. 

   The following factors have been driving the growth of financial derivatives: 

Increased volatility in asset prices in financial markets,

  Increased integration of national financial markets with the international

markets,

  Marked improvement in communication facilities and sharp decline in

their costs,

  Development of more sophisticated risk management tools, providing

economic agents a wider choice of risk management strategies, and innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets leading to higher returns.

 

Development of exchange-traded derivatives 

Duced risk as well as transactions costs as compared to individual financial assets.

Exchange-traded vs. OTC derivatives markets

   The OTC derivatives markets have the following features compared to exchange-traded derivatives: 

1. The management of counter-party (credit) risk is decentralized and located within individual institutions, 

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

3. There are no formal rules for risk and burden-sharing, 

4. There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants, and 

5. The OTC contracts are generally not regulated by a regulatory authority and the exchange’s self regulatory organization, although they are affected indirectly by national legal systems, banking supervision and market surveillance. 

TABLE 1

 

DERIVATIVES MARKET IN INDIA 

Approval for derivatives trading

      The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24–member committee under the

Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India.  

      The committee submitted its report on March 17, 1998 prescribing necessary pre–conditions for introduction of derivatives trading in India. The committee recommended that derivatives should be declared as ‘securities’ so that regulatory framework applicable to trading of ‘securities’ could also govern trading of securities. SEBI also set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma, to recommend measures for risk containment in derivatives market in India. The report, which was submitted in October 1998, worked out the operational details of margining system, methodology for charging initial margins, broker net worth, deposit requirement and real–time monitoring requirements. 

  The SCRA was amended in December 1999 to include derivatives within the ambit of securities’ and the regulatory framework was developed for governing derivatives trading. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recognized stock exchange, thus precluding OTC derivatives. The government also rescinded in March 2000, the three–decade old notification, which prohibited forward trading in securities. 

      Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2000. SEBI permitted the derivative segments of two stock exchanges, NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE–30(Sensex) index. This was followed by approval for trading in options based on these two indexes and options on individual securities. The trading in index options commenced in June 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. Trading and settlement in derivative contracts is done in accordance with the rules, byelaws, and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and notified in the official gazette. 

Derivatives market at NSE 

         The derivatives trading on the exchange commenced with S&P CNX Nifty Index futures on June12th2000. The trading in index options commenced on June4th 2001 and trading in options on individual securities commenced on

July2nd 2001. Single stock futures were launched on November9th 2001. The index futures and options contract on NSE are based on S&P CNX Nifty Index.

     

   Currently, the futures contracts have a maximum of 3-month expiration cycles.

        

          Three contracts are available for trading, with 1 month, 2 months and 3 months expiry. A new contract is introduced on the next trading day following the expiry of the near month contract. 

Trading mechanism at NSE

          The futures and options trading system of NSE, called NEAT-F&O trading system, provides a fully automated screen–based trading for Nifty futures & options and stock futures & options on a nationwide basis and an online monitoring and surveillance mechanism. It supports anonymous order driven market which provides complete transparency of trading operations and operates on strict price–time 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 2–tier 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 on account of his clients.

  Trading Member Clearing Member: TM–CM is a CM who

is also a TM. TM–CM may clear and settle his own proprietary trades and client’s trades as well as clear and settle for other TMs.

  Professional Clearing Member:  PCM is a CM who is not a

TM. Typically, banks or custodians could become a PCM and clear and settle for TMs.

Clearing and settlement

 

      NSCCL undertakes clearing and settlement of all deals executed on the NSEs F&O segment. It acts as legal counterparty to all deals on the F&O segment and guarantees settlement. We take a brief look at the clearing and settlement mechanism. 

Clearing 

      The first step in clearing process is working out open positions or obligations of members. A CM’s 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 TM’s 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. Clients’ positions are arrived at by summing together net (buy-sell) positions of each individual client for each contract. A TMs open position is the sum of proprietary open position, client open long position and client open short position.

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 CM’s are required to open a separate bank account with NSCCL designated clearing banks for F&O segment.  

Risk management system 

The salient features of risk containment measures on the F&O segment are: 

  Anybody interested in taking membership of F&O segment is required to take membership of “CM and F&O” or “CM, WDM and F&O”. An existing member of CM segment can also take membership of F&O segment.  

      NSCCL charges an upfront initial margin for all the open positions of a CM up to client level. It follows the VaR based margining system through SPAN system. NSCCL computes the initial margin percentage for each Nifty index futures contract on a daily basis and informs the CMs. The CM in turn collects the initial margin from the TMs and their respective clients. 

       NSCCL’s on-line position monitoring system monitors a CM’s open positions on a real-time basis. Limits are set for each CM based on his base capital and additional capital deposited with NSCCL. The on-line position monitoring system generates alerts whenever a CM reaches a position limit set up by NSCCL. NSCCL monitors the CM’s and TMs for mark to market value violation and for contract-wise positions limit violation.

      CM’s are provided with a trading terminal for the purpose of monitoring the open positions of all the TMs clearing and settling through them. A CM may set exposure limits for a TM clearing and settling through him. NSCCL assists the CM to monitor the intra-day exposure limits set up by a CM and whenever a TM exceeds the limits, it withdraws the trading facility provided to such TM. 

      A separate Settlement Guarantee Fund for this segment has been created out of the capital deposited by the members with NSCCL     

INTRODUCTION TO FORWARD CONTRACTS

What are forward contracts?

      A derivative as a term conjures up visions of complex numeric calculations, speculative dealings and comes across as an instrument which is the prerogative of a few ‘smart finance professionals’. In reality it is not so. In fact, a derivative transaction helps cover risk, which would arise on the trading of securities on which the derivative is based and a small investor can benefit immensely.

      A derivative security can be defined as a security whose value depends on the values of other underlying variables. Very often, the variables underlying the derivative securities are the prices of traded securities.

Let us take an example of a simple derivative contract:

Ram buys an Infosys futures contract. He will make a profit of Rs 1000 if the price of Infosys

rises by Rs 1000. If the price is unchanged Ram will receive nothing. If the stock price of Infosys falls by Rs 800 he will lose Rs

800.

      As we can see, the above contract depends upon the price of the Infosys scrip, which is the underlying security. Similarly, a future trading has already

started in Sensex futures and Nifty futures. The underlying security in this case is the BSE Sensex and NSE Nifty.

Derivatives and futures are basically of 3 types:

Forwards and Futures Options Swaps

Forward contract

      A forward contract is the simplest mode of a derivative transaction. It is an agreement to buy or sell an asset (of a specified quantity) at a certain future time for a certain price. No cash is exchanged when the contract is entered into.

Illustration 1:

       Shyam wants to buy a TV, which costs Rs 10,000 but he has no cash to buy it outright. He can only buy it 3 months hence. He, however, fears that prices of televisions will rise 3 months from now. So in order to protect himself from the rise in prices Shyam enters into a contract with the TV dealer that 3 months from now, he will buy the TV for Rs 10,000. What Shyam is doing is that he is locking the current price of a TV for a forward contract. The forward contract is settled at maturity. The dealer will deliver the asset to Shyam at the end of three months and Shyam in turn will pay cash equivalent to the TV price on delivery.

Illustration 2:

       Ram is an importer who has to make a payment for his consignment in six months time. In order to meet his payment obligation he has to buy dollars six months from today. However, he is not sure what the Re Vs $ rate will be then. In order to be sure of his expenditure he will enter into a contract with a bank to buy dollars six months from now at a decided rate. As he is entering into a contract on a future date it is a ‘forward contract’ and the underlying security is the foreign currency.

      The difference between a share and derivative is that shares/securities is an asset while derivative instrument is a contract.

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 core.

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.

      Every time an investor takes a long or short position on a stock, he also has a 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.

 

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. We shall learn in subsequent lessons how one can leverage ones position by taking position in the futures market.

      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 Feb. 2008

Table-2

Contract monthExpiry/settlementFeb 2008 Feb 28March 2008 Mar 27Apr 2008 Apr 24

FUTURES CONTRACT IN NIFTY ON Feb 23 2008

Table-3

  Contract monthExpiry/settlementMar 2008 Mar 27

Apr 2008 Apr 24May 2008 May 29

   

The index futures symbols are represented as follows:

Table-4

BSE NSEBSXFeb2008 (FEB contract)FUTDXNIFTY28-FEB2008BSXMar2008(Mar contract)FUTDXNIFTY27-MAR2008BSXApr2008 (Apr contract)FUTDXNIFTY24-APR2008

OPERATORS IN DERIVATIVES MARKET:

o Hedgers: -   Operators who want to transfer a risk component of their portfolio.

o Speculators: - Operators who intentionally take the risk from hedgers in pursuit of profit.

o Arbitrageurs: - Operators who operate in the different markets simultaneously, in pursuit of profit and eliminate miss-pricing.

  Hedging

      We have seen how one can take a view on the market with the help of index futures. 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:

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

Table-5

Cost (Rs)Selling priceProfit1000 4000 3000

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

TABLE REPRESENTING POSITION WHEN INVESTOR DEFAULTS AND HONOURS.

Table-6

Shyam defaults Shyam honours1000 (Initial Investment) 3000 (Initial profit)1000 (penalty from Shyam)(-1000) discount given to Shyam- (No gain/loss) 2000 (Net gain)

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

      The above 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 movements 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:

o Determine the beta of the portfolio. If the beta of any stock is not known, it is safe to assume that it is 1.

o 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 his 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 short sell 1.2 * 1 million = 1.2 million worth of Nifty.

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

TABLE REPRESENTING NET EFFECT DUE TO INDEX MOVE

Table-7 

  Index up 10%Index down 10%Gain/(Loss) in PortfolioRs 120,000 (Rs 120,000)Gain/(Loss) in Futures (Rs 120,000) Rs 120,000Net 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 have seen how one can use hedging in the futures market to offset losses in the cash market. 

  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:

      Ram 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 Nov 1, 2007, he buys 100 Sensex futures @ 19000 on expectations that the index will rise in future. On Jan 1, 2008, the Sensex rises to 19800 and at that time he sells an equal number of contracts to close out his position.

Selling Price: 19800*100              = Rs 19,80,000

Less: Purchase Cost: 19000*100 = Rs 19,00,000

                               --------------------            Net gain                                             Rs 80,000

                               --------------------

      Ram has made a profit of Rs 80,000 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 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 at least 3 months.

 

Arbitrage

      An arbitrageur is basically risk averse. He enters into those contracts were he can earn risk less profits. When markets are imperfect, buying in one market and simultaneously selling in other market gives risk less 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 special software for buying all 50 Nifty stocks in the spot market).

o Take the case of the NSE Nifty. o Assume that Nifty is at 5100 and 3 month’s Nifty futures is at

5400. o The futures price of Nifty futures can be worked out by taking the

interest cost of 3 months into account. o If there is a difference then arbitrage opportunity exists.

Let us take the example of single stock to understand the concept better.

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

Sale                   = 1070

Cost= 1000+30 = 1030     (1000*12%=120, 120*(3/12) =30)

Arbitrage profit =    40 

      These kinds 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.

 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.

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 450 per share and the 3 months futures of Wipro is Rs 470 then one can purchase Wipro at Rs 450 in spot by borrowing @ 12% annum for 3 months and sell Wipro futures for 3 months at Rs.470.

      Here F=450+13.5= 463.50 and is less than prevailing futures price and hence there are chances of arbitrage.

Sale = 470.00

Cost = 450+13.50 = 463.50 (450*12%=54, 42*3/12=13.50)

Arbitrage profit =470-463.50=6.50

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

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  

Speculation

      We have seen earlier that trading in index futures helps in taking a view of the market, hedging, speculation and arbitrage. In this module we will see 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 Feb 15, 2008, ‘X’ feels that the market will rise so he buys 100 Nifties with an expiry date of Feb 22 at an index price of 5300 costing Rs 5,30,000 (100*5300).  

On Feb 20 the Nifty futures have risen to 5400 so he squares off his position at 5400.

‘X’ makes a profit of Rs 10000 (5400-5300)=100*100)

Scenario 2:

On Feb 15, 2008, ‘X’ feels that the market will fall so he sells 100 Nifties with an expiry date of Feb 22 at an index price of 5300 costing Rs 5,30,000. (100*5300).

On Feb 22 the Nifty futures falls to 5180 so he squares off his position at 5180.

‘X’ makes a profit of Rs 12000 (5300-5180=120*100).

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

  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 http://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 ‘stock picker’ 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:

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

2. 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 10.3 lakh at Rs 206 per share on Feb 15, 2008. Assuming that the beta of HLL is 1.10. How many Nifty futures does ‘X’ have to sell if the index futures is ruling at 5300?

To hedge he needs to sell 10.3 lakh * 1.10 = Rs.11, 33,000.  Lakh on the index futures i.e. 214 Nifty futures.

On Feb 22, 2008, the Nifty future is at 5195 and HLL is at 201. ‘X’ closes both positions earning Rs 3665, i.e. his position on HLL drops by Rs 25,000. (10.3/206=5000, 206-201=5*5000) and his short position on Nifty gains Rs 28665 (5300-5195=105*273).

Therefore, the net gain is 28,665-25000= Rs 3665.

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 5300 * 100 (market lot) = Rs 5,30,000

The number of contracts to be sold is:        1.19*10 crore  

              ------------------- = 224 contracts

            5,30,000

If you sell more than 224 contracts you are over hedged and sell less than 224 contracts you are under hedged.

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

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 100 units of FUTIDX NIFTY 22 Feb 2008 at Rs 5300.

.The initial margin payable as calculated by VaR is 10%.

Total long position = Rs 5,30,000 (100*5300)

Initial margin (10%) = Rs 53,000

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

Settlements

      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.

What is Open Interest?

      Open interest indicates the total gross outstanding open positions in the market for that particular series.

      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.                                                                       

TABLE-11: OPEN INTEREST MEASURING TABLE 

Action Resulting open interestNew buyer (long) and new seller (short) Trade to form a new contract.

Rise

Existing buyer sells and existing seller buys –The old contract is closed.

Fall

New buyer buys from existing buyer. The Existing buyer closes his position by selling to new buyer.

No change – there is no increase in long contracts being held

Existing seller buys from new seller. The Existing seller closes his position by buying from new seller.

No change – there is no increase in short contracts being held

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.  

Table-12: TABLE INDICATING OPEN INTEREST     

                                  MOVEMENTS

Price           Open interestMarket

   Strong

   Warning signal

Weak

 Warning signal

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

Selecting the right index

      In selecting the index and contract month one should consider the following points.

Expiration date: If the investor has a month or two’s view about the market then he should choose that index futures which has a similar time left for expiry.

Liquidity : The index and the contract month, which is the most liquid, must be used. This will save cost because of the low bid-ask spread. This also saves hedging costs.

Stock should be correlated to the index : The stock to be hedged should have a correlation with the index selected.

Potential mispricing : One should sell index futures contract which is overpriced. In such an event one can not only hedge but also earn some profit in selling high.

      In a nutshell, one should hedge by using the most popular and fairly priced index and delivery month should not be very far since liquidity and predictability of very few contracts are low.

Options

      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, 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.

      We have seen in the Derivatives School how index futures can be used to protect oneself from volatility or market risk. Here we will try and understand some basic concepts of options.  

What are options?

      Some people remain puzzled by options. The truth is that most people have been using options for some time, because options are built into everything from mortgages to insurance.

      An option is a contract, which gives the buyer the right, but not the obligation to buy or sell shares of the underlying security at a specific price on or before a specific date.

      ‘Option’, as the word suggests, is a choice given to the investor to either honor 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.

      A Call Option is an option to buy a stock at a specific price on or before a certain date. In this way, Call options are like security deposits. If, for example, you wanted to rent a certain property, and left a security deposit for it, the money would be used to insure that you could, in fact, rent that property at the price agreed upon when you returned. If you never returned, you would give up your security deposit, but you would have no other liability. Call options usually increase in value as the value of the underlying instrument rises.

      When you buy a Call option, the price you pay for it, called the option premium, secures your right to buy that certain stock at a specified price called the strike price. If you decide not to use the option to buy the stock, and you are not obligated to, your only cost is the option premium.

      Put Options are options to sell a stock at a specific price on or before a certain date. In this way, Put options are like insurance policies

      If you buy a new car, and then buy auto insurance on the car, you pay a premium and are, hence, protected if the asset is damaged in an accident. If this happens, you can use your policy to regain the insured value of the car. In this way, the put option gains in value as the value of the underlying instrument decreases. If all goes well and the insurance is not needed, the insurance company keeps your premium in return for taking on the risk.

      With a Put Option, you can "insure" a stock by fixing a selling price. If something happens which causes the stock price to fall, and thus, "damages" your asset, you can exercise your option and sell it at its "insured" price level. If the price of your stock goes up, and there is no "damage," then you do not need to use the insurance, and, once again, your only cost is the premium. This is the primary function of listed options, to allow investors ways to manage risk.

      Technically, an option is a contract between two parties. The buyer receives a privilege for which he pays a premium. The seller accepts an obligation for which he receives a fee.

Option

      An option is a contract between two parties giving the taker (buyer) the right, but not the obligation, to buy or sell a parcel of shares at a predetermined price possibly on, or before a predetermined date. To acquire this right the taker pays a premium to the writer (seller) of the contract.

There are two types of options:

o Call Options o 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 BPCL JAN 370 Call --Premium 8

This contract allows Raj to buy 100 shares of BPCL at Rs 370 per share at any time between the current date and the end of next January. 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.

Shyam 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 as shown in graph-1.

      GRAPH - I

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

Nifty is at 5300. The following are Nifty options traded at following quotes.

Table-13: NIFTY OPTIONS SPECIFICATION TABLE

Option contractStrike priceCall premiumFeb Nifty 5300 Rs 5300  @

31.00  5325 Rs 5325  @

20.00     Mar Nifty 5300 Rs 5300 @ 24.00  5325 Rs 5325 @ 30.00

      A trader is of the view that the index will go up to 5375 in Mar 2008 but does not want to take the risk of prices going down. Therefore, he buys 10 options of Mar contracts at 5325. He pays a premium for buying calls (the right to buy the contract) for (30*100)*10= Rs 30,000/-.

      In Mar 2008 the Nifty index goes up to 5375. He sells the options or exercises the option and takes the difference in spot index price which is (5375-5325) * 100 (market lot) = 5,000 per contract. Total profit = 50,000/- (5,000*10)

      He had paid Rs 5,300/- premium for buying the call option. So he earns by buying call option is Rs 200/- (5,500-5,300).

      If the index falls below 5325 the trader will not exercise his right and will opt to forego his premium of Rs 5,300 per option. 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 & 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 INFOSYSTEC (INFOSYS Technologies) Mar 2300 Put --Premium 25

This contract allows Sam to sell 100 shares INFOSYSTEC at Rs 2300 per share at any time between the current date and the end of Mar. To have this privilege, Sam pays a premium of Rs 2,500 (Rs 25 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 as shown in graph-2.

GRAPH-2

Illustration 3:

An investor on July 15 is of the view that SunPharma 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 SunPharma.  

Quotes are as under :

Spot   Rs 600

Jul Put at 610 Rs 10

Jul Put at 630 Rs 30

He purchases 1000 SunPharma Puts at strike price 630 at Put price of Rs 30/- He pays Rs 30,000/- as Put premium.

His position in following price position is discussed below.

1. Jul Spot price of SunPharma = 580  2. Jul Spot price of SunPharma = 640

   In the first situation the investor is having the right to sell 1000 SunPharma shares at Rs 630/- the price of which is Rs 580/-. By exercising the option he earns Rs (630-580) = 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 & 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.

Table-14: Call options & put Options-Long & Short Positions  

  CALL OPTIONS

PUT OPTIONS

If you expect a fall in price(Bearish)

Short Long

If you expect a rise in price (Bullish)

Long Short

 

Table-15: Features of Buyer and Writer of CALL and PUT  

CALL OPTION BUYER CALL OPTION WRITER (Seller) Pays premium Right to exercise and buy

the shares Profits from rising prices

Limited losses, Potentially unlimited gain

Receives premium Obligation to sell shares if

exercised Profits from falling prices or

remaining neutral

Potentially unlimited losses, limited gain

PUT OPTION BUYER PUT OPTION WRITER (Seller)

Pays premium Right to exercise and sell

shares Profits from falling prices

Limited losses, Potentially unlimited gain

Receives premium Obligation to buy shares if

exercised Profits from rising prices or

remaining neutral

Potentially unlimited losses, limited gain

   

     

Option styles

      Settlement of options is based on the expiry date. However, there are two 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.

E.g.: Sam purchases 1 NIFTY Mar 5300 Call --Premium 20. The exchange will settle the contract on the last Thursday of March. 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".

E.g.: Sam purchases 1 NTPC Feb 202 Call --Premium 9

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

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

Option Class & 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.

E.g.: 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.

STOCK WIPRO Comp SERIES OF CALLS & PUTS FROM Jan- Mar 2008

Table-16 

Calls Puts. JANFEBMARJANFEBMARWipro Comp  

46045 60 75 15 20 2848035 45 65 25 28 35 50020 42 48 30 40 55 

E.g.: Wipro Comp JAN 500 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

Concepts

Important Terms

(Strike price, In-the-money, Out-of-the-Money, At-the-Money, Covered call and Covered Put)

Strike price :

      The Strike Price denotes the price at which the buyer of the option has a right to purchase or sell the underlying. Five different strike prices will be available at any point of time. The strike price interval will be of 20. If the index is currently at 5300 the strike prices available will be 5260, 5280, 5300, 5320 and 5340. The strike price is also called Exercise Price. This price is fixed by the exchange for the entire duration of the option depending on the movement of the underlying stock or index in the cash market.

In-the-money:

      A Call Option is said to be "In-the-Money" if the strike price is less than the market price of the underlying stock. A Put Option is In-The-Money when the strike price is greater than the market price.

E.g.: Raj purchases 1 WIPRO Jan  490 Call --Premium 10 .In the above example, the option is "in-the-money", till the market price of WIPRO is ruling above the strike price of Rs 490, which is the price at which Raj would like to buy 100 shares anytime before the end of June.

Similarly, if Raj had purchased a Put at the same strike price, the option would have been "in-the- money", if the market price of WIPRO was lower than Rs 490 per share.

Out-of-the-Money:

      A Call Option is said to be "Out-of-the-Money" if the strike price is greater than the market price of the stock. A Put option is Out-Of-Money if the strike price is less than the market price.

E.g.: Sam purchases 1 INFOSYSTEC Jan 5400 Call --Premium 25

      In the above example, the option is "out-of- the- money", if the market price of INFOSYSTEC is ruling below the strike price of Rs 5400, which is the price at which SAM would like to buy 100 shares anytime before the end of January.

      Similarly, if Sam had purchased a Put at the same strike price, the option would have been "out-of-the-money", if the market price of INFOSYSTEC was above Rs 5400 per share.

At-the-Money:

The option with strike price equal to that of the market price of the stock is considered as being "At-the-Money" or Near-the-Money.

E.g.: Raj purchases 1 TCS Jun 900 Call or Put--Premium 10

In the above case, if the market price of TCS is ruling at Rs 900, which is equal to the strike price, then the option is said to be "at-the-money".

If the index is currently at 5300 the strike prices available will be 5260, 5280, 5300, 5320, and 5340. The strike prices for a call option those are greater than the underlying (Nifty or Sensex) are said to be out-of-the-money in this case 5320 and 5340 considering that the underlying is at 5300. Similarly in-the-money strike prices will be 5260, and 5280 which are lower than the underlying of 5300.

At these prices one can take either a positive or negative view on the markets i.e. both call and put options will be available. Therefore, for a single series 10 options (5 calls and 5 puts) will be available and considering that there are three series a total number of 30 options will be available to take positions in.

Covered Call Option

Covered option helps the writer to minimize his loss. In a covered call option, the writer of the call option takes a corresponding long position in the stock in the cash market; this will cover his loss in his option position if there is a sharp increase in price of the stock. Further, he is able to bring down his average cost of acquisition in the cash market (which will be the cost of acquisition less the option premium collected).

E.g.: Raj believes that CEAT has hit rock bottom at the level of Rs.90 and it will move in a narrow range. He can take a long position in CEAT shares and at the same time write a call option with a strike price of 95 and collect a premium of Rs.5 per share. This will bring down the effective cost of CEAT shares to 85 (90-5). If the price stays below 90 till expiry, the call option will not be exercised and the writer will keep the Rs.5 he collected as premium. If the price goes above 90 and the Option is exercised, the writer can deliver the shares acquired in the cash market.

Covered Put Option

Similarly, a writer of a Put Option can create a covered position by selling the underlying security (if it is already owned). The effective selling price will

increase by the premium amount (if the option is not exercised at maturity). Here again, the investor is not in a position to take advantage of any sharp increase in the price of the asset as the underlying asset has already been sold. If there is a sharp decline in the price of the underlying asset, the option will be exercised and the investor will be left only with the premium amount. The loss in the option exercised will be equal to the gain in the short position of the asset.

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

Review of Options Pricing Factors

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.

IMPACT OF UNDERLYING PRICE MOVEMENTS ON PREMIUM COST

Table-17 

OptionUnderlying pricePremium costCall

    

Put     

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.

Table-18: IMPACT OF TIME TO EXPIRY ON PREMIUM COST 

OptionTime to expiryPremium costCall

     

Put     

 

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

Table-19: IMPACT OF VOLATILITY ON PREMIUM COST 

OptionVolatilityPremium costCall

     

Put     

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.

Table-20: IMPACT OF INTEREST RATES ON PREMIUM COST

OptionInterest ratesPremium costCall

    

Put    

Options Pricing Models

      There are various option pricing models which traders use to arrive at the right value of the option. Some of the most popular models have been enumerated below.

 The Binomial Pricing Model

      The binomial model is an options pricing model which was developed by William Sharpe in 1978. Today, one finds a large variety of pricing models which differ according to their hypotheses or the underlying instruments upon which they are based (stock options, currency options, options on interest rates).  

  Key Regulations

      In India we have two premier exchanges The National Stock Exchange of India (NSE) and The Bombay Stock Exchange (BSE) which offer options trading on stock indices as well as individual securities.

      Options on stock indices are European in kind and settled only on the last of expiration of the underlying. NSE offers index options trading on the NSE Fifty

index called the Nifty. While BSE offers index options on the country’s widely used index Sensex, which consists of 30 stocks.

      Options on individual securities are American. The number of stock options contracts to be traded on the exchanges will be based on the list of securities as specified by Securities and Exchange Board of India (SEBI). Additions/deletions in the list of securities eligible on which options contracts shall be made available shall be notified from time to time.  

Underlying:

      Underlying for the options on individual securities contracts shall be the underlying security available for trading in the capital market segment of the exchange.

Security descriptor

: The security descriptor for the options on individual securities shall be:

o Market type - N o Instrument type - OPTSTK o Underlying - Underlying security o Expiry date - Date of contract expiry o Option type - CA/PA o Exercise style - American Premium Settlement method: Premium

Settled; CA - Call American o PA - Put American.

Trading cycle:

      The contract cycle and availability of strike prices for options contracts on individual securities shall be as follows:

      Options on individual securities contracts will have a maximum of three-month trading cycle. New contracts will be introduced on the trading day following the expiry of the near month contract.

      On expiry of the near month contract, new contract shall be introduced at new strike prices for both call and put options, on the trading day following the expiry of the near month contract. (See Index futures learning centre for further reading)  

Strike price intervals:

      The exchange shall provide a minimum of five strike prices for every option type (i.e. call & put) during the trading month. There shall be two contracts in-the-money (ITM), two contracts out-of-the-money (OTM) and one contract at-the-money (ATM). The strike price interval for options on individual securities is given in the accompanying table.

      New contracts with new strike prices for existing expiration date will be introduced for trading on the next working day based on the previous day's underlying close values and as and when required. In order to fix on the at-the-money strike price for options on individual securities contracts the closing underlying value shall be rounded off to the nearest multiplier of the strike price interval. The in-the-money strike price and the out-of-the-money strike price shall be based on the at-the-money strike price interval.

Expiry day: Options contracts on individual securities as well as index options shall expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts shall expire on the previous trading day.

Order type:

      Regular lot order, stop loss order, immediate or cancel, good till day, good till cancelled, good till date and spread order. Good till cancelled (GTC) orders shall be cancelled at the end of the period of 7 calendar days from the date of entering an order.

 Permitted lot size:

      The value of the option contracts on individual securities shall not be less than Rs 2 lakh at the time of its introduction. The permitted lot size for the options contracts on individual securities shall be in multiples of 100 and fractions if any, shall be rounded off to the next higher multiple of 100.

Price steps:

  The price steps in respect of all options contracts admitted to dealings on the exchange shall be Re 0.05.     

Quantity freeze:

Orders which may come to the exchange as a quantity freeze shall be the lesser of the following:

1 per cent of the market wide position limit stipulated of options on individual securities

Or

Notional value of the contract of around Rs 5 crore.

       In respect of such orders, which have come under quantity freeze, the member shall be required to confirm to the exchange that there is no inadvertent error in the order entry and that the order is genuine. On such confirmation, the exchange at its discretion may approve such order subject to availability of turnover/exposure limits, etc.

Base price:

        Base price of the options contracts on introduction of new contracts shall be the theoretical value of the options contract arrived at based on Black-Scholes model of calculation of options premiums. The base price of the contracts on subsequent trading days will be the daily close price of the options contracts. However in such of those contracts where orders could not be placed because of application of price ranges, the bases prices may be modified at the discretion of the exchange and intimated to the members.

Price ranges:

      There will be no day minimum/maximum price ranges applicable for the options contract. The operating ranges and day minimum/maximum ranges for options contract shall be kept at 99 per cent of the base price. In view of this the members will not be able to place orders at prices which are beyond 99 per cent of the base price. The base prices for option contracts may be modified, at the discretion of the exchange, based on the request received from trading members as mentioned above.

Exposure limits:

        Gross open positions of a member at any point of time shall not exceed the exposure limit as detailed hereunder:

Index Options: Exposure Limit shall be 33.33 times the liquid net worth.

Option contracts on individual Securities : Exposure Limit shall be 20 times the liquid net worth.

Member wise position limit:

      When the open position of a Clearing Member, Trading Member or Custodial Participant exceeds 15 per cent of the total open interest of the market or Rs 100 crore, whichever is higher, in all the option contracts on the same underlying, at any time, including during trading hours. For option contracts on individual securities, open interest shall be equivalent to the open positions multiplied by the notional value. Notional Value shall be the previous day's closing price of the underlying security or such other price as may be specified from time to time.     

Market wide position limits:

        Market wide position limits for option contracts on individual securities shall be lower of:

*20 times the average number of shares traded daily, during the previous calendar month, in the relevant underlying security in the underlying segment of the relevant exchange or, 10 per cent of the number of shares held by non-promoters in the relevant underlying security i.e. 10 per cent of the free float in terms of the number of shares of a company.

      The relevant authority shall specify the market wide position limits once every month, on the expiration day of the near month contract, which shall be applicable till the expiry of the subsequent month contract.   

Advantages of option trading

Risk management:

        Put options allow investors holding shares to hedge against a possible fall in their value. This can be considered similar to taking out insurance against a fall in the share price.

Time to decide:

      By taking a call option the purchase price for the shares is locked in. This gives the call option holder until the Expiry Day to decide whether or not to exercise the option and buy the shares. Likewise the taker of a put option has time to decide whether or not to sell the shares.  

Speculation:

        The ease of trading in and out of an option position makes it possible to trade options with no intention of ever exercising them. If an investor expects the market to rise, they may decide to buy call options. If expecting a fall, they may decide to buy put options. Either way the holder can sell the option prior to expiry to take a profit or limit a loss. Trading options has a lower cost than shares, as there is no stamp duty payable unless and until options are exercised.

Leverage:

  Leverage provides the potential to make a higher return from a smaller initial outlay than investing directly. However, leverage usually involves more risks than a direct investment in the underlying shares. Trading in options can allow investors to benefit from a change in the price of the share without having to pay the full price of the share.

      We can see below how one can leverage ones position by just paying the premium.

METHOD OF LEVERAGING ONE’S POSITION BY PAYING PREMIUM

Table-21 

  Option PremiumStockBought on Jan 15 Rs 380 Rs 4000Sold on Jan 15 Rs 670 Rs 4500Profit Rs 290 Rs 500ROI (Not annualised)76.3% 12.5% 

Income generation:

      Shareholders can earn extra income over and above dividends by writing call options against their shares. By writing an option they receive the option premium upfront. While they get to keep the option premium, there is a possibility that they could be exercised against and have to deliver their shares to the taker at the exercise price. 

Strategies:

      By combining different options, investors can create a wide range of potential profit scenarios. To find out more about options strategies read the module on trading strategies.

Bull Market Strategies

Calls in a Bullish Strategy Puts in Bullish Strategy

Bullish call spread StrategiesBullish put Spread Strategies

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 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 5300 and the option premium is Rs 100. The option will be exercised only if the value of the underlying is greater than Rs 5300 (the strike price). If the buyer exercises the call at Rs 5500 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.                  5500 – 5300 – 100 = Rs 100

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 realized. The investor delivers on his short call and receives a higher price than he is paid for receiving delivery on his long call.

 

      The investor’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: we have taken live data from NSE on JAN 15th 2008.

      ON JAN 15th 2008 the spot nifty is 5300, and you buy a FEB call option with a strike price of Rs 5250 and pay a premium of Rs 150. At the same time you sell another FEB call option on scrip with a strike price of Rs 5350 and receive a premium of Rs 100. 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 50 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 purchase 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:

BOUGHT 5250 nifty 22nd FEB 2008 @ RS 150.00

Sold 5350 nifty 22nd FEB 2008 @ RS 100.00

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

= 5350 - 5250 - 50 = 50

Maximum Loss = Lower strike premium - Higher strike premium                          

= 150 – 100 = 50

Breakeven Price = Lower strike price + Net premium paid                           

= 5250 + 50 = 5300

VERIFICATION

Break  even point verification.

Now the closing price =5300

PROFIT/LOSS

ON 5250 NIFTY call there is profit of rs 50.00(closing price - strike price)

(5300-5250 = 50).

ON 5350 NIFTY call there is a loss 50 (Closing price – Strike price)

(5300 – 5350 =  -50).

Total profit/loss = 50-50 =0

NOTE: Hence there is no loss and profit at BEP our calculation is correct and it is verified.

Maximum  profit verification.

Assume the closing price of nifty is 5650.

PROFIT/LOSS

ON 5250 NIFTY call there is profit of Rs 250.00(closing price - strike price - premium)

(5650-5250 -150=250).

ON 4200 nifty call there is a loss of Rs 200.00(-(closing price-strike price) +premium)

(-(5650-5350) +100 = 200).

Total profit = 250- 200 =50.

NOTE: Hence the maximum profit is 50 our calculation is correct and it is verified.

Maximum loss verification.

Assume the closing price of nifty is 5150.

PROFIT/LOSS

On 5250 NIFTY call there is loss of rs (-150) ( it is a out of the money option and it expires worthlessly.)

On 5350 NIFTY call there is a profit of rs 100 (it is a out of the money option, the buyer laves the option as unexercised.)

Total loss = (-150+100=-50).

NOTE: Hence the maximum loss is 50 our calculation is correct and it is verified.

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 strike put.              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.

On JAN 15th  2008 the spot nifty is 5300, and you buy a FEB put option on a scrip with a strike price of Rs 5250 at a premium of Rs 25 and sell a put option with a strike price of Rs 5350 at a premium of Rs 55.

      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:

Sold 5250 nifty 22nd FEB 2008 @ RS 25.00

Bought 5350 nifty 22nd FEB 2008 @ RS 55.00

Maximum profit = Net option premium income or net credit                             

= 55 - 25 = 30

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

= 5350 - 5250 - 30 = 70

Breakeven Price = Higher Strike price - Net premium income

= 5350 - 30 = 5320

VERIFICATION:                       

Break even point verification.

Now the closing price =5300

PROFIT/LOSS

On 5250 NIFTY put there is loss of rs -25.00(It is aout of the money option)

On 5350 NIFTY put there is a profit 25 .00(premium-profit)

(55-30=25).

Total profit/loss = 25-25 =0

NOTE: Hence there is no loss and profit at BEP our calculation is correct and it is verified.

Maximum  profit verification.

Assume the closing price of nifty is 5650.

PROFIT/LOSS

On 5250 NIFTY put there is lost of rs 25.00(out of the money, premium is loss)

On 5350 nifty put there is a profit of rs 55.00(out the money, option writer gains the premium)

Total profit =55-25=30.

NOTE: Hence the maximum profit is 30 our calculation is correct and it is verified.

Maximum  loss verification.

Assume the closing price of nifty is 5250.

PROFIT/LOSS

On 5250 NIFTY call there is profit of rs 75 (profit-premium)

Profit=(100-25=75)

On 5350 NIFTY call there is a loss of rs 145 (premium-loss)

Loss(55-200=-145)

Total loss = (-145+75=-70).

NOTE: Hence the maximum loss is 70 our calculation is correct and it is verified.

                

SUMMARY 

By very nature, the financial markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking asset prices.

  The derivative products initially emerged for hedging purpose, later on

these products are used all the participants in the market, like hedgers, speculators and arbitragers.

 

The various derivative contracts that have come into use are forwards, futures, options, warrants, leaps, baskets, swaps and Swaptions.

  Hedging using index derivatives has become a central part of risk

management in the modern economy as index derivatives allow people to cheaply alter their risk exposure to an index (hedging) and to implement forecasts about index movements (speculation),protecting the downfall of their portfolio value with index beta value(arbitration).

  Derivative contracts are introduced in a phased manner in India

according to the recommendations of the L.C.Gupta committee as follows:   

  Index futures – 12th June 2000       Index options –  4th June

2001       stock options –  2nd July 2001       stock futures –  9th Nov 2001

  When comparing last six months’ data of F&O segment and cash

segment, period ending with June 2007, It has been observed that the trade value in F&O segment increased  to 64% and the cash segment has increased to 49%. It has also been observed that the F&O segment has consistently been 2 times of the cash segment, and for the month of June 2007 it is 2.43 time of the cash segment.

  The futures and options trading system of NSE, called NEAT-F&O

trading system, provides a fully automated screen–based trading for Nifty futures & options and stock futures & options on a nationwide basis and an online monitoring and surveillance mechanism. It supports an order driven market.

  While entering the order the dealer should specify the order type (buy

open, buy close, and sell open, sell close) and PRO or CLI.

  All futures and options contracts are cash settled. The settlement amount

for a clearing member (CM) is netted across all their trading member(TM) / clients, with respect to their obligations on mark- to – marker (MTM), premium, and exercise settlement.

                  

                               

                   

What we Learnt 

We learnt that stock market have many ups and downs. There are many losers and gainers. In the month of January 2008 there is a big crash in the markets i.e, from a healthy

21000 to it has fallen

nearly 16000’s. There are many traders who faced the consequences. An image showing a person dejected with the market crash. The profits are unlimited because the markets may go up or down. 

 

 

The person dejected with the market crash.

                                                                              

RELIANCE POWER 

Recently reliance power has entered in to the market. It’s IPO

was issued in the month of January. And in February it has hit the screen. Nearly they issued eleven crore shares in the IPO. And its price range was between 405 to 455. And it

also issued bonus shares to the traders after hitting the market. But after coming in to the market it’s value was

decreased up to 330. 

                                                            

   

And it came in to the market on Feb 11, 2008. The logo of the reliance power is shown above. 

  

    

RECOMMENDATION  

1. By using the bull market strategies the investors profit potential is maximized. 

2. And the maximum profit &loss and BEP are all known to the investor, before investment in to the spread, hence he can take risk management activities. His risk is minimized. 

3.  The investors must use these bull market strategies to optimise their returns, and minimize the losses.             

BIBILOGRAPHYBOOKS:

Futures and options     Vohra & Bogri

Futures and options    Mahajan.

News paper

THE TIMES OF INDIA

BUSINESS STANDARDS

BUSINESS LINE  

And various news papers. 

NCFM Derivatives core module work book. NSENEWS, National Stock Exchange Rules, regulations and bye laws, (F&O segment) of NSE & NSCCL Under standing futures markets by Robert W. Kolb Indian Securities market Review,2001, National Stock Exchange

 

Websites:

o www.nse-india.com o www.sebi.gov.in o www.derivativesindia.com o www.derivatives-r-us.com o www.mof.nic.in o www.icicidirect.com