A Project Report ON A Study on Derivatives (Future & Options) AT INDIABULLS SECURITIES LTD Secunderabad MASTER OF BUSINESS ADMINISTRATION Submitted By: PENJARLA PRAVEEN [HALLTICKET NO: 141509672049] Project submitted in partial fulfilment for award of the degree of PENDEKANTI INSTITUTE OF MANAGEMENT 1
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A Project Report
ON
A Study on Derivatives
(Future & Options)
AT
INDIABULLS SECURITIES LTD
Secunderabad
MASTER OF BUSINESS ADMINISTRATION
Submitted By:
PENJARLA PRAVEEN
[HALLTICKET NO: 141509672049]
Project submitted in partial fulfilment for award of the degree of
PENDEKANTI INSTITUTE OF MANAGEMENT
(Affiliated to Osmania University)
Ibrahimbagh, Hyderabad.
(2009-2011)
1
DECLARATION
I hereby declare that, the project report entitled “A Study on DERIVATIVES (FUTURES &
OPTIONS) with special reference to INDIABULLS SECURITIES LTD, is an original work done
and submitted by me for the partial fulfilment of the requirement for the award of degree of masters
of business administration for the academic year 2009 -2011. I also further declare that this project
has neither has been reproduced nor been submitted elsewhere to any other university for any other
purpose, to the best of my knowledge and belief.
Date:
Place: P.PRAVEEN
2
ABSTRACT
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. Derivative
products initially emerged as hedging devices against fluctuations in commodity prices, and
commodity-linked derivatives remained the sole form of such products for almost three hundred
years. Financial derivatives came into spotlight in the post-1970 period due to growing instability
in the financial markets. However, since their emergence, these products have become very
popular and by 1990s, they accounted for about two-thirds of total transactions in derivative
products. In recent years, the market for financial derivatives has grown tremendously in terms of
variety of instruments available, their complexity and also turnover. In the class of equity
derivatives the world over, futures and options on stock indices have gained more popularity than
on individual stocks, especially among institutional investors, who are major users of index-linked
derivatives. Even small investors find these useful due to high correlation of the popular indexes
with various portfolios and ease of use.
This project deals mainly with futures and options, the terminologies involved, difference
between them , their eligibility criteria, how are they traded, how futures and options are used
for hedging, settlement process strategies, and the software’s used.
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ACKNOWLEDGEMENT
I am thankful to the management of “A STUDY ON DERIVATOVES (FUTURES & OPTIONS)”
for my project work.
However, in particular, I would like to thank Mr.S.JAGADISHWAR Associate Vice
President Indiabulls Securities limited and Mr.S.SATISH KUMAR for appraising me of the
situation with necessary background helps to complete this project work.
And also I am very thankful to Mr. G. SAMUEL, PRINCIPAL, PENDEKANTI
INSTITUTE OF MANAGEMENT, HYDERABAD. I am deeply indebted to my guide Dr.
G.SATISH head of the department taking under sparking his variable time throughout the project
work.
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TABLE OF CONTENT
5
S.NO CONTENT Pg,no
1. INTRODUCTION 7-11
1.1 INTRODUCTION
1.2 SCOPE OF THE STUDY
1.3 STATEMENT OF THE PROBLEMS
1.4 OBJECTIVES OF THE STUDY
1.6 LIMITATIONS
1.6 RESEARCH METHODOLOGY
2. LITERATURE REVIEW 12-42
2.1 INTRODUCTION OF DERIVATIVES
2.2 HISTORICAL VIEW OF FUTURES & OPTIONS
2.3 FUTURES
2.4 OPTIONS
2.5 ELIGIBILITY CRITERIA FOR SECURITIES OF TRADED
2.6 TRADING MECHANISM OF FUTURES & OPTIONS
2.7 STEPS INVOLVED IN FUTURES &OPTIONS TRADING
3. COMPANY PROFILE 43-54
4. DATA ANALYSIS & INTERPRETATION 55-65
4.1 ANALYSIS OF FUTURE
4.2 RELATION OF FP AND WITH SP
4.3 ANALYSIS OF OPTIONS
5. SUMMARY AND CONCLUSION 66-69
5.1 RESULTS & DISCUSSIONS
5.2 SUGGESTIONS
5.3 CONCLUSION
6. BIBILOGRAPHY
//
6
LIST OF TABLES
S.NO CONTENTS Pg. No
1. T1--Data for FUTSTK-WIPRO from 01-12-2010 to 30-12-2010 56
2. T2--Data for FUTSTK-WIPRO from 01-12-2010 to 30-12-2010 58
LIST OF FIGURES
S.NO CONTENTS Pg. No
1. MAJOR PLAYERS IN DERIVATIVE MARKET: 16
2. PAY-OFF FOR A BUYER OF FUTURES 23
3. PAY-OFF FOR A SELLER OF FUTURES 24
4. PAY-OFF PROFILE FOR BUYER OF A CALL OPTION 29
5. PAY-OFF PROFILE FOR SELLER OF A CALL OPTION 30
6. PAY-OFF PROFILE FOR BUYER OF A PUT OPTION 32
7. PAY-OFF PROFILE FOR SELLER OF A PUT OPTION 33
8. Indiabulls Group 44
9. ORGANISATIONAL STRUCTURE 46
10. POWER INDIA BULLS 53
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CHAPTER-1
INTRODUCTION
1.1 INTRODUCTION
8
Derivatives are a wide group of financial securities defined on the basis of other financial
securities, i.e., the price of a derivative is dependent on the price of another security, called the
underlying. These underlying securities are usually shares or bonds, although they can be various
other financial products, even other derivatives. As a quick example, let’s consider the derivative
called a ‘call option’, defined on a common share. The buyer of such a product gets the right to buy
the common share by a future date. But she might not want to do so—there’s no obligation to buy it,
just the choice, the option. Let’s now flesh out some of the details. The price at which she can buy
the underlying is called the strike price, and the date after which this option expires is called the
strike date. In other words, the buyer of a call option has the right, but not the obligation to take a
long position in the underlying at the strike price on or before the strike date. Call options are further
classified as being European, if this right can only be exercised on the strike date and American, if it
can be exercised any time up and until the strike date.
Derivatives are amongst the widely traded financial securities in the world. Turnover
in the futures and options markets are usually many times the cash (underlying) markets. Our
treatment of derivatives in this module is somewhat limited: we provide a short introduction about of
the major types of derivatives traded in the markets and their pricing.
Financial derivatives came into spotlight in the year 1970 period due to growing
instability in the financial markets. However since their emergence, these accounted for about two-
third of totals transactions in derivatives products. In recent years, the market for financial
derivatives has grown tremendously in terms of variety of instruments available, there complexity &
also turn over. In the class of equity derivatives Futures & options on stock also turn over. In the
class of equity derivatives, futures & options on stock indicates gained more popularly than
individual stocks.
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1.2 SCOPE OF THE STUDY
The scope of the study is limited to “DERIVATIVES” with the special reference to Indian
context and the National stock exchange has been taken as a representative sample for the
study. The study includes futures and options.
My analysis part is limited to selecting the investment option it means that whether we have
to invest cash market or derivatives market.
I have taken only four different organizations from four different industries to analyze and
interpret the results.
Based upon four criteria’s only open interest is evaluated for analyzing the trend of market as
well as price movement.
The study is not Based on the international perspective of derivatives markets, which exists in
NASDAQ, CBOT etc.
This study mainly covers the area of hedging and speculation. The main aim of the study is to
prove how risks in investing in equity shares can be reduced and how to make maximum
return to the other investment.
1.3 STATEMENT OF THE PROBLEM
The main problem in the derivatives is we can’t able to decide that time and derivative
product which is more risky and return depend upon the time and product only we can earn more
returns with taking more risk. In this following project I came to know that based upon some
valuations and time conditions we can easily identify that which product is more efficient for earning
more returns. In this research I used only two derivative products they are FUTURES and
OPTIONS. Another one is OPEN INTEREST concept it is very new to market. This additional work
proposes based upon open interest and volume we can tell the when the market is bullish as well as
bearish and identifies that price movements easily when they are going to rise and when they are
coming fall depends upon price volume changes.
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1.4 OBJECTIVES OF THE STUDY
The objectives for my research are as below
To calculate the risk and return of investment in futures and investment in options
To identifies the market trend and price movement based upon the open interest changes
To analyze the role of futures and options in Indian financial system
To understand about the derivatives market.
To know why derivatives is considered safer than cash market.
To construct portfolio and analyses the risk return relationship.
To hedge the most profitable portfolio.
1.5 LIMITATIONS
Share market is so much volatile and it is difficult to forecast any thing about it whether you
trade through online or offline
The time available to conduct the study was only 2 ½ months. It being a wide topic had a
limited time.
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1.6 RESEARCH METHODOLOGY
Research Methodology is a systematic procedure of collecting information in order to analyse
and verify a phenomenon. the collection of information is done in two principle sources. They are as
follows
1. Primary Data
2. Secondary Data
Primary Data:
It is the information collected directly without any references. In this study it is gathered
through interviews with concerned officers and staff, either individually or collectively, sum of the
information has been verified or supplemented with personal observation in trading times and
conducting personal interviews with the concerned officers of INDIABULLS SECURITIES LTD.
Secondary Data:
The secondary data was collected from already published sources such as, NSE websites,
internal records, reference from text books and journal relating to derivatives. The data collection
includes:
a) Collection of required data from NSE and BSE websites
b) Reference from text books and journals relating to Indian stock market system and financial
derivatives.
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CHAPTER-2
LITERATURE REVIEW
13
CONCEPTUAL AND THEORITICAL REVIEW
2.1 INTRODUCTION OF DERIVATIVES
DEFINITION
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".
FACTORS DRIVING THE GROWTH OF DERIVATIVES
Over the last three decades, the derivatives market has seen a phenomenal growth. A large
variety of derivative contracts have been launched at exchanges across the world. Some of the factors
driving the growth of financial derivatives are:
1. Increased volatility in asset prices in financial markets,
2. Increased integration of national financial markets with the international markets,
3. Marked improvement in communication facilities and sharp decline in their costs,
4. Development of more sophisticated risk management tools, providing economic agents a wider
choice of risk management strategies, and
5. Innovations in the derivatives markets, which optimally combine the risk and returns over a large
number of financial assets leading to higher returns, reduced risk as well as transactions costs as
compared to individual financial assets.
2.2 HISTORICAL VIEW OF FUTURES AND OPTIONS
Early forward contracts in the US addressed merchants' concerns about ensuring that there
were buyers and sellers for commodities. However 'credit risk" remained a serious problem. To deal
with this problem, a group of Chicago businessmen formed the Chicago Board of Trade (CBOT) in
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1848. The primary intention of the CBOT was to provide a centralized location known in advance for
buyers and sellers to negotiate forward contracts. In 1865, the CBOT went one step further and listed
the first 'exchange traded" derivatives contract in the US, these contracts were called 'futures
contracts". In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, was reorganized to allow
futures trading. Its name was changed to Chicago Mercantile Exchange (CME). The CBOT and the
CME remain the two largest organized futures exchanges, indeed the two largest "financial"
exchanges of any kind in the world today. The first stock index futures contract was traded at Kansas
City Board of Trade. Currently the most popular stock index futures contract in the world is based on
S&P 500 index, traded on Chicago Mercantile Exchange. Index futures, futures on T-bills and Euro-
Dollar futures are the three most popular futures contracts traded today. Other popular international
exchanges that trade derivatives are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE
in Japan, MATIF in France, Euro ex etc.
INDEX FUTURES (JUNE 12, 2000)
INDEX OPTIONS (JUNE 4, 2001)
STOCK OPTIONS (JULY 2, 2001)
STOCK FUTURES (NOVEMBER 9, 2001)
Flow of futures and options in NSE
15
Risks involved in Derivatives:
Derivatives are used to separate risks from traditional instruments and transfer these risks to
parties willing to bear these risks. The fundamental risks involved in derivative business includes
A. Credit Risk: This is the risk of failure of a counterpart to perform its obligation as per the
contract. Also known as default or counterpart risk, it differs with different instruments.
B. Market Risk: Market risk is a risk of financial loss as result of adverse movements of prices
of the underlying asset/instrument.
C. Liquidity Risk: The inability of a firm to arrange a transaction at prevailing market prices is
termed as liquidity risk. A firm faces two types of liquidity risks:
Related to liquidity of separate products.
Related to the funding of activities of the firm including derivatives.
D. Legal Risk: Derivatives cut across judicial boundaries, therefore the legal aspects associated
with
The deal should be looked into carefully.
MAJOR PLAYERS IN DERIVATIVE MARKET:
There are three major players in their derivatives trading.
1. Hedgers.
2. Speculators.
3. Arbitrageurs.
Hedgers: The party, which manages the risk, is known as “Hedger”. Hedgers seek to protect
themselves against price changes in a commodity in which they have an interest.
16
Speculators: They are traders with a view and objective of making profits. They are willing to take
risks and they but upon whether the markets would go up or come down.
Arbitrageurs: Risk less profit making is the prime goal of arbitrageurs. They could be making
money even with out putting their own money in, and such opportunities often come up in the market
but last for very short time frames. They are specialized in making purchases and sales in different
markets at the same time and profits by the difference in prices between the two centres.
Fig 1: MAJOR PLAYERS IN DERIVATIVE MARKET:
17
MAJOR PLAYERSIN
DERIVATIVE MARKET
HEDGERS SPECULATORS ARBITRAGEURS
Contract Periods:
At any point of time there will be always be available nearly 3months contract periods in
Indian Markets.
These were
1) Near Month
2) Next Month
3) Far Month
For example in the month of September 2008 one can enter into September futures contract or
October futures contract or November futures contract. The last Thursday of the month specified in
the contract shall be the final settlement date for the contract at both NSE as well as BSE It is also
know as Expiry Date.
Settlement:
The settlement of all derivative contracts is in cash mode. There is daily as well as final
settlement. Outstanding positions of a contract can remain open till the last Thursday of the month.
As long as the position is open, the same will be marked to market at the daily settlement price, the
difference will be credited or debited accordingly and the position shall be brought forward to the
next day at the daily settlement price. Any position which remains open at the end of the final
settlement day (i.e. last Thursday) shall closed out by the exchanged at the final settlement price
which will be the closing spot value of the underlying asset.
Margins:
There are two types of margins collected on the open position, viz., initial margin which is
collected upfront which is named as “SPAN MARGIN” and mark to market margin, which is to be
18
paid on next day. As per SEBI guidelines it is mandatory for clients to give margins, fail in which
the outstanding positions or required to be closed out.
Members of F & O segment:
There are three types of members in the futures and options segment. They are trading
members, trading cum clearing member and professional clearing members.
Trading members are the members of the derivatives segment and carrying on the transaction
on the respective exchange.
The clearing members are the members of the clearing corporation who deal with payments
of margin as well as final settlements.
The professional clearing member is a clearing member who is not a trading member.
Typically, banks and custodians become professional clearing members.
It is mandatory for every member of the derivatives segment to have approved users who
passed SEBI approved derivatives certification test, to spread awareness among investors.
2.3 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. The futures contracts are standardized and exchange traded. To
facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the
contract. It is a standardized contract with standard underlying instrument, a standard quantity and
quality of the underlying instrument that can be delivered, (or which can be used for reference
purposes in settlement) and a standard timing of such settlement.
The standardized items in a futures contract are:
Quantity of the underlying
19
Quality of the underlying
The date and the month of delivery
The units of price quotation and minimum price change
Location of settlement
Futures contracts in physical commodities such as wheat, cotton, gold, silver, cattle, etc. have
existed for a long time. Futures in financial assets, currencies, and interest bearing
instruments like treasury bills and bonds and other innovations like futures contracts in stock
indexes are relatively new developments.
The futures market described as continuous auction markets and exchanges providing the
latest information about supply and demand with respect to individual commodities, financial
instruments and currencies, etc
Futures exchanges are where buyers and sellers of an expanding list of commodities;
financial instruments and currencies come together to trade. Trading has also been initiated
in options on futures contracts. Thus, option buyers participate in futures markets with
different risk. The option buyer knows the exact risk, which is unknown to the futures trader.
Future Contract
Suppose you decide to buy a certain quantity of goods. As the buyer, you enter into an
agreement with the company to receive a specific quantity of goods at a certain price
every month for the next year. This contract made with the company is similar to a
futures contract, in that you have agreed to receive a product at a future date, with the
price and terms for delivery already set. You have secured your price for now and the next
year - even if the price of goods rises during that time. By entering into this agreement
with the company, you have reduced your risk of higher prices.
20
So, a futures contract is an agreement between two parties: a short position - the party who
agrees to deliver a commodity - and a long position - the party who agrees to receive a
commodity. In every futures contract, everything is specified: the quantity and quality of
the commodity, the specific price per unit, and the date and method of delivery. The
“price” of a futures contract is represented by the agreed-upon price of the underlying
commodity or financial instrument that will be delivered in the future.
Features of Futures Contracts:
The principal features of the contract are as fallows.
Organized Exchanges: Unlike forward contracts which are traded in an over – the - counter
market, futures are traded on organized exchanges with a designated physical location where
trading takes place. This provides a ready, liquid market which futures can be bought and
sold at any time like in a stock market.
Standardization: In the case of forward contracts the amount of commodities to be
delivered and the maturity date are negotiated between the buyer and seller and can be tailor
made to buyer’s requirement. In a futures contract both these are standardized by the
exchange on which the contract is traded.
Clearing House: The exchange acts a clearinghouse to all contracts struck on the trading
floor. For instance a contract is struck between capital A and B. upon entering into the
records of the exchange, this is immediately replaced by two contracts, one between A and
the clearing house and another between B and the clearing house. In other words the
exchange interposes itself in every contract and deal, where it is a buyer to seller, and seller to
buyer. The advantage of this is that A and B do not have to undertake any exercise to
investigate each other’s credit worthiness. It also guarantees financial integrity of the market.
The enforce the delivery for the delivery of contracts held for until maturity and protects itself
21
from default risk by imposing margin requirements on traders and enforcing this through a
system called marking – to – market.
Actual delivery is rare: In most of the forward contracts, the commodity is actually
delivered by the seller and is accepted by the buyer. Forward contracts are entered into for
acquiring or disposing of a commodity in the future for a gain at a price known today. In
contrast to this, in most futures markets, actual delivery takes place in less than one present of
the contracts traded. Futures are used as a device to hedge against price risk and as a way of
betting against price movements rather than a means of physical acquisition of the underlying
asset. To achieve, this most of the contracts entered into are nullified by the matching
contract in the opposite direction before maturity of the first.
Margins: In order to avoid unhealthy competition among clearing members in reducing
margins to attract customers, a mandatory minimum margins are obtained by the members
from the customers. Such a stop insures the market against serious liquidity crises arising out
of possible defaults by the clearing members. The members collect margins from their clients
has may be stipulated by the stock exchanges from time to time and pass the margins to the
clearing house on the net basis i.e. at a stipulated percentage of the net purchase and sale
position.
FUTURES TERMINOLOGY
Spot price: The price at which an asset trades in the spot market.
Futures price: The price at which the futures contract trades in the futures market.
Contract cycle: The period over which a contract trades. The index futures contracts on the NSE
have one- month, two-months and three months expiry cycles which expire on the last Thursday of
the month. Thus a January expiration contract expires on the last Thursday of January and a February
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expiration contract ceases trading on the last Thursday of February. On the Friday following the last
Thursday, a new contract having a three- month expiry is introduced for trading.
Expiry date: It is the date specified in the futures contract. This is the last day on which the contract
will be traded, at the end of which it will cease to exist.
Contract size: The amount of asset that has to be delivered under one contract. Also called as lot
size.
Basis: In the context of financial futures, basis can be defined as the futures price minus the spot
price. There will be a different basis for each delivery month for each contract. In a normal market,
basis will be positive. This reflects that futures prices normally exceed spot prices.
Cost of carry: The relationship between futures prices and spot prices can be summarized in terms
of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to
finance the asset less the income earned on the asset.
Initial margin: The amount that must be deposited in the margin account at the time a futures
contract is first entered into is known as initial margin.
Marking-to-market: In the futures market, at the end of each trading day, the margin account is
adjusted to reflect the investor's gain or loss depending upon the futures closing price. This is called
marking-to-market.
Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that the
balance in the margin account never becomes negative. If the balance in the margin account falls
below the maintenance margin, the investor receives a margin call and is expected to top up the
margin account to the initial margin level before trading commences on the next day.
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LOSS
PROFIT
F
L
P
E1E2
TYPES OF FUTURES
On the basis of the underlying asset they derive, the futures are divided into two types:
Stock Futures
Index Futures
PARTIES IN THE FUTURES CONTRACT
There are two parties in a futures contract, the buyers and the seller. The buyer of the futures
contract is one who is LONG on the futures contract and the seller of the futures contract is who is
SHORT on the futures contract.
The pay-off for the buyers and the seller of the futures of the contracts are as follows:
Fig-2: PAY-OFF FOR A BUYER OF FUTURES
Figure 3.2
CASE 1:- The buyers bought the futures contract at (F); if the futures
Price Goes to E1 then the buyer gets the profit of (FP).
24
F
LOSS
PROFIT
E1
P
E2
L
CASE 2:- The buyers gets loss when the futures price less then (F); if
The Futures price goes to E2 then the buyer the loss of (FL).
Fig: PAY-OFF FOR A SELLER OF FUTURES
Figure 3.3
F = FUTURES PRICE
E1, E2 = SATTLEMENT PRICE
CASE 1:- The seller sold the future contract at (F); if the future goes to
E1 Then the seller gets the profit of (FP).
CASE 2:- The seller gets loss when the future price goes greater than (F);
If the future price goes to E2 then the seller get the loss of (FL).
25
HOW THE FUTURE MARKET WORKS
The futures market is a centralized marketplace for buyers and sellers from around the
world who meet and enter into futures contracts. Pricing can be based on an open outcry
system, or bids and offers can be matched electronically. The futures contract will state the
price that will be paid and the date of delivery. Almost all futures contracts end without the
actual physical delivery of the commodity.
2.4 OPTIONS
INTRODUCTION TO OPTIONS
In this section, we look at the next derivative product to be traded on the NSE, namely
options. Options are fundamentally different from forward and futures contracts. An option gives
the holder of the option the right to do something. The holder does not have to exercise this right. In
contrast, in a forward or futures contract, the two parties have committed themselves to doing
something. Whereas it costs nothing (except margin requirement) to enter into a futures contracts, the
purchase of an option requires as up-front payment.
DEFINITION
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 buyers 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.
26
PROPERTIES OF OPTION
Options have several unique properties that set them apart from other securities. The
following are the properties of option:
Limited Loss
High leverages potential
Limited Life
PARTIES IN AN OPTION CONTRACT
There are two participants in Option Contract.
Buyer/Holder/Owner of an Option:
The Buyer of an Option is the one who by paying the option premium buys the right but not
the obligation to exercise his option on the seller/writer.
Seller/writer of an Option:
The writer of a call/put option is the one who receives the option premium and is thereby
obliged to sell/buy the asset if the buyer exercises on him.
Characteristics of Options:
The following are the main characteristics of options:
1. Options holders do not receive any dividend or interest.
2. Options only capital gains.
3. Options holder can enjoy a tax advantage.
4. Options holders are traded an O.T.C and in all recognized stock exchanges.
5. Options holders can control their rights on the underlying asset.
6. Options create the possibility of gaining a windfall profit.
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7. Options holders can enjoy a much wider risk-return combinations.
8. Options can reduce the total portfolio transaction costs.
9. Options enable with the investors to gain a better return with a limited amount of investment.
TYPES OF OPTIONS
The Options are classified into various types on the basis of various variables. The following are
the various types of options.
1. On the basis of the underlying asset:
On the basis of the underlying asset the option are divided in to two types:
Index options:
These options have the index as the underlying. Some options are European while others
are American. Like index futures contracts, index options contracts are also cash settled.
Stock options:
Stock Options are options on individual stocks. Options currently trade on over 500 stocks in
the United States. A contract gives the holder the right to buy or sell shares at the specified price.
2. On the basis of the market movements :
On the basis of the market movements the option are divided into two types. They are:
Call Option:
A call Option gives the holder the right but not the obligation to buy an asset by a certain date for a
certain price. It is brought by an investor when he seems that the stock price moves upwards.
28
Put Option:
A put option gives the holder the right but not the obligation to sell an asset by a certain date for a
certain price. It is bought by an investor when he seems that the stock price moves downwards.
3. On the basis of exercise of option:
On the basis of the exercise of the Option, the options are classified into two Categories.
American Option:
American options are options that can be exercised at any time up to the expiration date. Most
exchange –traded options are American.
European Option:
European options are options that can be exercised only on the expiration date itself. European
options are easier to analyse than American options, and properties of an American option are
frequently deduced from those of its European counterpart.
29
OTM
LOSS
S
P E2
R PROFIT
ITM
ATM E1
PAY-OFF PROFILE FOR BUYER OF A CALL OPTION
The Pay-off of a buyer options depends on a spot price of an underlying asset. The following graph
shows the pay-off of buyers of a call option.
Figure 3.4
S = Strike price ITM = In the Money
Sp = premium/loss ATM = At the Money
E1 = Spot price 1 OTM = Out of the Money
E2 = Spot price 2
SR = Profit at spot price E1
30
ITM
PROFIT
E1
P
S
ATM
E2
OTM
R
LOSS
CASE 1: (Spot Price > Strike price)
As the Spot price (E1) of the underlying asset is more than strike price (S).
The buyer gets profit of (SR), if price increases more than E1 then profit also increase more than (SR)
CASE 2: (Spot Price < Strike Price)
As a spot price (E2) of the underlying asset is less than strike price (S)
The buyer gets loss of (SP); if price goes down less than E2 then also his loss is limited to his
premium (SP)
PAY-OFF PROFILE FOR SELLER OF A CALL OPTION
The pay-off of seller of the call option depends on the spot price of the underlying asset. The
following graph shows the pay-off of seller of a call option:
Figure 3.5
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S = Strike price ITM = In the Money
SP = Premium / profit ATM = At The money
E1 = Spot Price 1 OTM = Out of the Money
E2 = Spot Price 2
SR = loss at spot price E2
CASE 1: (Spot price < Strike price) As the spot price (E1) of the underlying is less than strike price
(S). The seller gets the profit of (SP), if the price decreases less than E1 then also profit of the seller
does not exceed (SP).
CASE 2: (Spot price > Strike price)
As the spot price (E2) of the underlying asset is more than strike price (S) the Seller gets loss of (SR),
if price goes more than E2 then the loss of the seller also increase more than (SR).
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PROFIT
ITM
R
E1 ATM
P LOSS
OTM
E2S
PAY-OFF PROFILE FOR BUYER OF A PUT OPTION
The Pay-off of the buyer of the option depends on the spot price of the underlying asset. The
following graph shows the pay-off of the buyer of a call option.
Figure 3.6
S = Strike price ITM = In the Money
SP = Premium / loss ATM = At the Money
E1 = Spot price 1 OTM = Out of the Money
E2 = Spot price 2
SR = Profit at spot price E1
CASE 1: (Spot price < Strike price)
As the spot price (E1) of the underlying asset is less than strike price (S). The buyer gets the profit
(SR), if price decreases less than E1 then profit also increases more than (SR).
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LOSS
OTM
R
S
E1
P
PROFIT
ITM
ATM
E
2
CASE 2: (Spot price > Strike price)
As the spot price (E2) of the underlying asset is more than strike price (S),
The buyer gets loss of (SP), if price goes more than E2 than the loss of the buyer is limited to his
premium (SP).
PAY-OFF PROFILE FOR SELLER OF A PUT OPTION
The pay-off of a seller of the option depends on the spot price of the underlying asset. The following
graph shows the pay-off of seller of a put option.
Figure 3.7
S = Strike price ITM = In the Money
SP = Premium/profit ATM = At the Money
E1 = Spot price 1 OTM = Out of the Money
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E2 = Spot price 2
SR = Loss at spot price E1
CASE 1: (Spot price < Strike price)
As the spot price (E1) of the underlying asset is less than strike price (S), the seller gets the loss of
(SR), if price decreases less than E1 than the loss also increases more than (SR).
CASE 2: (Spot price > Strike price)
As the spot price (E2) of the underlying asset is more than strike price (S), the seller gets profit of
(SP), of price goes more than E2 than the profit of seller is limited to his premium (SP).
FACTORS AFFECTING THE PRICE OF AN OPTION
The following are the various factors that affect the price of an option they are:
Stock Price:
The pay-off from a call option is an amount by which the stock price exceeds the strike price.
Call options therefore become more valuable as the stock price increases and vice versa. The pay-off
from a put option is the amount; by which the strike price exceeds the stock price. Put options
therefore become more valuable as the stock price increases and vice versa.
Strike price:
In case of a call, as a strike price increases, the stock price has to make a larger upward move
for the option to go in-the –money. Therefore, for a call, as the strike price increases option becomes
less valuable and as strike price decreases, option become more valuable
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Time to expiration:
Both put and call American options become more valuable as a time to expiration increases.
Volatility:
The volatility of a stock price is measured of uncertain about future stock price movements.
As volatility increases the chance that the stock will do very well or very poor increases. The value
of both calls and puts therefore increases as volatility increase.
Risk- free interest rate:
The put option prices decline as the risk-free rate increases where as the price of call always
increases as the risk-free interest rate increases.
Dividends:
Dividends have the effect of reducing the stock price on the X- dividend rate. This has a
negative effect on the value of call options and a positive effect on the value of put options.
OPTIONS TERMINOLOGY
Option price/premium:
Option price is the price which the option buyer pays to the option seller. It is also referred to
as the option premium.
Expiration date:
The date specified in the options contract is known as the expiration date, the exercise date,
the strike date or the maturity.
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Strike price:
The price specified in the option contract is known as the strike price or the exercise price.
Intrinsic value and time value for calls:
In the case of a call, intrinsic value is the amount by which the underlying futures price
exceeds the strike price:
Futures Price – Strike Price = Intrinsic Value
(must be positive or 0)
Example: June CME Live Cattle futures are trading at 82.50 cents/lb. and the June 80 CME Live
Cattle call option is trading at 3.50 cents/lb. What are the time value and intrinsic value components
of the premium?
Futures Price – Strike Price = Intrinsic Value
82.50 – 80.00 = 2.50
Time value represents the amount option traders are willing to pay over intrinsic value, given the
amount of time left to expiration for the futures to advance in the case of
calls, or decline in the case of puts.
Options Premium – Intrinsic Value = Time Value
3.50 – 2.50 = 1.00
Time Value + Intrinsic Value = Premium
1.00 + 2.50 = 3.50
Intrinsic value and time value for puts:
In the case of a put, intrinsic value is the amount by which the underlying futures price is below the
strike price:
Intrinsic Value = Strike Price – Futures Price (must be positive or 0)
Time Value = Put Option Premium – Intrinsic Value
Put Option Premium = Put Time Value + Put Intrinsic Value
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Example: What are the time value and intrinsic value of a CME Eurodollar 95.00 put if the
underlying futures are trading at 94.98 and the option premium is 0.03?
Strike Price – Futures Price = Intrinsic Value
95.00 – 94.98 = 0.02
There are 0.02 points of intrinsic value.
Options Premium – Intrinsic Value = Time Value
0.03 – 0.02 = 0.01
2.5 ELIGIBILITY CRITERIA FOR SECURITIES/INDICES TRADED IN F&O
Eligibility criteria of stocks
1. The stock is chosen from amongst the top 500 stocks in terms of average daily market
capitalization and average daily traded value in 206 the previous six months on a rolling
basis.
2. The stock's median quarter-sigma order size over the last six months should be not less than
Rs. 1 lakh. For this purpose, a stock's quarter sigma order size should mean the order size (in
value terms) required to cause a change in the stock price equal to one-quarter of a standard
deviation.
3. The market wide position limit in the stock should not be less than Rs.50 crore. The market
wide position limit (number of shares) is valued taking the closing prices of stocks in the
underlying cash market on the date of expiry of contract in the month. The market wide
position limit of open position (in terms of the number of underlying stock) on futures and
option contracts on a particular underlying stock should be lower of:- 20% of the number of
shares held by non-promoters in the relevant underlying security i.e. free-float holding.
4. If an existing security fails to meet the eligibility criteria for three months consecutively then
no fresh month contract will be issued on that security.
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5. However, the existing unexpired contracts can be permitted to trade till expiry and new
strikes can also be introduced in the existing contract months.
6. For unlisted companies coming out with initial public offering, if the net public offer is
Rs.500 crores or more, then the exchange may consider introducing stock options and stock
futures on such stocks at the time of its listing in the cash market.
Eligibility criteria of indices
The exchange may consider introducing derivative contracts on an index if the stocks
contributing to 80% weightage of the index are individually eligible for derivative trading. However,
no single ineligible stocks in the index should have a weightage of more than 5% in the index. The
above criteria is applied every month, if the index fails to meet the eligibility criteria for three
months consecutively, then no fresh month contract would be issued on that index, However, the
existing unexpired contacts will be permitted to trade till expiry and new strikes can also be
introduced in the existing contracts.
2.6 TRADING MECHANISM OF FUTURES AND OPTIONS
The futures and options trading system of NSE, called NEAT-F&O trading system, provides
a fully automated screen-based trading for Index futures &options and Stock futures & options on a
nationwide basis and an online monitoring and surveillance mechanism. It supports an anonymous
order driven market which provides complete transparency of trading operations and operates on
strict 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, 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 Immediate or Cancel, Limit/Market price, Stop loss, etc. can be built into an order.
The Clearing Members (CM) use the trader workstation for the purpose of monitoring the trading
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member(s) for whom they clear the trades. Additionally, they can enter and set limits to positions,
which a trading member can take.
PRICING FUTURES
Forwards/ futures contract are priced using the cost of carry model. The cost of carry
model calculates the fair value of futures contract based on the current spot price of the underlying
asset. The formula used for pricing futures is given below:
F = SerT
Where :
F = Futures Price
S = Spot price of the underlying asset
R = Cost of financing (using a continuously compounded interest rate)
T = Time till expiration in years
E = 2.71828 (The base of natural logarithms)
Example: Security of ABB Ltd trades in the spot market at Rs. 850. Money can be invested at
11% per annum.
The fair value of a one-month futures contract on ABB is calculated as
follows:
850 * 12 857.80
1
0.1 1
F = SerT = e
The presence of arbitrageurs would force the price to equal the fair value of the asset. If the futures
price is less than the fair value, one can profit by holding a long position in the futures and a short
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position in the underlying. Alternatively, if the futures price is more than the fair value, there is a
scope to make a profit by holding a short position in the futures and a long position in the
underlying. The increase in demand/ supply of the futures (and spot) contracts will force the futures
price to equal the fair value of the asset.
PRICING OPTIONS
Our brief treatment of options in this module initially looks at pay-off diagrams, which chart
the price of the option with changes in the price of the underlying and then describes how call and
option prices are related using put-call parity. We then briefly describe the celebrated Black-Scholes
formula to price a European option.
Payoffs from an option contract refer to the value of the option contract for the parties (buyer and
seller) on the date the option is exercised. For the sake of simplicity, we do not consider the initial
premium amount while calculating the option payoffs. In case of call options, the option buyer would
exercise the option only if the market price on the date of exercise is more than the strike price of the
option contract. Otherwise, the option is worthless since it will expire without being exercised.
Similarly, a put option buyer would exercise her right if the market price is lower than the exercise
price.
The payoff of a call option buyer at expiration is:
Max [(Market price of the share – Exercise Price), 0]
The following figures shows the payoff diagram for call options buyer and seller (assumed
exercise price is 100)
The payoff for a buyer of a put option at expiration is:
Max [(Exercise price –Market price of the share), 0]
The payoff diagram for put options buyer and seller (assumed exercise price is 100)
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2.7 STEPS INVOVED IN F & O TRADING PROCESS
1. PLACING THE ORDER
For placing an order, if it’s a buy order press F11 and to place a sell order press
F12.
The following details have to be entered to place a buy / sell order
Client id every client have an unique ID which has to be entered before placing an order.
Quantity of the order
OPTIDX / OPTSTK select the suitable option, whether to trade on index or stock
options.
MARKET/LIMIT
INDEX choose the index under which you want to trade
Trigger price its a stop loss order beyond at which loss is not bearable. An order placed
with a broker to buy or sell at a specified price (or better) after a given stop price has been
reached or passed.
Disc qty the quantity of the order can be disclosed
Strike price the price specified in the options contract is known as the strike price or the
exercise price.
DAY/IOC it’s an order
CALL/PUT
2. ORDER CONFORMATION
It’s a confirmation from the exchange that the orders have been executed. It gives
the information about online order reference number, exchange order number, trade number,
quantity of the order and the client id.
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3. DOCUMENTS SUBMITED TO THE CLIENT
CONTRACT NOTE
At the end of the day digital contract note is sent to each and every client regarding the
details about the each and every transaction done on that specific day, the brokerage
amount and taxes levied.
CLIENT LEDGER
It gives the details of the client’s debts and credits.
4. CLIENT SUPPORT
5. COMPLIANCE POLICY
CALLS RECORD: Every order placed through telephone is recorded
CONFIRMATION OF ORDERS: Every order which is executed will be intimated to
the client
SIGNATURES of walking clients have to be verified every time
6. RISK MANAGEMENT SYSTEM (RMS): It specifies the initial margin requirements for
each futures and options contract on a daily basis
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CHAPTER-3
COMPANY PROFILE
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INTRODUCTION
Indiabulls Group is one of the top business houses in the country with business interests in
Real Estate, Infrastructure, and Financial Services, Retail, Multiplex and Power sectors. Indiabulls
Group companies are listed in Indian and overseas financial markets. The Net worth of the Group
exceeds USD 3 billion. Indiabulls has been conferred the status of a “Business Super brand” by The
Brand Council, Super brands India.
Indiabulls Financial Services is an integrated financial services powerhouse providing
Consumer Finance, Housing Finance, Commercial Loans, Life Insurance, Asset Management and