sharekhan

It is not important whether you are right or wrong, but how much money you make when you are right & how much money you lose when you are wrong is important.George Soros

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TABLE OF CONTENTSy y y y y y

Certificate Acknowledgement Executive Summary Objective of the Study Methodology Job Description

Chapter 1. Introduction of Sharekhan Limited

About Sharekhan Limited Sharekhan Limiteds Management Team Products and Services of Sharekhan Limited Types of account in Sharekhan Limited How to open an account with Sharekhan Limited? Research section in Sharekhan Limited Awards and Achievements

Chapter 2. Introduction to Derivatives

Derivatives defined Emergence of Derivatives History of Derivatives Global Derivative Markets Derivatives Market in India Participants and Functions Types of Derivative Instruments Derivative Market at NSE Approval for Derivative Trading Clearing and Settlements Index Derivatives Trading Order type and Condition SEBI Advisory Committee on Derivative

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Chapter 3. Introduction to Futures and Options

Forward Contracts Future Contracts Options Payoffs for Derivative Contracts

Chapter 4. Hedging, Arbitrage and Speculation Strategies Hedging Strategies with examples Arbitrage Strategies with examples Speculation Strategies with examples Chapter 5. Applicability of Derivative Instruments

Risk Management: Concept and Definition Risk Management with Future Contract Risk Management with Options Introduction to Option Strategies

Chapter 6. Achievements in Futures and Options Segment Comparative Analysis of F&O Segment with Cash Segment NSE Position Top 5 Traded Symbols Chapter 7. Conclusion Chapter 8. Suggestions and Recommendations Chapter 9. The Reference Material Glossary Bibliography

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EXECUTIVE SUMMARYConceptually the mechanism of stock market is very simple. People who are exposed to the same risk come together and agree that if anyone of the person suffers a loss the other will share the loss and make good to the person who lost. The initial part of the project focuses on the job and responsibilities I was allotted as a summer trainee. It also makes the readers aware about the techniques and methodology used to bring this report alive. It also describe about the objective of this study. It also enlightens the readers about Sharekhan Limiteds strategies to acquire new customers. Further the project tells us about the profile of the company (Sharekhan Ltd.). It provides knowledge to the readers regarding the companys history, mission, vision, customer base and the reasons to be associated with the company. Also it gives special emphasis on the selling of products and management of the company. The next few chapters are devoted to the study of the Derivative Market and Derivative Instruments in a very basic way. It also suggests some of the strategies that can be applied to earn more even when the market is too much

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volatile. The readers can also find the comparative analysis of the Derivative Market and the Cash Market in the Indian context. The next part of the project throws light upon my findings and analysis about the company and the suggestions for the company for better performance.

OBJECTIVE OF THE STUDYTo find out whether the Derivative Instruments are applicable in the Indian Stock Market which can work both in good and bad times so that it can minimize our risk and maximize our returns. As a result one can have conviction in his portfolio in the hugely volatile stock market because a difficult and serious problem for all investors today is that there is entirely too much free information, hype, promotion, personal opinion, and advice about derivative instruments are there in stock market. One get it from friends, relatives, people at work, the Internet, brokers, stock analysts, advisers, entertaining cable TV market programs, and other media. It can be very risky and potentially dangerous. Realistically, there are not too many people one can listen to if he want to avoid confusing, contradictory, and faulty personal market opinions. So one need to confine himself to just a very few sources of relevant facts and data and a sound system that has proven to be accurate and profitable over time. Therefore, the objective of the Dissertation is to do in depth research on these derivative instruments.

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METHODOLOGYDuring this project, I have analyzed the Futures and Options. I have tried to analyze the instruments as per the Market Participant and the Market Trend. Initially, I have given a brief introduction about the instruments, so that the reader is aware of basics of the subject. I have tried to identify various terms related to derivative trading, for which I have introduced a separate chapter, Terms related to derivative market Then I have tried to segregate the use of Instruments as per the Market Participants and Market Trend. I identified hedging, arbitrage and speculation strategies using both futures and options, and then segregated them into a chapter each. Segregation involved a thorough study of the strategies and possible use. Then I have done a secondary data based study on growth of Indian Derivative Market, which includes the comparison of derivative market with cash market, data regarding the traded volume and number of contracts traded from December 2007 till May 2008. I have also analyzed the top five most traded symbols in futures and options segment.

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JOB DESCRIPTIONThe company placed me as a Summer Trainee. I have been handling the Following responsibilities: My job profile was to sale the products of the organization. My job profile was to coordinate the team and also help them to sale the product and also help them in field. My job profile was to generate the leads by cold calling. My job profile was to understand customers needs and advising them to make a portfolio as per their investment. My job profile was to do sales promotion through e-mails, canopies, making cold calling, distributing pamphlets and etc.

AREA ASSIGNED

I covered areas like Delhi, Gurgaon, Ghaziabad, Faridabad and NCR.

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TARGET ASSIGNED y

To sell 18 accounts per month.

TARGET MARKET

Different properties dealers. Charted accountants. Lawyers Travel agencies Transport business House wives Businessmen Corporate Employees etc.

DAY TO DAY JOB DESCRIPTION y y y y y y

Reporting time: 9.30 AM Fixing appointment with clients. Visit clients place. Demonstrate the product on Internet to the client. Completing the formalities like filling the application form and documentation. Cold calling.

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Chapter 1

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Introduction of Sharekhan ltd.

INTRODUCTION OF SHAREKHAN LTD.ABOUT SHAREKHAN LIMITEDSharekhan Ltd. is one of the leading retail stock broking house of SSKI Group which is running successfully since 1922 in the country. It is the retail broking arm of the Mumbai-based SSKI Group, which has over eight decades of experience in the stock broking business. Sharekhan offers its customers a wide range of equity related services including trade execution on BSE, NSE, Derivatives, depository services, online trading, investment advice etc.

The firms online trading and investment site - www.sharekhan.com - was launched on Feb 8, 2000. The site gives access to superior content and transaction facility to retail customers across the country. Known for its10

jargon-free, investor friendly language and high quality research, the site has a registered base of over one lakh customers. The content-rich and research oriented portal has stood out among its contemporaries because of its steadfast dedication to offering customers best-of-breed technology and superior market information. The objective has been to let customers make informed decisions and to simplify the process of investing in stocks. On April 17, 2002 Sharekhan launched Speed Trade, a net-based executable application that emulates the broker terminals along with host of other information relevant to the Day Traders. This was for the first time that a netbased trading station of this caliber was offered to the traders. In the last six months Speed Trade has become a de facto standard for the Day Trading community over the net. Sharekhans ground network includes over 640 centers in 280 cities in India which provide a host of trading related services. Sharekhan has always believed in investing in technology to build its business. The company has used some of the best-known names in the IT industry, like Sun Microsystems, Oracle, Microsoft, Cambridge Technologies, Nexgenix, Vignette, Verisign Financial Technologies India Ltd, Spider Software Pvt Ltd. to build its trading engine and content. The Morakhiya family holds a majority stake in the company. HSBC, Intel & Carlyle are the other investors. With a legacy of more than 80 years in the stock markets, the SSKI group ventured into institutional broking and corporate finance 18 years ago. Presently SSKI is one of the leading players in institutional broking and corporate finance activities. SSKI holds a sizeable portion of the market in each of these segments. SSKIs institutional broking arm accounts for 7% of the market for Foreign Institutional portfolio investment and 5% of all Domestic Institutional portfolio investment in the country. It has 60 institutional clients spread over India, Far East, UK and US. Foreign Institutional Investors generate about 65% of the organizations revenue, with a daily turnover of over US$ 2 million. The Corporate Finance section has a list of very prestigious clients and has many firsts to its credit, in terms of the size of deal, sector tapped etc. The group has placed over US$ 1 billion in private equity deals. Some of the clients include BPL Cellular Holding, Gujarat Pipavav, Essar, Hutchison, Planetasia, and Shoppers Stop.

PROFILE OF THE COMPANY11

Name of the company: Year of Establishment: Headquarter :

Sharekhan ltd. 1925 ShareKhan SSKI A-206 Phoenix House Phoenix Mills Compound Lower Parel Mumbai - Maharashtra, INDIA- 400013 Service Provider Depository Services, Online Services and Technical Research. Over 3500 Data Not Available www.sharekhan.com Your Guide to The Financial Jungle.

Nature of Business Services

: :

Number of Employees : Revenue Website Slogan : : :

VisionTo be the best retail brokering Brand in the retail business of stock market.

MissionTo educate and empower the individual investor to make better investment decisions through quality advice and superior service.

Sharekhan is infact Among the top 3 branded retail service providers No. 1 player in online business Largest network of branded broking outlets in the country serving more than 7,00,000 clients.

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REASON TO CHOOSE SHAREKHAN LIMITED

Experience

SSKI has more than eight decades of trust and credibility in the Indian stock market. In the Asia Money broker's poll held recently, SSKI won the 'India's Best Broking House for 2004' award. Ever since it launched Sharekhan as its retail broking division in February 2000, it has been providing institutionallevel research and broking services to individual investors.Technology

With its online trading account one can buy and sell shares in an instant from any PC with an internet connection. One can get access to its powerful online trading tools that will help him take complete control over his investment in shares.Accessibility

Sharekhan provides ADVICE, EDUCATION, TOOLS AND EXECUTION services for investors. These services are accessible through its centers across the country over the internet (through the website www.sharekhan.com) as well as over the Voice Tool.Knowledge

In a business where the right information at the right time can translate into direct profits, one can get access to a wide range of information on Sharekhan limiteds content-rich portal. One can also get a useful set of knowledge-based tools that will empower him to take informed decisions.Convenience

One can call its Dial-N-Trade number to get investment advice and execute his transactions. Sharekhan ltd. have a dedicated call-centre to provide this service via a Toll Free Number 1800-22-7500 & 1800-22-7050 from anywhere in India.Customer Service

Sharekhan limiteds customer service team will assist one for any help that one may require relating to transactions, billing, demat and other queries. Its13

customer service can be contacted via a toll-free number, email or live chat on www.sharekhan.com.Investment Advice

Sharekhan has dedicated research teams of more than 30 people for fundamental and technical researches. Its analysts constantly track the pulse of the market and provide timely investment advice to its clients in the form of daily research emails, online chat, printed reports and SMS on their mobile phone.

SHAREKHAN LIMITEDS MANAGEMENT TEAM Dinesh Murikya Tarun Shah Shankar Vailaya : : : : : : : Owner of the company CEO of the company Director (Operations) Director (Products & Technology) Head of Research Vice President of Equity Derivatives Vice President of Research

Jaideep Arora Pathik Gandotra Rishi Kohli Nikhil Vora

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PRODUCTS AND SERVICES OF SHAREKHAN LIMITEDThe different types of products and services offered by Sharekhan Ltd. are as follows:y y y y y y y y y

Equity and derivatives trading Depository services Online services Commodities trading Dial-n-trade Portfolio management Share shops Fundamental research Technical research

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TYPES OF ACCOUNT IN SHAREKHAN LIMITEDSharekhan offers two types of trading account for its clints Classic Account (which include a feature known as Fast Trade Advanced

Classic Account for the online users) and Speed Trade Account

CLASSIC ACCOUNTThis is a User Friendly Product which allows the client to trade through website www.sharekhan.com and is suitable for the retail investor who is risk-averse and hence prefers to invest in stocks or who does not trade too frequently. This account allow investors to buy and sell stocks online along with the following features like multiple watch lists, Integrated

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Banking, Demat and digital contracts, Real-time portfolio tracking with price alerts and Instant credit & transfer. This account comes with the following features: a. Online trading account for investing in Equities and Derivatives b. Free trading through Phone (Dial-n-Trade) I. Two dedicated numbers(1800-22-7500 and 39707500) for placing the orders using cell phones or landline phones II. Automatic funds transfer with phone banking facilities (for Citibank and HDFC bank customers) III. Simple and Secure Interactive Voice Response based system for authentication IV. get the trusted, professional advice of Sharekhan limiteds Tele Brokers V. After hours order placement facility between 8.00 am and 9.30 am c. Integration of: Online Trading +Saving Bank + Demat Account. d. Instant cash transfer facility against purchase & sale of shares. e. IPO investments. f. Instant order and trade confirmations by e-mail. g. Single screen interface for cash and derivatives.

SPEED TRADE ACCOUNTThis is an internet-based software application, which enables one to buy and sell in an instant. It is ideal for active traders and jobbers who transact frequently during days session to capitalize on intra-day price movement. This account comes with the following features: a. b. c. d. e. f. g. Instant order Execution and Confirmation. Single screen trading terminal for NSE Cash, NSE F&O & BSE. Technical Studies. Multiple Charting. Real-time streaming quotes, tic-by-tic charts. Market summary (Cost traded scrip, highest value etc.) Hot keys similar to brokers terminal.17

h. Alerts and reminders. i. Back-up facility to place trades on Direct Phone lines. j. Live market debts.

CHARGE STRUCTUREFee structure for General Individual:Charge Account Opening Classic Account Rs. 750/= Speed Trade Account Rs. 1000/=

Intra-day 0.10 %Brokerage

Intra-day - 0.10% Delivery - 0.50%

Delivery - 0.50 % Depository Charges:Account Opening Charges Annual Maintenance Charges

Rs. NIL Rs. NIL first year Rs. 300/= p.a. from second calendar year onward

HOW TO OPEN AN ACCOUNT WITH SHARE KHAN LIMITED?For online trading with Sharekhan Ltd., investor has to open an account. Following are the ways to open an account with Sharekhan Ltd.:y

One need to call them at phone number provided below and asks that he want to open an account with them. a. One can call on the Toll Free Number: 1-800-22-7500 to speak to a Customer Service executive b. Or If one stays in Mumbai, he can call on 022-66621111 One can visit any one of Sharekhan Limiteds nearest branches. Sharekhan has a huge network all over India (640 centers in 280 cities). One can also log on to http://sharekhan.com/Locateus.aspx link to find out the nearest branch.

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One can send them an email at [email protected] to know about their products and services. One can also visit the site www.sharekhan.com and click on the option Open an Account to fill a small query form which will ask the individual to give details regarding his name, city he lives in, his email address, phone number, pin code of the city, his nearest Sharekhan Ltd. shop and his preferences regarding the type of account he wants. These information are compiled in the headquarter of the company that is in Mumbai from where it is distributed through out the countrys branches in the form of leads on the basis of cities and nearest share shops. After that the executives of the respective branches contact the prospective clients over phone or through email and give them information regarding the various types of accounts and the documents they need to open an account and then fix appointment with the prospective clients to give them demonstration and making them undergo the formalities to open the account. After that the forms that has collected from the clients, is scrutinized in the branch and then it is sent to Mumbai for further processing where after a few days the clients account are generated and activated. After the accounts are activated, a Welcome Kit is dispatched from Mumbai to the clients address mentioned in the documents provided by them. As soon as the clients receive the Welcome Kit, which contains the clients Trading ID and Trading Password, they can start trading and investing in shares.

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Generally the process of opening an account follows the following steps:LEAD MANAGEMENT SYSTEM (LMS) / REFERENCES CONTACT THE PERSON OVER PHONE OR THROUGH EMAIL

FIXING AN APPOINTMENT WITH THE PERSON

GIVING DEMONSTRATION

YES

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NO

DOCUMENTATION

FILLING UP THE FORM

SUBMISSION OF THE FORM

LOGIN OF THE FORM

SENDING ACCOUNT OPENING KIT TO THE CLIENT

TRADING

Apart from two passport size photographs, one needs to provide with the following documents in order to open an account with Sharekhan Limited.:y y

Photocopy of the clients PAN Card which should be duly attached Photo copy of any of the following documents duly attached which will serve as correspondence address proof: a. b. c. d. e. Passport (valid) Voters ID Card Ration Card Driving License (valid) Electricity Bill (should be latest and should be in the name of the client) f. Telephone Bill (should be latest and should be in the name of the client) g. Flat Maintenance Bill (should be latest and should be in the name of the client)20

h. Insurance Policy (should be latest and should be in the name of the client) i. Lease or Rent Agreement. j. Saving Bank Statement** (should be latest)y

Two cheques drawn in favour of Sharkhan Limited, one for the Account Opening Fees and the other for the Margin Money (the minimum margin money is Rs. 5000).

** A cancelled cheque should be given by the client if he provides Saving Bank Statement as a proof for correspondence address. NOTE: Only Saving Bank Account cheques are accepted for the purpose of Opening an account.

RESEARCH SECTION IN SHAREKHAN LIMITEDSharekhan Limited has its own in-house Research Organisation which is known as Valueline. It comprises a team of experts who constantly keep an eye on the share market and do research on the various aspects of the share market. Generally the research is based on the Fundamentals and Technical analysis of different companies and also taking into account various factors relating to the economy. Sharekhan Limiteds research on the volatile market has been found accurate most of the time. Sharekhan's trading calls in the month of November 2007 has given 89% strike rate. Out of 37 trading calls given by Sharekhan in the month of November 2007, 33 hit the profit target. These exclusive trading picks come only to Sharekhan Online Trading Customer and are based on in-depth technical analysis. As a customer of Sharekhan Limited, one receives daily 5-6 Research Reports on their emails which they can use as tips for investing in the market. These reports are named as Pre-Market Report, Eagle Eye, High Noon, Investors Eye,21

Daring Derivatives and Post-Market Report. Apart from these, Sharekhan Limited issues a monthly subscription by the name of Valueline which is easily available in the market.

AWARDS AND ACHIEVEMENTSy

SSKI has been voted as the Top Domestic Brokerage House in the research category, twice by Euromoney Survey and four times by Asiamoney Survey. Sharekhan Limited won the CNBC AWARD for the year 2004.

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Introduction to Derivatives

INTRODUCTION TO DERIVATIVESThe 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 lockingin asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by lockingin asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors.

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DERIVATIVES DEFINEDDerivative 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 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 simple word it can be said that Derivatives are financial contracts whose value/price is dependent on the behavior of the price of one or more basic underlying assets (often simply known as underlying). These contracts are legally binding agreements, made on the trading screen of stock exchanges, to buy or sell an asset in future. The asset can be a share, index, interest rate, bond, rupee dollar exchange rate, sugar, crude oil, soybean, cotton, coffee, etc. In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R) A) defines derivative to include 1. 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. 2. A contract which derives its value from the prices, or index of prices, of underlying securities. A very simple example of derivatives is curd, which is derivative of milk. The price of curd depends upon the price of milk which in turn depends upon the demand and supply of milk.

EMERGENCE OF DERIVATIVESDerivative 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, their25

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. The lower costs associated with index derivatives visavis derivative products based on individual securities is another reason for their growing use.

HISTORY OF DERIVATIVESEarly 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 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. During the mid eighties, financial futures became the most active derivative instruments generating volumes many times more than the commodity futures. 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, Eurex etc.

GLOBAL DERIVATIVE MARKETSThe derivatives markets have grown manifold in the last two decades.. According to the Bank for International Settlements (BIS), the approximate size of global derivatives market was US$ 109.5 trillion as at endDecember 2000. The total estimated notional amount of outstanding overthecounter (OTC) contracts26

stood at US$ 95.2 trillion as at endDecember 2000, an increase of 7.9% over endDecember 1999. Growth in OTC derivatives market is mainly attributable to the continued rapid expansion of interest rate contracts, which reflected growing corporate bond markets and increased interest rate uncertainty at the end of 2000. The amount outstanding in organized exchange markets increased by 5.8% from US$ 13.5 trillion as at end December 1999 to US$ 14.3 trillion as at endDecember 2000. The turnover data are available only for exchangetraded derivatives contracts. The turnover in derivative contracts traded on exchanges has increased by 9.8% during 2000 to US$ 384 trillion as compared to US$ 350 trillion in 1999(Table 1.2). While interest rate futures and options accounted for nearly 90% of total turnover during 2000, the popularity of stock market index futures and options grew modestly during the year. According to BIS, the turnover in exchange traded derivative markets rose by a record amount in the first quarter of 2001, while there was some moderation in the OTC volumes.

DERIVATIVE MARKET IN INDIAThe 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 24member 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 preconditions 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 realtime monitoring requirements.

The SCRA was amended in December 1999 to include derivatives within the ambit of securities and the regulatory framework was developed for governing27

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 threedecade 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 BSE30 (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.

The derivatives trading on the exchange commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 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.

PARTICITANTS AND FUNCTIONSPARTICIPANTSDerivative contracts have several variants. The most common variants are forwards, futures, options and swaps. The following three broad categories of participants

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Hedgers: - Hedgers face risk associated with the price of an asset. They use futures or options markets to reduce or eliminate this risk Speculators: - Speculators wish to bet on future movements in the price of an asset. Futures and options contracts can give them an extra leverage; that is, they can increase both the potential gains and potential losses in a speculative venture. Arbitrageurs: - Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit.

FUNCTIONSThe derivatives market performs a number of economic functions. 1. Prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract.

2. The derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them. 3. Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk. 4. Speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kind of mixed markets.

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5. An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefit of which are immense. 6. Derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity.

TYPES OF DERIVATIVE INSTRUMENTSForwards: A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at todays preagreed 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 Securities. These are options having a maturity of up to three years. 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:

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a. Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency. b.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.

DERIVATIVE MARKET AT NSEThe derivatives trading on the exchange commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 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.

APPROVAL FOR DERIVATIVE TRADINGTRADING MECHANISMThe futures and options trading system of NSE, called NEAT-F&O trading system, provides a fully automated screenbased trading for Nifty futures & options and stock futures & options on a nationwide basis and an online monitoring and surveillance mechanism. It supports an anonymous order driven market which provides complete transparency of trading operations and operates on strict pricetime priority. It is similar to that of trading of equities in the Cash Market (CM) segment. The NEAT-F&O trading system is accessed by two types of users. The Trading Members(TM) have access to functions such as order entry, order matching, and order and trade management. It provides tremendous flexibility31

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 CRITERIANSE admits members on its derivatives segment in accordance with the rules and regulations of the exchange and the norms specified by SEBI. NSE follows 2tier membership structure stipulated by SEBI to enable wider participation. Those interested in taking membership on F&O segment are required to take membership of CM and F&O segment or CM, WDM and F&O segment. Trading and clearing members are admitted separately. Essentially, a clearing member (CM) does clearing for all his trading members (TMs), undertakes risk management and performs actual settlement. There are three types of CMs:Self Clearing Member: A SCM clears and settles trades executed by him only either on his own account or on account of his clients. y Trading Member Clearing Member: TMCM is a CM who is also a TM. TMCM may clear and settle his own proprietary trades and clients trades as well as clear and settle for other TMs. y 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. The TMCM and the PCM are required to bring in additional security deposit in respect of every TM whose trades they undertake to clear and settle. Besides this, trading members are required to have qualified users and sales persons, who have passed a Certification programme approved by SEBI. y

CLEARING AND SETTLEMENTSNSCCL 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.Clearing:

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The first step in clearing process is working out open positions or obligations of members. A CMs open position is arrived at by aggregating the open position of all the TMs and all custodial participants clearing through him, in the contracts in which they have traded. A TMs open position is arrived at as the summation of his proprietary open position and clients open positions, in the contracts in which they have traded. 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 CMs are required to open a separate bank account with NSCCL designated clearing banks for F&O segment.

INDEX DERIVATIVESIndex derivatives are derivative contracts which derive their value from an underlying index. The two most popular index derivatives are index futures and index options. Index derivatives have become very popular worldwide. In his report, Dr.L.C.Gupta attributes the popularity of index derivatives to the advantages they offer.y

y

Institutional and large equity-holders need portfolio-hedging facility. Indexderivatives are more suited to them and more costeffective than derivatives based on individual stocks. Pension funds in the US are known to use stock index futures for risk hedging purposes. Index derivatives offer ease of use for hedging any portfolio irrespective of its composition.

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y

y

y

Stock index is difficult to manipulate as compared to individual stock prices, more so in India, and the possibility of cornering is reduced. This is partly because an individual stock has a limited supply, which can be cornered. Stock index, being an average, is much less volatile than individual stock prices. This implies much lower capital adequacy and margin requirements. Index derivatives are cash settled, and hence do not suffer from settlement delays and problems related to bad delivery, forged/fake certificates.

Requirements for an index derivatives market1. Index: The choice of an index is an important factor in determining the extent to which the index derivative can be used for hedging, speculation and arbitrage. A well diversified, liquid index ensures that hedgers and speculators will not be vulnerable to individual or industry risk. 2. Clearing corporation settlement guarantee: The clearing corporation eliminates counterparty risk on futures markets. The clearing corporation interposes itself into every transaction, buying from the seller and selling to the buyer. This insulates a participant from credit risk of another. 3. Strong surveillance mechanism: Derivatives trading brings a whole class of leveraged positions in the economy. Hence the need to have strong surveillance on the market both at the exchange level as well as at the regulator level. 4. Education and certification: The need for education and certification in the derivatives market can never be overemphasized. A critical element of financial sector reforms is the development of a pool of human resources with strong skills and expertise to provide quality intermediation to market participants. With the entire above infrastructure in place, trading of index futures and index options commenced at NSE in June 2000 and June 2001 respectively.

TRADINGHere, I shall take a brief look at the trading system for NSEs futures and options market. However, the best way to get a feel of the trading system is to actually watch the screen and observe how it operates.34

Futures and options trading systemThe futures & 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 as well as an online monitoring and surveillance mechanism. It supports an order driven market and provides complete transparency of trading operations. It is similar to that of trading of equities in the cash market segment. The software for the F&O market has been developed to facilitate efficient and transparent trading in futures and options instruments. Keeping in view the familiarity of trading members with the current capital market trading system, modifications have been performed in the existing capital market trading system so as to make it suitable for trading futures and options.

Entities in the trading systemThere are four entities in the trading system. Trading members, clearing members, professional clearing members and participants.1. Trading members: Trading members are members of NSE. They can trade either on their own account or on behalf of their clients including participants. The exchange assigns a Trading member ID to each trading member. Each trading member can have more than one user. The number of users allowed for each trading member is notified by the exchange from time to time. Each user of a trading member must be registered with the exchange and is assigned a unique user ID. The unique trading member ID functions as a reference for all orders/trades of different users. This ID is common for all users of a particular trading member. It is the responsibility of the trading member to maintain adequate control over persons having access to the firms User IDs. 2. Clearing members: Clearing members are members of NSCCL. They carry out risk management activities and confirmation/inquiry of trades through the trading system. 3. Professional clearing members: A professional clearing members is a clearing member who is not a trading member. Typically, banks and custodians become professional clearing members and clear and settle for their trading members.

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4. Participants: A participant is a client of trading members like financial institutions. These clients may trade through multiple trading members but settle through a single clearing member.

BASIS OF TRADINGThe NEAT F&O system supports an order driven market, wherein orders match automatically. Order matching is essentially on the basis of security, its price, time and quantity. All quantity fields are in units and price in rupees. The lot size on the futures market is for 200 Nifties. The exchange notifies the regular lot size and tick size for each of the contracts traded on this segment from time to time. When any order enters the trading system, it is an active order. It tries to find a match on the other side of the book. If it finds a match, a trade is generated. If it does not find a match, the order becomes passive and goes and sits in the respective outstanding order book in the system.

ORDER TYPES AND CONDITIONSThe system allows the trading members to enter orders with various conditions attached to them as per their requirements. These conditions are broadly divided into the following categories: y Time conditions y Price conditions y Other conditions Several combinations of the above are allowed thereby providing enormous flexibility to the users. The order types and conditions are summarized below.

Time conditionsy Day order: A day order, as the name suggests is an order which is valid for the day on which it is entered. If the order is not executed during the day, the system cancels the order automatically at the end of the day. Good till canceled (GTC): A GTC order remains in the system until the user cancels it. Consequently, it spans trading days, if not traded on the day the order is entered. The maximum number of days an order can

y

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remain in the system is notified by the exchange from time to time after which the order is automatically cancelled by the system. Each day counted is a calendar day inclusive of holidays. The days counted are inclusive of the day on which the order is placed and the order is cancelled from the system at the end of the day of the expiry period.y Good till days/date (GTD): A GTD order allows the user to specify the number of days/date till which the order should stay in the system if not executed. The maximum days allowed by the system are the same as in GTC order. At the end of this day/date, the order is cancelled from the system. Each day/date counted are inclusive of the day/date on which the order is placed and the order is cancelled from the system at the end of the day/date of the expiry period.

y

Immediate or Cancel(IOC): An IOC order allows the user to buy or sell a contract as soon as the order is released into the system, failing which the order is cancelled from the system. Partial match is possible for the order, and the unmatched portion of the order is cancelled immediately.

Price conditiony Stop loss: This facility allows the user to release an order into the system, after the market price of the security reaches or crosses a threshold price e.g. if for stoploss buy order, the trigger is 1027.00, the limit price is 1030.00 and the market (last traded) price is 1023.00, then this order is released into the system once the market price reaches or exceeds 1027.00. This order is added to the regular lot book with time of triggering as the time stamp, as a limit order of 1030.00. For the stop loss sell order, the trigger price has to be greater than the limit price.

Other conditions

y

Market price: Market orders are orders for which no price is specified at the time the order is entered (i.e. price is market price). For such orders, the system determines the price.

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y

Trigger price: Price at which an order gets triggered from the stoploss book. Limit price: Price of the orders after triggering from stoploss book. Pro: Pro means that the orders are entered on the trading members own account.

y y

y

Cli: Cli means that the trading member enters the orders on behalf of a client.

Inquiry windowThe inquiry window enables the user to view information such as Market by Order(MBO), Market by Price(MBP), Previous Trades(PT), Outstanding Orders(OO), Activity log(AL), Snap Quote(SQ), Order Status(OS), Market Movement(MM), Market Inquiry(MI), Net Position, On line backup, Multiple index inquiry, Most active security and so on. Relevant information for the selected contract/security can be viewed. We shall look in detail at the Market by Price (MBP) and the Market Inquiry (MI) screens.

Placing orders on the trading systemFor both the futures and the options market, while entering orders on the trading system, members are required to identify orders as being proprietary or client orders. Proprietary orders should be identified as Pro and those of clients should be identified as Cli. Apart from this, in the case of Cli trades, the client account number should also be provided. The futures market is a zero sum game i.e. the total number of long in any contract always equals the total number of short in any contract. The total number of outstanding contracts (long/short) at any point in time is called the Open interest. This Open interest figure is a good indicator of the liquidity in every contract. Based on studies carried out in international exchanges, it is found that open interest is maximum in near month expiry contracts.

Market spread/combination order entry38

The NEAT F&O trading system also enables to enter spread/combination trades. shows the spread/combination screen. This enables the user to input two or three orders simultaneously into the market. These orders will have the condition attached to it that unless and until the whole batch of orders finds a counter match, they shall not be traded. This facilitates spread and combination trading strategies with minimum price risk.

Basket tradingIn order to provide a facility for easy arbitrage between futures and cash markets, NSE introduced basket-trading facility. Figure 10.4 shows the basket trading screen. This enables the generation of portfolio offline order files in the derivatives trading system and its execution in the cash segment. A trading member can buy or sell a portfolio through a single order, once he determines its size. The system automatically works out the quantity of each security to be bought or sold in proportion to their weights in the portfolio.

Futures and options market instrumentsThe F&O segment of NSE provides trading facilities for the following derivative instruments: 1. Index based futures 2. Index based options 3. Individual stock options 4. Individual stock futures

Contract specifications for index futuresNSE trades Nifty futures contracts having one-month, two-month and threemonth expiry cycles. All contracts expire on the last Thursday of every month. Thus a January expiration contract would expire on the last Thursday of January and a February expiry contract would cease trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three-month expiry would be introduced for trading. Depending on the time period for which you want to take an exposure in index futures contracts, you can place buy and sell orders in the respective contracts.

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The Instrument type refers to Futures contract on index and Contract symbol - NIFTY denotes a Futures contract on Nifty index and the Expiry date represents the last date on which the contract will be available for trading. Each futures contract has a separate limit order book. All passive orders are stacked in the system in terms of price-time priority and trades take place at the passive order price (similar to the existing capital market trading system). The best buy order for a given futures contract will be the order to buy the index at the highest index level whereas the best sell order will be the order to sell the index at the lowest index level. Trading is for a minimum lot size of 200 units. Thus if the index level is around 1000, then the appropriate value of a single index futures contract would be Rs.200,000. The minimum tick size for an index future contract is 0.05 units. Thus a single move in the index value would imply a resultant gain or loss of Rs.10.00 (i.e. 0.05*200 units) on an open position of 200 units.

Contract specification for index optionsOn NSEs index options market, contracts at different strikes, having onemonth, two-month and three-month expiry cycles are available for trading. There are typically one-month, two-month and three-month options, each with five different strikes available for trading.

Contract specifications for stock optionsTrading in stock options commenced on the NSE from July 2001. These contracts are American style and are settled in cash. The expiration cycle for stock options is the same as for index futures and index options. A new contract is introduced on the trading day following the expiry of the near month contract. NSE provides a minimum of five strike prices for every option type (i.e. call and put) during the trading month. There are at least two inthe money contracts, two outof themoney contracts and one atthemoney contract available for trading.

ChargesThe maximum brokerage chargeable by a TM in relation to trades effected in the contracts admitted to dealing on the F&O segment of NSE is fixed at 2.5% of the contract value in case of index futures and 2.5% of notional value of the contract[(Strike price + Premium) * Quantity] in case of index options, exclusive

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of statutory levies. The transaction charges payable by a TM for the trades executed by him on the F&O segment are fixed at Rs.2 per lakh of turnover (0.002%)(Each side) or Rs.1 lakh annually, whichever is higher. The TMs contribute to Investor Protection Fund of F&O segment at the rate of Rs.10 per crore of turnover (0.0001%).

SEBI ADVISORY COMMITTEE ON DERIVATIVESThe SEBI Board in its meeting on June 24, 2002 considered some important issues relating to the derivative markets which include: y Physical settlement of stock options and stock futures contracts. y Review of the eligibility criteria of stocks on which derivative products are permitted. y Use of sub-brokers in the derivative markets. y Norms for use of derivatives by mutual funds. The recommendations of the Advisory Committee on Derivatives on some of these issues were also placed before the SEBI Board. The Board desired that these issues be reconsidered by the Advisory Committee on Derivatives (ACD) and requested a detailed report on the aforesaid issues for the consideration of the Board.

REGULATORY OBJECTIVESThe LCGC outlined the goals of regulation admirably well in Paragraph 3.1 of its report. We endorse these regulatory principles completely and base our recommendations also on these same principles. We therefore reproduce this paragraph of the LCGC Report: The Committee believes that regulation should be designed to achieve specific, Well-defined goals. It is inclined towards positive regulation designed to encourage healthy activity and behavior. It has been guided by the following objectives: (a) Investor Protection: Attention needs to be given to the following four aspects: (i) Fairness and Transparency (ii) Safeguard for clients moneys41

(iii) Competent and honest service(b) Quality of markets: The concept of Quality of Markets goes well beyond market integrity and aims at enhancing important market qualities, such as cost-efficiency, price-continuity, and price-discovery. This is a much broader objective than market integrity. (c) Innovation: While curbing any undesirable tendencies, the regulatory framework should not stifle innovation which is the source of all economic progress, more so because financial derivatives represent a new rapidly developing area, aided by advancements in information technology.

Chapter 3

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Introduction to Futures and OptionsINTRODUCTION TO FUTURES AND OPTIONSIn recent years, derivatives have become increasingly important in the field of finance. While futures and options are now actively traded on many exchanges, forward contracts are popular on the OTC market. In this chapter we shall study in detail these three derivative contracts.

FORWARD CONTRACT

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A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward contracts are normally traded outside the exchanges. The salient features of forward contracts are: y They are bilateral contracts and hence exposed to counterparty risk. y Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality. y The contract price is generally not available in public domain. y On the expiration date, the contract has to be settled by delivery of the asset. y If the party wishes to reverse the contract, it has to compulsorily go to the same counterparty, which often results in high prices being charged. Forward contracts are very useful in hedging and speculation. The classic hedging application would be that of an exporter who expects to receive payment in dollars three months later. He is exposed to the risk of exchange rate fluctuations.Limitations of forward markets Forward markets world-wide are afflicted by several problems: y Lack of centralization of trading, y Illiquidity, and y Counterparty risk

FUTURE CONTRACTFutures markets were designed to solve the problems that exist in forward markets. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contracts, the futures contracts are standardized and exchange traded. In simple words, Futures are exchange-traded contracts to buy or sell an asset in future at a price agreed upon today. The asset can be share, index, interest rate, bond, rupee-dollar exchange rate, sugar, crude oil, soybean, cotton, coffee etc.

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To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. It is a standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered, (or which can be used for reference purposes in settlement) and a standard timing of such settlement. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. More than 99% of futures transactions are offset this way. The standardized items in a futures contract are: y Quantity of the underlying asset y Quality of the underlying assets (not required in case of financial futures) y The date and the month of delivery y The units of price quotation (not the price) y Minimum fluctuation in price (tick size) y Location of settlement y Settlement style.

ADVANTAGES OF FUTURE TRADING IN INDIA1. High Leverage: The primary attraction, of course, is the potential for large profits in a short period of time. The reason that futures trading can be so profitable is the high leverage. To own a futures contract an investor only has to put up a small fraction of the value of the contract (usually around 10-20%) as margin. 2. Profit in Both Bull & Bear Markets: In futures trading, it is as easy to sell (also referred to as going short) as it is to buy (also referred to as going long). By choosing correctly, you can make money whether prices go up or down. 3. Lower Transaction Cost: Another advantage of futures trading is much lower relative commissions. Your commission for trading a futures contract is one tenth of a percent (0.10-0.20%). 4. High Liquidity: Most futures markets are very liquid, i.e. there are huge amounts of contracts traded every day. This ensures that market orders can be placed very quickly as there are always buyers and sellers for most contracts.

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USING FUTURES ON INDIVIDUAL SECURUTIESIndex futures began trading in India in June 2000. A year later, options on index were available for trading. July 2001 saw the launch of options on individual securities (herein referred to as stock options) and the onset of rolling settlement. With the launch of futures on individual securities (herein referred to as stock futures) on the 9th of November, 2001, the basic range of equity derivative products in India seems complete. Of the above mentioned products, stock futures are particularly appealing due to familiarity and ease in understanding. A purchase or sale of futures on a security gives the trader essentially the same price exposure as a purchase or sale of the security itself. In this regard, trading stock futures is no different from trading the security itself. Besides speculation, stock futures can be effectively used for hedging and arbitrage reasons.

DIFFERENCES BETWEEN FORWARD AND FUTURE CONTRACTForward contracts are often confused with futures contracts. The confusion is primarily because both serve essentially the same economic functions of allocating risk in the presence of future price uncertainty. However futures are a significant improvement over the forward contracts. A future contract is nothing but a form of forward contract. One can differentiate a forward contract from a future contract on the following lines:

Customized vs Standardized: Forward contracts are customized whilefuture contracts are standardized. Terms of forward contracts are negotiated between the buyer and the seller. While the terms of future contracts are decided by the exchange on which these are traded.

Counter Party Risk: In forward contracts there is a risk of counterparty default. In case of futures, the exchange becomes counter party to each trade and guarantees settlement.

Liquidity: Futures are much more liquid and their price is transparentas their price and volume are reported in media. But this is not so in the case of forward contract.

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Squaring off: A forward contract can be reversed with only the samecounter party with whom it was entered into. A future contract can be reversed on the screen of the exchange as the latter is the counter party to all futures trades.

THEORETICAL WAY OF PRICING FUTURESThe theoretical price of a futures contract is spot price of the underlying plus the cost of carry. Please note that futures are not about predicting future prices of the underlying assets. In general, Futures Price = Spot Price + Cost of Carry The Cost of Carry is the sum of all costs incurred if a similar position is taken in cash market and carried to expiry of the futures contract less any revenue that may arise out of holding the asset. The cost typically includes interest cost in case of financial futures (insurance and storage costs are also considered in case of commodity futures). Revenue may be in the form of dividend. Though one can calculate the theoretical price, the actual price may vary depending upon the demand and supply of the underlying asset.

FUTURES TERMINOLOGIESy y 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 threemonth expiry cycles which expire on the last Thursday of the month. Thus a January expiration contract expires on the last Thursday of January and a February expiration contract ceases trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three-month expiry is introduced for trading.

y

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y

Expiry date: It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist. Contract size: The amount of asset that has to be delivered less than one contract. For instance, the contract size on NSEs futures market is 200 Nifties. 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 investors gain or loss depending upon the futures closing price. This is called markingto 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.

y

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OPTIONSOptions 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, the48

two parties have committed themselves to doing something. Whereas it costs nothing (except margin requirements) to enter into a futures contract, the purchase of an option requires an upfront payment.

OPTIONS TERMINOLOGIESy Index options: These options have the index as the underlying. Some options are European while others are American. Like indexing futures contracts, indexing options contracts are also cash settled. Stock options: Stock options are options on individual stocks. Options currently trade on over 500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified price. Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer. Writer of an option: The writer of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him. There are two basic types of options, call options and put options. Call option: A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price. Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price. Option price: Option price is the price, which the option buyer pays to the option seller. It is also referred to as the option premium. Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity. Strike price: The price specified in the options contract is known as the strike price or the exercise price.

y

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y

American options: American options are options that can be exercised at any time upto the expiration date. Most exchange-traded options are American. European options: European options are options that can be exercised only on the expiration date itself. European options are easier to analyze than American options, and properties of an American option are frequently deduced from those of its European counterpart. In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cash flow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price > strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price. At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cash flow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price). Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cash flow if it were exercised immediately. A call option on the index is out-of-the-money when the current index stands at a level, which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price. Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an options time value, all else equal. At expiration, an option should have no time value.

y

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TYPES OF OPTIONS

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1. Call Options- A call option gives the holder (buyer/ one who is long call), the right to buy specified quantity of the underlying asset at the strike price on or before expiration date. The seller (one who is short call) however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy. Example: An investor buys One European call option on Infosys at the strike price of Rs. 3500 at a premium of Rs. 100. If the market price of Infosys on the day of expiry is more than Rs. 3500, the option will be exercised.

The investor will earn profits once the share price crosses Rs. 3600 (Strike Price + Premium i.e. 3500+100). Suppose stock price is Rs. 3800, the option will be exercised and the investor will buy 1 share of Infosys from the seller of the option at Rs 3500 and sell it in the market at Rs 3800 making a profit of Rs. 200 {(Spot price - Strike price) Premium}. In another scenario, if at the time of expiry stock price falls below Rs. 3500 say suppose it touches Rs. 3000, the buyer of the call option will choose not to exercise his option. In this case the investor loses the premium (Rs 100), paid which should be the profit earned by the seller of the call option.2. Put Options- A Put option gives the holder (buyer/ one who is long Put), the right to sell specified quantity of the underlying asset at the strike price on or before an expiry date. The seller of the put option (one who is short Put) however, has the obligation to buy the underlying asset at the strike price if the buyer decides to exercise his option to sell. Example: An investor buys one European Put option on Reliance at the strike price of Rs. 300/- , at a premium of Rs. 25/-. If the market price of Reliance, on the day of expiry is less than Rs. 300, the option can be exercised as it is 'in the money'. The investor's Break-even point is Rs. 275/ (Strike Price - premium paid) i.e., investor will earn profits if the market falls below 275.

Suppose stock price is Rs. 260, the buyer of the Put option immediately buys Reliance share in the market @ Rs. 260/- & exercises his option selling the Reliance share at Rs 300 to the option writer thus making a net profit of Rs. 15 {(Strike price - Spot Price) - Premium paid}.

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In another scenario, if at the time of expiry, market price of Reliance is Rs 320/ -, the buyer of the Put option will choose not to exercise his option to sell as he can sell in the market at a higher rate. In this case the investor loses the premium paid (i.e. Rs 25/-), which shall be the profit earned by the seller of the Put option. (Please see table)

THE OPTIONS GAMECall Option Put Option

1.Option Buys the right to Buys the right to sell buyer or buy the underlying the underlying asset option holder asset at the at the specified price specified price

2. Option Has the obligation to Has the obligation to seller or sell the underlying buy the underlying option writer asset (to the option asset (from the holder) at the option holder) at the specified price specified price

LEVERAGE AND RISK

Options can provide leverage. This means an option buyer can pay a relatively small premium for market exposure in relation to the contract value (usually 100 shares of underlying stock). An investor can see large percentage gains from comparatively small, favorable percentage moves in the underlying index. Leverage also has downside implications. If the underlying stock price does not rise or fall as anticipated during the lifetime of the option, leverage can magnify the investment's percentage loss. Options offer their owners a predetermined, set risk. However, if the owner's options expire with no value, this loss can be the entire amount of the premium paid for the option. An uncovered option writer, on the other hand, may face unlimited risk.

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In-the-money, At-the-money, Out-of-the-money

An option is said to be at-the-money, when the option's strike price is equal to the underlying asset price. This is true for both puts and calls. A call option is said to be in-the-money when the strike price of the option is less than the underlying asset price. For example, a Sensex call option with strike of 3900 is in-the-money, when the spot Sensex is at 4100 as the call option has value. The call holder has the right to buy a Sensex at 3900, no matter how much the spot market price has risen. And with the current price at 4100, a profit can be made by selling Sensex at this higher price. On the other hand, a call option is out-of-the-money when the strike price is greater than the underlying asset price. Using the earlier example of Sensex call option, if the Sensex falls to 3700, the call option no longer has positive exercise value. The call holder will not exercise the option to buy Sensex at 3900 when the current price is at 3700. (Please see table)

Striking the price

Call Option

Put Option

1.In-the-money

Strike Price less than Strike Price greater Spot Price of than Spot Price of underlying asset underlying asset

2. At-the-money

Strike Price equal to Spot Price of underlying asset

Strike Price equal to Spot Price of underlying asset

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3. Out-of-themoney

Strike Price greater than Spot Price of underlying asset

Strike Price less than Spot Price of underlying asset

y

A put option is in-the-money when the strike price of the option is greater than the spot price of the underlying asset. For example, a Sensex put at strike of 4400 is in-the-money when the Sensex is at 4100. When this is the case, the put option has value because the put holder can sell the Sensex at 4400, an amount greater than the current Sensex of 4100. Likewise, a put option is out-of-the-money when the strike price is less than the spot price of underlying asset. In the above example, the buyer of Sensex put option won't exercise the option when the spot is at 4800. The put no longer has positive exercise value.

y

Options are said to be deep in-the-money (or deep out-of-the-money) if the exercise price is at significant variance with the underlying asset price.

The amount by which an option, call or put, is in-the-money at any given moment is called its intrinsic value. Thus, by definition, an at-the-money or out-of-the-money option has no intrinsic value; the time value is the total option premium. This does not mean, however, these options can be obtained at no cost. Any amount by which an option's total premium exceeds intrinsic value is called the time value portion of the premium. It is the time value portion of an option's premium that is affected by fluctuations in volatility, interest rates, dividend amounts and the passage of time. There are other factors that give options value, therefore affecting the premium at which they are traded. Together, all of these factors determine time value.Option Premium = Intrinsic Value + Time Value

FACTORS THAT AFFECT THE VALUE OF AN OPTION PREMIUM

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There are two types of factors that affect the value of the option premium:Quantifiable Factors: 1. Underlying stock price, 2. The strike price of the option, 3. The volatility of the underlying stock, 4. The time to expiration and; 5. The risk free interest rate. Non-Quantifiable Factors: 1. Market participants' varying estimates of the underlying asset's future volatility 2. Individuals' varying estimates of future performance of the underlying asset, based on fundamental or technical analysis 3. The effect of supply & demand- both in the options marketplace and in the market for the underlying asset 4. The "depth" of the market for that option - the number of transactions and the contract's trading volume on any given day.

DIFFERENT PRICING MODELS FOR OPTIONSThe theoretical option pricing models are used by option traders for calculating the fair value of an option on the basis of the earlier mentioned influencing factors. An option pricing model assists the trader in keeping the prices of calls & puts in proper numerical relationship to each other & helping the trader make bids & offer quickly. The two most popular option pricing models are:y

Black Scholes Model which assumes that percentage change in the price of underlying follows a normal distribution. Binomial Model which assumes that percentage change in price of the underlying follows a binomial distribution. 55

y

Pricing models include the binomial options model for American options and the Black-Scholes model for European options.

OPTIONS TRADINGAs described earlier, four possible option selections exist for a trader: a. long a call, b. long a put, c. short a call, and d. short a put. These four can be used independently, together, or in conjunction with other financial instruments to create a number of option-trading strategies. These combinations enable a trader to develop an option-trading model which meets the trader's specific trading needs, expectations, and style, and enables him or her to anticipate every conceivable situation in the market. This trading structure can be adapted to handle any type of market outlook, whether it is bullish, bearish, choppy, or neutral. Options are unique trading instruments. They can be used for a multitude of purposes, providing tremendous versatility and utility. Among their multiple applications are the following: to speculate on the movement of an asset; to hedge an existing position in an asset; to hedge other option positions; to generate income by writing options against different quantities of options strategies that arise from these applications and the fact that the scope of this book is limited, we will devote coverage to a cursory explanation of two of the most popular strategies which are designed to take advantage of market movement: spreads and straddles.

WHY TO USE OPTIONS?There are two main reasons why an investor would use options: y to Speculate and y to Hedge.

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Speculation One can think of speculation as betting on the movement of a security. The advantage of options is that one isnt limited to making a profit only when the market goes up. Because of the versatility of options, one can also make money when the market goes down or even sideways.

Speculation is the territory in which the big money is made - and lost. The use of options in this manner is the reason options have the reputation of being risky. This is because when one buys an option; he have to be correct in determining not only the direction of the stock's movement, but also the magnitude and the timing of this movement. To succeed, he must correctly predict whether a stock will go up or down, and he have to be right about how much the price will change as well as the time frame it will take for all this to happen. So why do people speculate with options if the odds are so skewed? Aside from versatility, it's all about using leverage. When one is controlling 100 shares with one contract, it doesn't take much of a price movement to generate substantial profits.Hedging The other function of options is hedging. Think of this as an insurance policy. Just as one insures his house or car, options can be used to insure your investments against a downturn. Critics of options say that if he is so unsure of his stock pick that he needs a hedge, he shouldn't make the investment. On the other hand, there is no doubt that hedging strategies can be useful, especially for large institutions. Even the individual investor can benefit. One can imagine that he wanted to take advantage of technology stocks and their upside, but say he also wanted to limit any losses. By using options, he would be able to restrict his downside while enjoying the full upside in a cost-effective way.

HOW OPTIONS WORKS?Let's say that on May 1, the stock price of L&T is $67 and the premium (cost) is $3.15 for a July 70 Call, which indicates that the expiration is the third Friday of July and the strike price is $70. The total price of the contract is $3.15 x 100 = $315. In reality, you'd also have to take commissions into account, but we'll ignore them for this example.57

Remember, a stock option contract is the option to buy 100 shares; that's why you must multiply the contract by 100 to get the total price. The strike price of $70 means that the stock price must rise above $70 before the call option is worth anything; furthermore, because the contract is $3.15 per share, the break-even price would be $73.15. When the stock price is $67, it's less than the $70 strike price, so the option is worthless. But don't forget that you've paid $315 for the option, so you are currently down by this amount.

Three weeks later the stock price is $78. The options contract has increased along with the stock price and is now worth $8.25 x 100 = $825. Subtract what you paid for the contract, and your profit is ($8.25 - $3.15) x 100 = $510. You almost doubled our money in just three weeks! You could sell your options, which are called "closing your position," and take your profits - unless, of course, you think the stock price will continue to rise. For the sake of this example, let's say we let it ride. By the expiration date, the price drops to $62. Because this is less than our $70 strike price and there is no time left, the option contract is worthless. We are now down to the original investment of $315. To recap, here is what happened to our option investment:Date Stock Price Option Price Paper Gain/Loss May 1 May 21 Expiry Date

$67 $3.15

$78 $8.25 $825 $510

$62 worthless $0 -$315

Contract Value $315

$0

The price swing for the length of this contract from high to low was $825, which would have given us over double our original investment. This is leverage in action.Exercising Versus Trading-Out

So far we've talked about options as the right to buy or sell (exercise) the underlying. This is true, but in reality, a majority of options are not actually58

exercised. In our example, you could make money by exercising at $70 and then selling the stock back in the market at $78 for a profit of $8 a share. You could also keep the stock, knowing you were able to buy it at a discount to the present value. However, the majority of the time holders choose to take their profits by trading out (closing out) their position. This means that holders sell their options in the market, and writers buy their positions back to close. According to the CBOE, about 10% of options are exercised, 60% are traded out, and 30% expire worthless.Intrinsic Value and Time Value

At this point it is worth explaining more about the pricing of options. In our example the premium (price) of the option went from $3.15 to $8.25. These fluctuations can be explained by intrinsic value and time value. Basically, an option's premium is its intrinsic value + time value. Remember, intrinsic value is the amount in-the-money, which, for a call option, means that the price of the stock equals the strike price. Time value represents the possibility of the option increasing in value. So, the price of the option in our example can be thought of as the following: Premium = Intrinsic Value + Time Value $8.25 = $8 + $0.25 In real life options almost always trade above intrinsic value. If you are wondering, we just picked the numbers for this example out of the air to demonstrate how options work.

WHEN NOT TO BUY AN OPTION?It is also important to consider the time or the date at which one should enter the option market. Avoid trading in an illiquid option market.y

Avoid purchasing call options just prior to a stock going ex-dividend. Avoid buying or selling options based upon anticipated news (buyo