derivative indu

8/2/2019 Derivative Indu

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AProject

OnStudy of Nifty Derivatives

&Risk Minimization Trading Strategy

IN PARTIAL FULFILMENT FOR THE REQUIREMT OF THE PROJECT

STUDY COURSE OF TWO YEAR (FULL TIME) M.B.A. PROGRAMME

INDEX

Sr.

no Topics

Pg.

no.

1INTRODUCTION TO INDIAN CAPITAL MARKET 1

2 INTRODUCTION TO DERIVATIVES 4

3DEVELOPMENT OF DERIVATIVES MARKET IN

INDIA

9

4 RESEARCH METHODOLOGY 12

5 STOCK MARKET DERIVATIVES 15


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6 INTRODUCTION TO FUTURES 19

7 INTRODUCTION TO OPTIONS 37

8 INDICATORS OF INVESTING IN FUTURES &OPTION

62

9 OPEN INTEREST 64

10PUT/CALL RATIO

68

11

ANALYSIS[a]STUDY OF SHORT TERM TREND OF NIFTY DERIVATIVESUSING:

Open Interest Put/Call Ratio

[b]RISK MINIMIZATION TRADING STRATEGIES USINGFUTURES & OPTION

71

FINDINGS 177

CONCLUSION 179

BIBLIOGRAPHY

180

GLOSSARY181


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CHAPTER1

INTRODUCTION TOCAPITAL


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CH. 1 INTRODUCTION TO INDIAN CAPITAL MARKET

CAPITAL MARKETIn todays era investor invest their funds after basic analysis. The basicfunction of financial market is to facilitate the transfer of funds from surplus

sectors that is from (lenders) to deficit sectors (borrowers). If we look at the

financial cycle then we can say that households make their savings, which isprovided to industrial sectors, which earn profit and finally this profit will go to

the households in the form of interest and dividend.

Indian Financial System is made-up of 2 types of markets i.e. Money market &Capital Market. The money market has 2 components-The organized &unorganized. The organized market is dominated by commercial banks. The

other major participants are RBI, LIC, GIC, UTI, and STCI. The mainfunction of it is that of borrowing & lending of short term funds. On the other

hand unorganized money market consists of indigenous bankers & money

lenders. This sector is continuously providing finance for trade as well aspersonal consumption.

Capital Market

Primary Market

Secondary Market

To create funds, new firms use Primary Market by publishing their issues in

different instruments. On the other hand Secondary Market provides base

for trading and securities that have already been issued.

PAST OF SHARE MARKET

Before 1996, all the transactions were done through physical form in securitymarket. Because of physical form investors were facing so many problems.

At that time the certificates were transferred to the purchase holder. On the

other hand they are now transferred directly in their electronic form which ismuch more quicker and safer.


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BSE

The Stock Exchange, Mumbai, popularly known as "BSE" was established in

1875 as "The Native Share and Stock Brokers Association". It is the

oldest one in Asia, even older than the Tokyo Stock Exchange, which was

established in 1878. It is a voluntary non-profit making Association of Persons

(AOP) and is currently engaged in the process of converting itself into

demutualised and corporate entity. It has evolved over the years into its

present status as the premier Stock Exchange in the country. It is the first

Stock Exchange in the Country to have obtained permanent recognition in

1956 from the Govt. of India under the Securities Contracts (Regulation) Act,

1956.

NSE

To obviate the problem, RELATED TO PHYSICAL FORM the NSE introducedscreen based trading system (SBTC) where a member can punch into the

computer the quantities of shares & the prices at which he wants to transact.


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CAHPTER2

INTRODUCTION TO

DERIVATIVES

CH 2 INTRODUCTION TO DERIVATIVES


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The term "Derivative" indicates that it has no independent value, i.e. its valueis entirely "derived" from the value of the underlying asset. The underlying

asset can be securities, commodities, bullion, currency, live stock or anythingelse. In other words, Derivative means a forward, future, option or any other

hybrid contract of pre determined fixed duration, linked for the purpose of

contract fulfilment to the value of a specified real or financial asset or to anindex of securities.

Derivatives in mathematics, means a variable derived from another variable.Similarly in the financial sense, a derivative is a financial product, which has

been derived from a market for another product. Without the underlying

product, derivatives do not have any independent existence in the market.

Derivatives have come into existence because of the existence of risks in

business. Thus derivatives are means of managing risks. The parties

managing risks in the market are known as HEDGERS. Somepeople/organisations are in the business of taking risks to earn profits. Such

entities represent the SPECULATORS. The third player in the market, knownas the ARBITRAGERS take advantage of the market mistakes.

The need for a derivatives market

The derivatives market performs a number of economic functions:

1. They help in transferring risks from risk averse people to risk orientedpeople.

2. They help in the discovery of future as well as current prices.3. They catalyze entrepreneurial activity.

4. They increase the volume traded in markets because of participation of

risk-averse people in greater numbers.

5. They increase savings and investment in the long run.

Factors driving the growth of financial derivatives


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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, providingeconomic agents a wider choice of risk management strategies, and

5. Innovations in the derivatives markets, which optimally combine therisks and returns over a large number of financial assets leading to

higher returns, reduced risk as well as transactions costs as comparedto individual financial assets.

A derivative is a financial instrument whose value depends on the value of

other, more basic underlying variables.The main instruments under the derivative are:

1. Forward contract

2. Future contract3. Options

4. Swaps

1. Forward Contract:

A forward contract is a particularly simple derivative. It is an agreement to

buy or sell an asset at a certain future time for a certain price. The contract isusually between two financial institutions or between a financial institution and

one of its corporate clients. It is not normally traded on an exchange.

One of the parties to a forward contract assumes a long position and agrees tobuy the underlying asset on a specified future date for a certain specified

price. The other party assumes a position and agrees to sell the asset on thesame date for the same price. The specified price in a forward contract will be

referred to as delivery price. The forward contract is settled at maturity. Theholder of the short position delivers the asset to the holder of the long position

in return for a cash amount equal to the delivery price. A forward contract is

worth zero when it is first entered into. Later it can have position or negativevalue, depending on movements in the price of the asset.

2. Futures Contract:


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A futures contract is an agreement between two parties to buy or sell an assetat a certain time in the future for a certain price. Unlike forward contracts,

futures contract are normally traded on an exchange. To make tradingpossible, the exchange specifies certain standardized features of the contract.

As the two parties to the contract do not necessarily know each other, the

exchange also provides a mechanism, which gives the two parties a guaranteethat the contract will be honoured.

One way in which futures contract is different from a forward contract is that

an exact delivery date is not specified. The contract is referred to by itsdelivery month, and the exchange specifies the period during the month when

delivery must be made.

3. Options:

An option is a contract, which gives the buyer the right, but not the obligation,

to buy or sell specified quantity of the underlying assets, at a specific (strike)

price on or before a specified time (expiration date). The underlying may becommodities like wheat/rice/ cotton/ gold/ oil/ or financial instruments like

equity stocks/ stock index/ bonds etc.

There are basic two types of options. A call options gives the holder the right

to buy the underlying asset by a certain date for a certain price. A put optiongives the holder the right to sell the underlying asset by a certain date for a

certain price.

4. Swaps:

Swaps are private agreements between two companies to exchange cash

flows in the future according to a prearranged formula. They can be regardedas portfolios of forward contracts.

5. Warrants:

Options generally have lives of upto one year, the majority of options tradedon options exchanges having a maximum maturity of nine months. Longer-

dated options are called warrants and are generally traded over-the-counter.

6. LEAPS:


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The acronym LEAPS means Long-Term Equity Anticipation Securities. Theseare options having a maturity of up to three years.

7. Baskets: Basket options are options on portfolios of underlying assets. Theunderlying asset is usually a moving average or a basket of assets. Equity

index options are a form of basket options.

Types of Traders in Derivatives Market:

1. Hedgers

Hedgers are interested in reducing a risk that they already face. The purposeof hedging is to make the outcome more certain. It does not necessarily

improve the outcome.

2. Speculators

Whereas hedgers want to eliminate an exposure to movements in the price ofassets, speculators wish to take a position in the market. Either they are

betting that a price will go up or they are betting that it will go down.Speculating using futures market provides an investor with a much higher

level of leverage than speculating using spot market. Options also give extraleverage.

3. ArbitrageursThey are a third important group of participants in derivatives market.

Arbitrage involves locking in a riskless profit by entering simultaneously intotransactions in two or more markets. Arbitrage is sometimes possible when

the futures price of an asset gets out of line with its cash price.


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CHAPTER3

DEVELOPMENT OF

DERIVATIVES MARKET IN INDIA

CH 3 DEVELOPMENT OF DERIVATIVESMARKET IN INDIA


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The first step towards introduction of derivatives trading in India was thepromulgation 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 appropriateregulatory framework for derivatives trading in India. The committee

submitted its report on March 17, 1998 prescribing necessary preconditionsfor introduction of derivatives trading in India. The committee recommended

that derivatives should be declared as securities so that regulatoryframework 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 derivativesmarket in India. The report, which was submitted in October 1998, worked

out the operational details of margining system, methodology for charginginitial margins, broker net worth, deposit requirement and realtime

monitoring requirements.

The Securities Contract Regulation Act (SCRA) was amended in December1999 to Include derivatives within the ambit of securities and the regulatory

framework was developed for governing derivatives trading. The act also

made it clear that derivatives shall be legal and valid only if such contracts aretraded 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 thefinal approval to this effect in May 2001. SEBI permitted the derivativesegments of two stock exchanges, NSE and BSE, and their clearing

house/corporation to commence trading and settlement in approvedderivatives 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 andoptions on individual securities.

The trading in BSE Sensex options commenced on June 4, 2001 and the

trading in options on individual securities commenced in July 2001. Futurescontracts on individual stocks were launched in November 2001. The

derivatives trading on NSE commenced with S&P CNX Nifty Index futures onJune 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 andoptions contract on NSE are based on S&P CNX.


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Trading and settlement in derivative contracts is done in accordance with therules, byelaws, and regulations of the respective exchanges and their clearing

house/corporation duly approved by SEBI and notified in the official gazette.Foreign Institutional Investors (FIIs) are permitted to trade in all Exchange

traded derivative products.

Measures specified by SEBI to protect the rights of investor inthe Derivative Market

1. Investor's money has to be kept separate at all levels and ispermitted to be used only against the liability of the Investor and is not

available to the trading member or clearing member or even any otherinvestor.

2. The Trading Member is required to provide every investor with a

risk disclosure document which will disclose the risks associated with the

derivatives trading so that investors can take a conscious decision totrade in derivatives.3. Investor would get the contract note duly time stamped for

receipt of the order and execution of the order. The order will be

executed with the identity of the client and without client ID order will notbe accepted by the system. The investor could also demand the trade

confirmation slip with his ID in support of the contract note. This willprotect him from the risk of price favour, if any, extended by the

Member.

4.In the derivative markets all money paid by the Investor towardsmargins on all open positions is kept in trust with the Clearing

House/Clearing corporation and in the event of default of the Trading orClearing Member the amounts paid by the client towards margins are

segregated and not utilised towards the default of the member. However,

in the event of a default of a member, losses suffered by the Investor, ifany, on settled / closed out position are compensated from the Investor

Protection Fund, as per the rules, bye-laws and regulations of thederivative segment of the exchanges.


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CHAPTER

4

RESEARCH

METHODOLOGY


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CH 4 RESEARCH METHODOLOGY

Objectives

To determine the short term trend of nifty future using the important

derivatives market indicators like Open interest and Put Call ratio.To determine the derivatives trading strategy on the basis of different market

outlooks which will minimize the risk exposure and at the same times will

maximize the profits.Scope of study

We have done the study of nifty futures only.We have studied the short term trend of nifty futures for the month of Feb,

2010 only.

We have used two important indicators Open Interest and Put-Call Ratio onlyto determine the trend of Nifty.

Data collection sourcesPrimary No

Secondary

Various stock market web sites

Magazines

Capitaline Neo software

Odin diet Software

Beneficiaries of study

Derivative traders

Hedge funds

Institutional investors

Arbitragers

Hedger

Speculators

Jobbers

Investors


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Student

Share broker

Broking houses

Limitations

We have taken only Nifty futures for the purpose of study and not any

other stock.

The period of study is only one month derivative contract which may not

give the same result every time.

We have use only two indicators namely Open Interest and Put-Call

ratio to determine the trend of Nifty.

Few of the strategies prescribed in the study may give unlimited loss if

the market goes other way round.

There are many other factors which may lead the Nifty futures apartfrom the one which we have studied like technical analysis, Cost of

Carry etc.


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CHAPTER

5

STOCK MARKET

DERVATIVES


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CH 5 Stock Market Derivatives

Futures & Options

In India, the National Stock Exchange of India Limited (NSE) commenced

trading in derivatives with the launch of index futures on June 12, 2000. Thefutures contracts are based on the popular benchmark S&P CNX Nifty Index.

The Exchange introduced trading in Index Options (also based on Nifty) onJune 4, 2001. NSE also became the first exchange to launch trading in options

on individual securities from July 2, 2001.Futures on individual securities were introduced on November 9, 2001.

Futures and Options on individual securities are available on 180 securitiesstipulated by SEBI.
http://www.nseindia.com/content/fo/fo_NIFTY.htmhttp://www.nseindia.com/content/fo/fo_underlyinglist.htmhttp://www.nseindia.com/content/fo/fo_NIFTY.htmhttp://www.nseindia.com/content/fo/fo_underlyinglist.htm


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Instruments available in India

The National stock Exchange (NSE) has the following derivative products:

Products

Index Futures

IndexOptions

Futures onIndividual

Securities

Options onIndividual

Securities

UnderlyingInstrument

S&P CNX NiftyS&P CNXNifty

180 securities

stipulated bySEBI

180securitiesstipulatedby SEBI

Type European American

TradingCycle

Maximum of 3-month trading cycle.

At any point in time,there will be 3

contracts available :

1) near month,

2) mid month &

3) far month

Same asindexfutures

Same as indexfutures

Same asindexfutures

Expiry DayLast Thursday of the

expiry month

Same asindex

futures

Same as index

futures

Same asindex

futures

Contract

Size

Permitted lot size is200 & multiplesthereof

Same asindexfutures

As stipulatedby NSE (not

less than Rs.2lacs)

As

stipulatedby NSE (notless thanRs.2 lacs)

BSE also offers similar products in the derivatives segment

Minimum contract size

The Standing Committee on Finance, a Parliamentary Committee, at thetime of recommending amendment to Securities Contract (Regulation)Act, 1956 had recommended that the minimum contract size of

derivative contracts traded in the Indian Markets should be pegged notbelow Rs. 2 Lakhs. Based on this recommendation SEBI has specified

that the value of a derivative contract should not be less than Rs. 2

Lakh at the time of introducing the contract in the market.


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Lot size of a contract

Lot size refers to number of underlying securities in one contract.

Additionally, for stock specific derivative contracts SEBI has specifiedthat the lot size of the underlying individual security should be in

multiples of 100 and fractions, if any, should be rounded of to the nexthigher multiple of 100. This requirement of SEBI coupled with therequirement of minimum contract size forms the basis of arriving at the

lot size of a contract.

For example, if shares of XYZ Ltd are quoted at Rs.1000 each and the

minimum contract size is Rs.2 lacs, then the lot size for that particularscripts stands to be 200000/1000 = 200 shares i.e. one contract in XYZ

Ltd. covers 200 shares.


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CHAPTER

6

INTRODUCTION TO

FUTURES


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CH 6 INTRODUCTION TO FUTURES

Introduction of futures in India

The first derivative product introduced in the Indian securities market was

INDEX FUTURES" in June 2000. In India the STOCK FUTURES were first

introduced on November 9, 2001 how Futures Markets Came About

Many people see pictures of the large crowd of traders standing in a crowd

yelling and signaling with their hands, holding pieces of paper, and writing

frantically. To the outsider, it looks like chaos. But do you really think thatthere is in fact chaos going on in the worlds futures pits? Not a chance.

Actually, everyone in the crowd knows exactly what's going on. It is in fact,another language. Learn the language and you know what is going on.

How does this differ from the way things operated in the 'old days'? Before

there were organized grain and commodity markets, farmers would bring their

harvested crops to major population centers. There they would search forbuyers. There were no storage facilities; and many times the harvest would

rot before buyers were found. Also, because many farmers would bring theircrops to market at the same time, the price of the crops or commodities

would be driven down. There was tremendous supply in relation to demand.

The reverse was true in the spring. Many times there would be a shortage ofcrops and commodities and the price would rise sharply. There was no

organized or central marketplace where competitive bidding could take place.

Initially, the first organized and central marketplaces were created to providespot prices for immediate delivery. Shortly thereafter, forward contracts were

also established. These 'forwards' were forerunners to the present day futurescontract.

Futures prices and the bid and asked price are continuously transmittedthroughout the world electronically. Regardless of what geographic location

the speculator or hedger is located in, he has the same access to priceinformation as everyone else. Farmers, bankers, manufacturers, corporations,

all have equal access. All they have to do is call their broker and arrange forthe purchase or sale of a futures contract. The person who takes the opposite

side of your trade may be a competitor who has a different outlook on thefuture price, it may be a floor broker, or it could be a speculator.


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Types of Futures

Agricultural

The first type of agricultural contract is the grains. This group includes corn,

oats, and wheat. The second type of agricultural contract is the oils and meal.This group includes soybeans, soya meal, soya oil, sunflower seed oil, and

sunflower seed. The third group of agricultural commodities is livestock. Thisgroup includes live hogs, cattle, and pork bellies. The fourth type of

agricultural commodities is the forest products group. This group includeslumber and plywood. The fifth group of agricultural commodities is textiles.

This group includes cotton. The last type of agricultural commodity is

foodstuffs. This group includes cocoa, coffee, orange juice, rice, and sugar.

For each of these commodities there are different contract months available.

There are also different grades available. And there are different types of the

commodity available. Contract months generally revolve around the harvestcycle. More actively traded commodities usually have more contract monthsavailable. Almost every month a new type of contract appears to meet the

needs of a continuously growing corporate and institutional market.

Metallurgical

The group of metallurgical commodities includes the metals and the

petroleum's. The metals group includes gold, silver, copper, palladium, andplatinum. The petroleum group includes crude oil, gasoline, heating oil, and

propane. Different contract months, grades, amounts, and types, of these

contracts are available. Almost every month a new type of contract appears tomeet the needs of a continuously growing corporate and institutional market.

Interest Bearing Assets

This group of futures began trading in 1975. Yet it is this group that has seenthe most explosive growth. This group of futures contracts includes Treasury

Bills, Treasury Bonds, Treasury Notes, Municipal Bonds, and EurodollarDeposits. The entire yield curve is represented and it is possible to trade these

instruments with tremendous flexibility as to maturity. It is also possible to

trade contracts with the same maturity but different expected interest ratedifferentials. In addition, foreign exchanges also trade debt instruments.

Almost every month a new type of contract appears to meet the needs of acontinuously growing corporate and institutional market.

Indexes


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transaction from one settlement period (seven days) to the next settlementperiod for the payment of a fee known as badla charges.

In the badla system, due to limited settlement period and no future price

discovery, speculators could manipulate prices, thus causing loss to small

investors and ultimately eroding investors confidence in the capital market.The last eight years have emphasised the necessity of futures trading in the

capital market. In the absence of an efficient futures market, there was noprice discovery; therefore, prices could be moved in any desired direction.

Recent developments in the capital market culminated in a ban on badla fromJuly 2001.

In the absence of futures trading, certain operators- either on their own or incollusion with corporate management teams at times manipulated prices in

the secondary market, causing irreparable damage to the growth of themarket. The small and medium investors, who are the backbone of the

market, whose savings come to the market via primary or secondary route

shied away, having burnt their fingers. As the small investor avoided thecapital market, the downturn in the secondary market ultimately affected the

primary market because people stopped investing in shares for fear of loss orliquidity. Introducing futures contracts in major shares along with index

futures helped to revive the capital markets. This did not only provide liquidity

and efficiency to the market, but also helped in future price discovery

With renewed interest in old economy stocks, activity in the stock futuresmarket seems to be widening too. While initial trading was restricted to

information technology stocks like Satyam, Infosys or Digital, today puntersare slowly building positions in counters such as SBI, Telco. Tisco, Larsen andToubro (L&T) and BPCL. This has increased volumes and depth in the market

but has also resulted in the outstanding position reaching almost Rs 1,000crore.

FeaturesEvery futures contract is a forward contract. They:

Are entered into through exchange, traded on exchange and clearingcorporation/house provides the settlement guarantee for trades.

Are of standard quantity; standard quality (in case of commodities). Have standard delivery time and place.

Frequently used terms in futures market


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Contract Size It specifies the amount of the asset that has to bedelivered under one contract.

Multiplier - It is a pre-determined value, used to arrive at the contract

size. It is the price per index point.

Tick Size - It is the minimum price difference between two quotes of

similar nature. Contract Month - The month in which the contract will expire.

Open interest - Total outstanding long or short positions in the marketat any specific point in time. As total long positions for market would be

equal to total short positions, for calculation of open Interest, only one

side of the contracts is counted.

Volume - No. of contracts traded during a specific period of time. During

a day, during a week or during a month.

Long position- Outstanding/unsettled purchase position at any point oftime.

Short position - Outstanding/ unsettled sales position at any point oftime.

Open position - Outstanding/unsettled long or short position at anypoint of time.

Physical delivery - Open position at the expiry of the contract is settledthrough delivery of the underlying. In futures market, delivery is low.

Cash settlement - Open position at the expiry of the contract is settled

in cash. Index Futures fall in this category. In India we have only cashsettlement system.

Concept of basis in futures market

Basis is defined as the difference between cash and futures prices:

Basis = Cash prices - Future prices.

Basis can be either positive or negative (in Index futures, basis

generally is negative).

Basis may change its sign several times during the life of the contract.

Basis turns to zero at maturity of the futures contract i.e. both cash andfuture prices converge at maturity.

Under normal market conditions Futures contracts are priced above the spotprice. This is known as the Contango Market

It is possible for the Futures price to prevail below the spot price. Such asituation is known as backwardation. This may happen when the cost of carry

is negative, or when the underlying asset is in short supply in the cash marketbut there is an expectation of increased supply in future example

agricultural products.

India may not be a big deal in international stock markets, but it has pulled itoff in the derivatives segment. Individual stock futures have picked up well in


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India. In India the stock futures are the most popular among all thederivatives. They are similar with the old-age carry-forward system and are

very simple. In India, this is one of the reasons why stock futures areattracting more interest than options.

Sensex Futures

Sensex Futures are futures whose underlying asset is the stock market index.

The index is an indicator of the broad market which reflects stock marketmovements. It is one of the oldest and reliable barometers of the Indian

Stock Market; it provides time series data over a fairly long period of time.The Sensex enables one to effectively gauge stock market movements. The

BSE 30 Sensex was first compiled in 1986 and is the market capitalizationweighted index of 30 scripts which represents 30 large well-established and

financially sound companies. The Sensex represents a broad spectrum ofcompanies in a variety of industries. It represents 14 major industry groupswhich are large enough to be used for effective hedging. Given the lower cost

structure and the overwhelming popularity of the Sensex, Sensex futures areexpected to garner large volumes. The Sensex is the first index to be

launched by any Stock Exchange in India and has the the largest social recall

attached with it.

The Indian market is witnessing low volumes as it is in its nascent stages of

growth. Retail participation will improve with better understanding andcomfort with the product whereas the market is yet to witness institutional

participation. FIIs have not been able to participate as they are still awaitingcertain clarifications pertaining to margins from the Reserve Bank of India.

Why Sensex Futures?

Sensex futures are expected to evolve as the most liquid contract in the

country. This is because Institutional investors in India and abroad, moneymanagers and small investors use the Sensex when it comes to describing the

mood of the Indian Stock markets. Thus is has been observed that the Sensex

is an effective proxy for the Indian stock markets. Higher liquidity in theproduct essentially translates to lower impact cost of trading in Sensex

futures. The arbitrage between the futures and the equity market is furtherexpected to reduce impact cost. Trading in Stock index futures is likely to be

pre-dominantly retail driven. Internationally, stock index futures are an

institutional product with 60% of the volumes generated from hedging needs.Immense retail participation to the extent of 80 - 90% is expected in India

based on the following factors:


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Stock Index Futures require lower capital adequacy and marginrequirements when compared to margins on carry forward of individual

scripts. Index futures have lower brokerage costs. Savings in cost is possible through reduced bid-ask spreads where

stocks are traded in packaged forms. The impact cost will be much lower in case of stock index futures as

opposed to dealing in individual scripts. The chances of manipulation are much lesser since the market is

conditioned to think in terms of the index and therefore would prefer totrade in stock index futures.

The Stock index futures are expected to be extremely liquid given the

speculative nature of our markets and the overwhelming retail participationexpected to be fairly high. In the near future, stock index futures will

definitely see incredible volumes in India. It will be a blockbuster product and

is pitched to become the most liquid contract in the world in terms of numberof contracts traded if not in terms of notional value.

The advantage to the equity or cash market is in the fact that they wouldbecome less volatile as most of the speculative activity would shift to stock

index futures. The stock index futures market should ideally have more depth,volumes and act as a stabilizing factor for the cash market. However, it is to

early to base any conclusions on the volume or to form any firm trend.

Interpreting Futures Data

Derivatives market data is available on the Derivatives Trading andSettlement System (DTSS) under the head market summary. This terminal is

provided to all members of the Derivatives Segment. Non-members can have

access to the same information via the financial newspapers or from the DailyOfficial List of the Stock Exchange.

Theoretical way of Pricing Index Futures

The theoretical way of pricing any Future is to factor in the current price and

holding costs or cost of carry.


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In general, the Futures Price = Spot Price + Cost of Carry

Cost of carry is the sum of all costs incurred if a similar position is taken in

cash market and carried to maturity of the futures contract less any revenuewhich may result in this period. The costs typically include interest in case of

financial futures (also insurance and storage costs in case of commodityfutures). The revenue may be dividends in case of index futures.

Apart from the theoretical value, the actual value may vary depending ondemand and supply of the underlying at present and expectations about the

future. These factors play a much more important role in commodities,

especially perishable commodities than in financial futures.

In general, the Futures price is greater than the spot price. In special cases,

when cost of carry is negative, the Futures price may be lower than Spotprices.

S&P CNX Nifty Futures

A futures contract is a forward contract, which is traded on an Exchange. NSEcommenced trading in index futures on June 12, 2000. The index futures

contracts are based on the popular market benchmark S&P CNX Nifty index.

NSE defines the characteristics of the futures contract such as the underlyingindex, market lot, and the maturity date of the contract. The futures contracts

are available for trading from introduction to the expiry date.

Contract Specifications Trading Parameters

Contract Specifications

Security descriptor

The security descriptor for the S&P CNX Nifty futures contracts is:Market type : N

Instrument Type : FUTIDX

Underlying : NIFTYExpiry date : Date of contract expiry

Instrument type represents the instrument i.e. Futures on Index.Underlying symbol denotes the underlying index which is S&P CNX Nifty

Expiry date identifies the date of expiry of the contract

Underlying Instrument


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The underlying index is S&P CNX NIFTY.

Trading cycle

S&P CNX Nifty futures contracts have a maximum of 3-month trading cycle -

the near month (one), the next month (two) and the far month (three). A newcontract is introduced on the trading day following the expiry of the near

month contract. The new contract will be introduced for three month duration.This way, at any point in time, there will be 3 contracts available for trading in

the market i.e., one near month, one mid month and one far month duration

respectively.

Expiry day

S&P CNX Nifty futures contracts expire on the last Thursday of the expiry

month. If the last Thursday is a trading holiday, the contracts expire on theprevious trading day.

Trading Parameters

Contract sizeThe permitted lot size of S&P CNX Nifty futures contracts is 200 and multiples

thereof

Base Prices

Base price of S&P CNX Nifty futures contracts on the first day of trading would

be the previous days closing Nifty value. The base price of the contracts onsubsequent trading days would be the daily settlement price of the futurescontracts.

Price bands

There are no day minimum/maximum price ranges applicable for S&P CNXNifty futures contracts. However, in order to prevent erroneous order entry by

trading members, operating ranges are kept at + 10 %. In respect of orders

which have come under price freeze, members would be required to confirmto the Exchange that there is no inadvertent error in the order entry and that

the order is genuine. On such confirmation the Exchange may approve suchorder.

Futures on Individual Securities

A futures contract is a forward contract, which is traded on an Exchange. NSE

commenced trading in futures on individual securities on November 9, 2001.


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The futures contracts are available on 31 securities stipulated by theSecurities & Exchange Board of India (SEBI). (Selection criteria for securities)

NSE defines the characteristics of the futures contract such as the underlying

security, market lot, and the maturity date of the contract. The futures

contracts are available for trading from introduction to the expiry date.



Security descriptor

The security descriptor for the futures contracts is:

Market type : NInstrument Type : FUTSTK


Instrument type represents the instrument i.e. Futures on Index.

Underlying symbol denotes the underlying security in the Capital Market(equities) segment of the Exchange



Futures contracts are available on 31 securities stipulated by the Securities &Exchange Board of India (SEBI). These securities are traded in the CapitalMarket segment of the Exchange.

Trading cycleFutures contracts have a maximum of 3-month trading cycle - the near month

(one), the next month (two) and the far month (three). New contracts areintroduced on the trading day following the expiry of the near month

contracts. The new contracts are introduced for three month duration. This

way, at any point in time, there will be 3 contracts available for trading in themarket (for each security) i.e., one near month, one mid month and one far

month duration respectively.

Expiry day

Futures contracts expire on the last Thursday of the expiry month. If the lastThursday is a trading holiday, the contracts expire on the previous trading

day.


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Trading Parameters

Contract sizeThe permitted lot size for the futures contracts on individual securities shall be

the same as the same lot size of options contract for a given underlying

security or such lot size as may be stipulated by the Exchange from time totime.

The value of the option contracts on individual securities may not be less than

Rs. 2 lakhs at the time of introduction. The permitted lot size for the options

contracts on individual securities would be in multiples of 100 and fractions ifany shall be rounded off to the next higher multiple of 100.

Base Prices

Base price of futures contracts on the first day of trading (i.e. on introduction)would be the previous days closing value of the underlying security. The base

price of the contracts on subsequent trading days would be the dailysettlement price of the futures contracts.

Price bands

There are no day minimum/maximum price ranges applicable for futurescontracts. However, in order to prevent erroneous order entry by trading

members, operating ranges are kept at + 20 %. In respect of orders which

have come under price freeze, members would be required to confirm to the

Exchange that there is no inadvertent error in the order entry and that theorder is genuine. On such confirmation the Exchange may approve such order.

DIFFERENCE BETWEEN FUTURES AND OPTIONS

Although exchange-traded futures and options may act as substitutes for each

other, they have some crucial differences. In futures, the risk exposure andprofit potential are unlimited for both the parties, while in options, risk

exposure is unlimited and profit potential limited for the sellers, and it is the

other way round for the buyers. The maturity of contracts is longer in futures


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than in options. In futures, there is no premium paid or received by anyparty, while in options the buyers have to pay a premium to the sellers. While

Futures impose obligations on both the parties, options do so only on thesellers. Both the parties have to put in margins in futures trading, but only the

sellers have to do so in options trading.

DIFFERENCE BETWEEN FORWARD AND FUTURES CONTRACTS

DIFFERENCE FORWARDS FUTURES

1. Size of contracts

2. Price of contract

Decided by buyer andseller

Remains fixed till

Standardized in eachcontract

Changes every day


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3. Mark to market

4. Margin

5. Counterparty risk

6. No. of contracts inA year

7. Hedging

8. Liquidity

9. Nature of market

10. Mode of delivery

maturity

Not done

No margin required

Present

There can be anynumber of contracts

These are tailor-madefor a specific date andquantity, so perfect

hedging is possible

No liquidity

Over the counter

Specifically decided.

Most of the contracts

result in delivery.

Marked to market

every day

Margins are to be paidby both buyers andsellers

Not present

No. of contracts in ayear are fixed between

4 and 12.

Hedging is by nearestmonth and quantitycontracts so it is not

perfect

Highly liquid

Exchange traded

Standardised. Most of

the contracts are cash

settled.

STOCK INDICES IN INDIAN STOCK MARKET

A stock price moves for two possible reasons news about the company or

stock (such as strike in the factory, grant of a major contract or new productlaunch) or news about the economy (such as growth in the economy, are

related budget announcement or a war or warlike situation). The job of anindex is to capture the movement of the stock market with reference to news


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about the economy and the country. Each stock movement contains themixture of two elements, stock news and index news. The most important

stock market indices on which index futures contracts have been introducedare the S & P CNX nifty and the BSE sensex.

Margin Money

The aim of margin money is to minimize the risk of default by either counter-

party. The payment of margin ensures that the risk is limited to the previous

days price movement on each outstanding position. However, even thisexposure is offset by the initial margin holdings. Margin money is like a

security deposit or insurance against a possible Future loss of value.

Different Types of Margin

Yes, there can be different types of margin like Initial Margin, Variationmargin, Maintenance margin and Additional margin.

Objective of Initial Margin

The basic aim of Initial margin is to cover the largest potential loss in one day.

Both buyer and seller have to deposit margins. The initial margin is depositedbefore the opening of the day of the Futures transaction. Normally this margin

is calculated on the basis of variance observed in daily price of the underlying(say the index) over a specified historical period (say immediately preceding 1

year). The margin is kept in a way that it covers price movements more than

99% of the time. Usually three sigma (standard deviation) is used for thismeasurement. This technique is also called value at risk (or VAR).Based on

the volatility of market indices in India, the initial margin is expected to bearound 8-10%.

Variation or Mark-to-Market Margin

All daily losses must be met by depositing of further collateral - known as

variation margin, which is required by the close of business, the following day.Any profits on the contract are credited to the clients variation margin

account.


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Maintenance Margin

Some exchanges work on the system of maintenance margin, which is set at a

level slightly less than initial margin. The margin is required to be replenishedto the level of initial margin, only if the margin level drops below the

maintenance margin limit. For e.g.. If Initial Margin is fixed at 100 andMaintenance margin is at 80, then the broker is permitted to trade till such

time that the balance in this initial margin account is 80 or more. If it drops

below 80, say it drops to 70, and then a margin of 30 (and not 10) is to bepaid to replenish the levels of initial margin. This concept is not expected to

be used in India.

Additional Margin

In case of sudden higher than expected volatility, additional margin may be

called for by the exchange. This is generally imposed when the exchange fears

that the markets have become too volatile and may result in some crisis, likepayments crisis, etc. This is a preemptive move by exchange to preventbreakdown.

Cross Margining

This is a method of calculating margin after taking into account combinedpositions in Futures, options, cash market etc. Hence, the total margin

requirement reduces due to cross-Hedges. This is unlikely to be introduced inIndia immediately.

Settlement MechanismFutures Contracts on Index or Individual Securities

Daily Mark-to-Market Settlement


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The positions in the futures contracts for each member are marked-to-marketto the daily settlement price of the futures contracts at the end of each trade

day.

The profits/ losses are computed as the difference between the trade price or

the previous days settlement price, as the case may be, and the current dayssettlement price. The CMs who have suffered a loss are required to pay themark-to-market loss amount to NSCCL which is in turning passed on to the

members who have made a profit. This is known as daily mark-to-marketsettlement.

Theoretical daily settlement price for unexpired futures contracts, which are

not traded during the last half an hour on a day, is currently the pricecomputed as per the formula detailed below:

F = S * e rt

Where:

F = theoretical futures price

S = value of the underlying index

r = rate of interest (MIBOR)

t = time to expiration

Rate of interest may be the relevant MIBOR rate or such other rate as may bespecified.

After daily settlement, all the open positions are reset to the daily settlement

price.

CMs are responsible to collect and settle the daily mark to market profits /losses incurred by the TMs and their clients clearing and settling through

them. The pay-in and pay-out of the mark-to-market settlement is on T+1days (T = Trade day). The mark to market losses or profits are directly

debited or credited to the CMs clearing bank account.

Final Settlement

On the expiry of the futures contracts, NSCCL marks all positions of a CM to

the final settlement price and the resulting profit / loss is settled in cash.


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The final settlement of the futures contracts is similar to the daily settlementprocess except for the method of computation of final settlement price. The

final settlement profit / loss is computed as the difference between trade priceor the previous days settlement price, as the case may be, and the final

settlement price of the relevant futures contract.

Final settlement loss/ profit amount is debited/ credited to the relevant CMsclearing bank account on T+1 day (T= expiry day).

Open positions in futures contracts cease to exist after their expiration day

SETTLEMENT OF INDEX FUTURES CONTRACT

Stock index futures transactions are settled by cash delivery. No physical

delivery of stock is given by the short. The long also does not make payment

for the full value. In case of Nifty futures contract, the last trading day is thelast Thursday of the contracts expiring month. The amount is determined by

referring to the cash price at the close of trading in the cash market on thelast trading day in the futures contract. This procedure is generally followed in

the case of all indices except the S & P 500 index. The S & P 500 uses a

different settlement procedure. The final trading day for this contract is alwaysThursday and all open contracts at that time are settled as per special opening

quotations in the cash market on the following Friday morning.


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CHAPTER7

INTRODUCTION TOOPTION


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CH 7 INTRODUCTION TO OPTIONS

As its name signifies, an option is the right to buy or sell a particular asset for

a limited time at a specified rate. These contracts give the buyer a right, butdo not impose an obligation, to buy or sell the specified asset at a set price on

or before a specified date. Today, options are traded not only in commodities,

but in all financial assets such as treasury bills (T-bills), forex, stocks andstock indices.

We will discuss the basics of option contracts- how they work and how they

are priced, stock index options and stock option in India.An active over the counter (OTC) option market existed in USA for more than

a century under the auspices of the Put and Call Dealers Association. Options

were first traded in an organized exchange in 1973 when Chicago BoardOption Exchange (CBOE) came into existence. The CBOE standardized the call

options on 18 common stocks.

In India, options were traditionally traded on the OTC market with names

such as teji, mandi, teji-mandi, put, call etc. Commodity options were bannedby the forward Contract Regulation Act, 1952, which is still in force. Similarly,

options on securities were also banned in the Securities Contracts(Regulation) Act in 1969. However, with liberalization and with governments

realization of the virtues of options, options in securities were legally allowed

in 1995. Now both NSE and BSE have started trading in option contracts intheir respective indices and also in some selected scripts. This marked the

beginning of options in an organized form in India. In the forex market, theRBI has allowed certain options to corporate with forex exposure and to all

authorized dealers. Such options are generally traded in the dollar \ rupee

rate. These are basically OTC options. With the ban on badla and rollingsettlement in major scripts, the use of equity options has increased

substantially. These innovative exchange traded instruments provide allpossible opportunities for speculation, hedging and arbitrage. Now let us

discuss basics of options:

Four Components to an Option

There are four components to an option. They are: The underlying security,the type of option (put or call), the strike price, and the expiration date. Let's

take an XYZ November 100-call option as an example. XYZ is the underlyingsecurity. November is the expiration month. 100 is the strike price

(sometimes referred to as the exercise price). And the option is a call (theholder has the right, not the obligation, to buy 100 shares of XYZ at a price of

100).


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The Parties to an Option

There are two parties to an option. There is the party who buys the option;

and there is the party who sells the option. The party who sells the option isthe writer. The party who writes the option has the obligation to fulfill the

terms of the contract need to it be exercised. This can be done by deliveringto the appropriate broker 100 shares of the underlying security for each

option written.

Types of Option Contracts

The options are of two styles. 1) European option and2) American option

An American style option is the one, which can be exercised by the buyer on

or before the expiration date, i.e. anytime between the day of purchase of the

option and the day of its expiry. The European kind of option is the one thatcan be exercised by the buyer on the expiration day only and not anytime

before that.

The options are of two types. 1) Call option and

2) Put option.

Call Option

A call option gives the holder/buyer, the right to buy specified quantity of the

underlying asset at the strike price on or before expiration date. The sellerhowever, has the obligation to sell the underlying asset if the buyer of the call

option decides to exercise his option to buy. One can buy call option when heor she expects the market to be bullish and sell call option when he or she

expects the market to be bearish.

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 theday of expiry is more than Rs.3500, the option will be exercised. The investor

will earn profits once the share price crosses Rs.3600. Suppose stock price isRs.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 atRs.3800 making a profit of Rs.200.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 toexercise his option. In this case the investor loses the premium, paid which

shall be the profit earned by the seller of the call option.


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Put Option

A put option gives the buyer the right to sell specified quantity of theunderlying asset at the strike price on or before an expiry date. The seller of

the put option however, has the obligation to buy the underlying asset at the

strike price if the buyer decides to exercise his options to sell. One can buyput option when he or she expects the market to be bearish and sell put

option when he or she expects the market to be bullish.

Example: An investor buys one European put option on Reliance at the strikeprice 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 will be exercised. The investor

will earn profits once the share price goes below 275. Suppose stock price isRs.260, the buyer of the put option immediately buys Reliance share in the

market @ Rs.260 and exercises his option selling the Reliance share at Rs.300to the option writer thus making a net profit of Rs.15.

In another scenario, if at the time of expiry stock price of Reliance is Rs.320,the buyer of the put option will choose not to exercise his option. In this case

the investor loses the premium, paid which shall be the profit earned by theseller of the put option.

In-the-Money, At-the-Money, Out-the-Money

An option is said to be at-the-money, when the options strike price is equalto 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. On the other hand, a call option is out-of-

the-money when the strike price is greater than the underlying asset price

A put option is in-the-money when the strike price of the option is greaterthan the spot price of the underlying asset. A put option is out-the-money

when the strike price is less than the spot price of underlying asset.

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

CALL OPTION PUT OPTION


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In-the-money Strike price < spot

price

Strike price > spot

price

At-the-money Strike price = spot

price

Strike price = spot

price

Out-the-money Strike price > spot

price

Strike price < spot

price

Stock index options

The stock index options are options where the underlying asset is a

stock Index.

For Example: Options on S&P 500 Index/ options on BSE Sensex etc.

Options on individual stocks

Options contracts where the underlying asset is an equity stock, aretermed as options on stocks.

They are mostly American style options cash settled or settled byphysical delivery.

Frequently used terms in options market

Underlying- The specific security/ asset on which an options contract is

based.

Option premium this is the price paid by the buyer to the seller toacquire the right to buy or sell.

Strike price or exercise price the strike or exercise price of an option is

the specified / pre-determined price of the underlying asset at which thesame can be bought or sold if the option buyer exercises his right to

buy/ sell on or before the expiration day.

Expiration date is the date on which the option expires. On expiration

date, either the option is exercised or it expires worthless.

Exercise date is the date on which the option is actually exercised.

Open interest the total number of options contracts outstanding in themarket at any given point of time.

Option holder is the one who buys an option which can be a call or a

put option.

Option seller/ writer is the one who is obligated to buy or to sell.

Option class all listed options of a particular type(i.e., call or put) on aparticular underlying instrument, e.g., all Sensex Call options (or) allSensex put options

Option series an option series consists of all the options of a given

class with the same expiration date and strike price. E.g.BSXCMAY3600is an option series, which includes all Sensex call options that are traded

with strike price of 3600 and expiry in May.


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Option Greeks the option Greeks are the tools that measure thesensitivity of the option price to the factors like price and volatility of

the underlying, time to expiry etc.

Option Calculator an option calculator is a tool to calculate the price ofan option on the basis of various influencing factors like the price of the

underlying and its volatility, time to expiry, risk free interest rate etc.

Option value

An option premium or the value of the option can be broken into two parts:

1. Intrinsic value and

2. Time value.

The intrinsic value of an option is defined as the amount by which an option isin-the-money or the immediate exercise value of the option when the

underlying position is marked-to-market.

For a call option: Intrinsic Value = spot price strike priceFor a put option: Intrinsic Value = strike price - spot price

The intrinsic value of an option must be a positive number or zero. It can not

be negative.

Time value is the amount option buyers are willing to pay for the possibility

that the option may become profitable prior to expiration due to favourablechange in the price of the underlying. An option loses its time value as its

expiration date nears. At expiration an option is worth only its intrinsic value.

Time value cannot be negative.

Factors affecting the value of an option (premium)


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There are two types of factors that affect the value of the option premium:

1) Quantifiable factors:

Underlying stock price The strike price of the option

The volatility of the underlying stock

The time to expiration

The risk free interest rate.

2) Non-Quantifiable Factors:

Market participants varying estimates of the underlying assetsfuture volatility

Individuals varying estimates of future performance of theunderlying asset, based on fundamental or technical analysis.

The effect of supply and demand- both in the options marketplace

and in the market for the underlying asset.

The depth of the market for that option the number oftransactions and the contracts trading volume on any given day.

Effect of various factors on option value


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As discussed earlier we know that the option price is affected by differentfactors. In this section, the effect of various factors is shown in the following

table:

Factor

Option

Ty

pe

Impact on OptionValue

Componentof Option

Value

Share price

moves upCall Option

Option Value will also

move up

Intrinsic

Value

Share price

moves downCall Option

Option Value will move

down

Intrinsic

Value

Share pricemoves up

Put OptionOption Value will movedown

IntrinsicValue

Share prices

moves downPut Option

Option Value will move

up

Intrinsic

Value

Time to expire ishigh

Call Option Option Value will be high Time Value

Time to expire is

lowCall Option Option Value will be low Time Value

Tim e to expireis high

Put Option Option Value will be high Time Value

Time to expire is

lowPut Option Option Value will be low Time Value

Volatility is high Call Option Option Value will be high Time Value

Volatility is low Call Option Option Value will be low Time Value

Volatility is high Put Option Option Value will be high Time Value

Volatility is low Put Option Option Value will be low Time Value

Margins


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When call and put options are purchased, the option price must be paid in full.Investors are not allowed to buy options on margin. This is because options

already contain substantial leverage. However the option seller needs tomaintain funds in a margin account. This is because the broker and the

exchange need to be satisfied that the investor will not default if the option is

exercised. The size of the margin required depends on the circumstances.

Different pricing models for options

The theoretical option pricing models are used by option traders for

calculating the fair value of an option on the basis of the earlier mentionedinfluencing factors. An option pricing model assists the trader in keeping the

price of calls and puts in proper numerical relationship to each other and

helping the trader make bids and offer quickly. The two most popular potionpricing models are

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 theunderlying follows a binomial distribution.

Who decides on the premium paid on options & how is it calculated?

Options premium is not fixed by the Exchange. The fair value/ theoreticalprice of an option can be known with the help of pricing models and then

depending on market conditions the price is determined by competitive bidsand offers in the trading environment. An options premium/ price is the sum

of intrinsic value and time value (explained above). If the price of the

underlying stock is held constant, the intrinsic value portion of an optionpremium will remain constant as well. Therefore, any change in the price of

the option will be entirely due to a change in the options time value. The timevalue component of the option premium can change in response to a change

in the volatility of the underlying, the time to expiry, interest rate fluctuations,

dividend payments and to the immediate effect of supply and demand for boththe underlying and its option.

Advantages of options

Besides offering flexibility to the buyer in form of right to buy or sell, the

major advantage of options is their versatility. They can be as conservative oras speculative as ones investment strategy dictates.


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Some of the benefits of options are as under:

High leverage as by investing small amount of capital (in form of

premium), one can take exposure in the underlying asset of much

greater value.

Pre-known maximum risk for an option buyer.

Large profit potential and limited risk for option buyer. One can protect his equity portfolio from a decline in the market by way

of buying a protective put wherein on buys puts against an existingstock position. This option position can supply the insurance needed to

overcome the uncertainty of the marketplace. Hence, by paying arelatively small premium (compared to the market value of the stock),

an investor knows that no matter how far the stock drops, it can be soldat the strike price of the put anytime until the put expires.

Risk and gains involved in options

The risk/loss of an option buyer is limited to the premium that he haspaid whereas his gains are unlimited.

The risk of an option writer is unlimited where his gains are limited tothe premiums earned.

When a physical delivery uncovered call is exercised upon, the writer

will have to purchase the underlying asset and his loss will be theexcess of the purchase price over the exercise price of the call reduced

by the premium received for writing the call.

The writer of a put option bears a risk of loss if the value of theunderlying asset declines below the exercise price. The writer of a put

bears the risk of a decline in the price of the underlying a sset

potentially to zero.

S&P CNX Nifty Options

An option gives a person the right but not the obligation to buy or sellsomething. An option is a contract between two parties wherein the buyer

receives a privilege for which he pays a fee (premium) and the seller accepts


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an obligation for which he receives a fee. The premium is the price negotiatedand set when the option is bought or sold. A person who buys an option is

said to be long in the option. A person who sells (or writes) an option is saidto be short in the option.

NSE introduced trading in index options on June 4, 2001. The optionscontracts are European style and cash settled and are based on the popular

market benchmark S&P CNX Nifty index.


Contract SpecificationsSecurity descriptor

The security descriptor for the S&P CNX Nifty options contracts is:

Market type : NInstrument Type : OPTIDX


Option Type : CE/ PE

Strike Price: Strike price for the contract

Instrument type represents the instrument i.e. Options on Index.Underlying symbol denotes the underlying index, which is S&P CNX Nifty


Option type identifies whether it is a call or a put option. CE - Call European,PE - Put European.


The underlying index is S&P CNX NIFTY.

Trading cycle

S&P CNX Nifty options contracts have a maximum of 3-month trading cycle -the near month (one), the next month (two) and the far month (three). On


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expiry of the near month contract, new contracts are introduced at new strikeprices for both call and put options, on the trading day following the expiry of

the near month contract. The new contracts are introduced for three monthduration.

Expiry day

S&P CNX Nifty options contracts expire on the last Thursday of the expirymonth. If the last Thursday is a trading holiday, the contracts expire on the

previous trading day.

Strike Price Intervals

The Exchange provides a minimum of five strike prices for every option type(i.e. call & put) during the trading month. At any time, there are two contracts

in-the-money (ITM), two contracts out-of-the-money (OTM) and one contractat-the-money (ATM).

New contracts with new strike prices for existing expiration date are

introduced for trading on the next working day based on the previous day'sclose Nifty values, as and when required. In order to decide upon the at-the-

money strike price, the Nifty closing value is rounded off to the nearest 10.

The in-the-money strike price and the out-of-the-money strike price are basedon the at-the-money strike price interval.

Trading Parameters

Contract size


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The permitted lot size of S&P CNX Nifty options contracts is 50 and multiplesthereof

Price bands

There are no day minimum/maximum price ranges applicable for optionscontracts. However, in order to prevent erroneous order entry, operating

ranges and day minimum/maximum ranges for options contract are kept at99% of the base price. In view of this, members will not be able to place

orders at prices which are beyond 99% of the base price. Members desiring to

place orders in option contracts beyond the day min-max range would berequired to send a request to the Exchange. The base prices for option

contracts may be modified, at the discretion of the Exchange, based on therequest received from trading members.

Options on Individual Securities

An option gives a person the right but not the obligation to buy or sell

something. An option is a contract between two parties wherein the buyerreceives a privilege for which he pays a fee (premium) and the seller accepts

an obligation for which he receives a fee. The premium is the price negotiated

and set when the option is bought or sold. A person who buys an option issaid to be long in the option. A person who sells (or writes) an option is said

to be short in the option.

NSE became the first exchange to launch trading in options on individualsecurities. Trading in options on individual securities commenced from July 2,

2001. Option contracts are American style and cash settled and are availableon 31 securities stipulated by the Securities & Exchange Board of India

(SEBI). (Selection criteria for securities)



Security descriptorThe security descriptor for the options contracts is:


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Market type : NInstrument Type : OPTSTK

Underlying : Symbol of underlying securityExpiry date : Date of contract expiry

Option Type : CA / PA

Strike Price: Strike price for the contractInstrument type represents the instrument i.e. Options on individual

securities.Underlying symbol denotes the underlying security in the Capital Market

(equities) segment of the ExchangeExpiry date identifies the date of expiry of the contract

Option type identifies whether it is a call or a put option. CA - Call American,

PA - Put American.

Underlying InstrumentOption contracts are available on 31 securities stipulated by the Securities &

Exchange Board of India (SEBI). These securities are traded in the Capital

Market segment of the Exchange.

Trading cycle

Options contracts have a maximum of 3-month trading cycle - the near month(one), the next month (two) and the far month (three). On expiry of the near

month contract, new contracts are introduced at new strike prices for both calland put options, on the trading day following the expiry of the near month

contract. The new contracts are introduced for three month duration.

Expiry day

Options contracts expire on the last Thursday of the expiry month. If the lastThursday is a trading holiday, the contracts expire on the previous trading

day.

Strike Price Intervals


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The Exchange provides a minimum of five strike prices for every option type(i.e. call & put) during the trading month. At any time, there are two contracts

in-the-money (ITM), two contracts out-of-the-money (OTM) and one contractat-the-money (ATM).

The strike price interval would be:

Price of Underlying Strike Price interval (Rs.)

Less than or equal to Rs. 50 2.50

>Rs.50 to < Rs150 5

> Rs.150 to < Rs.250 10

> Rs.250 to < Rs.500 20

> Rs.500 to < Rs.1000 30

> Rs.1000 to < Rs.2500 50

>Rs.2500 100

New contracts with new strike prices for existing expiration date are

introduced for trading on the next working day based on the previous day'sunderlying close values, as and when required. In order to decide upon the at-

the-money strike price, the underlying closing value is rounded off to thenearest strike price interval.

The in-the-money strike price and the out-of-the-money strike price are basedon the at-the-money strike price interval.

Trading Parameters


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Contract size

The value of the option contracts on individual securities may not be less thanRs. 2 lakhs at the time of introduction. The permitted lot size for the options

contracts on individual securities would be in multiples of 100 and fractions if

any, shall be rounded off to the next higher multiple of 100.

Price bands

There are no day minimum/maximum price ranges applicable for optionscontracts. However, in order to prevent erroneous order entry, operating

ranges and day minimum/maximum ranges for options contracts are kept at

99% of the base price. In view of this, members will not be able to placeorders at prices which are beyond 99% of the base price. Members desiring to

place orders in option contracts beyond the day min-max range would berequired to send a request to the Exchange. The base prices for option

contracts may be modified, at the discretion of the Exchange, based on therequest received from trading members.

How does option get settled?Option is a contract which has a market value like any other tradable

commodity. Once an option is bought there are following alternatives that anoption holder has:

One can sell an option of the same series as the one had bought and

close out/square off his/ her position in that option at any time on orbefore the expiration.

One can exercise the option on the expiration day in case of European

option or; on or before the expiration day in case of an American option.In case the option is out of money at the time of expiry, it will expire

worthless.

Settlement Mechanism:Options Contracts on Index or Individual Securities

Daily Premium Settlement


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Premium settlement is cash settled and settlement style is premium style. Thepremium payable position and premium receivable positions are netted across

all option contracts for each (Clearing Member) CM at the client level todetermine the net premium payable or receivable amount, at the end of each

day.

The CMs who have a premium payable position are required to pay thepremium amount to NSCCL which is in turn passed on to the members who

have a premium receivable position. This is known as daily premiumsettlement.

CMs are responsible to collect and settle for the premium amounts from the

TMs and their clients clearing and settling through them.

The pay-in and pay-out of the premium settlement is on T+1 days

(T = Trade day). The premium payable amount and premium receivableamount are directly debited or credited to the CMs clearing bank account.

Interim Exercise Settlement for Options on Individual Securities

Interim exercise settlement for Option contracts on Individual Securities is

effected for valid exercised option positions at in-the-money strike prices, atthe close of the trading hours, on the day of exercise. Valid exercised option

contracts are assigned to short positions in option contracts with the same

series, on a random basis. The interim exercise settlement value is the

difference between the strike price and the settlement price of the relevantoption contract.

Exercise settlement value is debited/ credited to the relevant CMs clearing

bank account on T+3 day (T= exercise date ).

Final Exercise Settlement

Final Exercise settlement is effected for option positions at in-the-money

strike prices existing at the close of trading hours, on the expiration day of an


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option contract. Long positions at in-the money strike prices are automaticallyassigned to short positions in option contracts with the same series, on a

random basis.

For index options contracts, exercise style is European style, while for options

contracts on individual securities, exercise style is American style. FinalExercise is Automatic on expiry of the option contracts.

Option contracts, which have been exercised, shall be assigned and allocatedto Clearing Members at the client level.

Exercise settlement is cash settled by debiting/ crediting of the clearing

accounts of the relevant Clearing Members with the respective Clearing Bank.

Final settlement loss/ profit amount for option contracts on Index is debited/credited to the relevant CMs clearing bank account on T+1 day (T = expiry

day).

Final settlement loss/ profit amount for option contracts on IndividualSecurities is debited/ credited to the relevant CMs clearing bank account on

T+3 day (T = expiry day).

Open positions, in option contracts, cease to exist after their expiration day.

The pay-in / pay-out of funds for a CM on a day is the net amount across

settlements and all TMs/ clients, in F&O Segment.

Options on Futures ContractsPut and call options are being traded on an increasing number of futurescontracts. Trading options on futures allows the speculator to participate in

the futures market and know in advance what the maximum loss on hisposition will be. The purchase of a call entitles the option buyer the right, but

not the obligation, to purchase a futures contract at a specified price at any

time during the life of the option. The underlying futures contract and theprice are specified. The purchase of a put option entitles the option buyer the

right, not the obligation, to sell a specified futures contract at a specifiedprice. Keep in mind that the profit realized with an option strategy is reduced

by the option premium. The option's price is determined in the same fashionthat an equity option is determined.

THE BLACK-SCHOLES MODEL

The Black-Scholes model is the most important option pricing model, whichalmost accurately values the option price. Option trading got a big boost after

the model was developed in 1973. Originally, it was for non-dividend paying


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stocks, but was subsequently modified to be useful for value other assetoptions as well. This model uses the following equations for pricing European

call options.

C = SN(d1) X exp-rt N(d2)

d1= ln(S/X exp-rt)/t + 0.5 td2= d1- t

here,c= option price

S = spot priceX= strike price

r= risk-free interest rate

t= time to expiration

= annualised volatility of stock returns (standard deviation of stock

returns)ln is the natural logarithmN ( ) is the cumulative probability distribution function for a standardized

normal variable

These equations are easy to use. The B-S model requires five variables,

out of which four are easily available: current stock price, strike price, risk-free interest rate and the options time to expiration. The only variable that is

not directly available is the expected volatility of the stocks return, which isestimated using historical data.

There are other models apart from the Black-Scholes model. Thepopular ones are the Binomial Model developed by Cox, Ross and Rubinstein

and the Adison Whaley Model. These are slightly more sophisticated than theBlack Scholes Model. However, the Option Values are not significantly

different. For example, if one Model gives you a Value of Rs 14.12, another

might come up with a Value of Rs 14.26. As a retail buyer of Options, youmight find that the difference between the bid and the ask at any point of

time is probably higher than the differences between Option Values of variousModels.

VOLATILITY

Volatility of a stock price is a measure of how uncertain we are about future

stock price movements. As volatility increases, the chance that the stock will

do very well or very poorly increases. For the owner of the stock, these two


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outcomes tend to offset each other. However, this is not so for the owner of acall or put. The owner of the call option benfits from price increases but has

limited downside risk in the event of price decreases since the most that he orshe can lose is the price of the option. Similarly, the owner of a put benefits

from price decreases but has limited downside risk in the event of price

increases. The values of both calls and puts therefore increase as volatilityincreases.

There are two kinds of volatility. 1) Historical volatility2) Implied volatility

Historical Volatility is a statistical measurement of past price movements.

Implied volatility measures whether option premiums are relatively expensive

or inexpensive. Implied volatility is calculated based on the currently tradedoption premiums.

1) Historical Volatility:

Historical volatility is a statistical measurement of past price movements. It isfound by finding the standard deviation of the price relative on any

underlying.

In mathematical form it is given by the following equation.

( )

2

11

1

= =

n

inS

Where

n+1 : number of observationsSi : stock price at end ofith interval (i =1,2,3,.,n)

ui : ln(Si/ Si-1)There is an important issue concerned with whether time should be measured

in calendar days or trading days when volatility parameters are being

estimated and used. The empirical research carried out to date indicates thatthe trading days should be used. In other words, days when the exchange is

closed should be ignored for the purpose of the volatility calculation.Choosing an appropriate value for n is not easy. There is a difference of

opinion among traders as to the number of days that should be considered. In

the Indian context, we currently find that Options are available for 3 months.However, most of the trading happens in the first month. Thus, the relevant

period for forecasting is one month or lower. Accordingly, it would be sensibleto consider Volatility based on the past 10 trading days and for the past 20


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trading days. Longer periods would perhaps not be relevant in the presentcontext.

What the above formula gives is the Daily Volatility. If we want to know the

Annual Volatility, we should multiply with the square root of the number of

working days in a year. For example, suppose we found daily volatility 4.43%and if one year has 256 working days, square root of 256 days is 16 days.

Thus in the above case the Annual Volatility is 4.43% x 16 = 70.88%.

In a similar manner, if we want to know the Volatility of the next 9 days, the9-day Volatility will be 4.43% x 3 = 13.29%.

Note: in this project, we have taken n=10 for finding the historical volatilityof any scrip.

2) Implied Volatility:

Implied volatility is the volatility implied by an option price observed in the

market. Implied volatility measures whether option premiums are relativelyexpensive or in

derivative indu

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