PROJECT ON

STUDY ON OPTION AND FUTURE TRADING IN INDIA

SUBMITTED TO: SUBMITTED BY:

SATYENDRA PRATAP SINGH VIDYA BHOOSHAN SINGH E-MAIL- vbs.bhooshan@gmail.com

FUTURE AND OPTION TRADING IN INDIA

What are options?

An option is a contract, which gives the buyer (holder) 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 be commodities like wheat/ rice/ cotton/ gold/ oil or financial instruments like equity stocks/ stock index/ bonds etc.

Option Premium - This is the price paid by the buyer to the seller to acquire 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 the same can be bought or sold if the option buyer exercises his right to buy/ sell on or before the expiration day.Expiration date - The date on which the option expires is known as Expiration Date. On Expiration date, either the option is exercised or it expires worthless.Exercise Date - is the date on which the option is actually exercised. In case of European Options the exercise date is same as the expiration date while in case of American Options, the options contract may be exercised any day between the purchase of the contract and its expiration date (see European/ American Option)

Open Interest - The total number of options contracts outstanding in the market at any given point of time.Option Holder: is the one who buys an option which can be a call or a put option. He enjoys the right to buy or sell the underlying asset at a specified price on or before specified time. His upside potential is unlimited while losses are limited to the Premium paid by him to the option writer.Option seller/ writer: is the one who is obligated to buy (in case of Put option) or to sell (in case of call option), the underlying asset in case the buyer of the option decides to exercise his option. His profits are limited to the premium received from the buyer while his downside is unlimited.Option Class: All listed options of a particular type (i.e., call or put) on a particular underlying instrument, e.g., all Sensex Call Options (or) all Sensex 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. BSXCMAY3600 is an options series which includes all Sensex Call options that are traded with Strike Price of 3600 & Expiry in May.

(BSX Stands for BSE Sensex (underlying index), C is for Call Option , May is expiry date and strike Price is 3600).What is Assignment?

When the holder of an option exercises his right to buy/ sell, a randomly selected option seller is assigned the obligation to honor the underlying contract, and this process is termed as Assignment.

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

What are 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 a 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}.

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.

How are options different from futures?

The significant differences in Futures and Options are as under:

Futures are agreements/contracts to buy or sell specified quantity of the underlying assets at a price agreed upon by the buyer and seller, on or before a specified time. Both the buyer and seller are obligated to buy/sell the underlying asset.

In case of options the buyer enjoys the right and not the obligation, to buy or sell the underlying asset.

Futures Contracts have symmetric risk profile for both buyers as well as sellers, whereas options have asymmetric risk profile.

In case of Options, for a buyer (or holder of the option), the downside is limited to the premium (option price) he has paid while the profits may be unlimited.

For a seller or writer of an option, however, the downside is unlimited while profits are limited to the premium he has received from the buyer.

Futures trading is a business that gives you everything you've ever wanted from a business of your own. Roberts (1991) calls it the world's perfect business. It offers the potential for unlimited earnings and real wealth. You can run it working at your own hours as well as continuing to do whatever you're doing now.

Futures Trading is a form of investment which involves speculating on the price of a

security going up or down in the future.

A security could be a stock (RIL, TISCO, etc), stock index (NSE Nifty Index),

commodity (Gold, Silver, etc), currency, etc.

Unlike other kinds of investments, such as stocks and bonds, when you trade

futures, you do not actually buy anything or own anything. You are speculating on

the future direction of the price in the security you are trading. This is like a bet on

future price direction. The terms "buy" and "sell" merely indicate the direction you

expect future prices will take.

If, for instance, you were speculating on the NSE Nifty Index, you would buy a futures

contract if you thought the price would be going up in the future. You would sell a

futures contract if you thought the price would go down. For every trade, there is

always a buyer and a seller. Neither person has to own anything to participate. He

must only deposit sufficient capital with a brokerage firm to insure that he will be

able to pay the losses if his trades lose money.

What is a Futures Contract?

A futures contract is a standardized contract, traded on a futures exchange, to buy or

sell a certain underlying instrument at a certain date in the future, at a specified

price. The future date is called the delivery date or final settlement date. The pre-set

price is called the futures price. The price of the underlying asset on the delivery date

is called the settlement price.

A futures contract gives the holder the obligation to buy or sell, which differs from an

options contract, which gives the holder the right, but not the obligation. In other

words, the owner of an options contract may or may not exercise the contract.

Whereas in a futures contract, both parties of a "futures contract" must fulfill the

contract on the settlement date.

In a futures contract the seller delivers the shares/commodity to the buyer, or, if it is

a cash-settled future, as in the case of stock futures in India, cash is transferred from

the futures trader who sustained a loss to the one who made a profit. To exit or close

your position in an existing futures contract prior to the settlement date, the holder

of a futures position has to offset his position by either selling a long position or

buying back a short position, effectively closing out the futures position and its

contract obligations.

The futures contract is a standardized forward contract, which is an agreement

between two parties to buy or sell an asset (which can be of any kind) at a pre-

agreed future point in time specified in the futures contract. Some key features of a

futures contract are:

Standardization

A futures contract is highly standardized contract with the following details specified:

The underlying asset or instrument. This could be anything from a barrel of

crude oil, a kilo of Gold or a specific stock or share. 

The type of settlement, either cash settlement or physical settlement.

Currently in India most stock futures are settled in cash.

 

The amount and units of the underlying asset per contract. This can be the

weight of a commodity like a kilo of Gold, a fixed number of barrels of oil,

units of foreign currency, quantity of shares, etc.

The currency in which the futures contract is quoted.

The grade of the deliverable. In the case of bonds, this specifies which bonds

can be delivered. In the case of physical commodities, this specifies not only

the quality of the underlying goods but also the manner and location of

delivery.

The delivery month.

The last trading date. 

Trading in futures is regulated by the Securities & Exchange Board of India (SEBI).

SEBI exists to guard against traders controlling the market in an illegal or unethical

manner, and to prevent fraud in the futures market.

How does Futures Trading Work?

There are two basic categories of futures participants: hedgers and speculators.

In general, hedgers use futures for protection against adverse future price

movements in the underlying cash commodity. The rationale of hedging is based

upon the demonstrated tendency of cash prices and futures values to move in

tandem.

Hedgers are very often businesses, or individuals, who at one point or another deal in

the underlying cash commodity. Take, for instance, a major food processor who cans

corn. If corn prices go up. he must pay the farmer or corn dealer more. For protection

against higher corn prices, the processor can "hedge" his risk exposure by buying

enough corn futures contracts to cover the amount of corn he expects to buy. Since

cash and futures prices do tend to move in tandem, the futures position will profit if

corn prices rise enough to offset cash corn losses.

Speculators are the second major group of futures players. These participants

include independent traders and investors. For speculators, futures have important

advantages over other investments:

If the trader's judgment is good. he can make more money in the futures market

faster because futures prices tend, on average, to change more quickly than real

estate or stock prices, for example. On the other hand, bad trading judgment in

futures markets can cause greater losses than might be the case with other

investments.

Futures are highly leveraged investments. The trader puts up a small fraction of the

value of the underlying contract (usually 10%-25% and sometimes less) as margin,

yet he can ride on the full value of the contract as it moves up and down. The money

he puts up is not a down payment on the underlying contract, but a performance

bond. The actual value of the contract is only exchanged on those rare occasions

when delivery takes place. (Compare this to the stock investor who generally has to

put up 100% of the value of his stocks.) Moreover the futures investor is not charged

interest on the difference between the margin and the full contract value.

Settling Futures Contracts in India

Futures contracts are usually not settled with physical delivery. The purchase or sale

of an offsetting position can be used to settle an existing position, allowing the

speculator or hedger to realize profits or losses from the original contract. At this

point the margin balance is returned to the holder along with any additional gains, or

the margin balance plus profit as a credit toward the holder's loss. Cash settlement is

used for contracts like stock or index futures that obviously cannot result in delivery.

The purpose of the delivery option is to insure that the futures price and the cash

price of good converge at the expiration date. If this were not true, the good would

be available at two different prices at the same time. Traders could then make a risk-

free profit by purchasing stocks in the market with the lower price and selling in the

futures market with the higher price. That strategy is called arbitrage. It allows some

traders to profit from very small differences in price at the time of expiration.

Advantages of Futures Trading in India

There are many inherent advantages of trading futures over other investment

alternatives such as savings accounts, stocks, bonds, options, real estate and

collectibles.

1. 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’. In other

words, the investor can trade a much larger amount of the security than if he bought

it outright, so if he has predicted the market movement correctly, his profits will be

multiplied (ten-fold on a 10% deposit). This is an excellent return compared to buying

and taking physical delivery in stocks.

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. Therefore, trading in

the futures markets offers the opportunity to profit from any potential economic

scenario. Regardless of whether we have inflation or deflation, boom or depression,

hurricanes, droughts, famines or freezes, there is always the potential for profit

making opportunities.

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%). Commissions on individual stocks are typically as much as one

percent for both buying and selling.

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.

 

Index Futures Stock Futures Index Options Stock Options Total

Average Daily

Turnover (Rs. cr.)

No. of contracts

Turnover

(Rs. cr.)

No. of contracts

Turnover (Rs. cr.)

No. of contracts

Notional Turnove

r (Rs. cr.)

No. of contrac

ts

Notional

Turnover (Rs.

cr.)No. of

contractsTurnover (Rs. cr.)

2000-01 90580

2365 - - - - - - 90580 2365 11

2001-02 1025588

21483 1957856 51515 175900 3765

1037529 25163 4196873 101926 410

2002-03 2126763

43952 10676843 286533 442241 9246

3523062

100131 16768909 439862 1752

2003-04 17191668

554446 32368842 1305939 1732414 52816

5583071

217207 56886776 2130610 8388

2004-05 21635449

772147 47043066 1484056 3293558 121943

5045112

168836 77017185 2546982 10107

2005-06 58537886

151375

5 80905493 2791697 12935116 338469524077

618025

315761927

1 4824174 19220

2006-07 81487424

253957

410495540

1 3830967 25157438 791906528331

019379

521688357

3 7356242 29543

2007-08 156598579

3820667.3

203587952

7548563.2 55366038

1362110.9

9460631

359136.6

425013200

13090477.8 52153.3

2008-09 210428103

3570111.4

221577980

3479642.1

212088444

3731501.8

13295970

229226.8

657390497

11010482.2 45310.63

2009-10 167764155

3666122.5

134170615

4789930.2

308799569

7184797.5

12599151

454666.9

623333490

16095517.1 72177.21

Trend analysis of the of the option and future trading in India:

Index future no.of contracts

0

50000000

100000000

150000000

200000000

250000000

2000

-01

2001

-02

2002

-03

2003

-04

2004

-05

2005

-06

2006

-07

2007

-08

2008

-09

2009

-10

year

no

of

con

trac

t

No. of contracts

If we talk about the no of the contract which is rapidly increasing till 2008-2009 and then decline in the Indian market . there is major change during the 2006-07to 2008-09.

Since liberalization number of export oriented units in Information Technology, Biotechnology, other knowledge related sectors, BPO, KPO as well as traditional sectors like gems, jewelry, textiles, auto components etc have come up. These companies have their revenues denominated in a foreign currency often dollar. Their expenses are often in rupees. The units lose money if the dollar weakens. The foreign exchange management is to minimize losses due to currency fluctuations. As the time gap between finalizing an export/import order and receiving/making payment against it widens, the possibility of fluctuation of exchange rate rises.

In India, regulation has been steadily eased and turnover and liquidity in the foreign currency derivative markets has increased, although the use is mainly in shorter maturity contracts of one year or less. Forward and option contracts are the more popular instruments. Regulators had initially only allowed certain banks to deal in this market however now corporates can also write option contracts. There are many variants of these derivatives which investment banks across the world specialize in, and as the awareness and demand for these variants increases, RBI would have to revise regulations. For now, Indian companies are actively hedging their foreign exchanges risks with forwards, currency and interest rate swaps and different types of options such as call, put, cross currency and range-barrier options.

Ranbaxy and RIL depend heavily on these contracts for their hedging requirements. As discussed earlier, forwards contracts can be tailored to the exact needs of the firm and this could be the reason for their popularity. The tailor ability is a consideration as it enables the firms to match their exposures in an exact manner compared to exchange traded derivatives like futures that are standardized where exact matching is difficult.

RIL, Maruti Udyog and Mahindra and Mahindra are the only firms using currency swaps. Swap usage is a long term strategy for hedging and suggests that the planning horizons for these companies are longer than those of other firms. These businesses, by nature

involve longer gestation periods and higher initial capital outlays and this could explain their long planning horizons.

Index future Turnover (Rs. cr.)

0500000

10000001500000200000025000003000000350000040000004500000

2000

-01

2001

-02

2002

-03

2003

-04

2004

-05

2005

-06

2006

-07

2007

-08

2008

-09

2009

-10

years

Tu

rno

ver

Turnover (Rs. cr.)

Index future turnover increased from year 2002 till mid 2007 after that its turnover fell from 4000000 to 3500000, since then it is constant.

stock future

0

50000000

100000000

150000000

200000000

250000000

2001-02

2002-03

2003-04

2004-05

2005-06

2006-07

2007-08

2008-09

2009-10

year

no

of

con

trac

t

No. of contracts

No. of contracts increased form year 2001-02 till mid of year 2007-08 then it fell from that point of time till the current yr. due to advent of recession.

stock future turnover

010000002000000300000040000005000000600000070000008000000

2001-02

2002-03

2003-04

2004-05

2005-06

2006-07

2007-08

2008-09

2009-10

year

turn

ove

r cr

Turnover (Rs. cr.)

From year 2001-02 it constantly increased till mid of 2007-08 after that it decreased tillMid of 2008-09. after that it increased slightly and reached 50000000 cr.

Index options no of contracts

050000000

100000000150000000200000000250000000300000000350000000

2001-02

2002-03

2003-04

2004-05

2005-06

2006-07

2007-08

2008-09

2009-10

year

no

of

co

ntr

acts

No. of contracts

No. of contracts were very low in the initial stage till mid of 2004-05. After that it is increasing constantly till now and expected to go higher.

index options notional turnover

010000002000000300000040000005000000600000070000008000000

2001

-02

2002

-03

2003

-04

2004

-05

2005

-06

2006

-07

2007

-08

2008

-09

2009

-10

year

turn

ove

r in

cr

Notional Turnover (Rs.cr.)

Notional turnover were very low in the initial yrs. Then it constantly increased till current year and in present its turnover is around 8000000 cr.

Stock Option (No.of Contract)

02000000400000060000008000000

100000001200000014000000

2001-02

2002-03

2003-04

2004-05

2005-06

2006-07

2007-08

2008-09

2009-10

Years

No

. o

f C

on

trac

t

No. of contracts

No. of contracts were 1000000 in 2001-02. then it increased and reached 6000000 in mid of 2003-04. Then it was constant till year 2006-07. After that it increased and touched 14000000 in year 2008-09 and then fell to 12000000 in the current year.

Stock Option Notional Turnover (Rs. cr.)

0

100000

200000

300000

400000

500000

2001

-02

2002

-03

2003

-04

2004

-05

2005

-06

2006

-07

2007

-08

2008

-09

2009

-10

years

Tu

rno

ver

(in

Rs.

Cr.

)

Notional Turnover (Rs.cr.)

Stock option national turnover was very low in the initial years. It increased to 200000 cr. in mid 203-04. Then it decreased and was constant then till mid of 2005-06 and then finally it is 400000 cr. in the current year 2009-10.

Future and Option Average Daily Turnover (Rs. cr.)

01000020000300004000050000600007000080000

2000

-01

2001

-02

2002

-03

2003

-04

2004

-05

2005

-06

2006

-07

2007

-08

2008

-09

2009

-10

years

Rs.

Cr

Average Daily Turnover (Rs.cr.)

Daily turnover was very low in initial yrs. It was 20000 cr. in 2006-07 and increased to 50000+ in the yr 2007-08 and decrease 5000cr 2008-09 and then increase by the 15000+ in 2009-10.

Conclusion:

During the study of the option and future trading in India we found that the trading of the option and future (stock and index ) rapidly growing till 2008and then decline for the one year and then increase . The decline year was basically the 2008-09 because of the slow down in this year and then increase by the speed . This trend is basically very popular in India during these year so many persons trading by option and future in Indian market .

Bibliography:

www.Nseindia.com > F&O > Market Information > Historical Data > Business Growth in Derivatives segment