PROJECT REPORT ON

A Study about investment & transition in Indian derivative markets.

MASTER OF MANAGEMENT STUDIES (MMS)UNIVERSITY OF MUMBAI

SUBMITTED TOShri. Yashwantrao chavan shikshan prasarak mandalsSINHGAN INSTITUTE OF BUSINESS MANAGEMENTPLOT NO. 126, MAHADA COLONY, CHANDIVALI, MUMBAI-400072

UNDER THE GUIDANCE OFSUSHMA VERMA

SUBMITTED BYMANTHAN JOGANIACADEMIC YEAR2013-2014PROJECT REPORT ON

A Study about investment & transition in Indian derivative markets.

MASTER OF MANAGEMENT STUDIES2014SUBMITTEDIN PARTIAL FULLFILLMENT OF REQUIREMENT FOR THE AWARD OF DEGREE OF MASTER OF MANAGEMENT STUDIES

BY:MANTHAN JOGANIShri. Yashwantrao chavan shikshan prasarak mandalsSINHGAN INSTITUTE OF BUSINESS MANAGEMENTPLOT NO. 126, MAHADA COLONY, CHANDIVALI, MUMBAI-400072UNIVERSITY OF MUMBAI2014CERTIFICATE

This is to certify that MR. MANTHAN JOGANI has satisfactorily carried out the project work on the topicA Study about investment & transition in Indian derivative markets. for the MMS, in the academic year 2014 & has successfully completed the project work as a part of academic fulfillment of Masters of Management Studies (M.M.S.) Semester IV examination.

________________________ _______________Name & Signature of Project Guide DIRECTORSIBM

Place: - ________

Date:-________

DECLARATION

I, MR. MANTHAN JOGANI student of MMS (2014) hereby declare that I have completed the project on A Study about investment & transition in Indian derivative markets. I further declare that the information imparted is true and fair to the best of my knowledge.

SIGNATURE

ACKNOWLEDGEMENTI hereby express my heartiest thanks to all sources who have contributed to the making of this project. I oblige thanks to all those who have supported, provided their valuable guidance and helped for the accomplishment of this project. I also extent my hearty thanks to my friends, our co-ordinator, college teachers and all the well wishers.I also would like to thanks my project guide SUSHMA VERMA for her guidance and timely suggestion and the information provided by her on this particular topic.It is matter of outmost pleasure to express my indebt and deep sense of gratitude to various person who extended their maximum help to supply the necessary information for the present thesis, which became available on account of the most selfless cooperation.Above all its sincere thanks to the UNIVERSITY OF MUMBAI for which this project is given consideration and was done with outmost seriousness.

EXECUTIVE SUMMARY

One of the interesting developments in financial markets over the last 15 to 20 years has been the growing popularity of derivatives or contingent claims. In many situations, both hedgers and speculators find it more attractive to trade a derivative on an asset than to trade the asset itself. Some derivatives are traded on exchanges. Others are made available to corporate clients by financial institutions or added to new issues of securities by underwriters.

In this report we have included history of Derivatives. Than we have included Derivatives Market in India. Than after we have included stock market Derivatives.

In this report we have taken a first look at forward, futures and options contracts. A forward or futures contract involves an obligation to buy or sell an asset at a certain time in the future for a certain price. There are two types of options: calls and puts. A call option gives the holder the right to buy an asset by a certain date for a certain price. In India the derivatives market has grown very rapidly. There are mainly three types of traders: hedgers, speculators and arbitrageurs.

In the next section, we have tried to determine the study of Nifty derivatives for the short term period using the two important indicators namely Open Interest & Put/Call Ratio. In which Put/Call Ratio analysis proves to be more effective indicators. Moreover in the analysis of Put/Call Ratio, Combination of Open Interest & Volume gives more accurate results.

In the last section, we have determined different trading strategies for different market views i.e. Bullish, Bearish, Range bound & Volatile. On the basis of investors perceptions they can use suited strategies which will minimize the loss. There are also some arbitrage strategies prevailing in the market like reversal, conversion etc. which give fix amount of profit irrespective of market movements but it is not readily available in the market but one has to grab such Opportunities.INDEX

Sr. noTopics Pg. no.

1INTRODUCTION TO INDIAN CAPITAL MARKET8

2INTRODUCTION TO DERIVATIVES11

3DEVELOPMENT OF DERIVATIVES MARKET IN INDIA16

4RESEARCH METHODOLOGY19

5STOCK MARKET DERIVATIVES22

6INTRODUCTION TO FUTURES26

7INTRODUCTION TO OPTIONS46

8OPEN INTEREST65

9CONCLUSION70

10BIBLIOGRAPHY71

11GLOSSARY72

CHAPTER1INTRODUCTION TOCAPITAL

CH. 1 INTRODUCTION TO INDIAN CAPITAL MARKET

CAPITAL MARKETIn todays era investor invest their funds after basic analysis. The basic function 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 is provided 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 main function 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 as personal 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 MARKETBefore 1996, all the transactions were done through physical form in security market. 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 is much more quicker and safer.

BSEThe 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.NSETo obviate the problem, RELATED TO PHYSICAL FORM the NSE introduced screen based trading system (SBTC) where a member can punch into the computer the quantities of shares & the prices at which he wants to transact.

CAHPTER2INTRODUCTION TODERIVATIVES

CH 2 INTRODUCTION TO DERIVATIVESThe term "Derivative" indicates that it has no independent value, i.e. its value is entirely "derived" from the value of the underlying asset. The underlying asset can be securities, commodities, bullion, currency, live stock or anything else. 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 an index 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. Some people/organisations are in the business of taking risks to earn profits. Such entities represent the SPECULATORS. The third player in the market, known as 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 oriented people.1. They help in the discovery of future as well as current prices.1. They catalyze entrepreneurial activity.1. They increase the volume traded in markets because of participation of risk-averse people in greater numbers.1. They increase savings and investment in the long run.

Factors driving the growth of financial derivatives1. Increased volatility in asset prices in financial markets,1. Increased integration of national financial markets with the international markets,1. Marked improvement in communication facilities and sharp decline in their costs,1. Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies, and1. Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets leading to higher returns, reduced risk as well as transactions costs as compared to individual financial assets.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. Options4. 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 is usually 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 to buy 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 the same 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. The holder 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 negative value, depending on movements in the price of the asset.2. Futures Contract:

A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future for a certain price. Unlike forward contracts, futures contract are normally traded on an exchange. To make trading possible, 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 guarantee that 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 its delivery 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 be commodities 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 option gives 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 regarded as portfolios of forward contracts.5. Warrants: Options generally have lives of upto one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter.

6. LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options having a maturity of up to three years.7. Baskets: Basket options are options on portfolios of underlying assets. The underlying 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. HedgersHedgers are interested in reducing a risk that they already face. The purpose of hedging is to make the outcome more certain. It does not necessarily improve the outcome.

1. SpeculatorsWhereas hedgers want to eliminate an exposure to movements in the price of assets, 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 extra leverage.

1. ArbitrageursThey are a third important group of participants in derivatives market. Arbitrage involves locking in a riskless profit by entering simultaneously into transactions in two or more markets. Arbitrage is sometimes possible when the futures price of an asset gets out of line with its cash price.

CHAPTER3DEVELOPMENT OFDERIVATIVES MARKET IN INDIA

CH 3 DEVELOPMENT OF DERIVATIVES MARKET IN INDIAThe first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws(Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24member committee under the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee submitted its report on March 17, 1998 prescribing necessary preconditions for introduction of derivatives trading in India. The committee recommended that derivatives should be declared as securities so that regulatory framework applicable to trading of securities could also govern trading of securities. SEBI also set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma, to recommend measures for risk containment in derivatives market in India. The report, which was submitted in October 1998, worked out the operational details of margining system, methodology for charging initial margins, broker net worth, deposit requirement and realtime monitoring requirements.The Securities Contract Regulation Act (SCRA) was amended in December 1999 to Include derivatives within the ambit of securities and the regulatory framework was developed for governing derivatives trading. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recognized stock exchange, thus precluding OTC derivatives. The government also rescinded in March 2000, the threedecade old notification, which prohibited forward trading in securities.Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2001. SEBI permitted the derivative segments of two stock exchanges, NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE30(Sensex) index. This was followed by approval for trading in options based on these two indexes and options on individual securities. The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. The derivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001. The index futures and options contract on NSE are based on S&P CNX.Trading and settlement in derivative contracts is done in accordance with the rules, byelaws, and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and notified in the official gazette. Foreign Institutional Investors (FIIs) are permitted to trade in all Exchange traded derivative products.Measures specified by SEBI to protect the rights of investor in the Derivative Market 1. Investor's money has to be kept separate at all levels and is permitted to be used only against the liability of the Investor and is not available to the trading member or clearing member or even any other investor. 1. 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 to trade in derivatives. 1. 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 not be accepted by the system. The investor could also demand the trade confirmation slip with his ID in support of the contract note. This will protect him from the risk of price favour, if any, extended by the Member. 1. In the derivative markets all money paid by the Investor towards margins on all open positions is kept in trust with the Clearing House/Clearing corporation and in the event of default of the Trading or Clearing 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, if any, on settled / closed out position are compensated from the Investor Protection Fund, as per the rules, bye-laws and regulations of the derivative segment of the exchanges.

CHAPTER4RESEARCHMETHODOLOGY

CH 4 RESEARCH METHODOLOGY

Objectives

To determine the short term trend of nifty future using the important derivatives market indicators.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 studyWe have done the study of nifty futures only.We have studied the short term trend of nifty futures for the years.Data collection sourcesPrimary NoSecondary1. Various stock market web sites1. Magazines1. Capitaline Neo software1. Odin diet SoftwareBeneficiaries of study1. Derivative traders1. Hedge funds1. Institutional investors1. Arbitragers1. Hedger1. Speculators1. Jobbers1. Investors1. Student1. Share broker1. Broking houses

Limitations

1. We have taken only Nifty futures for the purpose of study and not any other stock.1. The period of study is only one month derivative contract which may not give the same result every time.1. We have use only two indicators namely Open Interest and Put-Call ratio to determine the trend of Nifty.1. Few of the strategies prescribed in the study may give unlimited loss if the market goes other way round.1. There are many other factors which may lead the Nifty futures apart from the one which we have studied like technical analysis, Cost of Carry etc.

CHAPTER5STOCK MARKETDERVATIVES

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. The futures contracts are based on the popular benchmark S&P CNX Nifty Index.

The Exchange introduced trading in Index Options (also based on Nifty) on June 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 stipulated by SEBI.

Instruments available in IndiaThe National stock Exchange (NSE) has the following derivative products:ProductsIndex Futures

Index OptionsFutures on Individual SecuritiesOptions on Individual Securities

Underlying InstrumentS&P CNX NiftyS&P CNX Nifty180 securities stipulated by SEBI180 securities stipulated by SEBI

TypeEuropeanAmerican

Trading CycleMaximum of 3-month trading cycle. At any point in time, there will be 3 contracts available :1) near month, 2) mid month & 3) far monthSame as index futuresSame as index futuresSame as index futures

Expiry DayLast Thursday of the expiry monthSame as index futuresSame as index futuresSame as index futures

Contract SizePermitted lot size is 200 & multiples thereofSame as index futuresAs stipulated by NSE (not less than Rs.2 lacs)As stipulated by NSE (not less than Rs.2 lacs)

BSE also offers similar products in the derivatives segment

1. Minimum contract sizeThe Standing Committee on Finance, a Parliamentary Committee, at the time 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 not below 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. 1. Lot size of a contractLot size refers to number of underlying securities in one contract. Additionally, for stock specific derivative contracts SEBI has specified that the lot size of the underlying individual security should be in multiples of 100 and fractions, if any, should be rounded of to the next higher multiple of 100. This requirement of SEBI coupled with the requirement 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 particular scripts stands to be 200000/1000 = 200 shares i.e. one contract in XYZ Ltd. covers 200 shares.

CHAPTER6INTRODUCTION TOFUTURES

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 that there 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 for buyers. There were no storage facilities; and many times the harvest would rot before buyers were found. Also, because many farmers would bring their crops 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 of crops 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 provide spot prices for immediate delivery. Shortly thereafter, forward contracts were also established. These 'forwards' were forerunners to the present day futures contract.

Futures prices and the bid and asked price are continuously transmitted throughout the world electronically. Regardless of what geographic location the speculator or hedger is located in, he has the same access to price information as everyone else. Farmers, bankers, manufacturers, corporations, all have equal access. All they have to do is call their broker and arrange for the 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 the future price, it may be a floor broker, or it could be a speculator.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. This group includes live hogs, cattle, and pork bellies. The fourth type of agricultural commodities is the forest products group. This group includes lumber 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 harvest cycle. More actively traded commodities usually have more contract months available. 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, and platinum. 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 to meet 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 seen the most explosive growth. This group of futures contracts includes Treasury Bills, Treasury Bonds, Treasury Notes, Municipal Bonds, and Eurodollar Deposits. 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 rate differentials. In addition, foreign exchanges also trade debt instruments. Almost every month a new type of contract appears to meet the needs of a continuously growing corporate and institutional market. Indexes

Today, there are futures on most major indexes. The S&P 500, New York Stock Exchange Composite, New York Stock Exchange Utilities Index, Commodities Research Bureau (CRB), Russell 2000, S&P 400 Midcap, Value Line, and the FT-Se 100 Index (London). Stock index futures are settled in cash. There is no actual delivery of a good. The only possibility for the trader to settle his positions is to buy or sell an offsetting position or in cash at expiration. Almost every month a new type of contract appears to meet the needs of a continuously growing corporate and institutional market.

Foreign Currencies

In the 1970's when freely floating exchange rates were established it became possible to trade foreign currencies. Most major foreign currencies are traded. The principal currencies traded are the Canadian dollar, Japanese yen, British pound, Swiss franc, French franc, Eurodollar, Euromark, and the Deutsch mark. The forward market in currencies is much larger than the foreign exchange futures market. Additionally, there is now cross currency futures that trade. Examples of these are the Deutsch mark/French franc and the Deutsch mark/yen. Almost every month a new type of contract appears to meet the needs of a continuously growing corporate and institutional market.

Miscellaneous

Today, the number and variety of futures contracts that trade increase every month. Catastrophe insurance, cheddar cheese, cocoa, coffee, sugar, orange juice, diammonium phosphate (fertilizer), and anhydrous ammonia. Most of the contracts that trade which are not very liquid, and which one would never trade, are very useful to certain parties. Generally, these are corporations, which are using these contracts to hedge positions. They use them primarily to lock in a pre-determined price for their cost of goods and offset risk. Because many of these commodities are not liquid, they are poor selections for the speculator to bet on.The Indian capital market has grown quite well in the last decade. In the boom period of 1992 and thereafter, even the common man living in a village was attracted to the stock market. The stock market was considered a profitable investment opportunity. Before July 2001, various stock exchanges including the BSE, NSE, and the Delhi Stock Exchange (DSE), provided carry forward facilities through the traditional badla system. By means of this system the purchase or sale of a security was not postponed till a particular future date; instead the system only provided for the carry forward of a transaction from one settlement period (seven days) to the next settlement period 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 no price discovery; therefore, prices could be moved in any desired direction. Recent developments in the capital market culminated in a ban on badla from July 2001.

In the absence of futures trading, certain operators- either on their own or in collusion with corporate management teams at times manipulated prices in the secondary market, causing irreparable damage to the growth of the market. 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 the capital market, the downturn in the secondary market ultimately affected the primary market because people stopped investing in shares for fear of loss or liquidity. 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 futures market seems to be widening too. While initial trading was restricted to information technology stocks like Satyam, Infosys or Digital, today punters are slowly building positions in counters such as SBI, Telco. Tisco, Larsen and Toubro (L&T) and BPCL. This has increased volumes and depth in the market but has also resulted in the outstanding position reaching almost Rs 1,000 crore.

FeaturesEvery futures contract is a forward contract. They: Are entered into through exchange, traded on exchange and clearing corporation/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

Contract Size It specifies the amount of the asset that has to be delivered 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 market at 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 of time. Short position - Outstanding/ unsettled sales position at any point of time. Open position - Outstanding/unsettled long or short position at any point of time. Physical delivery - Open position at the expiry of the contract is settled through 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 cash settlement 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 and future prices converge at maturity.Under normal market conditions Futures contracts are priced above the spot price. This is known as the Contango MarketIt is possible for the Futures price to prevail below the spot price. Such a situation 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 market but 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 it off in the derivatives segment. Individual stock futures have picked up well in India. In India the stock futures are the most popular among all the derivatives. 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 are attracting 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 market movements. 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 1986and is themarket capitalization weighted index of 30 scripts whichrepresents 30 large well-established and financially sound companies. The Sensex represents a broad spectrum of companies in a variety of industries. It represents 14 major industry groups which are large enough to be used for effective hedging. Given the lower cost structure and the overwhelming popularity of the Sensex, Sensex futures are expected 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 and comfort with the product whereas the market is yet to witness institutional participation. FIIs have not been able to participate as they are still awaiting certain 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, money managers 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 the product essentially translates to lower impact cost of trading in Sensex futures. The arbitrage between the futures and the equity market is further expected 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:1. Stock Index Futures require lower capital adequacy and margin requirements when compared to margins on carry forward of individual scripts. 1. Index futures have lower brokerage costs. 1. Savings in cost is possible through reduced bid-ask spreads where stocks are traded in packaged forms. 1. The impact cost will be much lower in case of stock index futures as opposed to dealing in individual scripts. 1. The chances of manipulation are much lesser since the market is conditioned to think in terms of the index and therefore would prefer to trade 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 participation expected 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 number of contracts traded if not in terms of notional value. The advantage to the equity or cash market is in the fact that they would become 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 and Settlement 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 Daily Official 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.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 revenue which may result in this period. The costs typically include interest in case of financial futures (also insurance and storage costs in case of commodity futures). The revenue may be dividends in case of index futures.Apart from the theoretical value, the actual value may vary depending on demand 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 Spot prices.

S&P CNX Nifty FuturesA futures contract is a forward contract, which is traded on an Exchange. NSE commenced 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 underlying index, market lot, and the maturity date of the contract. The futures contracts are available for trading from introduction to the expiry date.1. Contract Specifications 1. Trading ParametersContract Specifications

Security descriptorThe security descriptor for the S&P CNX Nifty futures contracts is:Market type : NInstrument Type : FUTIDXUnderlying : NIFTYExpiry date : Date of contract expiryInstrument type represents the instrument i.e. Futures on Index.Underlying symbol denotes the underlying index which is S&P CNX NiftyExpiry date identifies the date of expiry of the contract

Underlying Instrument

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 new contract 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 the previous trading day.

Trading Parameters

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

Base PricesBase 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 on subsequent trading days would be the daily settlement price of the futures contracts.

Price bands

There are no day minimum/maximum price ranges applicable for S&P CNX Nifty 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 confirm to the Exchange that there is no inadvertent error in the order entry and that the order is genuine. On such confirmation the Exchange may approve such order.

Futures on Individual SecuritiesA futures contract is a forward contract, which is traded on an Exchange. NSE commenced trading in futures on individual securities on November 9, 2001. The futures contracts are available on 31 securities stipulated by the Securities & 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. 1. Contract Specifications 1. Trading ParametersContract Specifications

Security descriptor

The security descriptor for the futures contracts is:Market type : NInstrument Type : FUTSTKUnderlying : NIFTYExpiry date : Date of contract expiryInstrument type represents the instrument i.e. Futures on Index.Underlying symbol denotes the underlying security in the Capital Market (equities) segment of the ExchangeExpiry date identifies the date of expiry of the contract

Underlying Instrument

Futures 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 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 are introduced 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 the market (for each security) i.e., one near month, one mid month and one far month duration respectively.

Expiry dayFutures contracts expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts expire on the previous trading day.

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 to time.

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 if any 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 daily settlement price of the futures contracts.

Price bands

There are no day minimum/maximum price ranges applicable for futures contracts. 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 the order 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 and profit 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 than in options. In futures, there is no premium paid or received by any party, 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 the sellers. 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

DIFFERENCEFORWARDSFUTURES

1. Size of contracts

1. Price of contract

1. Mark to market

1. Margin

1. Counterparty risk

1. No. of contracts in A year

7. Hedging

8. Liquidity

9. Nature of market

10. Mode of delivery

Decided by buyer and seller

Remains fixed till maturity

Not done

No margin required

Present

There can be any number of contracts

These are tailor-made for a specific date and quantity, so perfect hedging is possible

No liquidity

Over the counter

Specifically decided. Most of the contracts result in delivery.

Standardized in each contract

Changes every day

Marked to market every day

Margins are to be paid by both buyers and sellers

Not present

No. of contracts in a year are fixed between 4 and 12.

Hedging is by nearest month and quantity contracts 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 product launch) or news about the economy (such as growth in the economy, are related budget announcement or a war or warlike situation). The job of an index is to capture the movement of the stock market with reference to news about the economy and the country. Each stock movement contains the mixture of two elements, stock news and index news. The most important stock market indices on which index futures contracts have been introduced are the S & P CNX nifty and the BSE sensex.

Margin MoneyThe 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 this exposure 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 MarginYes, there can be different types of margin like Initial Margin, Variation margin, Maintenance margin and Additional margin.

Objective of Initial MarginThe 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 deposited before 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 this measurement. 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 be around 8-10%.

Variation or Mark-to-Market MarginAll 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.

Maintenance MarginSome 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 replenished to 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 and Maintenance 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 be paid to replenish the levels of initial margin. This concept is not expected to be used in India.

Additional MarginIn 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, like payments crisis, etc. This is a preemptive move by exchange to prevent breakdown.

Cross MarginingThis is a method of calculating margin after taking into account combined positions in Futures, options, cash market etc. Hence, the total margin requirement reduces due to cross-Hedges. This is unlikely to be introduced in India immediately.

Settlement MechanismFutures Contracts on Index or Individual Securities Daily Mark-to-Market Settlement The positions in the futures contracts for each member are marked-to-market to 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 days settlement price. The CMs who have suffered a loss are required to pay the mark-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-market settlement.Theoretical daily settlement price for unexpired futures contracts, which are not traded during the last half an hour on a day, is currently the price computed as per the formula detailed below:

F = S * e rtWhere: F = theoretical futures priceS = value of the underlying indexr = rate of interest (MIBOR)t = time to expirationRate of interest may be the relevant MIBOR rate or such other rate as may be specified.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+1 days (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.The final settlement of the futures contracts is similar to the daily settlement process except for the method of computation of final settlement price. The final settlement profit / loss is computed as the difference between trade price or 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 CMs clearing 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 the last 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 the last 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 always Thursday and all open contracts at that time are settled as per special opening quotations in the cash market on the following Friday morning.

CHAPTER7INTRODUCTION TOOPTION

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, but do 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 and stock 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 Board Option 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 banned by 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 in their respective indices and also in some selected scripts. This marked the beginning of options in an organized form in India. In the forex market, the RBI 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 rolling settlement in major scripts, the use of equity options has increased substantially. These innovative exchange traded instruments provide all possible opportunities for speculation, hedging and arbitrage. Now let us discuss basics of options:

Four Components to an OptionThere 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 underlying security. November is the expiration month. 100 is the strike price (sometimes referred to as the exercise price). And the option is a call (the holder has the right, not the obligation, to buy 100 shares of XYZ at a price of 100). The Parties to an OptionThere 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 is the 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 delivering to the appropriate broker 100 shares of the underlying security for each option written.

Types of Option ContractsThe options are of two styles. 1) European option and 2) 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 that can 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 OptionA 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 seller however, 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 he or 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 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. 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.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, paid which shall be the profit earned by the seller of the call option.

Put OptionA put option gives the buyer the right to sell specified quantity of the underlying asset at the strike price on or before an expiry date. The seller of the put option 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 buy put 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 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 will be exercised. The investor will earn profits once the share price goes below 275. Suppose stock price is Rs.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.300 to 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 the seller 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 equal to the underlying asset price. This is true for both puts and calls.

A call option is said to be in-the-money when the strike price of the option is less than the underlying asset price. 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 greater than 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 exercise price is at significant variance with the underlying asset price.

CALL OPTIONPUT OPTION

In-the-moneyStrike price < spot priceStrike price > spot price

At-the-moneyStrike price = spot priceStrike price = spot price

Out-the-moneyStrike price > spot priceStrike price < spot price

Stock index options1. The stock index options are options where the underlying asset is a stock Index.1. For Example: Options on S&P 500 Index/ options on BSE Sensex etc.Options on individual stocks1. Options contracts where the underlying asset is an equity stock, are termed as options on stocks.1. They are mostly American style options cash settled or settled by physical delivery.

Frequently used terms in options market

1. Underlying- The specific security/ asset on which an options contract is based.1. Option premium this is the price paid by the buyer to the seller to acquire the right to buy or sell.1. 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.1. Expiration date is the date on which the option expires. On expiration date, either the option is exercised or it expires worthless. 1. Exercise date is the date on which the option is actually exercised.1. Open interest the total number of options contracts outstanding in the market at any given point of time.1. Option holder is the one who buys an option which can be a call or a put option.1. Option seller/ writer is the one who is obligated to buy or to sell.1. 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 options1. 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 option series, which includes all Sensex call options that are traded with strike price of 3600 and expiry in May.1. Option Greeks the option Greeks are the tools that measure the sensitivity of the option price to the factors like price and volatility of the underlying, time to expiry etc.1. Option Calculator an option calculator is a tool to calculate the price of an 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 valueAn option premium or the value of the option can be broken into two parts: 1. Intrinsic value and 1. Time value.

The intrinsic value of an option is defined as the amount by which an option is in-the-money or the immediate exercise value of the option when the underlying position is marked-to-market.For a call option: Intrinsic Value = spot price strike 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 favourable change 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)

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

1. Quantifiable factors:

0. Underlying stock price0. The strike price of the option0. The volatility of the underlying stock0. The time to expiration0. The risk free interest rate.

1. Non-Quantifiable Factors:

1. Market participants varying estimates of the underlying assets future volatility1. Individuals varying estimates of future performance of the underlying asset, based on fundamental or technical analysis.1. The effect of supply and demand- both in the options marketplace and in the market for the underlying asset.1. The depth of the market for that option the number of transactions and the contracts trading volume on any given day.

Effect of various factors on option value

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

FactorOption TypeImpact on Option ValueComponent of Option Value

Share price moves upCall OptionOption Value will also move upIntrinsic Value

Share price moves downCall OptionOption Value will move downIntrinsic Value

Share price moves upPut OptionOption Value will move downIntrinsic Value

Share prices moves downPut OptionOption Value will move upIntrinsic Value

Time to expire is highCall OptionOption Value will be highTime Value

Time to expire is lowCall OptionOption Value will be lowTime Value

Tim e to expire is highPut OptionOption Value will be highTime Value

Time to expire is lowPut OptionOption Value will be lowTime Value

Volatility is highCall OptionOption Value will be highTime Value

Volatility is lowCall OptionOption Value will be lowTime Value

Volatility is highPut OptionOption Value will be highTime Value

Volatility is lowPut OptionOption Value will be lowTime Value

Margins

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 to maintain 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 mentioned influencing 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 potion pricing models are1. Black Scholes Model which assumes that percentage change in the price of underlying follows a normal distribution.1. Binomial Model which assumes that percentage change in price of the underlying 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/ theoretical price of an option can be known with the help of pricing models and then depending on market conditions the price is determined by competitive bids and 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 option premium 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 time value 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 both the 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 or as speculative as ones investment strategy dictates.Some of the benefits of options are as under:1. 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.1. Pre-known maximum risk for an option buyer.1. Large profit potential and limited risk for option buyer.1. 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 existing stock position. This option position can supply the insurance needed to overcome the uncertainty of the marketplace. Hence, by paying a relatively small premium (compared to the market value of the stock), an investor knows that no matter how far the stock drops, it can be sold at the strike price of the put anytime until the put expires.

Risk and gains involved in options1. The risk/loss of an option buyer is limited to the premium that he has paid whereas his gains are unlimited.1. The risk of an option writer is unlimited where his gains are limited to the premiums earned. 1. When a physical delivery uncovered call is exercised upon, the writer will have to purchase the underlying asset and his loss will be the excess of the purchase price over the exercise price of the call reduced by the premium received for writing the call.1. The writer of a put option bears a risk of loss if the value of the underlying 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 OptionsAn 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 buyer receives 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 is said to be long in the option. A person who sells (or writes) an option is said to be short in the option.

NSE introduced trading in index options on June 4, 2001. The options contracts are European style and cash settled and are based on the popular market benchmark S&P CNX Nifty index. 1. Contract Specifications 1. Trading ParametersContract SpecificationsSecurity descriptorThe security descriptor for the S&P CNX Nifty options contracts is:Market type : NInstrument Type : OPTIDXUnderlying : NIFTYExpiry date : Date of contract expiryOption Type : CE/ PEStrike 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 NiftyExpiry date identifies the date of expiry of the contractOption type identifies whether it is a call or a put option. CE - Call European, PE - Put European.

Underlying InstrumentThe underlying index is S&P CNX NIFTY.

Trading cycleS&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 expiry of the near month contract, new contracts are introduced at new strike prices 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 month duration.Expiry dayS&P CNX Nifty options contracts expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts expire on the previous trading day.Strike Price IntervalsThe 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 contract at-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's close 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 based on the at-the-money strike price interval.

Trading ParametersContract sizeThe permitted lot size of S&P CNX Nifty options contracts is 50 and multiples thereof

Price bands

There are no day minimum/maximum price ranges applicable for options contracts. However, in order to prevent erroneous order entry, operating ranges and day minimum/maximum ranges for options contract are kept at 99% 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 be required to send a request to the Exchange. The base prices for option contracts may be modified, at the discretion of the Exchange, based on the request received from trading members.

Options on Individual SecuritiesAn 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 buyer receives 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 is said 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 individual securities. Trading in options on individual securities commenced from July 2, 2001. Option contracts are American style and cash settled and are available on 31 securities stipulated by the Securities & Exchange Board of India (SEBI). (Selection criteria for securities) 1. Contract Specifications 1. Trading Parameters

Contract Specifications

Security descriptorThe security descriptor for the options contracts is:

Market type : NInstrument Type : OPTSTKUnderlying : Symbol of underlying securityExpiry date : Date of contract expiryOption Type : CA / PAStrike 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 contractOption 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 cycleOptions 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 call and put options, on the trading day following the expiry of the near month contract. The new contracts are introduced for three month duration.

Expiry dayOptions contracts expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts expire on the previous trading day.

Strike Price IntervalsThe 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 contract at-the-money (ATM).

The strike price interval would be:Price of UnderlyingStrike Price interval (Rs.)

Less than or equal to Rs. 502.50

>Rs.50 to < Rs1505

> Rs.150 to < Rs.25010

> Rs.250 to < Rs.50020

> Rs.500 to < Rs.100030

> Rs.1000 to < Rs.250050

>Rs.2500100

New contracts with new strike prices for existing expiration date are introduced for trading on the next working day based on the previous day's underlying 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 the nearest strike price interval.

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

Trading Parameters

Contract sizeThe 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 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 options contracts. 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 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 be required to send a request to the Exchange. The base prices for option contracts may be modified, at the discretion of the Exchange, based on the request 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 an option holder has:1. 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 or before the expiration.1. 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 SettlementPremium settlement is cash settled and settlement style is premium style. The premium payable position and premium receivable positions are netted across all option contracts for each (Clearing Member) CM at the client level to determine 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 the premium amount to NSCCL which is in turn passed on to the members who have a premium receivable position. This is known as daily premium settlement.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 receivable amount 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, at the 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 relevant option 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 option contract. Long positions at in-the money strike prices are automatically assigned 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. Final Exercise is Automatic on expiry of the option contracts.

Option contracts, which have been exercised, shall be assigned and allocated to 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 Individual Securities 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 Contracts Put and call options are being traded on an increasing number of futures contracts. Trading options on futures allows the speculator to participate in the futures market and know in advance what the maximum loss on his position 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 the price 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 specified price. 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 fashion that an equity option is determined.

CHAPTER8OPEN INTEREST

CH 8 OPEN INTEREST

Open Interest is the number of open contracts of a given future or option contract. An open contract can be a long or short contract that has not been exercised, closed out, or allowed to expire. Open interest is really more of a data field than an indicator.A fact that is sometimes overlooked is that a futures contract always involves a buyer and a seller. This means that one unit of open interest always represents two people, a buyer and a seller.Open interest increases when a buyer and seller create a new contract. This happens when the buyer initiates a long position and the seller initiates a short position. Open interest decreases when the buyer and seller liquidate existing contracts. This happens when the buyer is selling an existing long position and the seller is covering an existing short position.Open interest remains unchanged when only buyer close out his/her position or only seller close out his/her position.

Interpretation

Incidentally, in individual stocks, open interest can be a better indicator of demand than trading volumes in the underlying. Volumes are often used as an indication of bullishness. However, daily volumes reflect short-term daily trades that are closed out by settling rather than delivery. These day trades distort the picture of long-term demand.

In a stock that has a futures or derivatives market, it is possible to "correct" the volumes indicator by looking at the open interest position. Open interest reflects trading views that are not settled intra-session and hence can reflect sentiment in the stock more effectively. By itself, open interest only shows the liquidity of a specific contract or market. However, combining volume analysis with open interest sometimes provides subtle clues to the flow of money in and out of the market: Rising volume and rising open interest confirm the direction of the current trend. Falling volume and falling open interest signal that an end to the current trend may be imminent.

The following are some interpretation that can be made using open interest. Rising open interest in an uptrend is bullish Declining open interest in an uptrend is bearish. Rising open interest in a downtrend is bearish. Declining open interest in a downtrend is bullish. Within an uptrend, a sudden leveling off or decline in open interest often warns a change in trend. Very high open interest at market tops is dangerous and can intensify downside pressure.

There are a few interesting contrarian theories that revolve around the "Open Interest" in derivative contracts. The number of open contracts at the end of the day will vary according to demand for the underlying stock.

In case of futures trades, one must decide whether this is due to greater bullishness or bearishness since futures contracts aren't differentiated according to price -- they are simply bought and sold at a certain spread.

But options are differentiated according to price as well as position. Analysts can easily break down open interest into puts and calls. Then, the open interest put-call ratio can be analysed in a fashion similar to the traded put-call ratio.How to interpret the open interest?Scrip: HDIL.

DATESPOT PRICEVOLUMEOPEN INTERESTPUT-CALL RATIO

June 3641.006836003988000.75

June 4635.005316004144000.55

June 5647.807472004828000.54

June 6635.006636004440001.03

June 7624.006684004868000.75

June 10650.906032004676000.79

June 11661.008312004808000.66

June 12652.604904004868000.50

June 13651.0012432004988000.38

June 14644.005252005016000.44

June 17643.003320005036000.45

June 18644.304680004708000.26

The above table shows spot price, futures volume, futures open interest and put/call ratios on daily bases. As we have mentioned earlier that one must keep in mind that one must decide that increase in open interest is due to bullishness or bearishness in case of futures contracts. As we can see from the table that from June 3,09 to June 5,09 the open interest for futures contracts has increased considerably and this increase is due to bullishness so one can buy call option or sell put option. From the table we find that the spot price of the scrip has increased during the next three to four days. To decide when to close out the position one can use volumes as indicator. For example, on June 11,2009 the volume was increasing in large amount, this indicates that the next day the price of the scrip will fall and so the options price. So one can close out his/her position on June 11, 2009.

Similarly from June 11 to June 13 the open interest for futures has increased but this is due to bearishness so one can buy put option or sell call option.

CONCLUSION

There are many indicators which can be used while trading in derivative market but widely used & more effective are open interest & put call ratio. Investors can study both together & can arrive at meaningful trend. These indicators can also be jointly used with technical analysis indicators to find out profitable buying & selling points.

Trading strategy can be framed by individual taking several considerations like view for the market-bullish, bearish or uncertain, type of trader-hedger, speculator or arbitrageur, risk appetite, period of investment, type of analysis-fundamental or technical analysis etc.But important thing is to minimize loss & take the right opportunity. Now a day markets are very volatile, so it is in the interest of investors to frame volatile market strategies as stated above rather than to have one view. Investors should have constant look on the market to execute opportunistic strategies which gives fix amount of profit irrespective of market fluctuations. Investors rather than keeping one view bullish or bearish its better to have volatile market strategy with limited loss and limited profits.

BIBLIOGRAPHYBOOKS:1. OPTIONS AND FUTURES IN INDI