A Project Report On. In depth study of Derivative Market. In partial fulfillment of summer internship program of 2 years fulltime MBA Course

Transcription

1 A Project Report On In depth study of Derivative Market In partial fulfillment of summer internship program of 2 years fulltime MBA Course

2 Ch.1 INDUSRY OVERVIEW INTRODUCTION: Stock markets refer to a market place where investors can buy and sell stocks. The price at which each buying and selling transaction takes is determined by market forces (i.e. demand and supply for a particular stock). Exemplify how market forces determine stock prices, take an example of ABC Co. Ltd. which enjoys high investor confidence and there is an anticipation of an upward movement in its stock price. More and more people would want to buy this stock (i.e. high demand) and very few people will want to sell this stock at current market price (i.e. less supply). Therefore, buyers will have to bid a higher price for this stock to match the ask price from the seller which will increase the stock price of ABC Co. Ltd. On the contrary, if there are more sellers than buyers (i.e. high supply and low demand) for the stock of ABC Co. Ltd. in the market, its price will fall down. In earlier times, buyers and sellers used to assemble at stock exchanges to make a transaction but now with the dawn of IT, most of the operations are done electronically and the stock markets have become almost paperless. Now investors do not have to gather at the Exchanges, and can trade freely from their home or office over the phone or through Internet. Stock exchanges to some extent play an important role as indicators, reflecting the performance of the country s economic state of health. It is exposed to a high degree of volatility; prices fluctuate within minutes and are determined by the demand and supply of stocks at a given time. Stock brokers are the ones who buy and sell securities on behalf of individuals and institutions for some commission. The Securities and Exchange Board of India (SEBI) is the authorized body, which regulates the operations of stock exchanges, banks and other financial institutions.

3 The past performances in the capital markets especially the securities scam by Hasrshad Mehta has led to tightening of the operations by SEBI. In addition the international trading and investment exposure has made it imperative to better operational efficiency. With the view to improve, discipline and bring greater transparency in this sector, constant efforts are being made and to a certain extent improvements have been made. HISTORY: Indian Stock Markets are one of the oldest in Asia. Its history dates back to nearly 200 years ago. The earliest records of security dealings in India are meager and obscure. By 1830 s business on corporate stocks and shares in Bank and Cotton presses took place in Bombay. Though the trading list was broader in 1839, there were only half a dozen brokers recognized by banks and merchants during 1840 and The 1850 s witnessed a rapid development of commercial enterprise and brokerage business attracted many men into the field and by 1860 the number of brokers increased into 60. In the American Civil War broke out and cotton supply from United States of Europe was stopped; thus, the Share Mania in India begun. The number of brokers increased to about 200 to 250. However, at the end of the American Civil War, in 1865, a disastrous slump began (for example, Bank of Bombay share which had touched Rs.2850 could only be sold at Rs.87). At the end of the American Civil War, the brokers who thrived out of Civil War in 1874, found a place in a street (now appropriately called as Dalal Street) where they would conveniently assemble and transact business. In 1887, they formally established in Bombay, the Native Share and Stock Brokers Association (which is alternatively known as The Stock Exchange ). In 1895, the Stock Exchange acquired a premise in the same street and it was inaugurated in Thus the Stock Exchange at Bombay was consolidated. Thus in the same way, gradually with the passage of time number of exchanges were increased and at currently it reached to the figure of 24 stock exchanges.

4 DEVELOPMENT: An important early event in the development of the stock market in India was the formation of the Native Share and Stock Brokers Association at Bombay in 1875, the precursor of the present-day Bombay Stock Exchange. This was followed by the formation of associations / exchanges in Ahmedabad (1894), Calcutta (1908), and Madras (1937). In order to check such aberrations and promote a more orderly development of the stock market, the central government introduced a legislation called the Securities Contracts (Regulation) Act, Under this legislation, it is mandatory on the part of a stock exchanges to seek government recognition. As of January 2002 there were 23 stock exchanges recognized by the central Government. They are located at Ahemdabad, Bangalore, Baroda, Bhubaneshwar, Calcutta, Chenni,(the Madras stock Exchanges ), Cochin, Coimbatore, Delhi, Guwahati, Hyderbad, Indore, Jaipur, Kanpur, Ludhiana, Mangalore, Mumbai(the National Stock Exchange or NSE), Mumbai (The Stock Exchange), popularly called the Bombay Stock Exchange, Mumbai (OTC Exchange of India), Mumbai (The Inter-connected Stock Exchange of India), Patna, Pune, and Rajkot. Of course, the principle bourses are the National Stock Exchange and The Bombay Stock Exchange, accounting for the bulk of the business done on the Indian stock market. While the recognized stock exchanges have been accorded a privileged position, they are subject to governmental supervision and control. The rules of a recognized stock exchanges relating to the managerial powers of the governing body, admission, suspension, expulsion, and re-admission of its members, appointment of authorized representatives and clerks, so on and so forth have to be approved by the government. These rules can be amended, varied or rescinded only with the prior approval of the government. The Securities Contracts (Regulation) Act vests the government with the power to make enquiries into the affairs of a recognized stock exchange and its business, withdraw the recognition the task of regulating the stock exchange to the Securities Exchanges Board of India.

5 TRADITIONAL BROKING: Traditionally in the stock Market, the investors invest their money in shares under the guidance of the Brokers of any stock broking company. This is convenient to those investors who are not familiar with the computer and the use of internet. But it requires more dealers to the share broking companies to give guidance related to investment. There was a chance of inaccuracy of price because it is a time consuming process. The cost of the company also increases due to more paperwork. The investor point of view, there was a problem of privacy. The information of investor may leak by the broker. So, to remove these limitations of traditional broking, there was an emergence of new concept e-broking. E- Broking: Electronic trading, sometimes called E-Trading, is a method of trading securities (such as stocks, and bonds), foreign currency, and exchange traded derivatives electronically. It uses information technology to bring together buyers and sellers through electronic media to create a virtual market place. As we know, historically, stock markets were physical locations where buyers and sellers met and negotiated. With the improvement in communications technology, the need for a physical location is of diminishing importance as the buyers and sellers can electronically exchange indications of interests as well as negotiate from a remote location. Electronic trading makes transactions easier to complete, monitor, clear, and settle. These are major drivers for most market regulators to insist that all markets eventually must be developed electronically The significance of the E broking increases day by day due to the benefits like reduction in the cost of transactions, Greater liquidity, Greater competition, Increased Transparency etc.

6 Demat Account: Demat refers to a dematerialized account. Though the company is under obligation to offer the securities in both physical and demat mode, you have the choice to receive the securities in either mode. If you wish to have securities in demat mode, you need to indicate the name of the depository and also of the depository participant with whom you have depository account in your application. It is, however desirable that you hold securities in demat form as physical securities carry the risk of being fake, forged or stolen. Just as you have to open an account with a bank if you want to save your money, make cheque payments etc, Nowadays, you need to open a demat account if you want to buy or sell stocks. So it is just like a bank account where actual money is replaced by shares. You have to approach the DPs (remember, they are like bank branches), to open your demat account. Let's say your portfolio of shares looks like this: 150 of Infosys, 50 of Wipro, 200 of HLL and 100 of ACC. All these will show in your demat account. So you don't have to possess any physical certificates showing that you own these shares. They are all held electronically in your account. As you buy and sell the shares, they are adjusted in your account. Just like a bank passbook or statement, the DP will provide you with periodic statements of holdings and transactions. In India, a demat account, the abbreviation for dematerialised account, is a type of banking account which dematerializes paper-based physical stock shares. The dematerialised account is used to avoid holding physical shares: the shares are bought and sold through a stock broker.

7 Procedure: 1. Fill the demat request form (DRF) (obtained from a depository participant or DP with whom your depository account is opened). 2. Deface the share certificate(s) you want to dematerialize by writing across Surrendered for dematerialization. 3. Submit the DRF & share certificate(s) to DP. DP would forward them to the issuer / their R&T Agent. 4. After dematerialization, your depository account with your DP, would be credited with the dematerialized securities. Benefits: Immediate transfer of securities No stamp duty on transfer of securities Elimination of risks associated with physical certificates such as bad delivery Reduction in paperwork involved in transfer of securities Reduction in transaction cost Automatic credit into demat account of shares, arising out of bonus/split/consolidation/merger etc. Holding investments in equity and debt instruments in a single account.

8 TRANSACTION CYCLE: Decision to trade Placing Order Funds or Securities Transaction Cycle Trade Execution Settlement of trades Clearing of Trades A person holding assets (Securities/Funds), either to meet his liquidity needs or to reshuffle his holdings in response to changes in his perception about risk and return of the assets, decides to buy or sell the securities. He selects a broker and instructs him to place buy/sell order on an exchange. The order is converted to a trade as soon as it finds a matching sell/buy order. At the end of the trade cycle, the trades are netted to determine the obligations of the trading member s securities/funds as per settlement cycle. Buyer/seller delivers funds/ securities and receives securities/funds and acquires ownership of the securities. A securities transaction cycle is presented above. Just because of this Transaction cycle, the whole business of Securities and Stock Broking has emerged. And as an extension of stock broking, the business of Online Stock broking/ Online Trading/ E-Broking has emerged.

9 DEPOSITORY: A depository is like a bank wherein the deposits are securitis (shares, debentures, bonds, government securities etc.) in an electronic form. Depository interacts with its clients / investors through its agents, called Depository Participants normally known as DPs. No. of Depository in the country: Currently there are two depositories operational in the country. 1. National Securities Depository Ltd. (NSDL) 2. Central Depository Services Ltd. (CDSL) Services provided by Depository: Dematerialization (usually known as demat) is converting physical certificates to electronic form Rematerialization, known as remat, is reverse of demat, i.e. getting physical certificates from the electronic securities Transfer of securities, change of beneficial ownership Settlement of trades done on exchange connected to the Depository Electronic credit in public offering of the Companies Non - Cash corporate benefits, viz. Bonus / Rights - direct credit into electronic form

10 FIVE FORCE ANALYSIS POTENTIAL ENTERANT Financial Comanies Banks Foreign Players SUPPLIERS Web maintainers CDSL NSDL NSE BSE MCX NCDEX COMPETITORS Mutual Funds Companies Insurance Companies Banks BUYERS Small Investors Franchise/Business Partners MF Companies HUF Institutional Investors SUBSTITUTES Mutual Funds Insurance Bank FD

11 Ch. 2 STOCK EXCHANGES INTRODUCTION: The Security Contract (Regulation) Act, 1956 [SCRA] defines Stock Exchange as any Body of Individuals, whether incorporated or not, constituted for the purpose of assisting, regulating or controlling the business of buying, selling or dealing in Securities. Stock Exchange could be a Regional Stock Exchange whose area of operations is specified at the time of its recognition or national exchanges, which are permitted to have nationwide trading since inception. NSE was incorporated as a National Stock Exchange and similarly BSE as a Bombay Stock Exchange. In short we can say that Stock Exchange is nothing but a common platform where buyers and sellers come together to transact in stocks and share. It may be a physical entity where brokers trade on a physical floor via an Open Outcry system or a Virtual Environment. INDICES: An Index is a comprehensive measure of market trends, intended for investors who are concern with general stock market price movements. An Index comprises Stocks that have Large Liquidity and Market Capitalization. Each stock is given a weightage in the Index equivalent to its market capitalization. The Index of NSE is known as NIFTY while the Index of BSE is known as SENSEX. At the NSE, the capitalization of NIFTY (50 selected stocks) is taken as a base capitalization, with the value set at Similarly BSE, Sensitivity Index i.e., SENSEX comprises 30 selected stocks. The index value compares the day s Market Capitalization along with Base Capitalization and indicates how prices in general have moved over a period over a time.

12 Bombay Stock Exchange is the oldest stock exchange in Asia with a rich heritage, now spanning three centuries in its 133 years of existence. What is now popularly known as BSE was established as "The Native Share & Stock Brokers' Association" in BSE is the first stock exchange in the country which obtained permanent recognition (in 1956) from the Government of India under the Securities Contracts (Regulation) Act BSE's pivotal and pre-eminent role in the development of the Indian capital market is widely recognized. It migrated from the open outcry system to an online screen-based order driven trading system in Over the past 133 years, BSE has facilitated the growth of the Indian corporate sector by providing it with an efficient access to resources. There is perhaps no major corporate in India which has not sourced BSE's services in raising resources from the capital-market. Today, BSE is the world's number 1 exchange in terms of the number of listed companies and the world's 5th in transaction numbers. An investor can choose from more than 4,700 listed companies, which for easy reference, are classified into A, B, S, T and Z groups. A Governing Board having 20 directors is the apex body, which decides the policies and regulates the affairs of the Exchange. The Governing Board consists of 9 elected directors, who are from the broking community (one third of them retire ever year by rotation), three SEBI nominees, six public representatives and an Executive Director & Chief Executive Officer and a Chief Operating Officer. In BSE the index is popularly known as SENSEX i.e., Sensitivity Index. SENSEX is a basket of 30 constituent stocks. The base year of SENSEX is and the base value is 100.

13 NSE was incorporated in 1992 and was given recognition as a stock exchange in April It started operations in June 1994, with trading on the Wholesale Debt Market Segment. Subsequently it launched the Capital Market Segment in November 1994 as a trading platform for equities and the Futures and Options Segment in June 2000 for various derivative instruments. The National Stock Exchange of India Ltd. is the largest stock exchange of the country. In NSE the index is known as NIFTY. NIFTY is a basket of 50 constituent stocks. NSE has been able to take the stock market to the doorsteps of the investors. The technology has been harnessed to deliver the services to the investors across the country at the cheapest possible cost. It provides a nation-wide, screen-based, automated trading system, with a high degree of transparency and equal access to investors irrespective of geographical location. The high level of information dissemination through on-line system has helped in integrating retail investors on a nation-wide basis. The standards set by the exchange in terms of market practices, Products, technology and service standards have become industry benchmarks and are being replicated by other market participants. It has been playing a leading role as a change agent in transforming the Indian Capital Markets to its present form. The Indian Capital Markets are a far cry from what they used to be a decade ago in terms of market practices, infrastructure, technology, risk management, clearing and settlement and investor service. In an ongoing effort to improve NSE's infrastructure, a corporate network has been implemented, connecting all the offices at Mumbai, Delhi, Calcutta and Chennai. This corporate network enables speedy inter-office communications and data and voice connectivity between offices

14 National Commodity & Derivatives Exchange Limited is popularly known as NCDEX. The list of promoters mainly includes Life Insurance Corporation of India (LIC), National Bank for Agriculture and Rural Development (NABARD) and National Stock Exchange of India Limited (NSE) Before a decade no much importance was given to the financial assets like share, bonds etc. But now people would like to invest in commodities as well. Due to this, the need for a regulatory body emerged. As a result, NCDEX was incorporated on April 23, 2003 under the Companies Act, It obtained its Certificate for Commencement of Business on May 9, It commenced its operations on December 15, NCDEX is located in Mumbai and offers facilities to its members about 550 centers throughout India. The reach will gradually be expanded to more centres. NCDEX currently facilitates three types of commodities like agriculture, metals, energy which includes 57 commodities. NCDEX is the only commodity exchange in the country promoted by national level institutions. This unique parentage enables it to offer a bouquet of benefits, which are currently in short supply in the commodity markets. Other shareholders: Canara Bank, CRISIL Limited (formerly the Credit Rating Information Services of India Limited), Goldman Sachs, Intercontinental Exchange (ICE), Indian Farmers Fertilizer Cooperative Limited (IFFCO) and Punjab National Bank (PNB).

15 Multi Commodity Exchange is popularly known as MCX. It deals with round about 100 commodities. MCX is an independent commodity exchange in India. It was established in 2003 in Mumbai. MCX of India Limited is a new order exchange with a mandate for setting up a nationwide, online multi-commodity, Market place, offering unlimited opportunities to commodities market participants. As a true neutral market, MCX has taken many initiatives for users. Features: The exchange's competitor is National Commodity & Derivatives Exchange Ltd. popularly known as NCDEX With a growing share of 72%, MCX continues to be India's No. 1 commodity exchange Globally, MCX ranks no. 1 in silver, no. 2 in natural gas, no. 3 in crude oil and gold in futures trading The average daily turnover of MCX is about US$ 2.2 billion) MCX now reaches out to about 500 cities in India with the help of about 10,000 trading terminals Key Shareholders: Financial Technologies (I) Ltd., State Bank of India and it's associates, National Bank for Agriculture and Rural Development (NABARD), National Stock Exchange of India Ltd. (NSE), Fid Fund (Mauritius) Ltd. - an affiliate of Fidelity International, Corporation Bank, Union Bank of India, Canara Bank, Bank of India, Bank of Baroda, HDFC Bank and SBI Life Insurance Co. Ltd., ICICI ventures, IL&FS, Meryll Lynch

16 Securities & Exchange Board of India Securities and Exchange Board of India (SEBI) is an autonomous body created by the Government of India in 1988 and given statutory form in 1992 with the SEBI Act Its head office is in Mumbai, and has regional offices in Chennai and Delhi. SEBI is the regulator of Securities markets in India. The new chairman of SEBI, Mr. C. B. Bhave took charge on February Basic Objectives: to protect the interests of investors in securities; to promote the development of Securities Market; to regulate the securities market and for matters connected therewith or incidental thereto. Functions: It acts as a barometer for market behavior; It is used to benchmark portfolio performance; It is used in derivative instruments like index futures and index options; It can be used for passive fund management as in case of Index Funds.

17 Two broad approaches of SEBI is to integrate the securities market at the national level, and also to diversify the trading products, so that there is an increase in number of traders including banks, financial institutions, insurance companies, mutual funds, primary dealers etc. to transact through the Exchanges. The introduction of derivatives trading through Indian Stock Exchanges permitted by SEBI 2000 AD is a real landmark. SEBI appointed the L. C. Gupta Committee in 1998 to recommend the regulatory framework for derivatives trading and suggest bye-laws for Regulation and Control of Trading and Settlement of Derivatives Contracts. The Board of SEBI in its meeting held on May 11, 1998 accepted the recommendations of the committee and approved the phased introduction of derivatives trading in India beginning with Stock Index Futures. SEBI then appointed the J. R. Verma Committee to recommend Risk Containment Measures (RCM) in the Indian Stock Index Futures Market. The report was submitted in November,1998. However the Securities Contracts (Regulation) Act, 1956 (SCRA) required amendment to include "derivatives" in the definition of securities to enable SEBI to introduce trading in derivatives. The necessary amendment was then carried out by the Government in The Securities Laws (Amendment) Bill, 1999 was introduced. In December 1999 the new frame work was approved. Derivatives have been accorded the status of `Securities'. The ban imposed on trading in derivatives in 1969 under a notification issued by the Central Government was revoked. Thereafter SEBI formulated the necessary regulations/bye-laws and intimated the Stock Exchanges in the year The derivative trading started in India at NSE in 2000 and BSE started trading in the year 2001.

18 Ch.3 COMPANY OVERVIEW INTRODUCTION & HISTORY: Angel Broking is an organization whose vision, keen foresight and a passion to excel & stay ahead have made it one of India s leading Retail Stock Broking & Wealth Mgmt Houses today. Angel Broking recognized the opportunity offered by the stock markets to serve individual investors, and established the industries first retail-focused stock-broking house in The visionary in it also ensured that Angel Broking was the first broking firm to introduce the branch-concept as well as to adopt new technology for faster, more effective & affordable services to retail investors. The whole Group of Angel is promoted by Mr. Dinesh Thakkar (Chairman and Managing Director) and professionally managed by a team of direct employees. It has a nationwide network comprising of 18 regional centers, 82 branches, 3 PCG offices, registered sub brokers and business associates and active trading terminals, which cater to the requirements of about Lacks retail clients. Incorporated in1987 BSE membership in 1997 NSE membership in1998 Membership with NCDEX and MCX Depository Participant with CDSL Angel Broking focuses the business exclusively on the needs of individual clients. For the firm the customer always comes first. And therefore it takes pleasure in the professional quality of its work and in its ability to delight its clients.

19 The Angel Group has emerged as one of the top 5 retail stock broking houses in India, having memberships on BSE, NSE and the two leading commodity exchanges in the country i.e. NCDEX and MCX. Angel Broking Ltd is also registered as a depository participant with CDSL. It is the only 100% retail stock broking house offering a gamut of retail centric services like Research, Investment Advisory, Portfolio Management Services, E-Broking, Commodities, Depository Services, Private Client Group (PCG), MutualFund. The CSO of the Angel Broking is in Mumbai while the other Regional Hubs are adjacent to this table...

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22 PAST, PRESENT & FUTURE OF THE FIRM: Past: Dinesh Thakkar began as a Sub broker in 1987 Small team of 3 employees and 25 clients First to launch a web-enabled back office software Only retail broking house to generate client codes in hours It has the highest number of registered intermediaries in NSE First to concentrate on retail-centric research First to focus on small & mid-cap segments First to adopt the branch concept of doing Business Organization wide Quality Assurance Drive A first in retail broking space Human Resource initiatives Training & Development Angel was awarded the coveted Major Volume Driver Trophy from BSE for the Year & &

23 Present: Strong client base of branches Business Associates across the Country Active Terminals Direct Employee strength Angel has the largest no. of NSE registered sub-brokers We have the 3rd largest volume on BSE Future: 250 Branches by March ,00,000+ Clients Team strength people Market share 5 to 6% Present Business Ventures & Future Plans

24 CODE OF CONDUCT & CORE COMPETENCIES OF FIRM: Code of Conduct: Transparency Business Confidentiality Corporate Communication Brand Management Integrity in Financial Accounting Acts Amounting Misconduct (could lead to termination) Use of Assets and other Resources No favoritism in workplace No gossips at Work and Passing or Wasting of Time in any other way is not allowed Adhering to Dress Code Moral Respect of All Angelites Core Competencies: Top quality research & portfolio advisory services for equities Retail focused research products Robust internet trading facility Commodities research & broking services Depository services through CDSL Web based 24 x 7 back office software Good understanding of the sub-broker and retail customer need Professional work culture with a personal touch Cost- effective processes Single connectivity and speedy execution of trades. Private v-sat network for remote areas. Online technical support & help desk.

25 FEATURES AND BENEFITES ASSOCIATED WITH THE FIRM Features of Angel: Multiple exchanges on a single screen: Online trading on BSE / NSE (Cash and F&O), MCX and NCDEX on a single screen. Competitive brokerage rates: Organization is providing its clients the best value added services at the competitive brokerage rates. Online funds transfer: Organization is giving convenience of online transfer of funds from their bank accounts, to the margin account of Angel, online. Personalized service: Clients can avail of personalized advisory services from the trained and experienced dealers of Angel Broking, regarding trading opportunities. Back office infrastructure: Organization provides an automated web enabled centralized back-office whereby the clients can have access to their trade confirmation reports, holding statement, their net position, the margins and the statement of accounts and ledgers on a 24 X 7 basis. Benefits offered by company: No risk of loss, wrong transfer, mutilation or theft of share certificates. Reduced paper work. Speedier settlement process. Because of faster transfer and registration of securities in clients account, increased liquidity of clients securities. Instant disbursement of non-cash benefits like bonus and rights into your account. Efficient pledge mechanism. Wide branch coverage. Personalized and attentive services of trained help desk. Acceptance & execution of instruction on Fax. Zero upfront payment. Daily statement of transaction & holding statements on . No charges for extra transaction statement & holding statement

26 SERVICES PROVIDED BY THE FIRM E-Broking Angel Gold Angel Diet Angel Anywhere Angel Trade Commodities Application & Web-based Trading Platform Daily, Weekly & Monthly Research Reports Efficient Risk Management PMS Wealth Creation & Preservation Concept of Model Portfolio Periodic Evaluation Special Services for HNI Investment Advisory Expert Advice Timely Entry & Exit De-Risking Portfolio Guidance and Advice for optimum return

27 Mutual Fund Benefits of Expertise people More than 1500 Schemes Various Risk Return Profiles Advisory-based Services Weekly Reviews Dedicated MF Research IPO All major IPOs offered Advise from Angel Research Desk Issues and Company Details Private Client Group Minimum Portfolio size of Rs.1Cr Advice for timely exit & fresh investments Special Technical and Derivative strategies Depository Services Efficient pledge mechanism. Wide branch coverage.

28 MILESTONES: February, 2008 November, 2007 March, 2007 December, 2006 October, 2006 September, 2006 July, 2006 March, 2006 October, 2005 September, 2004 April, 2004 April, 2003 November, 2002 March, 2002 November, 1998 December, 1997 Crossed the 400,000 mark in unique trading accounts Received "Major Volume Driver" award for FY07 Crossed the 200,000 mark in unique trading accounts Crossed the 2,500 mark in terms of business associates. Received "Major Volume Driver" award for FY06 Commenced Mutual Fund and IPO distribution business Formally launched the PMS function Crossed the 100,000 mark in unique trading accounts and Completes the roll out of 50th branch Received the prestigious "Major Volume Driver" award for FY05 Launch of Online Trading Platform Incorporation of Commodities Broking division Publication of first Research Report First ever Investor seminar of Angel Group Web-enabled Back Office software developed Incorporation of Angel Capital and Debt Market Ltd. Incorporation of Angel Broking Ltd

29 Ch. 4 DERIVATIVE MARKET INTRODUCTION TO DERIVATIVES: Derivatives defined A derivative is a financial instrument that derives its value from an underlying asset. This underlying asset can be stocks, bonds, currency, commodities, metals and even intangible, simulated assets like stock indices. Simply we can say that derives some thing from someone. E.g. we derived price of curd from price of milk. It is derivatives. In the Indian context the Security Contract Act, 1956 defines derivative to include: 1) A security derived from a debt instrument, shares, and loans whether secured or unsecured, risk instrument or contract for any other from of security. 2) A contract which derives its value from of security. What is a derivative instrument? It is a contract whose value depends on or derives from the value of an underlying asset [say a share, forex, commodity or an index]. In its broadest sense a derivative attempts to hedge against the variability of any economic variable. Thus exposures or perceived risks to a firm arising from the variation in interest rates, exchange rates, commodity prices and equity prices can be hedged through an appropriate derivative structure. Such a derivative structure covers a wide variety of financial contracts viz. Futures, Forwards, Options, Swaps and different variations thereof. These contracts can be traded on the various Exchanges in a standardized manner or by custom designed for individual requirements.

30 The four important types of derivatives are based on the following: I) Bonds which vary in price according to interest rates II) Currencies III) Equities including stock indices IV) Commodities like metals, oil and agricultural produce The need for a derivatives market The derivatives market performs a number of economic functions: o They help in transferring risks from risk averse people to risk oriented people. o They help in the discovery of future as well as current prices. o They increase the volume traded in markets because of participation of risk oriented people in greater numbers. Derivatives are very similar to insurance. Insurance protects against specific risks, such as fire, floods, theft and so on. Derivatives on the other hand, take care of market risks - volatility in interest rates, currency rates, commodity prices, and share prices. Derivatives offer a sound mechanism for insuring against various kinds of risks arising in the world of finance. They offer a range of mechanisms to improve redistribution of risk which can be extended to every product existing from coffee to cotton and live cattle to debt instruments. Example Suppose you have a home of Rs.50, 00,000. You insure this house for premium of Rs Now you think about policy as an investment. Suppose after 1 year the house is as it was i.e., there is no damage occurred then, you have lost the premium of Rs Now suppose your house is fully damaged and broken in one year. You receive Rs.50, 00, 0000 on just paying premium of Rs.15, 000. If you have bought insurance of any sort you have bought an option. Option is one type of a derivative instrument.

31 In this era of globalization, the world is a riskier place and exposure to risk is growing. Risk cannot be avoided or ignored. Man, however is risk averse. The risk averse characteristic of human beings has brought about growth in derivatives. Derivatives help the risk averse individuals by offering a mechanism for hedging risks. A derivative instrument by itself does not constitute ownership. It is, instead, a promise to convey ownership. DEVELOPMENT OF DERIVATIVE MARKET IN INDIA: The 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 24 member 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 pre conditions 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. Verma, 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 real time 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 three decade old notification, which prohibited forward trading in securities.

32 Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 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 BSE 30 (Sense) 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 the derivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12, The important change is the shift to the settlement of derivatives contracts by physical delivery of individual stock into electric form. For this the exchanges need to have a vibrant mechanism for borrowing and lending securities. To avoid excessive volatility the exchanges may fix some limits for daily exercise and assignment of stocks options, since the stock options are of American style and can be exercised during the lifespan of a series. It is believed that it often helps hedgers and arbitrageurs, as it avoids basic risks while imposing additional costs on speculators. It seems to be a good move for the development of the derivative market as this step will complete the range of derivative product. Another important change is the shift to the settlement of derivatives contracts by physical delivery of individual stocks. For this the exchanges need to have a vibrant mechanism for lending and borrowing securities. To avoid excessive volatility the exchanges may fix some limits for daily exercise and assignment of stocks options, since the stock options are of American style and can be exercised any time during the lifespan of a series. It is believed that this system helps hedgers and arbitrageurs, as it avoids basis risk while imposing some additional costs on speculators. It seems to be a good move for the development of the derivatives market as this step will complete the range of derivative products.

33 SOMETHING ABOUT THE DERIVATIVE MARKET: Derivatives have probably been around for as long as people have been trading with one another. Forward contracting dates back at least to the 12th century, and May well have been around before then. Merchants entered into contracts with one another for future delivery of specified amount of commodities at specified price. A primary motivation for pre-arranging a buyer or seller for a stock of commodities in early forward contracts was to lessen the possibility that large swings would inhibit marketing the commodity after a harvest. FUNCTIONS OF DERIVATIVE MARKET The derivatives market performs a number of economic functions: 1. They help in transferring risks from risk adverse people to risk oriented people 2. They help in the discovery of future as well as current prices 3. They catalyze entrepreneurial activity 4. They increase the volume traded in markets because of participation of risk adverse people in greater numbers. 5. They increase savings and investment in the long run The securities market has two interdependent and inseparable segments, namely the primary market and the secondary market. Primary market: It is the channel for creation of new securities through financial instruments by public limited companies as well as government companies Secondary market: It deals in securities already issued. The resources in the primary market are mobilized either through the public issues or through private placement. A public issue is if anybody and everybody can subscribe for it, whereas if the issue is made available to a selected group of persons it is termed as private placement.

34 There are two major types of issuers who issue securities. The one who is corporate entities who issue mainly debt and equity instruments and the other is government (central as well as state) who issues debt securities. The secondary market enables participants who hold securities to trade in securities adjust their holdings according to the changes in the assessment of risk and return. The secondary market has further two components, namely: The Over the-counter (OTC) market The exchange traded market. Over the-counter (OTC) Tailor-made derivatives, not traded on a futures exchange, are traded on over-thecounter markets. OTC markets are informal markets where trades are negotiated. The OTC contracts are generally not regulated by a regulatory authority and the exchange s self-regulatory organization, although they are affected indirectly by national legal systems, banking supervision and market surveillance the OTC derivatives markets have the following features compared to exchange-traded derivatives: The management of counter-party (credit) risk is decentralized and located within individual institutions. There are no formal centralized limits on individual positions, leverage, or margining. There are no formal rules for risk and burden-sharing. There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants. The OTC contracts are generally not regulated by a regulatory authority and the exchange s self-regulatory organization, although they are affected indirectly by national legal systems, banking supervision and market surveillance.

35 However it is desirable to supplement the OTC market by an active exchangetraded derivative market. In fact, those who provide OTC derivative products can hedge their risks through the use of exchange-traded derivatives. In India, in the absence of exchange-traded derivatives, the risk of the OTC derivatives market cannot be hedged effectively. Exchange Traded Market Exchange-traded derivative market has the following features: an electronic exchange mechanism and emphasizes anonymous trading, full transparency, use of computers for order matching, centralization of order flow, price-time priority for order matching, large investor base, wide geographical access, lower costs of intermediation, settlement guarantee, better risk management, enhanced regulatory discipline, etc. Derivative trading commenced in India in June 2000 after SEBI granted the approval to this effect in May SEBI permitted the derivative trading on two stock exchanges, i.e. NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivative contracts. To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty Index and BSE-30 (Sensex) Index. This was followed by approval for trading in options based on these two indices and options on individual securities. The trading in index options commenced in June 2001 and trading in options on individual securities would commence in July 2001 while trading in futures of individual stocks started from November In June 2003, SEBI/RBI approved the trading on interest rate derivative instruments and only NSE introduced trading in interest rate futures contracts.

36 TYPE OF DERIVATIVES: Derivatives are complex instrument and come in various forms. Some of the most important and widely used derivatives are as follows: Derivatives Forward Options Future Swaps Call Option Put Option Interest Rate Swap Currency Swap From the above diagram, we can see that there are mainly 4 type of derivatives. We can have a brief idea of all the four types in the following manner: 1. Forward: A forward contract is an agreement in which two parties agree to under take an exchange of the underling asset at some future date at pre-determined price. A forward contract is customized contact between two parties, where settlement take place on a specific date the settlement date and price are agreed in advance by the parties concerned. Features of forward contract:- o They are bilateral contract and hence exposed to counter-party risk. o Each contract is custom designed and hence is unique in term of contract size, expiration date and the assets type and quality. o The contract price is generally not available in public domain. o The contract price has to be settled by delivery of the assets on expiration date. o In the case the party wishes to reverse the contract it has to compulsorily go to the same counter-party.

37 Forward contact is popular in the foreign exchange market and agriculture sector where commodity prices fluctuate a great deal. If the forward contract is close before the scheduled closing date, a penalty may be charged. The draw back of forward contract is lack standardization which prevents trading on an exchange and the risk of default. 2. Option: The buyer of an option has the right but not the obligation to buy or sell an agreed amount of stock on or before a specified future date. A call option is right to buy while a put option is to sell the particular stock. The rate, at which both parties are agreed for the transaction, is known as the strike or exercise price. There are 5 strike prices for any particular spot price. And these strike prices are determined by the Stock Exchange itself. Call Option: RIGHT TO BUY THE STOCK... Suppose Mr. A purchases a December call option at Rs.40 for a premium of Rs.15. That is he has purchased the right to buy that share for Rs.40 in December. If the stock rises above Rs.55 (40+15) he will break even and he will start making a profit. Suppose the stock does not rise and instead falls he will choose not to exercise the option and forego the premium of Rs.15 and thus limiting his loss to Rs.15. Put Option: RIGHT TO SELL THE STOCK... Raj is of the view that the a stock is overpriced and will fall in future, but he does not want to take the risk in the event of price rising so purchases a put option at Rs.70 on X. By purchasing the put option Raj has the right to sell the stock at Rs.70 but he has to pay a fee of Rs.15 (premium).so he will breakeven only after the stock falls below Rs.55 (70-15) and will start making profit if the stock falls below Rs.55. An option which can be exercised at any time before it expires is described as an American style option. One, which can only be exercised on the expiry date, is called a European style option.

38 Buying an option protects against downside risk and at the same times gives upside potential. You establish the worst possible rate at which you will / sell a commodity or stock but still have the possibility of improving on this rate. The buyer hence, has the best of both worlds. 3. Future: Futures are agreements between two parties to undertake a transaction at an agreed price on a specific future date. Futures contract are exchanged based instrument, which are traded on a regulated exchange. In general, future contract are related to various underlying assets such as commodities, market indices, interest rate and so on. In the futures, there is an agreement to buy or sell a specified quantity of financial instrument on a designed future date a price agreed upon by the buyer and seller today. e.g. if you buy 100 company X futures at 100 Rs. for march 31 delivery it means that on 31 march, you would pay the seller Rs and get return 100 shares of company X. In general there is no physical delivery of the underlying assets but the settlement is done by paying or receiving the difference of the actual price on March 31 and contracted price. Now suppose on the 31 march price of company X was 150.you would get Rs and if the price of company Xwas Rs. 70 then you would to pay Rs.3000 A significant point to note is that while a clearing house guarantees the performance of the future contracts, the parties in the contracts are required to keep margins with it. The margins are taken to ensure that each party to a contract performs its part. The margins are adjusted on a daily basis to account for the gains or losses, depending upon the situation. This is known as marking to the market and involves giving a credit to the buyer of the contract, if the price of the contract rises a debiting the seller s account by an equal amount. Similarly, the buyer s balance is reduced is reduced when the contract price declines and the seller s account is accordingly updated.

39 . The main difference between future and option trading is, in future contract, both the parties are required to deposit margins to the exchange while in case of option trading, only the party with the short position is called upon to pay margin. The party with the long position does not pay anything beyond the premium. Features of future contract:- o Every future contract is a forward contract. o They are entered in to through exchange, traded on exchange and clearing corporation/house provides the settlement guarantee for trades. o They are of standard quantity; standard quality (in case of commodities). o They have standard delivery time and price. The difference between Futures and Forwards

40 4. Swaps: A Swaps can be defined as an exchange of obligation by two parties for instance, an interest rate Swap(IRS). One company arranges with another to exchange interest rate payment. There are many types of Swaps like Assets Swap, Currency swaps and so on. While the widely used are, an interest rate Swaps (IRS) and Currency Swaps. Interest Rate Swap (IRS): One company may be paying fixed rate of interest but prefer floating rates. Another company may be paying a floating rate but would find a fixed rate advantageous. Thus it makes sense for both the companies to enter into an IRS agreement. An important advantage of IRS is that different firms can access funds at varying rates and terms. They may not always find these terms beneficial, they enter into Swap agreement. IRS enables them to access sources of funding at better rates than what they would be able to achieve on a direct basis. Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.

41 USERS OF DERIVATIVES: 1. Hedgers: Hedgers wish to eliminate or reduce price risk to which they are already exposed. To hedge is to enter into transaction that protects a business or assets against change in the underlying commodity. The instrument bought a hedge, tend to have the opposite value movement to the underlying asset. Financial and commodity markets are used to transfer risk form an individual or corporation to someone more willing and table to bear that risk. To begin with, suppose a leading trader buys a large quantity of wheat that would take two weeks to reach him. Now, he fears that the wheat prices may fall in the coming two weeks and so wheat may have to be sold at lower prices. The trader can sell futures (or forward) contracts with matching price, to hedge. Thus, if wheat prices do fall, the trader would lose money on the inventory of wheat but will profit from the futures contract, which would balance the loss. Another example, Mr. X enters into a contract with Mr. Y that 6 months from now, he will sell to Mr. Y, 15 dresses for Rs The cost of manufacturing for Mr. X is only Rs.2000 and he will make a profit of Rs.5000 if the sale is completed. However, Mr. X fears that Mr. Y may not honor his contract 6 months from now. So he inserts a new clause in the contract that is Mr. Y fails to honor the contract, he will have to pay a penalty of Rs And if Mr. Y honors the contract, Mr. X will offer a discount of Rs.1000 as incentive. Thus, if Mr. Y defaults, Mr. X will get a penalty of Rs.1000 but he will recover his initial investment. If Mr. Y honors the contract, Mr. X will still make a profit of Rs.4000 ( ). Thus Mr. X has hedged his risk against default and protected his initial investment

42 2. Speculators: Speculators are willing to take price risk from price changes in the underlying. In contract to hedgers, speculators buy or sell derivatives contracts in an attempt to earn profits. They are willing to assume the risk of price fluctuation, hoping to profits from them. Suppose, Mr. X is a trader but he has no time to track and analyze stock. However, he fancies his chances in predicting his market trend. So instead of buying different stocks he buys Sensex Futures. On May 1, 2000, he buys 100 Sensex 4000 on the expectations that the index will rise in future. On June 1, 2000, the Sensex rises to 4500 and at that time he sells an equal number of contracts to close out his position. Selling Price: 4500* 100=Rs ; Less: Purchase Cost: 4000*100=Rs ; Net Gain: Rs Mr. X has made a profit of Rs by taking a call on the future value of the Sensex. However, if the Sensex had fallen he would have made a loss. Similarly, if it would have been bearish he could do short sell of Sensex futures and made a profit from buying when it go down. In index futures players can have a long term view of the market up to at least 3 months.

43 3. Arbitrageurs: Arbitrageur profits from price differentials existing in two markets by simultaneously operating in two different markets. Arbitrageurs make risk less profits by exploiting the price differential on the same instrument or similar assets, often by trading on different exchanges. He buys the instrument at the lower price and promptly makes a resale at the higher price. Arbitrage plays a role in ensuring markets efficiency, in that it helps to eliminate pricing anomalies. Arbitrageurs are on the lookout for market inefficiencies and quickly look to eliminate them. For example: - If Wipro is quoted at Rs1000 per share and the 3 months futures of Wipro is Rs.1070, then one can purchase ITC at Rs.1000 in spot by 12% annum for 3 months and sell Wipro futures for 3 months at Rs Selling Price = 1070; Cost = =1030 Arbitrage profit = 40 i.e Thus, all class of investors is required for healthy functioning of the market. Hedgers provide economic substance to any financial market. Without them, the markets would lose their purpose and become mere tools of gambling. Speculators provide liquidity and depth to the market. Arbitrageurs bring price uniformity and help price discovery. ADVANTAGES OF DERIVATIVES: Derivatives are important financial instrument and perform a wide variety of functions. These functions range from hedging and insuring against adverse change to ensuring market efficiency. From an investor s point of view, derivatives offer a huge number of opportunities, whether he is risk-taker or risk averse.

44 Some of the important advantages are as follow: Hedging Risk Derivatives are used to hedge risks. They can be used as hedging devices by retail investors, portfolio manages and borrowers hedging against interest rate rise. Index futures can be used to hedge a portfolio against adverse movement in the stock market. Through the process of hedging, the buyer of the instrument implicitly transfers the risk to those who want to assume it for a consideration. Expanding portfolio Derivatives enable banks, traders or investors to be on price movement without having to deal with actual assets, if the value of the underlying goes up or down, the difference is simply settled in cash. Derivatives are more flexible than the underlying products. The value is based on the price of the underlying product, and most contract are settled in cash term so investor could gamble. Power to leverage Derivatives allow investor to take position of a large value by making a small investment. In futures, one takes a position by paying a margin in the range of 25-30%. In case of an option, one pays a premium that is a very small amount relative to the spot price and takes position in the markets. Power to defer The cash markets have a daily settlement mechanism. A speculator wanting to take a position in a stock has to either take delivery or square off his position the same day. Thus he is unable to take a position beyond a day.

45 With futures, one can take a position on a stock today, while the settlement takes place at a Future date. In this aspect, Futures are similar to the erstwhile Badla system as it enables carry forward of positions. Power to lend or borrow from the markets With futures, one can lend or borrow funds from the market. This will become more effective when actual deliveries are introduced in the derivatives markets. In case you need money for short-term requirements, you can sell your stocks in the cash market and buy Futures. You get the liquidity for some time and then you can get your stock back when the futures are settled. FACTORS CONTRIBUTING TO THE GROWTH OF DERIVATIVES: Factors contributing to the explosive growth of derivatives are price volatility, globalization of the markets, technological developments and advances in the financial theories. 1. PRICE VOLATILITY A price is what one pays to acquire or use something of value. Prices are generally determined by market forces. In a market, consumers have demand and producers or suppliers have supply, and the collective interaction of demand and supply in the market determines the price. These factors are constantly interacting in the market causing changes in the price over a short period of time. Such changes in the price are known as price volatility. This has three factors: the speed of price changes, the frequency of price changes and the magnitude of price changes.

46 This price volatility risk pushed the use of derivatives like futures and options increasingly as these instruments can be used as hedge to protect against adverse price changes in commodity, foreign exchange, equity shares and bonds. 2. GLOBALISATION OF MARKETS Earlier, managers had to deal with domestic economic concerns; what happened in other part of the world was mostly irrelevant. Now globalization has increased the size of markets and as greatly enhanced competition. It has benefited consumers who cannot obtain better quality goods at a lower cost. It has also exposed the modern business to significant risks and, in many cases, led to cut profit margins In Indian context, south East Asian currencies crisis of 1997 had affected the competitiveness of our products vis-à-vis depreciated currencies. Export of certain goods from India declined because of this crisis. Steel industry in 1998 suffered its worst set back due to cheap import of steel from south East Asian countries. Suddenly blue chip companies had turned in to red. The fear of china devaluing its currency created instability in Indian exports. Thus, it is evident that globalization of industrial and financial activities necessitates use of derivatives to guard against future losses. This factor alone has contributed to the growth of derivatives to a significant extent. 3. TECHNOLOGICAL ADVANCES A significant growth of derivative instruments has been driven by technological break through. Advances in this area include the development of high speed processors, network systems and enhanced method of data entry. Closely related to advances in computer technology are advances in telecommunications. Improvement in communications allow for instantaneous world wide conferencing, Data transmission by satellite. At the same time there were significant advances in software programmes without which computer and telecommunication advances would be meaningless.

47 Although price sensitivity to market forces is beneficial to the economy as a whole, resources are rapidly relocated to more productive use and better rationed overtime the greater price volatility exposes producers and consumers to greater price risk. The effect of this risk can easily destroy a business which is otherwise well managed. Derivatives can help a firm manage the price risk inherent in a market economy. To the extent the technological developments increase volatility, derivatives and risk management products become that much more important.

48 Ch. 5 FUTURES AND OPTION SEGMENT The derivatives trading on NSE started in June 1994, with trading on the Wholesale Debt Market Segment. Subsequently the NSE launched the Capital Market Segment in November 1994 as a trading platform for equities and the Futures and Options Segment in June 2000 for various derivative instruments. Trading Mechanism: The derivatives trading system at NSE is called NEAT-F&O trading system. It provides fully automated screen based trading for all kind of derivative products available on NSE on a nationwide basis. It uses a modern, fully computerized trading system designed to offer investors across the length and breadth of the country a safe and easy way to invest. The system supports an order driven market and provides complete transparency of trading operations. Trading in derivatives is essentially similar to that of trading of securities in the CM segment. Orders, as and when they are received, are first time stamped and then immediately processed for potential match. If a match is not found, then the orders are stored in different 'books'. Orders are stored in price-time priority in various books in the following sequence: Best Price Within Price, by time priority. Trading in derivatives is essentially similar to that of trading of securities in the Cash Market segment.

49 Contract Specification: The index futures and index options contract traded on NSE are based on S&P CNX IT Index and the CNX Bank Index, while stock futures and options are based on individual securities. Stock Futures and Options are based on individual securities. At any point of time there are only three contract months available for trading, with 1 month, 2 month and 3 months to expiry. These contracts expire on last Thursday of the expiry month and have a maximum of 3 month expiration cycle. A new contract is introduced on the next trading day following the expiry of the near month contract. The entire derivatives contracts are presently cash settled. If anyone wants to keep the stock at the end of the month, one can carry forward it. For that purpose one can sell the stock at the last Thursday of that particular month and can purchase the stock of next month on the same day. 1. Eligibility criteria of stocks o The stock shall be chosen from amongst the top 500 stocks in terms of average daily market capitalization and average daily traded value in the previous six months on a rolling basis. o The number of eligible securities may vary from month to month depending upon the changes in quarter, average daily market capitalization & average daily traded value calculated every month on a rolling basis for the past six months and the market wide position limit in that security. 2. Selection criteria for unlisted companies For unlisted companies coming out with initial public offering, if the net public offer is Rs.500 Crore or more, then the Exchange may consider introducing stock options and stock futures on such stocks at the time of its listing in the cash market.

50 3. Internet trading On March , 167 members on the F & O segment provided internet based trading facility to the investors. Transaction charges The maximum brokerage chargeable by a trading member in relation to trades affected in the contracts admitted to dealing on the F & O segment of NSE is fixed at 2.5% of the contract value in case of index futures and stock futures. In case of index options and stock options it is 2.5% of notional value of the contract [(Strike Price + Premium) Quantity)], exclusive of statutory levies. Settlement Mechanism All futures and options contract are cash settled i.e. through exchange of cash. The underlying for index futures/options of the Nifty index cannot be delivered. The settlement amount for a cash market is netted across all their TMs/clients, across various settlements. For the purpose of settlement, all CMs are required to open a separate bank account with NSCCL designated clearing banks for F & O segment. Settlement of Futures Contracts on Index or Individual Securities Futures contract have two types of settlements, the MTM settlement which happens on a continuous basis at the end of each day and the final settlement which happens on the last trading day of the futures contract.

51 Daily Mark-to-Market Settlement The position in the futures contracts for each member is 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 day s settlement price, as the case may be, and the current day s settlement price. The CMs who have suffered a loss are required to pay the mark-to-market loss amount to NSCCL which is in turn passed on to the members who have made a profit. This is known as daily mark-to-market settlement. 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 or loss is computed as the difference between trade price or the previous day s 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

52 INTRODUCTION OF FUTURE: A. Index futures Index futures are futures contract on the index itself. One can buy a 1, 2 or 3- month index future. If someone wants to take a call on the index, then index futures are the ideal instruments for him. Example: Nifty was formed in 1995 and given a base value of The value of Nifty today is What it means in simple terms is that, if Rs.1000 was invested in the stocks that form in the index, in the same proportion in which they are weighted in the index, then Rs.1000 would have become Rs.1550 today. B. Stock Future Stock future means dealing in specific scrip. E.g. if you buy or sell Reliance future it called stock future. National Stock exchange fixed lot size for each and every stock future. It means one can buy or sell that size of lot. Stock Futures are financial contracts where the underlying asset is an individual stock. Stock Future contract is an agreement to buy or sell a specified quantity of underlying equity share for a future date at a price agreed upon between the buyer and seller. The contracts have standardized specifications like market lot, expiry day, unit of price quotation, tick size and method of settlement. Example:- Spot Price of Stock 'A' = 3000, Interest Rate = 12% p.a. Futures Price of 1 month contract = *0.12*30/365 = = 3030

53 Index futures more popular than stock futures Globally, it has been observed that index futures are more popular as compared to stock futures. This is because the index future is a relatively low risk product compared to a stock future. It is easier to manipulate prices for individual stocks but very difficult to manipulate the whole index. Besides, the index is less volatile as compared to individual stocks and can be better predicted than individual stock. How is the future price arrived: Future price is nothing but the current market price plus the interest cost for the tenure of the future. This interest cost of the future is called as cost of carry. If F is the future price, S is the spot price and C is the cost of carry or opportunity cost, then, F=S+C F = S + Interest cost, since cost of carry for a finance is the interest cost Thus, F=S (1+r) T Where r is the rate of interest and T is the tenure of the futures contract. The rate of interest is usually the risk free market rate. Example: The spot price of Bharat Forge is Rs.300. The bank rate prevailing is 10%. What will be the price of one-month future? Solution: The price of a future is F= S (1+r) T The one-month Bharat Forge future would be the spot price plus the cost of carry. Since the bank rate is 10 %, we can take that as the market rate. This rate is an annualized rate and hence we recalculate it on a monthly basis. F=300(1+0.10) (1/12) F= Rs

54 Example: The shares of Infosys are trading at 3000 rupees. The 1-month future of Infosys is Rs The returns expected from the Govt. security funds for the same period is 10 %. Is the future of Infosys overpriced or under priced? Solution: The 1-month Future of Infosys will be F= 3000(1+0.10) (1/12) F= Rs But the price at which Infosys is traded is Rs Thus it is overpriced by Rs.76. Comparison of spot price and future price Future prices lead the spot prices. The spot prices move towards the future Prices and the gap between the two are always closing with as the time to settlement decreases. On the last day of the future settlement, the spot price equals the future price. The futures price can be lower than the spot price too. This depends on the fundamentals of the stock. If the stock is not expected to perform well and the market takes a bearish view on them, then the futures price can be lower than the spot price. Future prices can fall also due to declaration of dividend.

55 INTRODUCTION TO OPTION: Benefits of Options Trading 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 one's investment strategy dictates. High leverage as by investing small amount of capital (in form of premium), one can take exposure in the underlying asset of much greater value. Pre-known maximum risk for an option buyer Large profit potential and limited risk for option buyer One can protect his equity portfolio from a decline in the market by way of buying a protective put wherein one 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. Risks of an options buyer:- The risk/ loss of an option buyer is limited to the premium that he has paid. On the other hand, the profit is unlimited. Risks for an Option writer:- The risk of an Options Writer is unlimited where his gains are limited to the Premiums earned. Stock Index Options The Stock Index Options are options where the underlying asset is a Stock Index for e.g. Options on NSE Nifty Index / Options on BSE Sensex etc.

56 Options on individual stocks Options contracts where the underlying asset is an equity stock are termed as Options on stocks. They are mostly American style options. Prices are normally quoted in terms of the premium per share, although each contract is invariably for a larger number of shares, e.g Type of Options Striking The Price In-the-money At-the-money Out-of-the-money Call Option Strike Price less than Spot Price of underlying asset Strike Price equal to Spot Price of underlying asset Strike Price greater than Spot Price of underlying asset Put Option Strike Price greater than Spot Price of underlying asset Strike Price equal to Spot Price of underlying asset Strike Price less than Spot Price of underlying asset Interval Strike Prices

57 OPTION STRATEGIES: There are the various strategies about derivatives that limit losses. Option Strategies, or Options Based Investment Strategies, are calculated ways of using options singly or in combination in order to profit from one or more market movements. Option Strategies are a direct alternative to traditional buying and selling of stocks and offers greater profit potential with limited risk. There are basically two types of strategies in derivatives: A. Spread Strategies C. Combination Strategies A. Spread Strategies: Spread strategies involve dealing in only one type of option i.e. call option or put options. Spread means the difference between the two strike prices of the scrip of the same expiry period. For example, Satyam call options with strike price Rs.220 and Rs.230 of August, in this case the spread is of Rs.10. There are various spread strategies that we will see in the latter stage of this content. The examples of spread strategies are as follows (1) Bull Spread strategies with call options (2) Bull Spread strategies with put options (3) Butterfly Spread strategies

58 1. Bull Spread Using Calls: Spread trading strategy involves taking a position in two or more options of the same type. This strategy viz. Bull Spread is undertaken when one is bullish about the future price movements in the stock prices. However, Bull Spread can be affected using Calls as well as Puts. The latter is explained in the next head of strategy. This strategy calls for buying a Call Option on a stock and writing the Call Option on the same stock with the same maturity date, but with a higher exercise price. It may be noted that in case of Call Options, premium on the Option with lower exercise price is greater than that on Option with higher exercise price. So, in a way, this strategy involves some initial cost as the premium receivable for writing a Call Option (with a higher exercise price) would be less than the premium payable on the Call Option bought (with a lower exercise price). If on the expiry, the stock price is less than the lower exercise price, both the Call Options would be Out-of-money and, hence, both would expire unexercised. In that case, net outflow would be initial cost as represented by the difference between the premium payable (which is higher) and premium receivable. If on the expiry, the stock price lies between the two exercise prices, then the Call with the lower exercise price (which the investor has bought) would be exercised and the Call with the higher exercise price (which the investor has sold) would expire unexercised. So, the net profit would be the difference between the stock price and the exercise price of bought option minus the initial spread cost, as represented by the difference between the premium payable and the premium receivable.

59 If the last possibility i.e. the stock price being greater than the higher exercise price, happens, then, both the Call Options, being in the money, would be exercised. The resultant net profit would be the difference between the two exercise prices as reduced by the initial spread cost, as represented by the difference between the premium payable and the premium receivable. The payoff table for the Bull Spread (Using Calls) is as shown below: Price of Stock Payoff from Long Call Payoff from Short Call Total Payoff S 1 >= E 2 S 1 E 1 E 2 S 1 E 2 E 1 E 1 < S 1 < E 2 S 1 E 1 O (Not Exercised) S 1 E 1 S 1 <= E 1 O (Not Exercised) O (Not Exercised) 0 The corresponding graphical presentation is as shown under: Profit E 1 E 2 Stock Price Profit/ Loss of Long Call Loss Bull Spread (Using Calls) Profit/ Loss on Short Call

60 2. Bull Spread Using Puts: In this strategy, the investor purchases a Put Option on the underlying and writes a Put Option on the same underlying and with the same expiry date, but with a higher exercise price. Here also, there would be a difference between the premiums payable and premium receivable. The premium payable on the bought Put Option (with a lower exercise price) would be less as compared to the premium receivable on the sold Put Option (with a higher exercise price). Now, suppose, on the expiry, the price of the underlying is less than the lower exercise price, then both the Put Options would be exercised. The net result would be the difference between premium received and premium paid minus the loss on exercise prices of the two options (as represented by the difference between the two exercise prices). If, on the expiry, the price of the underlying is between the two exercise prices, then the Put Option with higher exercise price (which was sold by the investor) would be exercised and other Put Option would expire unexercised. The net payoff would be the difference between the premiums of both the options as reduced by the difference between the exercise price of the Put Option sold and the price of the underlying. The third possibility, that is to say, the price of the underlying being greater than the higher exercise price, happens, then both the options would expire unexercised, being out-of-money. In that case, our investor would end up earning the difference between the premium received on the written Put and the premium paid on the bought Put.

61 Explained in the next table is the conditional payoff flowing from the strategy just discussed. The payoff table for the Bull Spread (Using Puts) is as shown below: Price of Payoff from Payoff from Total Stock Long Call Short Call Payoff S 1 <= E 1 S 1 S 1 E 2 E 1 E 2 E 1 E 1 < S 1 O (Not S 1 E 2 S 1 E 2 < E 2 Exercised) S 1 >= O (Not O (Not 0 E 2 Exercised) Exercised) The corresponding graphical presentation is as shown under: Profit Profit/ Loss from Long Put Profit/ Loss from Short Put E 1 E 2 Stock Price Loss Bull Spread (Using Puts)

62 3. Butterfly: Butterfly spread or sandwich spread is a neutral option trading strategy. This is a combination of bull and bear spreads and involves three strike or exercise prices and four option positions. The strike prices used are two lower prices in bull spread and the higher strike price in the bear spread or vice-versa. Any type of option like put or call can be used. Butterfly spread is constructed when the investor buys one option at lower strike price and another at a higher strike price and sells two options at the middle strike price, or vice-versa. These options are all calls or puts and are of same underlying asset and have got same expiration date Butterfly spread can be long or short. Long Butterfly Spread When the investor expects that the underlying stock price does not rise or fall i.e. vary much by the expiration date or during the life of option then it is said that the option position entered is that of long butterfly spread. This can be constructed using either put or call option. A long butterfly consists of buying a long call of lower strike rate and selling two short calls with a middle strike rate and buying a long call at a higher strike rate. To enter this trade an initial cash outlay is required and hence is also called as debit spread. In similar manner a long butterfly can be made with put option too and is called long put butterfly. An illustration of a long butterfly spread is given below. Consider the following. Suppose the Call option of Maruti Udyog Ltd November expiry is as follows: MUL Rs.00 (Nov) at price Rs.5 MUL Rs.20 (Nov) at price Rs10 MUL Rs.40 (Nov) at price Rs.4

63 Now in the long Butterfly Spread, a MUL Rs.900 is bought at Rs.25 and two MUL Rs.920 are sold at Rs.10 and another call MUL Rs.940 is bought at Rs.4. The net premium paid will be then 25-2*10+4 = Rs.9/- The Breakeven Points In this case there are two breakeven points. The first breakeven point is at the lowest strike price plus net debit and the second one at highest strike price minus the net debit, whereby the net debit is the premium payable. Lower breakeven point is at = Rs 909/- Upper breakeven point is at = Rs 931/- The breakeven point and the profit potential is depicted below. Long Butterfly Spread Profit Potential Profit is obtained when the stock price is between Rs 931 and Rs.909/- When price is between Rs 909 and Rs 920, profit = stock price Rs.909 and when price is between Rs 920 and Rs.931, profit = Rs stock price. Maximum Profit = Middle strike price - the lower strike price - the net debit Here it will be = Rs.11/- Maximum loss = Net debit, as the investor will not exercise the options otherwise. Here it is Rs.9/-

64 Total cost = net debit * the number of shares. The long butterfly is a strategy that takes advantage of the time premium erosion of an option contract, but still allows the investor to have a limited known risk. This strategy involves only limited loss compared with a short straddle. Short Butterfly Spread Similar to long butterfly spread this is also a neutral strategy having limited risk limited return concept. However unlike the long butterfly the trader assumes that the stock is showing bullish trend or high volatility in price exists. A short butterfly consists of a writing a long call of lower strike rate and buying short two calls with a middle strike rate and selling a long one call at a higher strike rate. This position is also called as credit spread as a net credit is received upon entering this spread. Consider the same example as above. Here the converse of long butterfly is done to create a short butterfly position. Now in the Short Butterfly Spread, a MUL Rs.900 is sold at Rs.25 and two MUL Rs.920 are bought at Rs.10 and another call MUL Rs.940 is sold at Rs.4. The net premium receivable will be then 25-2*10+4 = Rs.9/- The Breakeven Points The first breakeven point is at the lowest strike price plus net credit and the second one at highest strike price minus the net credit, whereby the net credit is the premium receivable. Lower breakeven point is at = Rs.909/- Upper breakeven point is at = Rs.31/- The breakeven point and the profit potential is depicted below

65 Short Butterfly Spread Loss Potential Profit is obtained when the stock price is above Rs.931 or below Rs.909/- When price is between Rs.909 and Rs.920, loss = stock price Rs.909 and when price is between Rs.920 and Rs.931, loss = Rs.931stock price. Maximum Profit = Net credit Here it is Rs.9/- A short butterfly strategy profits as equally from a large move up as it does from a large move down. This approach like the long butterfly spread has also got neutral effect on time. i.e. the time value impact is neutral. However this strategy has got limited profit potential compared to a long straddle. B. Combination Strategies: Spread Strategies involve either call or put option but combination strategies involve trading of dealing with call and put option simultaneously. There are various types of combination strategies. The examples of combination strategies are as follows: (1) Straddle Strategy (2) Strangle strategy (3) Strap and Strip Strategy

66 1. Straddle: A Straddle is a strategy where you buy a Call Option as well as a Put Option on the same underlying scrip (or index) for the same expiry date for the same strike price. For example, if you buy a Satyam July Call Strike Price 240 and also buy a Satyam July Put Strike Price 240, you have bought a Straddle. As a buyer of both Call and Put, you will pay a Premium on both the transactions. If the Call costs Rs.12 and the Put Rs.9, your total cost will be Rs.21. Buy a Straddle You will buy a Straddle if you believe that Satyam will become volatile. Its current price is say Rs.240, but you think it will either rise or fall significantly. For example, you could believe that Satyam could rise upto Rs.300 or fall upto Rs.200 in the next fortnight or so.

67 Let us continue the above example. You have bought the Call and the Put and spent Rs.21. The current price and the strike price are the same Rs.240. Your profile will be determined as under: Satyam Closing Price Profit on Call Profit on Put Initial Cost Net Profit Thus you make maximum profit if the price falls significantly to Rs.200 or rises significantly to Rs.270. You will make a maximum loss of Rs.21 (your initial cost) if the price remains wherever it currently is. Other implications of Straddle As a buyer of the Straddle, you will pay initially for both the Call and the Put. You need not place any margins as you are a buyer of both Options. If time passes and the scrip remains at or around the same price (in this case Rs 240), you will find that the Option Premium of both the Call and the Put will decline (Time Value of Options decline with passage of time). Hence, you will suffer losses.

68 Sell a Straddle You bought a Straddle because you thought the scrip will become volatile. Conversely, the seller of the Straddle would believe that the scrip will act neutral. The seller will believe that the price of Satyam will stay around Rs.240 in the next fortnight or so. Accordingly, he will sell both the Call and the Put. If the price indeed remains around Rs.240, he will make a maximum gain of Rs.21. If the price were to move up or down, he will make a lower gain as he will have to pay either on the Call (if it moves up) or on the Put (if it moves down). Break-even point of the Straddle The Straddle has two break-even points viz. the Strike Price plus both Premium and the Strike Price minus both Premium. In the above example, the two break-even points are Rs.261 ( ) and Rs 219 (240 21). As seen earlier, the break-even points are the same for the buyer and the seller. Other implications for the seller As a seller, he will receive the Premium of Rs.21 on day one. He will have to place margins on both the Options and hence these requirements could be fairly high. If time passes and the scrip stays around Rs.240, the seller will be happy as the Option values will decline and he can buy back these Options at a lower level. On the other hand, if the scrip moves, he should be careful and think of closing out early. 2. Strangle: A strangle option strategy is a basic volatility strategy which comes with low risk but will require dramatic price moves to pay out profitably. The strangle calls for buying out of the money puts and out of the money calls with different strike prices but the same expiration date. While the risk characteristics are slightly different, strangle is very similar to the straddle in that it has two breakeven points and many of the other basic principles are similar.

69 Strangle Risk Characteristics Let's review the basic strangle risk characteristics graph so that we can better understand the risks and rewards associated to this strategy. As opposed to most of the other option strategies we have discussed, you can see that strangle has two breakeven points. While strangle has lower risk associated to it, the probability of profit is also less than that of the straddle as the breakeven points are further away. The general rule of thumb when purchasing strangle is to buy the put and the call with strike prices equal in distance from the current price. For example, if the security was trading at Rs.25, you would purchase the Rs.20 put and the 30 call. Long Strangle The risk of the strangle can be calculated in exactly the same way as that of the straddle: Risk = Call Premium + Put Premium Since this is a net credit transaction with two long options, the breakeven in either direction is just the strike price +/- options premiums.

70 Breakeven on the Upside (*b2 in diagram) = Strike Price + Call Premium + Put Premium Breakeven on the Downside (*b1 in diagram) = Strike Price - Call Premium - Put Premium The profit potential of this strategy is unlimited after breakeven. For more precision, you can use the following formulas at expiration to determine the gain or loss on this trade. Gain/Loss Scenarios: 1) Profit/Loss Scenario - Security Moves Higher than Call Strike = Security Closing Price - Call Strike Price - Call Premium - Put Premium 2) Profit/Loss Scenario - Security Moves Lower than Put Strike = Put Strike Price - Security Closing Price -Call Premium - Put Premium 3) When the security is trading above the put strike and less than the call strike, the trader experiences a 100% loss of his/her option premium paid. Short Strangle

71 While writing a short strangle, or going short the strangle, large swing could be tolerated in the price of the underlying before the trade moves into a losing position. It's a good strategy for playing a security that is stuck in a range. Typically selling 1 to 2 months of premium allows the buyer the least amount of time to make good on the option they have purchased. Risk = Unlimited on when stock moves above or below breakeven points. The breakeven calculations for the short strangles are the same as for the long strangle. A short strangle will always have a maximum profit potential equaling the premiums received from selling the strangle. Gain/Loss Scenarios: 1) When the security is trading above the put strike and below the call strike, both options that were shorted expire worthless. Profit = put premium received + call premium received

72 2) Profit/Loss Scenario - Security Moves Higher than Call Strike = Call Premium + Put Premium - Security Closing Price + Call Strike 3) Profit/Loss Scenario - Security Moves Lower than Put Strike = Call Premium + Put Premium - Put Strike + Security Closing Price 3. Strap and Strip: A Strip consists of a long position in one call and two puts with the same strike price and expiration date. A Strap consists of a long position in two calls and one put with the same strike price and expiration date. The profit patterns from straps and strips are shown in the example. In the strip the investor is betting that there will be a big stock price move and considers a decrease in the stock price to be more likely than an increase. In a strap the investor is also betting that there will be a big stock price move. However, in this case, an increase in the stock price is considered to be more likely than a decrease. Example: A stock is currently trading at Rs.69. A three-month call with a strike price of Rs.70 costs Rs.4, whereas a three-month put with the same strike price costs Rs.3. An investor feels that the stock price is likely to experience a significant jump(either up or down) in the next three months. The Strategy: The trader buys both the put and the call. The worst that can happen is that the stock price is Rs.70 in three months. In this case, the strategy costs Rs.7. The farther away from Rs.70 the stock price is, the more profitable the strategy becomes. For example, if the stock price is Rs.90, the strategy leads to a Rs.13. If the stock price is Rs.55, the strategy leads to a profit of Rs.8.

73 BULLISH STRATEGIES Long Calls For aggressive investors who are bullish about the short-term prospects for a stock, buying calls can be an excellent way to capture the upside potential with limited inside risk. Bull Call Spread For bullish investors who want to a nice low risk, limited return strategy without buying or selling the underlying stock, bull call spreads are a great alternative. This strategy involves buying and selling the same number of calls at different strike prices to minimize both the cash outlay and the overall risk. Bull Put Spread For bullish investors who want a nice low risk, limited return strategy, bull put spreads are another alternative. Like the bull call spread, the bull put spread involves buying and selling the same number of put options at different strike prices. Since puts with the higher strike are sold, the trade is initiated for a credit. Call Back Spread For bullish investors who expect big moves in already volatile stocks, call back spreads are a great limited risk, unlimited reward strategy. The trade itself involves selling a call (or calls) at a lower strike and buying a greater number of calls at a higher strike price. BEARISH STRATEGIES Long Put For aggressive investors who have a strong feeling that a particular stock is about to move lower, long puts are an excellent low risk, high reward strategy. Rather than opening yourself to enormous risk of short selling stock, you could buy puts (the right to sell the stock). While risk is limited to the initial investment, the profit potential is unlimited.

74 Put Back Spread For aggressive investors who expect big downward moves in already volatile stocks, back spreads are great strategies. The trade itself involves selling a put at a higher strike and buying a greater number of puts at a lower strike price. As the stock price moves lower, the profit potential is unlimited. Bear Call Spread For investors who maintain a generally negative feeling about a stock, bear spreads are a nice low risk, low reward strategies. This trade involves selling a lower strike call, usually at or near the current stock price, and buying a higher strike, out-of-the-money call. This spread profits when the stock price decreases and both calls expire worthless. Bear Put Spread For investors who maintain a generally negative feeling about a stock, bear spreads are another nice low risk, low reward strategy. This trade involves buying a put at a higher strike and selling another put at a lower strike. Like bear call spreads, bear put spreads profit when the price of the underlying stock decreases. NEUTRAL STRATEGIES Long Straddle For aggressive investors who expect short-term volatility yet have no bias up or down (i.e., a neutral bias), the long straddle is an excellent strategy. This position involves buying both a put and a call with the same strike price, expiration, and underlying. The potential loss is limited to the initial investment. The potential profit is unlimited as the stock moves up or down. Short Straddle For aggressive investors who don't expect much short-term volatility, the short straddle can be a risky, but profitable strategy. This strategy involves selling a put and a call with the same strike price, expiration, and underlying. In this case, the profit is limited to the initial credit received by selling options. The potential loss is unlimited as the market moves up or down.

75 Long Strangle For aggressive investors who expect short-term volatility yet have no bias up or down (i.e., a neutral bias), the long strangle is another excellent strategy. This strategy typically involves buying out-of-the-money calls and puts with the same strike price, expiration, and underlying. The potential loss is limited to the initial investment while the potential profit is unlimited as the market moves up or down. Short Strangle For aggressive investors who don't expect much short-term volatility, the short strangle can be a risky, but profitable strategy. This strategy typically involves selling out-of-the-money puts and calls with the same strike price, expiration, and underlying. The profit is limited to the credit received by selling options. The potential loss is unlimited as the market moves up or down. The Butterfly Ideal for investors who prefer limited risk, limited reward strategies. When investors expect stable prices, they can buy the butterfly by selling two options at the middle strike and buying one option at the higher and lower strikes. The options, which must be all calls or all puts, must also have the same expiration and underlying. Calendar Spread Calendar spreads are also known as time or horizontal spreads because they involve options with different expiration months. Because they are not exceptionally profitable on their own, calendar spreads are often used by traders who maintain large positions. Typically, a long calendar spread involves buying an option with a long-term expiration and selling an option with the same strike price and a short-term expiration.

76 OPTION TRADING STRATEGY FORMULAS BULL SPREAD (LONG CALL SPREAD) Difference between Strike Prices Debit Paid = Maximum Profit (The debit Paid is the maximum loss.) BULL SPREAD (SHORT PUT SPREAD) Difference between Strike Prices Credit = Maximum Loss (The credit received is the maximum profit.) BEAR SPREAD (LONG PUT SPREAD) Difference between Strike Prices Debit Paid = Maximum Profit (The debit Paid is the maximum loss.) BEAR SPREAD (SHORT CALL SPREAD) Difference between Strike Prices Credit = Maximum Loss (The credit received is the maximum profit.) LONG STRADDLE Strike Price (Call Price + Put Price) = Low Break-even Point Strike Price + (Call Price + Put Price) = High Break-even Point SHORT STRADDLE Strike Price (Call Price + Put Price) = Low Break-even Point Strike Price + (Call Price + Put Price) = High Break-even Point LONG STRANGLE OTM Put Strike Price (OTM Call Price + OTM Put Price) = Low Break-even Point OTM Call Strike Price + (OTM Call Price + OTM Put Price) = High Break-even Point

77 SHORT STRANGLE OTM Put Strike Price (OTM Call Price + OTM Put Price) = Low Break-even Point OTM Call Strike Price + (OTM Call Price + OTM Put Price) = High Break-even Point LONG BUTTERFLY Buy One + Sell Two + Buy One = Total Debit SHORT BUTTERFLY Sell One + Buy Two + Sell One = Total Cred

78 Ch. 6 Analysis of Questionnaire 1. Do you know what Derivative Market is and how transactions take place in it? Yes No % YES NO 89% Derivative is a market which is very popular in the stock market. We have selected the people who are trading in derivative. Out of those samples 89 % know what the derivative instrument is, how much it is riskier, how much return can it give & how to trade in derivative market. But 11 % of them are not cent per cent clear what derivative instrument is and how transactions take place in it, still they would like to trade in derivative market with the help of others.

79 2. How do you take decisions while investing in derivatives? Independently Broker s Advice Newspapers & Magazines Advice of Friends / Colleagues News Channels Independently Advice of Broker / Agent Newspapers & Magazines Advice of Friends / Colleagues News channels Out of 100 respondents, 55% take the decision at their own. 30% of them go for Advice of Broker, 7% take decision with the media channels. 5% and 3% take decision with the help of Newspapers and Advice of Friends respectively. 3. Which TV Channel do you watch?

80 CNN IBN NDTV Profit NDTV 24 * 7 NDTV CNBC NDTV Profit 13% CNN IBN 4% NDTV 24 X 7 3% NDTV 17% CNBC 63% It is not possible for everybody to go physically to any broking firm or trade online. So in such a situation, Television is one of the best sources to have awareness regarding stock market and its movement. There are many TV Channels available which show the scripts prices. But among them CNBC is the most preferable by the investors or traders. There are many reasons why out of 100, 63 have selected CNBC as their most preferable channel. The tips, guidelines for portfolio etc. are the main reasons given by them. 4. In derivative market, which of the following do you invest in?

81 Futures Options Both Futures Options Both To reduce the loss, there are many strategies available in the derivative market and to obtain benefit from that people generally would go for both future as well as option. And in our findings also 63 % of the people trade in both i.e., Future and Option, 24% do trading in Futures only and 12% do trading in Option only. 5. What type of Trader you are in derivative market?

82 Intraday Trader Position Holder Traders 46% Intraday Trader 54% Position Holder No body knows what tomorrow will be. Intraday traders are those who would like to square up their position at the same day. They believe in today. Even if they incur loss, they will square up their position. But position holders are those who would like to wait till their assumed price come. In our finding 54% of the respondents go for Intraday and remaining 46% go for holing their position till their expected price come.

83 6. According to you, from the given factors, which factor affects the most to market movement? Political Factors Foreign Movement in other Stock Company Government Policies Affairs Market Actions Political Factors Foreign Affairs Movement in other stock markets Company Actions Government Policies Out of the 100 respondents, 38 think that Political Factors are the main factors which affect most to the market movement. According to the respondents, after political factors, Movement in other stock markets and Government Policies are most considerable factors and for that 30% and 29% go for those factors respectively. Thus, the factors like Foreign Affairs and Company Actions are less affected according to the respondents.

84 7. From the given options, which one is your main purpose of investment in derivative? Speculation Arbitrage Hedging Arbitrage, 12 Speculating 36 Hedging, 52 From the above diagram, it is clear that 52% of the traders are Hedgers, 36 % are the Speculators and 12% are Arbitrageur. The main intention of all the three parties is different. The intention of hedgers is to hedge their fund and try to minimize their risk. While speculators want to earn more profit any how. And arbitrageurs want to take benefit of variation in prices.

85 8. Along with derivatives, would you like to invest in cash market? Yes No NO 13 YES In findings, it has been found that 87% of the respondents go for cash market along with the derivative market. But the remaining 13% would not prefer to for cash market with the derivative market. It is obvious that investment in Cash Market is safer than Trade in Derivative Market. The people who trade in derivative would also go for investment in cash market just to minimize the loss. There are many people who would like to invest only in Cash Market because they are risk averse people. But both the markets are having their own pros and cons. In derivative market very less cash on hand is required compare to cash but the risk in derivative is higher compare to cash market.

86 9. Which are the constraints that hold you back for trading or investing? Lack of risk taking Lack of guidance from Lack of fund Lack of knowledge Other ability broker availability Constraints Lack of Risk Taking ability Lack of guidance from broker Lack of fund availability Lack of knowledge Other For investment there would always be need of some cash on hand. In the findings, 36% respondents respond for the lack of fund availability and followed by lack of knowledge of the market as a whole. 22% are having lack of risk taking ability as their constraints. 8% and 5% are having lack of guidance from broker and other reasons respectively.

87 10. Following are the most considerable factors by the investors while trading in Derivatives rank them according to your preferences. Risk Return Volatility Price Status of the co. Rank 1 st Rank 3 rd Rank 4 th Rank 2 nd Rank 5 th From the survey, it has been found that people consider risk as the main factor while trading in derivative. The second factor is price. After considering risk and the price of any script, the people consider the return as a 3rd factor which required to be considered. Along with the above factors, there are also factors like volatility and status of the company which are kept in mind by the trader or investors of the stock market. But these are less affected compare to the first three factors i.e. risk, price and return, according to the survey. 11. Rank the following Broking Firms Angel Broking Marwadi Share Khan Kotak Security India Bulls Religare Motilal Oswal Rank 1 st Rank 5 th Rank 4 th Rank 3 rd Rank 6 th Rank 7 th Rank 2 nd Generally different people are having different kind of attitude towards different broking firms. Some people are more focused on brokerage charged by the broking firms while other focuses on services provided by different organization. So it is very difficult to identify and rank the broking firms with the sample of 100 people. Still we try to find the mindset of the people with their difference of opinion. And thus from the findings the rank to different broking firms are as shown in the above diagram. General Information:

88 1. Gender Ratio: Male Female Male Female S1 It is general thinking that Indian Women are generally risk averse and in opposite to that Men are risk oriented people. Even in this survey, it has been found the same thing. Out of 100 people 88% were male who trade in derivative market. While female were only 12%. It has also been noticed that women are more conscious for investment in Gold and Cash Market rather than trading in Derivative Market.

89 2. Age Group: Below Above From the findings, it has been seen that 66% of the respondents were below age group of 30 and only 1% of the respondents was above age group of % and 9% fall in the group of and respectively. It is general notice that the retired people generally do not prefer to take more risk. As we know derivative is a risky financial instrument, retired people would not like to trade in derivative. And in our finding also we have found the same.

90 3. Education: Undergraduate Graduate Post Graduate Out of 100 there were 18 respondents who were undergraduate, 50 were graduates and 32 were post graduate.

91 4. Occupation: Service Business Profession Other In this world of Globalization, to run a business profitably is very risky. So along with business, the businessmen generally do not prefer to take more risk in these financial derivative instruments. In the above diagram itself, it can be observed that 63% of the respondents were in service occupation who trade in derivatives. The service people would like to take risk as their monthly income is generally fixed which is not possible in any business. 19% of the respondents were in business. And 10% and 8% of the respondents were profession and other occupation (students, housewives etc.) respectively.