It is not imp importan tant whether you are right or wrong, but how much money you make when you are right & how much money you lose when you are wrong is important.
George Soros
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TABLE OF CONTENTS • • • • • •
Certificate Acknowledgement Executive Summary Objective of the Study Methodology Job Description
Chapter Chapt er 1. Introduct Intro duction ion of Sharekhan Share khan Limited imit ed ➢ ➢ ➢ ➢ ➢ ➢ ➢
About Sharekhan Limited Sharekhan Limited’s Management Team Products and Services of Sharekhan Limited Types of account in Sharekhan Limited How to open an account with Sharekhan Limited? Research section in Sharekhan Limited Awards and Achievements
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Chapter 2. Introduction to Derivatives Derivatives ➢ ➢ ➢ ➢ ➢ ➢ ➢ ➢ ➢ ➢ ➢ ➢ ➢ ➢
Derivatives defined Emergence of Derivatives History of Derivatives Global Derivative Markets Derivatives Market in India Participants and Functions Types of Derivative Instruments Derivative Market at NSE Approval for Derivative Trading Clearing and Settlements Index Derivatives Trading Order type and Condition SEBI Advisory Committee on Derivative
Chapter 3. Introduction to Futures and Options ➢ ➢ ➢ ➢
Forward Contracts Future Contracts Options Payoffs for Derivative Contracts
Chapter hapte r 4. Hedging, Hedg ing, Arbit A rbitrage rage and a nd Specula Spe culation tion Strat S trategie egies s ➢ ➢ ➢
Hedging Strategies with examples Arbitrage Strategies with examples Speculation Strategies with examples
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Chapter 5 . Applicability Appli cability of Derivative Deri vative Instruments Ins truments ➢ ➢ ➢ ➢
Risk Management: Concept and Definition Risk Management with Future Contract Risk Management with Options Introduction to Option Strategies
Chapter 6 . Achievements Achieveme nts in Futures and a nd Options Opti ons Segment ➢ ➢ ➢
Comparative Analysis of F&O Segment with Cash Segment NSE Position Top 5 Traded Symbols
Chapter Chapt er 7 . Conclus Co nclusion ion Chapter 8. Suggestions and Recommendations Chapter Chapt er 9. The Referenc Ref erence e Material Mater ial ➢ ➢
Glossary Bibliography
CERTIFICATE
This is to certify that Mr. Milton Sarkar, a student of Post Graduate Diploma in Business Administration from Graduate School of Business & Administration, 4
Greater Noida has completed his summer training project titled, “ A Study on Applic Applicabi abilit lity y of Deriv Derivati ative ve Instru Instrumen ments ts in India Indian n Stock Stock Marke Markett,” at Sharekhan Ltd., Greater Kailash Branch, New Delhi under my guidance and superv supervisi ision on from from 15th of May 2008 to 21st of July July 2008 2008.. This This is his his original work and he has put a lot of effort into it. He is a very hard working person and has patience to convince customers and also fulfill his secondary objectives. He has done good work with us and I wish him all the best for his bright future.
Project Guide Rakesh Kunwar (Assistant Manager- sales) Sharekhan Ltd.
CERTIFICATE OF ATTENDANCE 5
This is to certify that Mr. Milton Sarkar, who was engaged in our organization as a Summer Trainee, has been regular & punctual. He has attended the training from 15 th of May to 21st of July.
Signature Rakesh Kunwar (Assistant Manager- sales) Sharekhan Ltd.
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ACKNOWLEDGEMENT A project is never the work of an individual. It is moreover a combination of ideas, suggestions, review, contribution and work involving many folks. It cannot be completed without guidelines. It is my pleasure to acknowledge gratefully to all those honorable personalities who who help helped ed me lot lot into into the the crea creati tion on of this this proj projec ectt and and sha shared red thei theirr experiences. I would like to express my sincere indebtedness to Dr. P.L. Maggu (Executive Director, Graduate School of Business & Administration) for giving me the opportunity to work on this project and make it a success. I would like to express my deep sense of gratitude to my Industry guide, Mr. Rakesh Rakesh Kunwar, Kunwar, Asst. Manager Manager Sales– Sales– Sharekh Sharekhan an Ltd., Ltd., Greater Greater Kailash spent his valuabl valuable e time time and guided guided me. I have have Branc Branch, h, New Delhi Delhi,, who spent
benefited a great deal from his incisive analysis and erudite suggestions. The atmosphere of a learning organization that he has created along with his peers in Greater Kailash Branch has not only helped me but all the other trainees. Acknowledgements are also due to all the other staff members and executives in Shar Sharek ekha han n Ltd., Ltd., Grea Greate terr Kail Kailas ash h Bran Branch ch for for prov provid idin ing g info inform rmat atio ion n at various point of the project, especially the discussions on the market. I am also sincerely thankful to all the faculty members of Graduate School of Business & Administration for providing their help and advice whenever it was needed. Finally I wish to extend my sincere acknowledgement to my parents for their moral and financial support.
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Milton Sarkar
EXECUTIVE SUMMARY Conceptually the mechanism of stock market is very simple. People who are exposed to the same risk come together and agree that if anyone of the person suffers a loss the other will share the loss and make good to the person who lost. The initial part of the project focuses on the job and responsibilities I was allot allotted ted as a summer summer trainee. trainee. It also also makes makes the readers readers aware aware about about the the techniques and methodology used to bring this report alive. It also describe about the objective of this study. It also enlightens the readers about Sharekhan Limited’s strategies to acquire new customers. Further the project tells us about the profile of the company (Sha (Share rekh khan an Ltd.) Ltd.).. It prov provid ides es know knowle ledg dge e to the the read reader ers s rega regard rdin ing g the the compan company’s y’s histor history, y, missio mission, n, vision vision,, custom customer er base base and and the the reason reasons s to be associated with the company. Also it gives special emphasis on the selling of products and management of the company. The next few chapters are devoted to the study of the Derivative Market and Deri Deriva vati tive ve Inst Instru rume ment nts s in a very very basi basic c way. way. It also also sugg sugges ests ts some some of the the strategies that can be applied to earn more even when the market is too much volatile. The readers can also find the comparative analysis of the Derivative Market and the Cash Market in the Indian context. The next part of the project throws light upon my findings and analysis about the company and the suggestions for the company for better performance.
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OBJECTIVE OF THE STUDY To find out whether the Derivative Instruments are applicable in the Indian Stock Market which can work both in good and bad times so that it can minim minimize ize our our risk risk and and maxim maximize ize our our retur returns. ns. As As a result result one one can have have conv convic icti tion on in his his port portfo foli lio o in the the huge hugely ly vola volati tile le stoc stock k mark market et beca becaus use e a difficult and serious problem for all investors today is that there is entirely too much free information, hype, promotion, personal opinion, and advice about deriva derivativ tive e instru instrumen ments ts are there there in stock market market.. One get it from from friend friends, s, relati relatives ves,, people people at work, work, the the Intern Internet, et, broker brokers, s, stock stock analy analysts sts,, advise advisers, rs, entertaining cable TV market programs, and other media. It can be very risky and potentially dangerous. Realistically, there are not too many people one can listen to if he want to avoid confusing, contradictory, and faulty personal market opinions. So one need to confine himself to just a very few sources of relevant facts and data and a sound system that has proven to be accurate and profitable over time. Therefore, the objective of the Dissertation is to do in depth research on these derivative instruments.
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METHODOLOGY During this project, I have analyzed the Futures and Options. I have tried to analyze the instruments as per the Market Participant and the Market Trend. Initially, I have given a brief introduction about the instruments, so that the reader is aware of basics of the subject. I have tried to identify various terms related to derivative trading, for which I have introduced a separate chapter, “Terms related to derivative market” Then I have tried to segregate the use of Instruments as per the Market Participants and Market Trend. I identified hedging, arbitrage and speculation strategies using both futures and options, and then segregated them into a chapter each. Segregation involved a thorough study of the strategies and possible use. Then I have done a secondary data based study on growth of Indian Derivative Market, which includes the comparison of derivative market with cash market, data data rega regard rdin ing g the the trad traded ed volu volume me and and numb number er of cont contra ract cts s trad traded ed from from December 2007 till May 2008. I have also analyzed the top five most traded symbols in futures and options segment. 10
JOB DESCRIPTION The company placed me as a Summer Trainee. I have been handling the Following responsibilities:
➢ ➢ ➢ ➢
My job profile was to sale the products of the organization. organization. My job profile was to coordinate the team and also help them to sale the product and also help them in field. My job profile was to generate the leads by cold calling. My job profile was to understand customers’ needs and advising them to make a portfolio as per their investment. My job profile was to do sales promotion through e-mails, canopies, making cold calling, distributing pamphlets and etc.
AREA ASSIGNED
I covered areas like Delhi, Gurgaon, Ghaziabad, Ghaziabad, Faridabad and NCR. 11
TARGET ASSIGNED •
To sell 18 accounts per month.
TARGET MARKET ➢ ➢ ➢ ➢ ➢ ➢ ➢ ➢
Different properties dealers. Charted accountants. Lawyers Travel agencies Transport business House wives Businessmen Corporate Employees etc.
DAY TO DAY JOB DESCRIPTION • • • • •
•
Reporting time: 9.30 AM Fixing appointment with clients. Visit clients place. Demonstrate the product on Internet to the client. Completing the formalities like filling the application form and documentation. Cold calling.
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Chapter 1
13
Introductio n of Sharekhan ltd.
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INTRODUCTION OF SHAREKHAN LTD. ABOUT SHAREKHAN LIMITED Sharekhan Ltd. is one of the leading retail stock broking house of SSKI Group
which is running successfully since 1922 in the country. It is the retail broking arm arm of the the Mu Mumb mbai ai-b -bas ased ed SSKI SSKI Grou Group, p, whic which h has has over over eigh eightt deca decade des s of experience in the stock broking business. Sharekhan offers its customers a wide range of equity related services including trade execution on BSE, NSE, Derivatives, depository services, online trading, investment advice etc. The The firm firm’s ’s onli online ne trad tradin ing g and and inve invest stme ment nt site site - www www.sharekhan.com - was laun launch ched ed on Feb Feb 8, 2000 2000.. The The site site give gives s acce access ss to supe superi rior or cont conten entt and and transa transacti ction on facili facility ty to retail retail custom customers ers across across the count country. ry. Known Known for its jargon-free, investor friendly language and high quality research, the site has a registered base of over one lakh customers. The content-rich and research orie orient nted ed port portal al has has stoo stood d out out amon among g its its cont contem empo pora rari ries es beca becaus use e of its its steadf steadfast ast dedica dedicatio tion n to offeri offering ng custom customers ers best-o best-of-b f-bree reed d techno technolog logy y and and superior market information. The objective has been to let customers make informed decisions and to simplify the process of investing in stocks. On April April 17, 2002 Sharekhan Sharekhan launched Speed Trade, Trade, a net-based net-based executable executable appl applic icat atio ion n that that emul emulat ates es the the brok broker er term termin inal als s alon along g with with host host of othe otherr information relevant to the Day Traders. This was for the first time that a netbased trading station of this caliber was offered to the traders. In the last six months Speed Trade has become a de facto standard for the Day Trading community over the net. Sharekhan’s ground network includes over 640 centers in 280 cities in India which provide a host of trading related services. 15
Sharekhan has always believed in investing in technology to build its business. The company has used some of the best-known names in the IT industry, like Sun Sun Micros Microsyst ystems ems,, Oracle Oracle,, Micros Microsoft oft,, Cambr Cambridg idge e Techno Technolog logies ies,, Nexgen Nexgenix, ix, Vignette, Verisign Financial Technologies India Ltd, Spider Software Pvt Ltd. to build its trading engine and content. The Morakhiya family holds a majority stake in the company. HSBC, Intel & Carlyle are the other investors. With a legacy of more than 80 years in the stock markets, the SSKI group vent ventur ured ed into into inst instit itut utio iona nall brok brokin ing g and and corp corpor orat ate e fina financ nce e 18 year years s ago. ago. Presen Presently tly SSKI SSKI is one of the leadin leading g player players s in instit instituti utiona onall brokin broking g and and corporate finance activities. SSKI holds a sizeable portion of the market in each of these segments. SSKI’s institutional broking arm accounts for 7% of the the mark market et for for Fore Foreig ign n Inst Instit itut utio iona nall port portfo foli lio o inve invest stme ment nt and and 5% of all all Dome Domest stic ic Inst Instiitu tuti tion onal al port portfo foli lio o inve invest stme ment nt in the the coun countr try. y. It has has 60 inst instit itut utio iona nall clie client nts s spre spread ad over ver Indi India, a, Fa Farr East East,, UK and and US. US. Fore Foreig ign n Institutional Investors generate about 65% of the organization’s revenue, with a daily turnover of over US$ 2 million. The Corporate Finance section has a list of very prestigious clients and has many ‘firsts’ to its credit, in terms of the size of deal, sector tapped etc. The group has placed over US$ 1 billion in private equity deals. Some of the clients include BPL Cellular Holding, Gujarat Pipavav, Essar, Hutchison, Planetasia, and Shopper’s Stop.
PROFILE OF THE COMPANY Name of the company:
Sharekhan ltd.
Year of Establishment: Headquarter :
1925 ShareKhan SSKI A-206 Phoenix House Phoenix Mills Compound Lower Parel Mumbai - Maharashtra, INDIA- 400013
Nature of Business
:
Service Provider
Services
:
Depository Services, Online Services and Technical Research.
Number of Employees :
Over 3500
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Revenue
:
Website
:
Slogan
:
Data Not Available www.sharekhan.com Your Guide to The Financial Jungle.
Vision To be the best retail brokering Brand in the retail business of stock market.
Mission To educate and empower the individual investor to make better investment decisions through quality advice and superior service. Sharekhan is infact•
•
•
Among the top 3 branded retail service providers No. 1 player in online business Largest network of branded broking outlets in the country serving more than 7,00,000 clients.
REASON TO CHOOSE SHAREKHAN LIMITED Experience
SSKI has more than eight decades of trust and credibility in the Indian stock market. In the Asia Money broker's poll held recently, SSKI won the 'India's Best Broking House for 2004 ' award. Ever since it launched Sharekhan as its retail broking division in February 2000, it has been providing institutionallevel research and broking services to individual investors. Technology
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With its online trading account one can buy and sell shares in an instant from any PC with an internet connection. One can get access to its powerful online trading tools that will help him take complete control over his investment in shares. Accessibility
Sharekhan provides ADVICE, EDUCATION, TOOLS AND EXECUTION services for invest investors. ors. These These servic services es are are accessi accessible ble throu through gh its center centers s across across the the country over the internet (through the website www.sharekhan.com) as well as over the Voice Tool. Knowledge
In a business where the right information at the right time can translate into direct profits, one can get access to a wide range of information on Sharekhan limited’s content-rich portal. One can also get a useful set of knowledge-based tools that will empower him to take informed decisions. Convenience
One can call its Dial-N-Trade number to get investment advice and execute his transa transacti ctions ons.. Share Sharekha khan n ltd. ltd. have have a dedica dedicated ted call-c call-cent entre re to provid provide e this this service via a Toll Free Number 1800-22-7500 & 1800-22-7050 from anywhere in India. Customer Service
Sharekhan limited’s customer service team will assist one for any help that one may require relating to transactions, billing, demat and other queries. Its customer service can be contacted via a toll-free number, email or live chat on www.sharekhan.com. Investment Advice
Shar Sharek ekha han n has has dedi dedica cate ted d rese resear arch ch team teams s of more more than than 30 peop people le for for fundamental and technical researches. Its analysts constantly track the pulse of the market and provide timely investment advice to its clients in the form of daily research emails, online chat, printed reports and SMS on their mobile phone.
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SHAREKHAN LIMITED’S MANAGEMENT TEAM
➢
➢
➢ ➢
Dinesh Murikya
Tarun Shah
Shankar Vailaya
:
Owner of the company :
:
Jaideep Arora
CEO of the company Director (Operations)
:
Director (Products & Technology)
➢
Pathik Gandotra
:
Head of Research
➢
Rishi Kohli
:
Vice President of Equity Derivatives
➢
Nikhil Vora
:
Vice President of Research
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PRODUCTS AND SERVICES OF SHAREKHAN LIMITED The different types of products and services offered by Sharekhan Ltd. are as follows: •
Equity and derivatives trading
•
Depository services
•
Online services
•
Commodities trading
•
Dial-n-trade
•
Portfolio management
•
Share shops
•
Fundamental Fundamental research
•
Technical research
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TYPES OF ACCOUNT IN SHAREKHAN LIMITED Sharekhan offers two types of trading account for its clints ➢
Classic Account (which include a feature known as Fast Trade Advanced Classic Account for the online users) and
➢
Speed Trade Account
CLASSIC ACCOUNT This is a User Friendly Product which allows the client to trade through website www.sharekhan.com and is suitable for the retail investor who is 21
risk-averse and hence prefers to invest in stocks or who does not trade too frequently. This account allow investors to buy and sell stocks online along with the following features like multiple watch lists, Integrated Banking, Demat and digital contracts, Real-time portfolio tracking with price alerts and Instant credit & transfer. This account comes with the following features: a. Online Online trading trading account account for investing investing in Equitie Equities s and Derivatives Derivatives b. Free tradin trading g through through Phone Phone (Dial-n(Dial-n-Trad Trade) e) I.Two I. Two dedicated dedicated numbers(1800-2 numbers(1800-22-750 2-7500 0 and 39707500) for placing the orders using cell phones or landline phones Automatic funds transfer with phone banking facilities (for II.Automatic Citibank and HDFC bank customers) III. III.Si Simp mple le and and Secu Secure re Inte Intera ract ctiv ive e Voic Voice e Resp Respon onse se base based d system for authentication authentication IV. IV.get the trusted, professional advice of Sharekhan limited’s Tele Brokers V.After hours order placement facility between 8.00 am and 9.30 am c. Integration of: Online Trading +Saving Bank + Demat Account. d. Instant cash transfer facility against purchase & sale of shares. e. IPO investments. f. Instant order and trade confirmations by e-mail. g. Single screen interface for cash and derivatives.
SPEED TRADE ACCOUNT This is an internet-based software application, which enables one to buy and sell sell in an inst instan ant. t. It is idea ideall for for acti active ve trad trader ers s and and jobb jobber ers s who who tran transa sact ct frequently during day’s session to capitalize on intra-day price movement. This account comes with the following features: a. Instant Instant order order Execut Execution ion and and Confirm Confirmatio ation. n. 22
b. Single Single screen screen trading trading terminal terminal for NSE NSE Cash, NSE NSE F&O & BSE. c. Tech Techni nica call Stu Studi dies. es. d. Multip Multiple le Chart Charting ing.. e. Real-tim Real-time e streamin streaming g quotes, quotes, tic-by tic-by-tic -tic chart charts. s. f. Market Market summa summary ry (Cost (Cost traded traded scrip, scrip, high highest est value value etc.) g. Hot keys similar similar to to broker’s broker’s terminal terminal.. h. Alert Alerts s and and remind reminders ers.. i. Back-up Back-up facility facility to to place place trades trades on Direc Directt Phone Phone lines. lines. j. j. Live Live mark market et debt debts. s.
CHARGE STRUCTURE Fee structure for General Individual: Charge Account Opening
Brokerage
Classic Account
Speed Trade Account
Rs. 750/=
Rs. 1000/=
Intra-day – 0.10 %
Intra-day - 0.10%
Delivery - 0.50 %
Delivery - 0.50%
Depository Charges: Rs. NIL
Account Opening Charges Annual Maintenance Charges
Rs. NIL first year Rs. 300/= p.a. from second calendar year onward
HOW TO OPEN AN ACCOUNT WITH SHARE KHAN LIMI LI MITE TED D? For online trading with Sharekhan Ltd., investor has to open an account. Following are the ways to open an account with Sharekhan Ltd.: •
One need to call them at phone number provided below and asks that he want to open an account with them.
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a. One can call call on the Toll Toll Free Number: Number: 1-800-2 1-800-22-750 2-7500 0 to speak to a Customer Service executive b. Or If one stays stays in Mumba Mumbai, i, he can call call on 022-66 022-6662111 621111 1 •
•
•
One can visit any one of Sharekhan Sharekhan Limited’s Limited’s nearest branches. branches. Sharekhan has a huge network all over India (640 centers in 280 cities). One can also log on to “http://sharekhan.com/Locateus.aspx” “http://sharekhan.com/Locateus.aspx” link to find out the nearest branch. One can send them an email at
[email protected] to know about their products and services. One can also visit the site www.sharekhan.com and click on the option “Ope “Open n an Acco Accoun unt” t” to fill fill a smal smalll qu quer ery y form form whic which h will will ask ask the the individual to give details regarding his name, city he lives in, his email address, phone number, pin code of the city, his nearest Sharekhan Ltd. shop and his preferences regarding the type of account he wants. These information are compiled in the headquarter of the company that is in Mumbai from where it is distributed through out the country’s branches in the form of leads on the basis of cities and nearest share shops. After that the executives of the respective branches contact the pros prosp pecti ective ve clie clien nts over ver phon phone e or thro throu ugh ema email and and give give them information regarding the various types of accounts and the documents they they need need to open open an acco accoun untt and and then then fix fix appo appoin intm tmen entt with with the the pros prospe pect ctiv ive e clie client nts s to give give them them demo demons nstr trat atio ion n and and maki making ng them them undergo the formalities to open the account. After that the forms that has collected from the clients, is scrutinized in the branch and then it is sent to Mumbai for further processing where after a few days the clients’ account are generated and activated. After the accounts are activated, a Welc Welcom ome e Kit Kit is disp dispa atche tched d from from Mu Mumb mbai ai to the the clie client nts’ s’ addr addres ess s mentioned in the documents provided by them. As soon as the clients receive the Welcome Kit, which contains the clients’ Trading ID and Trading Password, they can start trading and investing in shares.
Generally the process of opening an account follows the following steps: LEAD MANAGEMENT MANAGEMENT SYSTEM SYSTEM LMS / REFEREN REFERENCES CES CONTACT CONTACT THE PERSON OVER PHONE OR THROUGH EMAIL 24
FIXING AN APPOINTMENT APPOINTMENT WITH THE PERSON GIVING DEMONSTRATION
YES
NO DOCUMENTATION FILLING UP THE FORM SUBMISSION OF THE FORM LOGIN OF THE FORM
SENDING ACCOUNT OPENING KIT TO THE CLIENT
TRADING
Apart Apart from from two passpo passport rt size size photog photograp raphs, hs, one needs needs to provid provide e with with the the following documents in order to open an account with Sharekhan Limited.: •
•
Photocopy of the clients’ PAN Card which should be duly attached Photo copy of any of the following documents duly attached which will serve as correspondence address proof: a. b. c. d. e.
Passp Passpor ortt (va (vali lid) d) Vote Voter’ r’s s ID ID Card Card Rati Ration on Card Drivin Driving g Licen License se (val (valid) id) Electricit Electricity y Bill (should (should be be latest and and should should be in the the name of the the client) 25
f. Teleph Telephone one Bill Bill (shoul (should d be latest latest and shoul should d be in the name name of the client) g. Flat Mainte Maintenanc nance e Bill (should (should be latest latest and should should be in the the name of the client) h. Insura Insurance nce Policy Policy (shoul (should d be latest latest and should should be in the name of the client) i. Leas Lease e or or Ren Rentt Agr Agree eeme ment nt.. j. Saving Saving Bank Bank Stat Stateme ement* nt*** (shoul (should d be latest latest)) •
Two cheques drawn in favour of Sharkhan Limited, one for the Account Open Openin ing g Fees Fees and and the the othe otherr for for the the Marg Margin in Mone Money y (the (the mini minimu mum m margin money is Rs. 5000).
** A cancelled cheque should be given by the client if he provides Saving Bank Statement as a proof for correspondence address. NOTE: Only Saving Bank Account cheques are accepted for the purpose of Opening an account.
RESEARCH SECTION IN SHAREKHAN LIMITED Share Sharekha khan n Limit Limited ed has its its own in-hou in-house se Resear Research ch Organi Organisat sation ion which which is known as Valueline. It comprises a team of experts who constantly keep an eye on the share market and do research on the various aspects of the share market. Generally the research is based on the Fundamentals and Technical analysis of different companies and also taking into account various factors relating to the economy.
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Sharekhan Limited’s research on the volatile market has been found accurate most of the time. Sharekhan's Sharekhan's trading trading calls in the month month of November November 2007 has given 89% strike rate. Out of 37 trading calls given by Sharekhan in the month of November 2007, 33 hit the profit target. These exclusive trading picks come only to Sharekhan Online Trading Customer and are based on in-depth technical analysis. As a customer of Sharekhan Limited, one receives daily 5-6 Research Reports on their emails which they can use as tips for investing in the market. These reports are named as Pre-Market Report, Eagle Eye, High Noon, Investors Eye, Daring Daring Deriva Derivativ tives es and Post-M Post-Mark arket et Repor Report. t. Apart Apart from from these, these, Sharek Sharekhan han Limited issues a monthly subscription by the name of Valueline which is easily available in the market.
AWARDS AWARDS AND ACHIEVEM HIE VEMENT ENTS S
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•
•
SSKI SSKI has has been been vote voted d as the the Top Top Dome Domest stic ic Brok Broker erag age e Hous House e in the the rese resear arch ch cate catego gory ry,, twic twice e by Euro Euromo mone ney y Surv Survey ey and and four four time times s by Asiamoney Survey. Sharekhan Limited Limited won the CNBC AWARD AWARD for the year 2004.
POLL RESULTS: BROKER PREFERENCE 5paise Sharekhan Motilal oswal ICICI Direct HDFC Indiabulls Kotak Others
119 194 38 192 46 121 59 116
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13.45% 21.92% 4.29% 21.69% 5.20% 13.67% 6.67% 13.11%
Chapter 2
29
Introductio n to Derivatives
INTRODUCTION TO DERIVATIVES
30
The emergence of the market for derivative products, most notably forwards, future futures s and and option options, s, can be traced traced back back to the the willin willingne gness ss of risk-a risk-aver verse se econom economic ic agents agents to gu guard ard themse themselve lves s agains againstt uncer uncerta taint inties ies arisi arising ng out out of fluctuations in asset prices. By their very nature, the financial markets are marke marked d by a very very high high degree degree of volati volatilit lity. y. Throug Through h the the use use of deriv derivati ative ve products, it is possible to partially or fully transfer price risks by locking–in asse assett pric prices es.. As inst instru rume ment nts s of risk risk mana manage geme ment nt,, thes these e gene genera rall lly y do not not influence the fluctuations in the underlying asset prices. However, by lockingin asset asset prices prices,, deriva derivativ tive e produc products ts minim minimize ize the impac impactt of fluctu fluctuati ations ons in asse assett pric prices es on the the prof profit itab abil ilit ity y and and cash cash flow flow situ situat atio ion n of risk risk-a -ave vers rse e investors.
DERIVATIVES DEFINED Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the “underlying”. “underlying”. In simple word it can be said that Derivatives are financial contracts whose value/price is dependent on the behavior of the price of one or more basic underlying assets (often simply known as underlying). These contracts are legally binding agreements, made on the trading screen of stock exchanges, to buy or sell an asset in future. The asset can be a share, index, interest rate, bond, rupee dollar exchange rate, sugar, crude oil, soybean, cotton, coffee, etc. In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R) A) defines “derivative” to include – 1. A security derived from a debt instrument, share, loan whether secured or unsecured, unsecured, risk instru instrument ment or or contract contract for for differences differences or or any other other form form of security.
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2. A contract which derives its value from the prices, or index of prices, of underlying securities. A very simple example of derivatives is curd, which is derivative of milk. The price of curd depends upon the price of milk which in turn depends upon the demand and supply of milk.
EMERGENCE OF DERIVATIVES Derivative products initially emerged as hedging devices against fluctuations in commodity prices, and commodity-linked derivatives remained the sole form of such products for almost three hundred years. Financial derivatives came into spotlight in the post-1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two-thirds of total transactions in derivative products. In recent years, the market for financial derivatives has grow grown n trem tremen endo dous usly ly in term terms s of vari variet ety y of inst instru rume ment nts s avai availa labl ble, e, thei theirr complexity and also turnover. In the class of equity derivatives the world over, futures and options on stock indices have gained more popularity than on individual stocks, especially among institutional investors, who are major users of index-linked derivatives. Even small investors find these useful due to high correlation of the popular indexes with various portfolios and ease of use. The lower costs associated with index derivatives vis–a–vis derivative products based on individual securities is another reason for their growing use.
HISTORY OF DERIVATIVES Earl Early y forw forwar ard d cont contra ract cts s in the the US addr addres esse sed d merc mercha hant nts’ s’ conc concer erns ns abou aboutt ensuring that there were buyers and sellers for commodities. However “credit risk” remained a serious problem. To deal with this problem, a group of Chicago businessmen formed the Chicago Board of Trade (CBOT) in 1848. The primary intention of the CBOT was to provide a centralized location known in advance for buyers and sellers to negotiate forward contracts. In 1865, the CBOT went one step further and listed the first “exchange traded” derivatives contract in the US, these contracts were called “futures contracts”. In 1919, Chicago Butter 32
and Egg Board, a spin-off of CBOT, was reorganized to allow futures trading. Its name was changed to Chicago Mercantile Exchange (CME). The CBOT and the CME CME remain remain the two larges largestt organ organize ized d futur futures es exchan exchanges ges,, indeed indeed the two largest “financial” exchanges of any kind in the world today. The first stock index futures contract was traded at Kansas City Board of Trade. Currently the most popular stock index futures contract in the world is based on S&P 500 index, traded on Chicago Mercantile Exchange. During the mid eighti eighties, es, finan financia ciall future futures s becam became e the the most most active active deriva derivativ tive e instru instrumen ments ts genera generatin ting g volum volumes es many many times times more more than than the commod commodity ity futur futures. es. Index Index futures, futures on T-bills and Euro-Dollar futures are the three most popular futures futures contract contracts s traded traded today. today. Other popular popular internat internationa ionall exchange exchanges s that trade derivatives are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE in Japan, MATIF in France, Eurex etc.
GLOBAL DERIVATIVE MARKETS The The deri deriva vati tive ves s mark market ets s have have grow grown n mani manifol fold d in the the last last two two deca decade des.. s.. According to the Bank for International Settlements (BIS), the approximate size of global derivatives market was US$ 109.5 trillion as at end–December 2000. The total total estimated estimated notional notional amount of outstan outstanding ding over–the–c over–the–count ounter er (OTC) contracts stood at US$ 95.2 trillion as at end–December 2000, an increase of 7.9% over end–December 1999. Growth in OTC derivatives market is mainly attributable to the continued rapid expansion of interest rate contracts, which refl reflec ecte ted d grow growin ing g corp corpor orat ate e bond bond mark market ets s and and incr increa ease sed d inte intere rest st rate rate uncertainty at the end of 2000. The amount outstanding in organized exchange markets increased by 5.8% from US$ 13.5 trillion as at end December 1999 to US$ 14.3 trillion as at end–December 2000. The turnover data are available only for exchange–traded derivatives contracts. The turnover in derivative contracts traded on exchanges has increased by 9.8% during 2000 to US$ 384 trillion as compared to US$ 350 trillion in 1999(Table 1.2). While interest rate futures and options accounted for nearly 90% of total turnover during 2000, the popularity of stock market index futures and options grew modestly during the year. According to BIS, the turnover in exchange– traded derivative markets rose by a record amount in the first quarter of 2001, while there was some moderation in the OTC volumes. 33
DERIVATIVE MARKET IN INDIA The The first first step step toward towards s introd introduct uction ion of deriva derivativ tives es tradin trading g in India India was the promu promulga lgatio tion n of the the Secur Securiti ities es Laws Laws (Amen (Amendme dment) nt) Ordina Ordinance nce,, 1995, 1995, which 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 trad tradin ing g of deri deriva vati tive ves. s. SEBI SEBI set set up a 24–m 24–mem embe berr comm commit itte tee e unde underr the 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 its repo report rt on Marc March h 17, 17, 1998 1998 pres prescr crib ibin ing g nece necess ssar ary y pre– pre–co cond ndit itio ions ns for for introduction of derivatives trading in India. The committee recommended that deriva derivativ tives es should should be declar declared ed as ‘secur ‘securiti ities’ es’ so that that regul regulato atory ry framew framework ork applicable to trading of ‘securities’ could also govern trading of securities. SEBI also set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma, to recommend measures for risk containment in derivatives market in India. The report report,, which which was submi submitte tted d in Octobe Octoberr 1998, 1998, worked worked out out the the opera operatio tional nal details of margining system, methodology for charging initial margins, broker net worth, deposit requirement and real–time monitoring requirements. The 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. Derivatives trading commenced in India in June 2000 after SEBI granted the fina finall appr approv oval al to this this effec effectt in May May 2000 2000.. SEBI SEBI perm permit itte ted d the the deri deriva vati tive ve seg segment ents of two sto stock exch excha anges, es, NSE and BSE, and thei theirr clea clearring ing 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 (Sensex) index. This was followed by approval for trading in options based on these two indexes and options on 34
individual securities. The trading in index options commenced in June 2001 and the trading in options on individual securities commenced in July 2001. Futur Fu tures es contra contracts cts on indivi individua duall stocks stocks were were launch launched ed in Novem November ber 2001. 2001. Trading and settlement in derivative contracts is done in accordance with the rules, byelaws, and regulations of the respective exchanges and their clearing house/corporation house/corporation duly approved by SEBI and notified in the official gazette.
The derivatives trading on the exchange commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001. The index futu future res s and and opti option ons s cont contra ract ct on NSE NSE are are base based d on S&P S&P CNX CNX Nift Nifty y Inde Index. x. Currently, the futures contracts have a maximum of 3-month expiration cycles. Thr Three ee cont contra ract cts s are are avai availa labl ble e for for trad tradin ing, g, with with 1 mont month, h, 2 mont months hs and and 3 months expiry. A new contract is introduced on the next trading day following the expiry of the near month contract.
PARTICITANTS AND FUNCTIONS PARTICIPANTS Deriva Derivativ tive e contra contracts cts have have severa severall varian variants. ts. The most most common common varia variants nts are forwards, futures, options and swaps. The following three broad categories of participants – Hedgers : - Hedgers face risk associated with the price of an asset. They use
futures or options markets to reduce or eliminate this risk Speculators: - Speculators wish to bet on future movements in the price of an
asset. Futures and options contracts can give them an extra leverage; that is, they can increase both the potential gains and potential losses in a speculative venture. Arbitrageurs : - Arbitrageurs are in business to take advantage of a
discrepanc discrepancy y between between prices in two different different markets. markets. If, for example, example, they see 35
the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit.
FUNCTIONS The derivatives market performs a number of economic functions. 1. Prices in an organized organized derivatives derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract.
2. The derivati derivatives ves market market helps to transfe transferr risks from those those who have have them but may not like them to those who have an appetite for them. 3. Deriva Derivativ tives, es, due to their inheren inherentt natur nature, e, are linked linked to the underly underlying ing cash cash market markets. s. With With the intro introduc ductio tion n of deriva derivativ tives, es, the underl underlyin ying g market market witnesses witnesses higher trading trading volumes volumes because because of participa participation tion by more more play player ers s who who woul would d not not othe otherw rwis ise e part partic icip ipat ate e for for lack lack of an arrangement to transfer risk. 4. Speculati Speculative ve trades shift shift to a more control controlled led environme environment nt of derivatives derivatives market. In the absence of an organized derivatives market, speculators trad trade e in the the unde underl rlyi ying ng cash cash mark market ets. s. Marg Margin inin ing, g, moni monito tori ring ng and and surveillance of the activities of various participants become extremely difficult in these kind of mixed markets. 5. An impor importan tantt incide incident ntal al benefi benefitt that that flows flows from from deriv derivati atives ves tradin trading g is that it acts as a catalyst for new entrepreneurial activity. The derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefit of which are immense.
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6. Deriva Derivativ tives es marke markets ts help help incre increase ase savings savings and investm investment ent in the the long long run. Transfer of risk enables market participants to expand their volume of activity.
TYPES OF DERIVATIVE INSTRUMENTS Forwards : A forward contract is a customized contract between two entities,
where settlement takes place on a specific date in the future at today’s preagreed price. Futures : A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are are spec specia iall type types s of forw forwar ard d cont contra ract cts s in the the sens sense e that that the the form former er are are standardized exchange-traded contracts. Options: Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. Warrants : Options generally have lives of up to one year, the majority of optio options ns traded traded on option options s exchan exchanges ges havin having g a maxim maximum um matu maturit rity y of nine nine months. Longer-dated options are called warrants and are generally traded over-the-counter. LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options having a maturity of up to three years. Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average of a basket of assets. Equity index options are a form of basket options. Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are: a. Interest rate swaps : These entail swapping only the interest related cash flows between the parties in the same currency.
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b.Currency swaps : These entail swapping both principal and interest between
the parties, with the cash flows in one direction being in a different currency than those in the opposite direction. Swaptions : Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.
DERIVATIVE MARKET AT NSE The derivatives trading on the exchange commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001. The index futures and options contract on NSE are based on S&P CNX Nifty Index. Curre Current ntly, ly, the the futur futures es contr contract acts s have have a maxim maximum um of 3-mon 3-month th expira expiratio tion n cycles. Three Three contr contract acts s are availabl available e for tradin trading, g, with with 1 month, month, 2 months months and 3 months expiry. A new contract is introduced on the next trading day following the expiry of the near month contract.
APPROVAL FOR DERIVATIVE TRADING TRADING MECHANISM The futures and options trading system of NSE, called NEAT-F&O trading system, provides a fully automated screen–based trading for Nifty futures & options and stock futures & options on a nationwide basis and an online monit monitori oring ng and and survei surveilla llance nce mecha mechanis nism. m. It suppor supports ts an anony anonymou mous s order order driven market which provides complete transparency of trading operations and operates on strict price–time priority. It is similar to that of trading of equities in the Cash Market (CM) segment. The NEAT-F&O trading system is accessed by two types of users.
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The Trading Members(TM) have access to functions such as order entry, order matching, and order and trade management. It provides tremendous flexibility to users in terms of kinds of orders that can be placed on the system. Various conditions like Good-till-Day, Good-till-Cancelled, Good till- Date, Immediate or Cancel, Limit/Market price, Stop loss, etc. can be built into an order. The Clea Cleari ring ng Memb Member ers s (CM) (CM) uses uses the the trad trader er work workst stat atio ion n for for the the purp purpos ose e of monitoring the trading member(s) for whom they clear the trades. Additionally, they can enter and set limits to positions, which a trading member can take.
MEMBERSHIP CRITERIA NSE admits members on its derivatives segment in accordance with the rules and regulations of the exchange and the norms specified by SEBI. NSE follows 2–tier membership structure stipulated by SEBI to enable wider participation. Those interested in taking membership on F&O segment are required to take membership of CM and F&O segment or CM, WDM and F&O segment. Trading and clearing members are admitted separately. Essentially, a clearing member (CM) does clearing for all his trading members (TMs), undertakes risk management and performs actual settlement. There are three types of CMs: •
Self Clearing Member: A SCM clears and settles trades executed by him
only either on his own account or on account of his clients. Trading Member Clearing Member : TM–CM is a CM who is also a TM. TM–CM may clear and settle his own proprietary trades and client’s trades as well as clear and settle for other TMs. Profession Professional al Clearing Clearing Member Member: PCM is a CM who is not a TM. Typically, banks or custodians could become a PCM and clear and settle for TMs. The TM–CM and the PCM are required to bring in additional security deposit in respect of every TM whose trades they undertake to clear and settle. Besides this, trading members are required to have qualified users and sales persons, who have passed a Certification programme approved by SEBI. •
•
CLEARING AND SETTLEMENTS 39
NSCCL undertakes clearing and settlement of all deals executed on the NSEs F&O segment. It acts as legal counterparty to all deals on the F&O segment and guarantees settlement. Clearing:
The first step in clearing process is working out open positions or obligations of memb member ers. s. A CM’s CM’s open open posi positi tion on is arri arrive ved d at by aggr aggreg egat atin ing g the the open open position of all the TMs and all custodial participants clearing through him, in the contracts in which they have traded. A TM’s open position is arrived at as the summation of his proprietary open position and clients open positions, in the contracts in which they have traded. TMs are required to identify the orders, whether proprietary (if they are their own trades) or client (if entered on behalf of clients). Proprietary positions are calculated on net basis (buy-sell) for each contract. Clients’ positions are arrived at by summing together net (buysell) positions of each individual client for each contract. A TM’s open position is the sum of proprietary open position, client open long position and client open short position. Settlement:
All futures and options contracts are cash settled, i.e. through exchange of cash. The underlying for index futures/options of the Nifty index cannot be delivered. These contracts, therefore, have to be settled in cash. Futures and opti option ons s on indi indivi vidu dual al secu securi riti ties es can can be deli delive vere red d as in the the spot spot mark market et.. However, it has been currently mandated that stock options and futures would also be cash settled. The settlement amount for a CM is netted across all their TMs/clients in respect of MTM, premium and final exercise settlement. For the purpose of settlement, all CMs are required to open a separate bank account with NSCCL designated clearing banks for F&O segment.
INDEX DERIVATIVES Index derivatives are derivative contracts which derive their value from an underlying index. The two most popular index derivatives are index futures 40
and index options. Index derivatives have become very popular worldwide. In his report, Dr.L.C.Gupta attributes the popularity of index derivatives to the advantages they offer. •
•
•
•
•
Instituti Institutional onal and large large equity-h equity-holder olders s need portfolio portfolio-hed -hedging ging facility. facility. Index–derivatives are more suited to them and more cost–effective than deriva derivativ tives es based based on indivi individu dual al stocks stocks.. Pensio Pension n funds funds in the US are known to use stock index futures for risk hedging purposes. Index derivatives offer ease of use for hedging any portfolio irrespective of its composition. Stock index is difficult to manipulate as compared to individual stock prices, more so in India, and the possibility of cornering is reduced. This is partly because an individual stock has a limited supply, which can be cornered. Stock Stock index, index, being being an averag average, e, is much much less less volati volatile le than than indivi individua duall stock stock prices prices.. This This impli implies es much much lower lower capita capitall adequ adequacy acy and margin margin requirements. Inde Index x deri deriva vati tive ves s are are cash cash sett settle led, d, and and henc hence e do not not suff suffer er from from settle settlemen mentt delays delays and and proble problems ms relate related d to bad delive delivery, ry, forged forged/fa /fake ke certificates.
Requirements for an index derivatives market 1. Index: The choice of an index is an important factor in determining the
extent to which the index derivative can be used for hedging, speculation and arbitrage. A well diversified, liquid index ensures that hedgers and speculators will not be vulnerable to individual or industry risk. clearing ng corpor corporati ation on 2. Clearing Clearing corporatio corporation n settleme settlement nt guarante guarantee e: The cleari eliminat eliminates es counterp counterparty arty risk on futures futures markets. markets. The clearing clearing corporati corporation on interposes itself into every transaction, buying from the seller and selling to the buyer. This insulates a participant from credit risk of another. 3. Strong surveillance mechanism : Derivatives trading brings a whole class
of leve levera rage ged d posi positi tion ons s in the the econ econom omy. y. Henc Hence e the the need eed to have have stro strong ng 41
surv survei eill llan ance ce on the the mark market et both both at the the exch exchan ange ge leve levell as well well as at the the regulator level. 4. Education and certification : The need for education and certification in
the deriva derivativ tives es marke markett can never never be overem overempha phasiz sized. ed. A critic critical al elemen elementt of financial sector reforms is the development of a pool of human resources with stro strong ng skil skills ls and and expe expert rtis ise e to prov provid ide e qu qual alit ity y inte interm rmed edia iati tion on to mark market et participants. With the entire above infrastructure in place, trading of index futures and index options commenced at NSE in June 2000 and June 2001 respectively.
TRADING Here, I shall take a brief look at the trading system for NSE’s futures and options market. However, the best way to get a feel of the trading system is to actually watch the screen and observe how it operates.
Futures and options trading system The The futu future res s & opti option ons s trad tradin ing g syst system em of NSE, NSE, call called ed NEAT NEAT-F -F&O &O trad tradin ing g system, provides a fully automated screen-based trading for Nifty futures & options and stock futures & options on a nationwide basis as well as an online monitoring and surveillance mechanism. It supports an order driven market and provides complete transparency of trading operations. It is similar to that of trading of equities in the cash market segment. The software for the F&O market has been developed to facilitate efficient and transparent trading in futures and options instruments. Keeping in view the familiarity of trading members with the current capital market trading system, modif modifica icatio tions ns have have been been perfor performed med in the existi existing ng capita capitall marke markett tradin trading g system so as to make it suitable for trading futures and options .
Entities in the trading system The There re are are four four enti entiti ties es in the the trad tradin ing g syst system em.. Trad Tradin ing g memb member ers, s, clea cleari ring ng members, professional clearing members and participants.
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Trading members are members of NSE. They can trade 1. Trading members : Trading either on their own account or on behalf of their clients including participants. The exchange assigns a Trading member ID to each trading member. Each trading member can have more than one user. The number of users allowed for each trading member is notified by the exchange from time to time. Each user user of a trad tradin ing g memb member er must must be regi regist ster ered ed with with the the exch exchan ange ge and and is assigned a unique user ID. The unique trading member ID functions as a reference for all orders/trades of different users. This ID is common for all users of a particular trading member. It is the responsibility of the trading member to maintain adequate control over persons having access to the firm’s User IDs. 2. Clearing members: Clearing members are members of NSCCL. They carry
out risk management activities and confirmation/inquiry confirmation/inquiry of trades through the trading system. professio sional nal cleari clearing ng membe members rs is a 3. Professio Professional nal clearing clearing members members: A profes clea cleari ring ng memb member er who who is not not a trad tradin ing g membe ember. r. Typi Typica call lly, y, bank banks s and and custod custodia ians ns becom become e profes professio siona nall clear clearing ing membe members rs and and clear clear and settl settle e for their trading members. 4. Participants : A participant is a client of trading members like financial
institutions. These clients may trade through multiple trading members but settle through a single clearing member.
BASIS OF TRADING The The NEAT NEAT F&O system system suppor supports ts an order order driven driven marke market, t, wherei wherein n orders orders match automatically. automatically. Order matching is essentially on the basis of security, its price, time and quantity. All quantity fields are in units and price in rupees. The lot size on the futures market is for 200 Nifties. The exchange notifies the regular lot size and tick size for each of the contracts traded on this segment from time to time. When any order enters the trading system, it is an active order. It tries to find a match on the other side of the book. If it finds a match, a trade is generated. If it does not find a match, the order becomes passive and goes and sits in the respective outstanding order book in the system. 43
ORDER TYPES AND CONDITIONS The system allows the trading members to enter orders with various conditions attac attached hed to them them as per per their their requir requireme ements nts.. These These condit condition ions s are broadl broadly y divided into the following f ollowing categories: Time conditions Price conditions Other conditions Several combinations of the above are allowed thereby providing enormous flexibility to the users. The order types and conditions are summarized below. • • •
Time conditions •
Day order: A day order, as the name suggests is an order which is valid
for the day on which it is entered. If the order is not executed during the day, the system cancels the order automatically automatically at the end of the day. •
Good till canceled (GTC) : A GTC order remains in the system until the
user cancels it. Consequently, it spans trading days, if not traded on the day the order is entered. The maximum number of days an order can remain in the system is notified by the exchange from time to time after which which the order order is au autom tomati atical cally ly cancel cancelled led by the the system system.. Each Each day counted is a calendar day inclusive of holidays. The days counted are incl inclus usiv ive e of the the day day on whic which h the the orde orderr is plac placed ed and and the the orde orderr is cancelled from the system at the end of the day of the expiry period. •
Good till days/date (GTD): A GTD order allows the user to specify the
number of days/date till which the order should stay in the system if not executed. The maximum days allowed by the system are the same as in GTC order. At the end of this day/date, the order is cancelled from the system. Each day/date counted are inclusive of the day/date on which
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the order is placed and the order is cancelled from the system at the end of the day/date of the expiry period.
•
Immediate or Cancel(IOC): An IOC order allows the user to buy or sell
a contract as soon as the order is released into the system, failing which the order is cancelled from the system. Partial match is possible for the order, and the unmatched portion of the order is cancelled immediately.
Price condition •
Stop– loss: This facility allows the user to release an order into the
syst system em,, afte afterr the the mark market et pric price e of the the secu securi rity ty reac reache hes s or cros crosse ses s a threshold price e.g. if for stop–loss buy order, the trigger is 1027.00, the limit price is 1030.00 and the market (last traded) price is 1023.00, then this order is released into the system once the market price reaches or exceeds 1027.00. This order is added to the regular lot book with time of triggering as the time stamp, as a limit order of 1030.00. For the stop– loss sell order, the trigger price has to be greater than the limit price.
Other conditions
•
Market price: Market orders are orders for which no price is specified at
the time the order is entered (i.e. price is market price). For such orders, the system determines the price. •
Trigger price : Price at which an order gets triggered from the stop–loss
book. •
Limit price: Price of the orders after triggering from stop–loss book.
•
Pro: Pro means that the orders are entered on the trading member’s own
account. 45
•
Cli: Cli means that the trading member enters the orders on behalf of a
client.
Inquiry window The inquiry window enables the user to view information such as Market by Orde Order( r(MB MBO) O),, Mark Market et by Pric Price( e(MB MBP) P),, Prev Previo ious us Trad Trades es(P (PT) T),, Ou Outs tsta tand ndin ing g Orders Orders(OO (OO), ), Activi Activity ty log(A log(AL), L), Snap Snap Quote( Quote(SQ) SQ),, Order Order Statu Status(O s(OS), S), Marke Markett Movement Movement(MM), (MM), Market Inquiry( Inquiry(MI), MI), Net Position, Position, On line backup, backup, Multiple Multiple index inquiry, Most active security and so on. Relevant information for the selected contract/security can be viewed. We shall look in detail at the Market by Price (MBP) and the Market Inquiry (MI) screens.
Placing orders on the trading system For both the futures and the options market, while entering orders on the trading system, members are required to identify orders as being proprietary or client orders. Proprietary orders should be identified as ‘Pro’ and those of clients should be identified as ‘Cli’. Apart from this, in the case of ‘Cli’ trades, the client account number should also be provided. The futures market is a zero sum game i.e. the total number of long in any contract always equals the total number of short in any contract. The total number of outstanding contracts (long/short) at any point in time is called the “Open interest”. This Open interest figure is a good indicator of the liquidity in every contract. Based on studies carried out in international exchanges, it is found that open interest is maximum in near month expiry contracts.
Market spread/combination order entry The The NEAT NEAT F&O tradin trading g system system also also enable enables s to enter enter sprea spread/co d/comb mbina inatio tion n trades. shows the spread/combination screen. This enables the user to input 46
two or three orders simultaneously into the market. These orders will have the condition attached to it that unless and until the whole batch of orders finds a coun counte terr matc match, h, they they shal shalll not not be trad traded ed.. This This faci facili lita tate tes s spre spread ad and and combination trading strategies with minimum price risk.
Basket trading In order order to provid provide e a facili facility ty for easy easy arbitr arbitrage age betwee between n future futures s and and cash cash markets, NSE introduced basket-trading facility. Figure 10.4 shows the basket trading screen. This enables the generation of portfolio offline order files in the derivatives trading system and its execution in the cash segment. A trading member can buy or sell a portfolio through a single order, once he determines its size. The system automatically automatically works out the quantity of each security to be bought or sold in proportion to their weights in the portfolio.
Futures and options market instruments The F&O segment of NSE provides trading facilities for the following derivative instruments: 1. Index based futures 2. Index based options 3. Individual stock options 4. Individual stock futures
Contract specifications for index futures NSE trades Nifty futures contracts having one-month, two-month and threemonth expiry cycles. All contracts expire on the last Thursday of every month. Thus a January expiration contract would expire on the last Thursday of Janu January ary and and a Februa February ry expiry expiry contra contract ct would would cease cease tradin trading g on the the last last Thurs Thursday day of Februa February. ry. On the the Friday Friday follow followin ing g the the last last Thursd Thursday, ay, a new new cont contra ract ct havi having ng a thre threee-mo mont nth h expi expiry ry woul would d be intr introd oduc uced ed for for trad tradin ing. g. Depending on the time period for which you want to take an exposure in index futures contracts, you can place buy and sell orders in the respective contracts. 47
The Instrument type refers to “Futures contract on index” and Contract symbol - NIFTY NIFTY denot denotes es a “Futu “Futures res contra contract ct on Nifty Nifty index” index” and the Expiry Expiry date date represents the last date on which the contract will be available for trading. Each futures contract has a separate limit order book. All passive orders are stacked in the system in terms of price-time priority and trades take place at the passive order price (similar to the existing capital market trading system). The best buy order for a given futures contract will be the order to buy the index at the highest index level whereas the best sell order will be the order to sell the index at the lowest index level. Trading is for a minimum lot size of 200 units. Thus if the index level is around 1000, then the appropriate value of a single index futures contract would be Rs.200,000. The minimum tick size for an index future contract is 0.05 units. Thus a single move in the index value would imply a resultant gain or loss of Rs.10.00 (i.e. 0.05*200 units) on an open position of 200 units.
Contract specification for index options On NSE’s index options market, contracts at different strikes, having onemonth, two-month and three-month expiry cycles are available for trading. There are typically one-month, two-month and three-month options, each with five different strikes available for trading.
Contract specifications for stock options Tra Tradi ding ng in stoc stock k opti option ons s comm commen ence ced d on the the NSE NSE from from July July 2001 2001.. Thes These e contracts are American style and are settled in cash. The expiration cycle for stock options is the same as for index futures and index options. A new contract is introduced on the trading day following the expiry of the near month contract. NSE provides a minimum of five strike prices for every option type (i.e. call and put) during the trading month. There are at least two in–the– money money contra contracts cts,, two out–o out–of– f– the–mo the–money ney contr contract acts s and one at–th at–the–m e–mone oney y contract available for trading.
Charges
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The maximum brokerage chargeable by a TM in relation to trades effected in the contracts admitted to dealing on the F&O segment of NSE is fixed at 2.5% of the contract value in case of index futures and 2.5% of notional value of the cont contra ract ct[( [(St Stri rike ke pric price e + Prem Premiu ium) m) * Qu Quan anti tity ty]] in case case of inde index x opti option ons, s, exclusive of statutory levies. The transaction charges payable by a TM for the trades executed by him on the F&O segment are fixed at Rs.2 per lakh of turnover (0.002%)(Each side) or Rs.1 lakh annually, whichever is higher. The TMs contribute to Investor Protection Fund of F&O segment at the rate of Rs.10 per crore of turnover (0.0001%).
SEBI ADVISORY COMMITTEE ON DERIVATIVES The SEBI Board in its meeting on June 24, 2002 considered some important issues relating to the derivative markets which include: Physical settlement of stock options and stock futures contracts. Review of the eligibility criteria of stocks on which derivative products are permitted. Use of sub-brokers in the derivative markets. Norms for use of derivatives by mutual funds. • •
• •
The recommendations of the Advisory Committee on Derivatives on some of these issues were also placed before the SEBI Board. The Board desired that these issues be reconsidered by the Advisory Committee on Derivatives (ACD) and requested a detailed report on the aforesaid issues for the consideration of the Board. REGULATORY REGULATORY OBJECTIVES OBJECTIVE S
The LCGC outlined the goals of regulation admirably well in Paragraph 3.1 of its report. We endorse these regulatory principles completely and base our recommendations also on these same principles. We therefore reproduce this paragraph of the LCGC Report: 49
“The Committee believes that regulation should be designed to achieve specific, Well-d Well-defi efined ned goals. goals. It is inclin inclined ed toward towards s positi positive ve regul regulati ation on design designed ed to encourage healthy activity and behavior. It has been guided by the following objectives: (a) Investor Investor Protecti Protection on: Attention needs to be given to the following four aspects: (i) Fairness and Transparency (ii) Safeguard for clients’ moneys (iii) Competent and honest service “Quality of Markets” goes well beyond (b) Quality of markets : The concept of “Quality market integrity and aims at enhancing important market qualities, such as cost-efficiency, price-continuity, and price-discovery. This is a much broader objective than market integrity. While curbin curbing g any any undesi undesirab rable le tenden tendencie cies, s, the the regula regulator tory y (c) Innovat Innovation ion: While framework should not stifle innovation which is the source of all economic prog progre ress, ss, more more so beca becaus use e fina financ ncia iall deri deriva vati tive ves s repr repres esen entt a new new rapid rapidly ly developing area, aided by advancements in information technology.”
Chapter 3 50
Introductio n to Futures and Options 51
INTRODUCTION TO FUTURES AND OPTIONS In recent years, derivatives have become increasingly important in the field of fina financ nce. e. Whil While e futu future res s and and opti option ons s are are now now acti active vely ly trad traded ed on many any exchanges, forward contracts are popular on the OTC market. In this chapter we shall study in detail these three derivative contracts.
FORWARD CONTRACT A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward contracts are normally traded outside the exchanges. The salient features of forward contracts are: They are bilateral contracts and hence exposed to counter–party risk. Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality. The contract price is generally not available in public domain. On the expiration date, the contract has to be settled by delivery of the asset. If the party wishes to reverse the contract, it has to compulsorily go to the same counterparty, which often results in high prices being charged. Forward contracts are very useful in hedging and speculation. The classic hedg hedgin ing g appl applic icat atio ion n woul would d be that that of an expo export rter er who who expe expect cts s to rece receiv ive e payment in dollars three months later. He is exposed to the risk of exchange rate fluctuations. • •
• •
•
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Limitations of forward markets
Forward markets world-wide are afflicted by several problems: Lack of centralization centralization of trading, Illiquidity, and Counterparty risk • • •
FUTURE CONTRACT Futures markets were designed to solve the problems that exist in forward markets. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contra contracts cts,, the future futures s contra contracts cts are are standa standardi rdized zed and exchan exchange ge traded traded.. In simple words, Futures are exchange-traded contracts to buy or sell an asset in future at a price agreed upon today. The asset can be share, index, interest rate, rate, bond, bond, rupeerupee-dol dollar lar excha exchange nge rate, rate, sugar, sugar, crude crude oil, oil, soybea soybean, n, cotton cotton,, coffee etc. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. It is a standardized contract with standard under underlyi lying ng instru instrumen ment, t, a standa standard rd qu quant antity ity and and qualit quality y of the under underlyi lying ng instrument that can be delivered, (or which can be used for reference purposes in settlement) and a standard timing of such settlement. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. More than 99% of futures transactions are offset this way. The standardized items in a futures contract are: Quantity of the underlying asset Qual Qu alit ity y of the the unde underl rlyi ying ng asse assets ts (not (not requ requir ired ed in case case of fina financ ncia iall futures) The date and the month of delivery The units of price quotation quotation (not the price) Minimum fluctuation fluctuation in price (tick size) Location of settlement • •
• • • •
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•
Settlement style.
ADVANTAGES OF FUTURE TRADING IN INDIA
1. High Leverage : The primary attraction, of course, is the potential for large
profits in a short period of time. The reason that futures trading can be so profitable is the high leverage. To ‘own’ a futures contract an investor only has to put up a small fraction of the value of the contract (usually around 10-20%) as ‘margin’. 2. Profit in Both Bull & Bear Markets: In futures trading, it is as easy to sell (also (also referred to as going short) as it is to buy (also referred referred to as going long). By choosing correctly, you can make money whether prices go up or down. 3. Lower Transaction Cost: Another advantage of futures trading is much
lower relative commissions. Your commission for trading a futures contract is one tenth of a percent (0.10-0.20%). 4. High Liquidity: Most futures markets are very liquid, i.e. there are huge
amounts of contracts traded every day. This ensures that market orders can be plac placed ed very very qu quic ickl kly y as ther there e are are alwa always ys buye buyers rs and and sell seller ers s for for most most contracts.
USING FUTURES ON INDIVIDUAL SECURUTIES Index futures began trading in India in June 2000. A year later, options on index were available for trading. July 2001 saw the launch of options on individual securities (herein referred to as stock options) and the onset of rolling settlement. With the launch of futures on individual securities (herein referred to as stock futures) on the 9th of November, 2001, the basic range of equity derivative products in India seems complete. Of the above mentioned products, stock futures are particularly appealing due to familiarity and ease in understanding. A purchase or sale of futures on a security gives the trader essentially the same price exposure as a purchase or sale of the security itself. 54
In this regard, trading stock futures is no different from trading the security itself. Besides speculation, stock futures can be effectively used for hedging and arbitrage reasons.
DIFFERENCES BETWEEN FORWARD AND FUTURE CONTRACT Forward contracts are often confused with futures contracts. The confusion is prima primaril rily y becau because se both both serve serve essent essentia ially lly the same same econom economic ic functi functions ons of allocating risk in the presence of future price uncertainty. However futures are a signif significa icant nt improv improveme ement nt over over the forwar forward d contr contract acts. s. A future future contra contract ct is noth nothin ing g but but a form form of forw forwar ard d cont contra ract ct.. One One can can diffe differe rent ntia iate te a forw forwar ard d contract from a future contract on the following lines: ➢
Customized vs Standardized: Forward contracts are customized while
future future contra contracts cts are standa standardi rdized zed.. Terms Terms of forwar forward d contra contracts cts are negotiated between the buyer and the seller. While the terms of future contracts are decided by the exchange on which these are traded. ➢
Counter Party Risk: In forward contracts there is a risk of counter
party default. In case of futures, the exchange becomes counter party to each trade and guarantees settlement. ➢
Liquidity: Futures are much more liquid and their price is transparent
as their price and volume are reported in media. But this is not so in the case of forward contract. ➢
Squaring off: A forward contract can be reversed with only the same
counter party with whom it was entered into. A future contract can be reversed on the screen of the exchange as the latter is the counter party to all futures trades.
THEORETICAL WAY OF PRICING FUTURES
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The theoretical price of a futures contract is spot price of the underlying plus the cost of carry. Please note that futures are not about predicting future prices of the underlying assets. In general, Futures Price = Spot Price + Cost of Carry The Cost of Carry is the sum of all costs incurred if a similar position is taken in cash market and carried to expiry of the futures contract less any revenue that may arise out of holding the asset. The cost typically includes interest cost cost in case case of fina financ ncia iall futu future res s (ins (insur uran ance ce and and stor storag age e cost costs s are are also also considered in case of commodity futures). Revenue may be in the form of dividend. Though one can calculate the theoretical price, the actual price may vary depending upon the demand and supply of the underlying asset.
FUTURES TERMINOLOGIES •
Spot price: The price at which an asset trades in the spot market.
•
Futures price: The price at which the futures contract trades in the
futures market. •
Contract cycle: The period over which a contract trades. The index
futures contracts on the NSE have one-month, two-months and threemonth expiry cycles which expire on the last Thursday of the month. Thus Thus a Januar January y expira expiratio tion n contra contract ct expire expires s on the last last Thursd Thursday ay of January and a February expiration contract ceases trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three-month expiry is introduced for trading. •
Expiry date: It is the date specified in the futures contract. This is the
last day on which the contract will be traded, at the end of which it will cease to exist.
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•
Contract size: The amount of asset that has to be delivered less than
one contract. For instance, the contract size on NSE’s futures market is 200 Nifties. •
Basis: In the context of financial futures, basis can be defined as the
futures price minus the spot price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices. •
Cost of carry: The relationship between futures prices and spot prices
can be summarized in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset. •
The amou amount nt that that must must be depo deposi site ted d in the the marg margin in Initial Initial margin: margin: The account at the time a futures contract is first entered into is known as initial margin.
•
Marking-to-market: In the futures market, at the end of each trading
day, the margin account is adjusted to reflect the investor’s gain or loss depending upon the futures closing price. This is called marking–to– market. •
Maintenance margin: This is somewhat lower than the initial margin.
This This is set to ensure ensure that the balan balance ce in the margi margin n accoun accountt never never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day.
OPTIONS Options are fundamentally different from forward and futures contracts. An option gives the holder of the option the right to do something. The holder does not have to exercise this right. In contrast, in a forward or futures contract, 57
the two parties have committed themselves to doing something. Whereas it costs nothing (except margin requirements) to enter into a futures contract, the purchase of an option requires an up–front payment.
OPTIONS TERMINOLOGIES •
Index options: These options have the index as the underlying. Some
options are European while others are American. Like indexing futures contracts, indexing options contracts are also cash settled. •
Stock options: Stock options are options on individual stocks. Options
currently trade on over 500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified price. •
Buyer of an option: The buyer of an option is the one who by paying
the option premium buys the right but not the obligation to exercise his option on the seller/writer. •
Writer of an option: The writer of a call/put option is the one who
receives the option premium and is thereby obliged to sell/buy the asse assett if the the buye buyerr exer exerci cise ses s on him. him. Ther There e are are two two basi basic c type types s of options, call options and put options. •
call opti option on give gives s the the hold holder er the the righ rightt but but not not the the Call Call option option: A call obligation to buy an asset by a certain date for a certain price.
•
put opti option on give gives s the the hold holder er the the righ rightt but but not not the the Put option option: A put obligation to sell an asset by a certain date for a certain price.
•
Option price: Option price is the price, which the option buyer pays to
the option seller. It is also referred to as the option premium. •
Expiration date : The date specified in the options contract is known as
the expiration date, the exercise date, the strike date or the maturity. •
Strike price: The price specified in the options contract is known as
the strike price or the exercise price. 58
•
American options: American options are options that can be exercised
at any time upto the expiration date. Most exchange-traded options are American. •
European options: European options are options that can be exercised
only only on the the expi expira rati tion on date date itse itself lf.. Eu Euro rope pean an opti option ons s are are easi easier er to analyze than American options, and properties of an American option are frequently deduced from those of its European counterpart. •
In-the-money option: An in-the-money (ITM) option is an option that
would lead to a positive cash flow to the holder if it were exercised immediately. immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price > strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price. •
At-the-money At-the-money option: An at-the-money (ATM) option is an option that
would lead to zero cash flow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price). •
out-of-th -the-m e-mone oney y (OTM) (OTM) option option is an Out-of-the-money Out-of-the-money option: An out-of opti option on that that woul would d lead lead to a nega negati tive ve cash cash flow flow if it were were exer exerci cise sed d immediately. A call option on the index is out-of-the-money when the current current index stands at a level, which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price.
•
Time value of an option: The time value of an option is the difference
between its premium and its intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an option’s time value, all else equal. At expiration, an option should have no time value. 59
TYPES OF OPTIONS 1. Call Options- A call option gives the holder (buyer/ one who is long call),
the right to buy specified quantity of the underlying asset at the strike price on or before expiration date. The seller (one who is short call) however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy. Example: An investor buys One European call option on Infosys at the strike
price of Rs. 3500 at a premium of Rs. 100. If the market price of Infosys on the day of expiry is more than Rs. 3500, the option will be exercised. The investor will earn profits once the share price crosses Rs. 3600 (Strike Price + Premium i.e. 3500+100). Suppose stock price is Rs. 3800, the option will be exercised and the investor will buy 1 share of Infosys from the seller of the option at Rs 3500 and sell it in the market at Rs 3800 making a profit of Rs. 200 {(Spot price - Strike price) Premium}. In another scenario, if at the time of expiry stock price falls below Rs. 3500 say suppose it touches Rs. 3000, the buyer of the call option will choose not to exercise his option. In this case the investor loses the premium (Rs 100), paid which should be the profit earned by the seller of the call option. 2. Put Options- A Put option gives the holder (buyer/ one who is long Put), the
right to sell specified quantity of the underlying asset at the strike price on or before an expiry date. The seller of the put option (one who is short Put) however, has the obligation to buy the underlying asset at the strike price if the buyer decides to exercise his option to sell. Example: An investor buys one European Put option on Reliance at the strike
price of Rs. 300/- , at a premium of Rs. 25/-. If the market price of Reliance, on the day of expiry is less than Rs. 300, the option can be exercised as it is 'in the the mone money' y'.. The The inve invest stor or's 's Brea Breakk-ev even en poin pointt is Rs. Rs. 275/ 275/ (Str (Strik ike e Pric Price e premium paid) i.e., investor will earn profits if the market falls below 275.
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Suppose stock price is Rs. 260, the buyer of the Put option immediately buys Reliance share in the market @ Rs. 260/- & exercises his option selling the Reliance share at Rs 300 to the option writer thus making a net profit of Rs. 15 {(Strike price - Spot Price) - Premium paid}. In another scenario, if at the time of expiry, market price of Reliance is Rs 320/ -, the buyer of the Put option will choose not to exercise his option to sell as he can sell in the market at a higher rate. In this case the investor loses the premium paid (i.e. Rs 25/-), which shall be the profit earned by the seller of the Put option. (Please see table)
THE OPTIONS GAME Call Option
Put Option
Buys the right to 1.Option buy the underlying buyer or option holder asset at the
Buys the right to sell the underlying asset at the specified price
specified price Has the obligation to Has the obligation to 2. Option sell the underlying buy the underlying seller or option writer asset (to the option asset (from the holder) at the specified price
option holder) at the specified price
LEVERAGE AND RISK
This mean means s an opti option on buye buyerr can can pay pay a Option Options s can can provid provide e levera leverage. ge. This relatively small premium for market exposure in relation to the contract value (usually 100 shares of underlying stock). An investor can see large percentage gains from comparatively small, favorable percentage moves in the underlying 61
index. Leverage also has downside implications. If the underlying stock price does not rise or fall as anticipated during the lifetime of the option, leverage can magnify the investment's percentage loss. Options offer their owners a predetermined, set risk. However, if the owner's options expire with no value, this loss can be the entire amount of the premium paid for the option. An uncovered option writer, on the other hand, may face unlimited risk. In-the-money, In-the-money, At-the-money, Out-of-the-money
An option is said to be ‘at-the-money’, when the option's strike price is equal to the underlying asset price. This is true for both puts and calls. A call option is said to be ‘in-the-money’ when the strike price of the option is less than the underlying asset price. For example, a Sensex call option with strike of 3900 is ‘in-the-money’, when the spot Sensex is at 4100 as the call option has value. The call holder has the right to buy a Sensex at 3900, no matter how much the spot market price has risen. And with the current price at 4100, a profit can be made by selling Sensex at this higher price. On the other hand, a call option is ‘out-of-the-money’ when the strike price is greater than the underlying asset price. Using the earlier example of Sensex call option, if the Sensex falls to 3700, the call option no longer has positive exercise value. The call holder will not exercise the option to buy Sensex at 3900 when the current price is at 3700. (Please see table)
Striking the price
Call Option
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Put Option
•
1.In-the-money
Strike Price less than Strike Price greater Spot Price of than Spot Price of underlying asset underlying asset
2. At-the-money At-the-money
Strike Price equal to Spot Price of underlying asset
Strike Price equal to Spot Price of underlying asset
3. Out-of-themoney
Strike Price greater than Spot Price of underlying asset
Strike Price less than Spot Price of underlying asset
A put option is in-the-money when the strike price of the option is greater than the spot price of the underlying asset . For example, a
Sensex put at strike of 4400 is in-the-money when the Sensex is at 4100. When this is the case, the put option has value because the put holder can sell the Sensex at 4400, an amount greater than the current Sensex of 4100. •
Likewise, a put option is out-of-the-money when the strike price is less than the spot price of underlying asset. In the above example, the
buyer of Sensex put option won't exercise the option when the spot is at 4800. The put no longer has positive exercise value. Options are said to be deep in-the-money (or deep out-of-the-money) if the exercise exercise price price is at signific significant ant variance variance with the underlyin underlying g asset asset price.
The amount by which an option, call or put, is in-the-money at any given moment is called its intrinsic value. Thus, by definition, an at-the-money or out-of-the-money option has no intrinsic value; the time value is the total option premium. This does not mean, however, these options can be obtained at no cost. Any amount by which an option's total premium exceeds intrinsic value is called the time value portion of the premium. 63
It is the the tim time valu value e port portio ion n of an opti option on's 's prem premiu ium m that that is affe affect cted ed by fluctuations in volatility, interest rates, dividend amounts and the passage of time. There are other factors that give options value, therefore affecting the premium at which they are traded. Together, all of these factors determine time value. Option Premium = Intrinsic Value + Time Value
FACTORS THAT AFFECT THE VALUE OF AN OPTION PREMIUM There are two types of factors that affect the value of the option premium: Quantifiable Factors:
1. Underl Underlyin ying g stock stock price, price, 2. The stri strike ke price price of of the opti option, on, 3. The volati volatility lity of the underlyin underlying g stock, stock, 4. The time time to to expira expiratio tion n and; and; 5. The risk risk free free inter interest est rate. rate. Non-Quantifiable Non-Quantifiable Factors:
1. Market Market participant participants' s' varying estimates estimates of the underlying underlying asset's future future volatility 2. Indivi Individua duals' ls' varyin varying g estim estimate ates s of futur future e perfo performa rmance nce of the the underl underlyin ying g asset, based on fundamental or technical analysis 3. The effect of supply supply & demanddemand- both in the the options options marketpla marketplace ce and in the market for the underlying asset 4. The "depth" "depth" of the marke markett for that that option option - the number number of transa transacti ctions ons and the contract's trading volume on any given day. 64
DIFFERENT PRICING MODELS FOR OPTIONS The theoretical option pricing models are used by option traders for calculating the fair value of an option on the basis of the earlier mentioned influencing factors. An option pricing model assists the trader in keeping the prices of calls & puts in proper numerical relationship to each other & helping the trader make bids & offer quickly. The two most popular option pricing models are: •
Black Black Scholes Scholes Model Model which assumes that percentage change in the
price of underlying follows a normal distribution. •
Binomial Model which assumes that percentage change in price of the
underlying follows a binomial distribution. Pricing models include the binomial options model for American options and the Black-Scholes model for European options.
OPTIONS TRADING As described earlier, four possible option selections exist for a trader: a. long long a call call,, b. long long a pu put, c. shor shortt a cal call, l, and and d. shor shortt a put. put. These four can be used independently, together, or in conjunction with other financial instruments to create a number of option-trading strategies. These combinations enable a trader to develop an option-trading model which meets the trader's specific trading needs, expectations, and style, and enables him or her to antici anticipat pate e every every concei conceivab vable le situat situation ion in the the marke market. t. This This tradin trading g structure can be adapted to handle any type of market outlook, whether it is bullish, bearish, choppy, or neutral.
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Options are unique trading instruments . They can be used for a multitude of purposes, providing tremendous versatility and utility. Among their multiple applications are the following: to speculate on the movement of an asset; to hedge an existing position in an asset; to hedge other option positions; to genera generate te income income by writin writing g option options s again against st differ different ent qu quan antit tities ies of option options s strategies that arise from these applications and the fact that the scope of this book is limited, we will devote coverage to a cursory explanation of two of the most most popul popular ar strat strategi egies es which which are design designed ed to take take advan advantag tage e of marke markett movement: spreads and straddles.
WHY TO USE OPTIONS? There are two main reasons why an investor would use options: to Speculate and to Hedge. • •
Speculation
One can think of speculation as betting on the movement of a security. The advantage of options is that one isn’t limited to making a profit only when the marke markett goes goes up. Because Because of the versatil versatility ity of option options, s, one can also also make make money when the market goes down or even sideways. Speculation is the territory in which the big money is made - and lost. The use of options in this manner is the reason options have the reputation of being risky. This is because when one buys an option; he have to be correct in determ determin ining ing not only only the the direct direction ion of the the stock' stock's s movem movement ent,, but also also the magnitude and the timing of this movement. To succeed, he must correctly predict whether a stock will go up or down, and he have to be right about how much the price will change as well as the time frame it will take for all this to happen. So why do people speculate with options if the odds are so skewed? Aside from versatility, it's all about using leverage. When one is controlling 100 shares with with one one contra contract, ct, it doesn' doesn'tt take take much much of a price price movem movement ent to genera generate te substantial profits.
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Hedging
The other function of options is hedging. Think of this as an insurance policy. Just as one insures his house or car, options can be used to insure your investments against a downturn. Critics of options say that if he is so unsure of his stock pick that he needs a hedge, he shouldn't make the investment. On the other hand, there is no doubt doubt that that hedgi hedging ng strate strategie gies s can be useful useful,, especially for large institutions. Even the individual investor can benefit. One can imagine that he wanted to take advantage of technology stocks and their upside, but say he also wanted to limit any losses. By using options, he would be able to restrict his downside while enjoying the full upside in a cost-effective way.
HOW OPTIONS WORKS? Let's say that on May 1, the stock price of L&T is $67 and the premium (cost) is $3.15 for a July 70 Call, which indicates that the expiration is the third Friday of July and the strike price is $70. The total price of the contract is $3.15 x 100 = $315. In reality, you'd also have to take commissions into account, but we'll ignore them for this example. Remember, a stock option contract is the option to buy 100 shares; that's why you must multiply the contract by 100 to get the total price. The strike price of $70 means that the stock price must rise above $70 before the call option is worth anything; furthermore, because the contract is $3.15 per share, the break-even price would be $73.15. When the stock price is $67, it's less than the $70 strike price, so the option is worthless. But don't forget that you've paid $315 for the option, so you are currently down by this amount. Three weeks later the stock price is $78. The options contract has increased along with the stock price and is now worth $8.25 x 100 = $825. Subtract what you paid for the contract, and your profit is ($8.25 - $3.15) x 100 = $510. You almost doubled our money in just three weeks! You could sell your options, which are called "closing your position," and take your profits 67
unless, of course, you think the stock price will continue to rise. For the sake of this example, let's say we let it ride. By the expiration date, the price drops to $62. Because this is less than our $70 strike price and there is no time left, the option contract is worthless. We are now down to the original investment of $315. To recap, here is what happened to our option investment: Date Stock Price Option Price Contract Value Paper Gain/Loss
May 1
May 21
Expiry Date
$67 $3.15 $315
$78 $8.25 $825
$62 worthless $0
$0
$510
-$315
The price swing for the length of this contract from high to low was $825, whi which ch woul would d have have give given n us over over doub double le our our orig origin inal al inve invest stme ment nt.. This This is leverage in action. Exercising Versus Trading-Out Trading-Out
So far we've talked about options as the right to buy or sell (exercise) the underlying. This is true, but in reality, a majority of options are not actually exercised. In our example, you could make money by exercising at $70 and then selling the stock back in the market at $78 for a profit of $8 a share. You could also keep the stock, knowing you were able to buy it at a discount to the present value. Howeve However, r, the the major majority ity of the the time time holder holders s choose choose to take take their their profit profits s by tradin trading g out (closi (closing ng out) out) their their positi position. on. This This means means that that holde holders rs sell sell their their options in the market, and writers buy their positions back to close. According to the CBOE, about 10% of options are exercised, 60% are traded out, and 30% expire worthless. Intrinsic Value and Time Value
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At this point it is worth explaining more about the pricing of options. In our example the premium (price) of the option went from $3.15 to $8.25. These fluctuations fluctuations can be explained by intrinsic value and time value. Basically, an option's premium is its intrinsic value + time value. Remember, intrinsic value is the amount in-the-money, which, for a call option, means that the price of the stock equals the strike price. Time value represents the possibility of the option increasing in value. So, the price of the option in our example can be thought of as the following: Premium = Intrinsic Value + Time Value Value $8.25 = $8 + $0.25 In real real life life opti option ons s almo almost st alwa always ys trad trade e abov above e intr intrin insi sic c valu value. e. If you you are are wondering, we just picked the numbers for this example out of the air to demonstrate how options work.
WHEN NOT TO BUY AN OPTION? It is also important to consider the time or the date at which one should enter the option market. Avoid trading in an illiquid option market. •
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Avoid purchasing call options just prior to a stock going ex-dividend. Avoid buying or selling options based upon anticipated news (buyouts in partic particul ular) ar).. Beside Besides s borde borderin ring g on uneth unethica icall tradin trading, g, the inform informat ation ion received is more likely to be rumor than correct. Avoid purchasing options well after the market has established a defined trend - this is especially true when day trading, as any option premium advantage will have dissipated. Avoid purchasing way out-of-the-money options when day trading, as any any favo favora rabl ble e pric price e move moveme ment nt will will have have a negl neglig igib ible le effe effect ct upon upon premium.
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Avoid purchasing call options when the underlying security is up for the day versus the prior day's close, unless one intends to take a trendfollowing stance. Avoid purchasing put options when the underlying security is down for the day versus the prior day's close, unless one intends to take a trendfollowing stance.
Be careful when holding long option positions beyond Friday's trading day's clos close e unle unless ss one one is opti option on posi positi tion on trad tradin ing. g. Many Many opti option on theo theore reti tici cian ans s recalculate their volatility, delta, and time decay numbers once a week, usually afte afterr the the clos close e of trad tradin ing g on Frid Friday ays s or over over the the week weeken end. d. The The resu result ltin ing g adjustments in these values most often have a negative effect on the value of the long option, which may be acceptable when holding an option over an extended period of time but is detrimental when day trading.
HOW TO READ AN OPTION TABLE? Column 1: Strike Price - This is the stated price per share for which an
underlying stock may be purchased (for a call) or sold (for a put) upon the exer exerci cise se of the the opti option on cont contra ract ct.. Opti Option on stri strike ke pric prices es typi typica call lly y move move by increments of $2.50 or $5 (even though in the above example it moves in $2 increments). This shows shows the the termin terminati ation on date date of an optio option n Colu Column mn 2: Expi Expiry ry Date Date - This contract. Remember that U.S.-listed options expire on the third Friday of the expiry month.
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Column 3: Call or Put - This column refers to whether the option is a call (C)
or put (P).
Column 4: Volume - This indicates the total number of options contracts
traded for the day. The total volume of all contracts is listed at the bottom of each table. Column 5: Bid - This indicates the price someone is willing to pay for the
options contract. Column 6: Ask - This indicates the price at which someone is willing to sell an
options contract. Column 7: Open Interest - Open interest is the number of options contracts
that are open; these are contracts that have neither expired nor been exercised.
PAYOFF FOR DERIVATIVES CONTRACT A payoff is the likely profit/loss that would accrue to a market participant with change in the price of the underlying asset. This is generally depicted in the
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form of payoff diagrams which show the price of the underlying asset on the X– axis and the profits/losses on the Y–axis.
PAYOFF FOR FUTURES Futures contracts have linear payoffs. In simple words, it means that the losses as well as profits for the buyer and the seller of a futures contract are unlimited. These linear payoffs are fascinating as they can be combined with options and the underlying to generate various complex payoffs. Payoff for buyer of futures: Long futures
The payoff for a person who buys a futures contract is similar to the payoff for a person who holds an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who buys a two-month Nifty index futures contract when the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio. When the index moves up, the long futures position starts making profits, and when the index moves down it starts making losses. Payoff for seller of futures: Short futures
The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who sells a two-month Nifty index futures contract when the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio. When the index moves down, the short futures position starts making profits, and when the index moves up, it starts making losses.
OPTIONS PAYOFF The The option optionall ally y charac character terist istic ic of option options s result results s in a non-l non-line inear ar payoff payoff for options. In simple words, it means that the losses for the buyer of an option are limite limited; d; howeve howeverr the profit profits s are potent potential ially ly unlim unlimite ited. d. For a writer writer,, the the 72
payoff is exactly the opposite. His profits are limited to the option premium; howeve howeverr his losses losses are potent potentia ially lly unlim unlimite ited. d. These These non-li non-line near ar payoffs payoffs are fascinating as they lend themselves to be used to generate various payoffs by using combinations of options and the underlying. We look here at the six basic payoffs. Payoff profile of buyer of asset: Long asset
In this basic position, an investor buys the underlying asset, Nifty for instance, for for 1220 1220,, and and sell sells s it at a futu future re date date at an unkn unknow own n pric price, e, once once it is purchased, the investor is said to be “long” the asset. Payoff profile for seller of asset: Short asset
In this this basi basic c posi positi tion on,, an inve invest stor or shor shorts ts the the unde underl rlyi ying ng asse asset, t, Nift Nifty y for for instance, for 1220, and buys it back at a future f uture date at an unknown price. Payoff profile le for buyer of call options: Long call
A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. If upon expiration, the spot price exceeds the strike price, he makes a profit. Higher the spot price more is the profit he makes. If the spot price of the underlying is less than the strike pric price, e, he lets lets his his opti option on expi expire re un-e un-exe xerc rcis ised ed.. His His loss loss in this this case case is the the premium he paid for buying the option. Payoff profile for writer of call options: Short call
A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. For selling the option, the writer of the option char charge ges s a prem premiu ium. m. The The prof profit it/l /los oss s that that the the buye buyerr make makes s on the the opti option on depends on the spot price of the underlying. Whatever is the buyer’s profit is the seller’s loss. If upon expiration, the spot price exceeds the strike price, the buyer will exercise the option on the writer. 73
Hence as the spot price increases the writer of the option starts making losses. Higher the spot price more is the loss he makes. If upon expiration the spot price of the underlying is less than the strike price, the buyer lets his option expire unexercised and the writer gets to keep the premium. Payoff profile for buyer of put options: Long put
A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. If upon expiration, the spot price is below the strike price, he makes a profit. Lower the spot price more is the profit he makes. If the spot price of the underlying is higher than the strike pric price, e, he lets lets his his opti option on expi expire re un-e un-exe xerc rcis ised ed.. His His loss loss in this this case case is the the premium he paid for buying the option. Payoff profile for writer of put options: Short put
A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. For selling the option, the writer of the option char charge ges s a prem premiu ium. m. The The prof profit it/l /los oss s that that the the buye buyerr make makes s on the the opti option on depends on the spot price of the underlying. Whatever is the buyer’s profit is the seller’s loss. If upon expiration, the spot price happens to be below the strike price, the buyer will exercise the option on the writer. If upon expiration the spot price of the underlying is more than the strike price, the buyer lets his option expire un-exercised and the writer gets to keep the premium.
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Chapter 4
Hedging, Arbitrage and 75
Speculatio n Strategies HEDGING, ARBITRAGE AND SPECULATION STRATEGIES HEDGING Hedgi edging ng is a way way of redu educin cing som some of the the risk risk invo invollved ved in holdi oldin ng an investment. There are many different risks against which one can hedge and many different methods of hedging. When someone mentions hedging, think of insurance. A hedge is just a way of insuring an investment against risk. Consider a simple (perhaps the simplest) case. Much of the risk in holding any particular stock is market risk; i.e. if the market falls sharply, chances are that 76
any particular stock will fall too. So if you own a stock with good prospects but you think the stock market in general is overpriced, you may be well advised to hedge your position. There are many ways of hedging against market risk. The simplest, but most expensive method, is to buy a put option for the stock you own. (It's most expensive because you're buying insurance not only against market risk but against the risk of the specific security as well.) If you're trying to hedge an entire portfolio, futures are probably the cheapest way to do so. But keep in mind the following f ollowing points. The efficiency of the hedge is strongly dependent on your estimate of the correlation between your high-beta portfolio and the broad market index. •
If the market goes up, you may need to advance more margin to cover your short position, and will not be able to use your stocks to cover the margin calls. If the the mark market et move moves s up, up, you you will will not not part partic icip ipat ate e in the the rall rally, y, beca becaus use e by intention, you've set up your futures position as a complete hedge. •
HEDGING STRATEGIES WITH EXAMPLES Hedging: Long security, short Nifty futures Investors studying the market often come across a security which they believe is intrinsically undervalued. It may be the case that the profits and the quality of the company make it seem worth a lot more than what the market thinks. A stock picker carefully purchases securities based on a sense that they are worth more than the market price. When doing so, he faces two kinds of risks:
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1. His understanding can be wrong, and the company is really not worth more than the market price; or, 2. The entire market moves against him and generates losses even though the underlying idea was correct. The second outcome happens all the time. A person may buy SBI at Rs.670 thinking that it would announce good results and the security price would rise. A few days later, Nifty drops, so he makes losses, even if his understanding of SBI was correct. The There re is a pecu peculi liar ar prob proble lem m here here.. Ever Every y buy buy posi positi tion on on a secu securi rity ty is simultaneously a buy position on Nifty. This is because a LONG SBI position position generally gains if Nifty rises and generally loses if Nifty drops. In this sense, a LONG SBI position is not a focused play on the valuation of SBI. It carries a LONG NIFTY position along with it, as incidental baggage. The stock picker may be thinki thinking ng he wants wants to be LONG LONG SBI, SBI, but a long long positi position on on SBI SBI effecti effectivel vely y forces him to be LONG SBI + LONG NIFTY. There is a simple way out. Every time you adopt a long position on a security, you should sell some amount of Nifty futures. This offsets the hidden Nifty exposure that is inside every long–security position. Once this is done, you will have a position, which is purely about the performance of the security. The position position LONG SBI+ SHORT NIFTY is a pure play on the value of SBI, without any extra risk from fluctuations of the market index. When this is done, the stock picker has “hedged away” his index exposure. The basic point of this hedging strategy is that the stock picker proceeds with his core skill, i.e. picking securities, at the cost of lower risk. Methodology
We need to know the “beta” of the security, i.e. the average impact of a 1% move in Nifty upon the security. If betas are not known, it is generally safe to assume the beta is 1. Suppose we take SBIN, where the beta is 1.2, and suppose we have a LONG SBIN position of Rs.3,33,000.
1.
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The size of the position that we need on the index futures market, to completely completely remove the hidden hidden Nifty exposure, is 1.2 *3,33,000, i.e. Rs 4.00.000 2.
3. Supp Suppos ose e Nif Nifty ty is at 2000 2000,, and and the the mar marke kett lot lot on on the the futu future res s mar marke kett is 200. 00. Hence ence each each market rket lot of Nift Nifty y is Rs 4,00, ,00,0 000. 00. To shor shortt Rs.4,00,000 of Nifty we need to sell one market lot. 4. We sell one market market lot of Nifty Nifty (200 nifties) to get the position: position: LONG SBIN Rs.3,33,000 SHORT NIFTY Rs.4,00,000 Thi This s posi positi tion on will will be esse essent ntia iall lly y immu immune ne to fluc fluctu tuat atio ions ns of Nift Nifty. y. The The profits/losses position will fully reflect price changes intrinsic to SBIN, hence only successful forecasts about SBIN will SBIN will benefit from this position. Returns on the position will be roughly neutral to movements of Nifty.
Hedging: Have portfolio, short Nifty futures The The only only cert certai aint nty y abou aboutt the the capi capita tall mark market et is that that it fluc fluctu tuat ates es!! A lot lot of investors who own portfolios experience the feeling of discomfort about overall market movements. Sometimes, they may have a view that security prices will fall in the near future. At other times, they may see that the market is in for a few days or weeks of massive volatility, and they do not have an appetite for this kind of volatility. The union budget is a common and reliable source of such volatility: market volatility is always enhanced for one week before and two weeks after a budget. Many investors simply do not want the fluctuations of these three weeks. This is particularly a problem if you need to sell shares in the near future, for example, in order to finance a purchase of a house. This planning can go wrong if by the time you sell shares, Nifty has dropped sharply. When you have such anxieties, there are two alternatives: Sell shares immediately. This sentiment generates “panic selling” which is rarely optimal for the investor. •
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Do noth nothin ing, g, i.e. i.e. suff suffer er the the pain pain of the the vola volati tili lity ty.. This This lead leads s to political pressures for government to “do something” when security prices fall. •
In addition, with the index futures market, a third and remarkable alternative becomes available: Remove Remove your your exposu exposure re to index index fluctu fluctuati ations ons tempor temporari arily ly using using index futures. This allows rapid response to market conditions, without “panic selling” of shares. It allows an investor to be in control of his risk, instead of doing nothing and suffering the risk. •
The idea here is quite simple. Every portfolio contains a hidden index exposure. This statement is true for all portfolios, whether a portfolio is composed of index securities or not. In the case of portfolios, most of the portfolio risk is accounted for by index fluctuations (unlike individual securities, where only 30–60% of the securitie securities s risk is accounted accounted for by index fluctuatio fluctuations).He ns).Hence nce a position position LONG PORTFOLIO + SHORT NIFTY can often become one–tenth as risky as the LONG PORTFOLIO position! Suppose we have a portfolio of Rs.1 million which has a beta of 1.25. Then a complete hedge is obtained by selling Rs.1.25 million of Nifty futures. Methodology
We need to know the “beta” of the portfolio, i.e. the average impact of a 1% move in Nifty upon the portfolio. It is easy to calculate the portfolio beta: it is the weighted average of securities betas. Suppose we have a portfolio composed of Rs.1 million of Hindalco, which has a beta of 1.4 and Rs.2 million of Hindustan Lever, which has a beta of 0.8, then the portfolio beta is (1 * 1.4 + 2 * 0.8)/3 or 1. If the beta of any securities is not known, it is safe to assume that it is 1.
1.
2. The The comp comple lete te hed hedge ge is is obt obtai aine ned d by adop adopti ting ng a posi positi tion on on the the ind index ex futures market, which completely removes the hidden Nifty exposure. In the above case, the portfolio is Rs.3 million with a beta of 1, hence we would need a position of Rs.3 million on the Nifty futures. 80
Suppose Nifty is 1250, and the market lot on the futures market is 200. Each market lot of Nifty costs Rs.250,000. Hence we need to sell 12 mark market et lots lots,, i.e. i.e. 2400 2400 Nift Niftie ies s to get get the the posi positi tion on:: LONG LONG PORT PORTFO FOLI LIO O Rs.3,000,000 SHORT NIFTY Rs.3,000,000.
3.
This position will be essentially immune to fluctuations fluctuations of Nifty. If Nifty goes up, the portfolio gains and the futures lose. If Nifty goes down, the futures gain and the the port portfol folio io lose loses. s. In eith either er case case,, the the inve invest stor or has has no risk risk from from mark market et fluctu fluctuati ations ons when when he is comple completel tely y hedged hedged.. The invest investor or should should adopt adopt this this strategy for the short periods of time where (a) the market volatility that he antic anticipa ipates tes makes makes him uncom uncomfor fortab table, le, or (b) when when his his financ financial ial planni planning ng involves selling shares at a future date and would be affected if Nifty drops. It does not make sense to use this strategy for long periods of time – if a two–year hedging is desired, it is better to sell the shares, invest the proceeds, and buy back shares after two years. This strategy makes the most sense for rapid adjustments. Another important choice for the investor is the degree of hedging. Complete hedging eliminates all risk of gain or loss. Sometimes the investor may be willing to tolerate some risk of loss so as to hang on to some risk of gain. In that case, partial hedging is appropriate. The complete hedge may require selling Rs.3 million of the futures, but the investor may choose to only sell Rs.2 million of the futures. In this case, two–thirds of his portfolio is hedged and one– third of the portfolio portfolio is held unhedged. unhedged. The exact degree of hedging hedging chosen depends upon the appetite for risk that the investor has.
Hedging: Have funds, buy Nifty futures Have you ever been in a situation where you had funds, which needed to get invested in equity? Or of expecting to obtain funds in the future which will get invested in equity. Some common occurrences of this include: _
A closed-end fund, which just finished its initial public offering, has cash, which is not yet invested.
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Suppose a person plans to sell land and buy shares. The land deal is slow and takes weeks to complete. It takes several weeks from the date that it becomes sure that the funds will come to the date that the funds actually are in hand. An open-ended fund has just sold fresh units and has received funds. •
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Getting invested in equity ought to be easy but there are three problems: 1. A pers person on may may nee need d time time to to rese resear arch ch sec secur urit itie ies, s, and and care carefu full lly y pick pick securities that are expected to do well. This process takes time. For that time time,, the the inve invest stor or is part partly ly inve invest sted ed in cash cash and and part partly ly inve invest sted ed in securities. During this time, he is exposed to the risk of missing out if the overall market index goes up. A person may have made up his mind on what portfolio he seeks to buy, but going to the market and placing market orders would generate large ‘impact costs’. The execution would be improved substantially if he could instead place limit orders and gradually accumulate the portfolio at favorable prices. This takes time, and during this time, he is exposed to the risk of missing out if the Nifty goes up.
2.
3. In some some case cases, s, such such as the the lan land d sal sale e abo above ve,, the the pers person on may may simp simply ly not have cash to immediately buy shares, hence he is forced to wait even if he feels that Nifty is unusually cheap. He is exposed to the risk of missing out if Nifty rises. So far, far, in Indi India, a, we have have had had exac exactl tly y two two alte altern rnat ativ ive e stra strate tegi gies, es, whic which h an investor can adopt: to buy liquid securities in a hurry, or to suffer the risk of staying in cash. With Nifty futures, a third alternative becomes available: The investor would obtain the desired equity exposure by buying index futures, immediately. A person who expects to obtain Rs.5 million by sellin selling g land land would would immed immediat iately ely enter enter into into a positi position on LONG LONG NIFTY NIFTY worth Rs.5 million. Similarly, a closed-end fund, which has just finished •
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its initial public offering and has cash, which is not yet invested, can immediately enter into a LONG NIFTY to the extent it wants to be invested in equi equity ty.. The The inde index x futu future res s mark market et is like likely ly to be more more liqu liquid id than than individual securities so it is possible to take extremely large positions at a low impact cost. Late Later, r, the the inve invest stor or/c /clo lose sedd-en end d fund fund can can grad gradua uall lly y acqu acquir ire e securities (either based on detailed research and/or based on aggressive limit orders). As and when shares are obtained, one would scale down the LONG NIFTY position position corresponding correspondingly. ly. No matter matter how slowly slowly securitie securities s are purchased, this strategy would fully capture a rise in Nifty, so there is no risk of missing out on a broad rise in the securities market while this process is taking place. Hence, this strategy allows the investor to take more more care care and and spen spend d more more time time in choo choosi sing ng secu securi riti ties es and and plac placin ing g aggressive limit orders. •
Hedging is often thought of as a technique that is used in the context of equity exposure. It is common for people to think that the owner of shares needs index futures to hedge against a drop in Nifty. Holding money in hand, when you want to be invested in shares, is a risk because Nifty may rise. Hence it is equally important for the owner of money to use index futures to hedge against a rise in Nifty!
Methodology
A person obtained Rs.4.8 million on 13 th March 2005. He made a list of 14 securities to buy, at 13 March prices, totaling Rs.4.8 million.
1.
At that that time time Nift Nifty y was was at 2000. 2000. He ente entere red d into into a LONG LONG NIFTY NIFTY MARCH MA RCH FUTURE FUTURES S posit position ion for 2400 2400 Niftie Nifties, s, i.e. i.e. his long long positi position on was worth 4,80,000. 2.
From 14 March 2005 to 25 March 2005 he gradually acquired the secu securi riti ties es.. On each each day, day, he purc purcha hase sed d one one secu securi riti ties es and and sold sold off off a corresponding amount of futures. 3.
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4. On eac each h day, day, the the sec secur urit itie ies s purc purcha hase sed d were were at at a chan change ged d pric price e (as (as compared to the price prevalent on 13 March). On each day, he obtained or paid the ‘mark–to–market margin’ on his outstanding futures position, thus capturing the gains on the index. By 25 Mar Mar 2005 2005 he had fully fully invested invested in all the shares shares that that he wanted (as of 13 Mar) and had no futures position left. 5.
ARBITRAGE Arbitrage is the practice of taking advantage of a state of imbalance between two (or possibly more) markets. A combination of matching deals are struck that exploit the imbalance, the profit being the difference between the market prices. A person who engages in arbitrage is called an arbitrageur. Arbitrage is the safest way to make money in the market. However, the scope for makin making g money money is diminu diminutiv tive. e. With With the help help of the the arbit arbitrag rage e strate strategie gies s discussed above, we can exploit the market condition and earn risk-free return. Arbitrage is game of strategy and also funds. A participant with ample funds can easily earn risk-free returns. On the other hand, a strategist can make riskless profits by making use of mispricing in the market. Arbitr Arbitrage age could could be inter inter-ex -excha change nge,, NSE NSE and BSE. BSE. Arbit Arbitrag rage e could could also also be between two segments of the market, Cash and F&O. Borrowing and lending is a common practice in arbitrage transaction, therefore, bank and financial institution are very active in arbitrage activities. The below stated strategies cover all the types of arbitrage possibilities using equity derivatives.
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ARBITRAGE STRATEGIES WITH EXAMPLES Arbitrage: Have funds, lend them to the market. Most people would like to lend funds into the security market, without suffering the risk. Traditional methods of loaning money into the security market suffer from (a) price risk of shares and (b) credit risk of default of the counter-party. What is new about the index futures market is that it supplies a technology to lend lend money money into into the marke markett withou withoutt suffer suffering ing any exposu exposure re to Nifty Nifty,, and without bearing any credit risk. The basic idea is simple. simple. The lender lender buys all 50 securities securities of Nifty on the cash market, and simultaneously sells them at a future date on the futures market. It is like a repo. There is no price risk since the position is perfectly hedged. There is no credit risk since the counter party on both legs is the NSCCL which supplies clearing services on NSE. It is an ideal lending vehicle for entities which are shy of price risk and credit risk, such as traditional banks and the most conservative corporate treasuries. Methodology
1. Cal Calcula culate te a port portfo foli lio o whi which buys buys all all the 50 secu securi ritties ies in Nift ifty in correc correctt propor proportio tion, n, i.e. i.e. where where the money money inves invested ted in each each securi security ty is proportional to its market capitalization. 2. Roun Round d off off the the num numbe berr of of sha share res s in in eac each h sec secur urit ity. y. 3. Usin Using g the the NEAT NEAT or or BOLT BOLT soft softw ware, re, a sing singlle keyst keystro roke ke can can fir fire off these 50 orders in rapid succession into the NSE or BSE trading system. This gives you the buy position 4. A moment later, sell Nifty futures of equal value. Now you are completely hedged, so fluctuations in Nifty do not affect you. 5. A few few days days lat later er,, you you will will ha have to to take take del deliv iver ery y of the the 50 50 secu securi riti ties es and pay for them. This is the point at which you are “loaning money to the market”.
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6. Som Some days days lat later (an (anytim ytime e you you wan want), t), you you will ill unwin wind the the enti entire re transaction. 7. At thi this s poin point, t, use use NEA NEAT T to sen send d 50 sel selll orde orders rs in in rapi rapid d succ succes essi sion on to sell off all the 50 securities. 8. A mom moment ent late later, r, reve revers rse e the the futu future res s posit positio ion. n. Now Now you yourr posit positio ion n is down to 0. 9. A few few days days lat later er,, you you wil willl hav have e to make make del deliv iver ery y of the the 50 secu securi riti ties es and receive money for them. This is the point at which “your money is repaid to you”. What is the interest rate that you will receive? We will use one specific case, where you will unwind the transaction on the expiration date of the futures. In this case, the difference between the futures price and the cash Nifty is the retu return rn to the the mone moneyl ylen ende der, r, with with two two comp compli lica cati tion ons: s: the the mone moneyl ylen ende derr additionally earns any dividends that the 50 shares pay while he has held them, and the moneylender suffers transactions costs (impact cost, brokerage) in doing these trades. On 1 March 2005, if the Nifty spot is 2100, and the Nifty March 2005 futures are at 2142 then the difference (2% for 30 days) is the return that the moneylender obtains.
Example
On 1 August, Nifty is at 2400. A futures contract is trading with 27th August expiration for 2460. A person wants to earn this return (60/2400 for 27 days). 1. He bu buys Rs. Rs.3 3 mil milli lion on of of Nift Nifty y on the the spo spott mark market et.. In doi doing ng thi this, s, he he places 50 market orders and ends up paying slightly more. His average cost of purchase is 0.3% higher, i.e. he has obtained the Nifty spot for 2407. 2. He sel sells ls Rs. Rs.3 3 mill millio ion n of the the fut futur ures es at at 2460 2460.. The The futu future res s mark market et is is extremely liquid so the market order for Rs.3 million goes through at near–zero impact cost. He takes delivery of the shares and waits. 3. Whil While e waiti waiting ng,, a few divi divide dend nds s come come int into o his his hand hands. s. The The divi divide dend nds s work out to Rs.14,000. 86
On 27 August, at 3:15, he puts in market orders to sell off his Nifty portfolio, putting 50 market orders to sell off all the shares. Nifty happens to have closed at 2420 and his sell orders (which suffer impact cost) goes through at 2413. 4.
5. The The futur futures es posi positi tion on spo spont ntan aneo eous usly ly expi expire res s on 27 Augu August st at at 2420 2420 (the value of the futures on the last day is always equal to the Nifty spot).
Hehas gained Rs.6 (0.25%) on the spot Nifty and Rs.40 (1.63%) on the the futu future res s for for a retu return rn of near near 1.88% 1.88% In addit additio ion, n, he has has gain gained ed Rs.14000 or 0.23% owing to the dividends for a total return of 2.11% for 27 days, risk free. 6.
It is easier to make a rough calculation of the return. To do this, we ignore the gain from dividends and we assume that transactions costs account for 0.4%. In the above case, the return is roughly 2460/2400 or 2.5% for 27 days, and we subtract 0.4% for transactions costs giving 2.1% for 27 days.
Arbitrage: Have securities, lend them to the market Owners Owners of a portfolio portfolio of shares shares often think think in terms of juicing juicing up their their returns returns by earning revenues from stocklending. However, stocklending schemes that are widely accessible do not exist in India. The index futures market offers a riskless mechanism for (effectively) loaning out shares and earning a positive return for them. It is like a repo; you would sell off your certificates and contract to buy them back in the future at a fixed price. There is no price risk (since you are perfectly hedged) and there is no credit credit risk risk (since (since your your counte counterpa rparty rty on both both legs legs of the transa transacti ction on is the NSCCL). The basic idea is quite simple. You would sell off all 50 securities in Nifty and buy them back at a future date using the index futures. You would soon receive money for the shares you have sold. You can deploy this money, as you
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like until the futures expiration. On this date, you would buy back your shares, and pay for them. Methodology
Supp Suppos ose e you you have have Rs.5 Rs.5 mill millio ion n of the the NSENSE-50 50 port portfo foli lio o (in (in thei theirr corr correc ectt proportion, with each share being present in the portfolio with a weight that is proportional to its market capitalization). capitalization). 1. Sell Sell off off all all 50 50 shar shares es on on the the cash cash mar marke ket. t. Thi This s can can be don done e usin using ga single keystroke using the NEAT software. 2.
Buy Buy ind index ex futu future res s of of an an equ equal al valu value e at at a futu future re date date..
3. A few few days days lat later er,, you you will will rec recei eive ve mon money ey and and hav have e to mak make e deli delive very ry of the 50 shares. 4.
Inve Invest st this this mone money y at at the the risk risklless ess int inter eres estt rat rate. e.
On the date that the futures expire, at 3:15 PM, put in 50 orders (using NEAT again) to buy the entire NSE-50 portfolio.
5.
6. A few few days days la later, ter, yo you wil will need need to to pay pay in th the mon money an and get get back back your shares. When is this worthwhile? When the spot-futures basis (the difference between spot Nifty and the futures Nifty) is smaller than the riskless interest rate that you can find in the economy. If the spot–futures basis is 2.5% per month and you you are are loan loanin ing g out out the the mone money y at 1.5% 1.5% per per mont month, h, it is not not prof profit itab able le.. Conversely, if the spot-futures basis is 1% per month and you are loaning out money at 1.2% per month, this stock lending could be profitable It is easy to approximate the return obtained in stock lending. To do this, we assume that transactions costs account for 0.4%. Suppose the spot–futures basis is X% and suppose the rate at which funds can be invested is Y %. Then the total return is (Y - X% - 0.4%) over the time that the position is held. 88
This can also be interpreted as a mechanism to obtain a cash loan using your portfolio of Nifty shares as collateral. In this case, it may be worth doing even if the spot–futures basis is somewhat wider. Example
Suppose the Nifty spot is 1100 and the two–month futures are trading at 1110. Hence the spot– futures basis (10/1100) is 0.9%. Assume that the transactions costs are 0.4%. Suppose cash can be riskless invested at 1% per month. Over two months, funds invested at 1% per month yield 2.01%. Hence the total return that can be obtained in stock lending is 2.01-0.9-0.4 or 0.71% over the two–mo two–month nth period period.. Let us make make this this concre concrete te using using a specif specific ic sequenc sequence e of trades. Suppose a person has Rs.4 million of the Nifty portfolio, which he would like to lend to the market. He puts in sell orders for Rs.4 million of Nifty using the feature in NEAT to rapidly place 50 market orders in quick succession. The seller always suffers impact cost; suppose he obtains an actual execution at 1098. 1.
A moment later, he puts in a market order to buy Rs.4 million of the the Nift Nifty y futu future res. s. The The orde orderr exec execut utes es at 1110 1110.. At this this poin point, t, he is completely hedged. 2.
A few days later, he makes delivery of shares and receives Rs.3.99 million (assuming an impact cost of 2/1100).
3.
Suppose helends this this out at 1% per month month for two months. months. At the end of two months, he get back Rs.40,70,199. Translated in terms of Nifty, this is 1098* or 1120.
4.
5. On the the exp expir irat atio ion n date date of of the the futu future res, s, he he puts puts in in 50 ord order ers, s, usi using ng NEAT, placing market orders to buy back his Nifty portfolio. Suppose Nifty Nifty has moved up to 1150 by this time. This makes shares are costlier
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in buying back, but the difference is exactly offset by profits on the futures contract. 6. When When the the mar marke kett ord order is is plac placed ed,, supp suppos ose e he he ends ends up up payi paying ng 115 1153 3 and not 1150, owing to impact cost. He has funds in hand of 1120, and the futures contract pays 40 (1150-1110) so he ends up with a clean profit, on the entire transaction, of 1120 + 40 - 1153 or 7. On a base of Rs.4 million, this is Rs.25,400.
Arbitrage: Overpriced futures: buy spot, sell futures As we discussed earlier, the cost-of-carry ensures that the futures price stay in tune with the spot price. Whenever the futures price deviates substantially substantially from its fair value, arbitrage opportunities arise. If you notice that futures on a security that you have been observing seem overpriced, how can you cash in on this opportunity to earn riskless profits? Say for instance, ABB trades at Rs.1000. One–month ABB futures trade at Rs.1025 and seem overpriced. As an arbitrageur, you can make riskless profit by entering into the following set of transactions. 1. On day day one, one, borr borrow ow fund funds; s; buy buy the the secu securi rity ty on the the cash cash/s /spo pott market at 1000. 2. Simultan Simultaneousl eously, y, sell the future futures s on the security security at 1025. 1025. 3. Take delivery delivery of the the security security purchased purchased and and hold the securit security y for a month. 4. On the the futu future res s expi expira rati tion on date date,, the the spot spot and and the the futu future res s pric price e converge. Now unwind the position. 5. Say the the security security closes closes at Rs.1015. Rs.1015. Sell Sell the the security. security. 6. Futu Futures res position position expires expires with with profit profit of Rs.10. Rs.10. 7. The The resu result lt is a risk riskle less ss profit profit of Rs.15 Rs.15 on the the spot spot posit positio ion n and and Rs.10 on the futures position. 90
8. Return Return the the borro borrowed wed funds funds.. When does it make sense to enter into this arbitrage? If your cost of borrowing funds to buy the security is less than the arbitrage profit possible, it makes sens sense e for for you you to arbi arbitr trag age. e. This This is term termed ed as cash cash–a –and nd–c –car arry ry arbi arbitr trag age. e. Remember however, that exploiting an arbitrage opportunity involves trading on the spot and futures market. In the real world, one has to build in the transactions costs into the arbitrage strategy.
Arbitrage: Underpriced futures: buy futures, sell spot Whenever the futures price deviates substantially from its fair value, arbitrage oppo opport rtun unit itie ies s aris arise. e. It coul could d be the the case case that that you you noti notice ce the the futu future res s on a security you hold seem underpriced. How can you cash in on this opportunity to earn riskless profits? Say for instance, ABB trades at Rs.1000. One–month ABB futures trade at Rs. 965 and seem underpriced. As an arbitrageur, you can make riskless profit by entering into the following set of transactions. 1. On day day one one,, sel selll the the secu securi rity ty in the the cas cash/ h/sp spot ot mark market et at 1000. 1000. 2. Make de delivery of of th the se security. 3. Simu Simult ltan aneo eous usly ly,, buy buy the the fut futur ures es on the the secu securi rity ty at 965. 965. 4. On the futures expiration date, the spot and the fut futures price converge. Now unwind the position. 5. Say Say the the secu securi rity ty clos closes es at Rs.9 Rs.975 75.. Buy Buy back back the the sec secur urit ity. y. 6. The The fut futur ures es posi positi tion on expi expire res s wit with h a prof profit it of Rs.1 Rs.10. 0. 7. The The resu result lt is is a riskl iskles ess s prof profit it of of Rs.2 Rs.25 5 on the the spot spot posi posittion ion and and Rs.10 on the futures position. If the returns you get by investing in riskless instruments is less than the return from the arbitrage trades, it makes sense for you to arbitrage. This is termed as reverse–cash–and–carry arbitrage. It is this arbitrage activity that ensures that the spot and futures prices stay in line with the cost–of–carry. As we can see, exploiting arbitrage involves trading on the spot market. As more and more players in the market develop the knowledge and skills to do cash– 91
and–carry and reverse cash–and–carry, we will see increased volumes and lower spreads in both the cash as well as the derivatives market.
SPECULATIONS Speculation has a lot of risks involved. Specially speculation in derivates is even more riskier as the derivatives are leveraged instruments. Speculator is responsible for liquidity in the market. Major part of the market volumes come from speculation, be it cash market or the F&O segment. Marke Markett partic participa ipants nts to specul speculate ate extens extensive ively ly use Index Index future futures s and stock stock futures. Inde Index x futu future res s attr attrac actt the the maxi maximu mum m volu volume mes s in the the deri deriva vati tive ves s segm segmen ent. t. Speculation in option is not very common, because buying an option is highly leveraged transaction. Speculation in options is naked positions, which are very risky. Speculation in the market index is very common, index is less volatile and index movement is easy to analyze than the individual stock movements. Spec Specul ulat atio ion n in indi indivi vidu dual al secu securi riti ties es attr attrac acts ts high highes estt risk risk,, are are indi indivi vidu dual al secu securi riti ties es are are more more vola volati tile le than than the the mark market et inde index. x. The The abov abovee-di disc scus usse sed d strategies are responsible for liquidity in the Derivatives segment hence leading to volumes in the cash segment also.
SPECULATION STRATEGIES WITH EXAMPLES Speculation: Bullish Index, long nifty futures Sometimes we think that the market index is going to rise and that we can make a profit by adopting a position on the index. After a good budget, or good corporate results, or the onset of a stable government, many people feel that the 92
index would go up. How does one implement a trading strategy to benefit from an upward movement in the index? Today, a person has two choices: 1. Buy Buy sele select cted ed liq liqui uid d secu securi riti ties es whic which h move move with with the the ind index ex,, and and sell sell them at a later date: or, 2.
Buy Buy the the enti entire re inde index x por portf tfol olio io and and the then n sell sell it at a lat later er dat date. e.
The first alternative is widely used – a lot of the trading volume on liquid securities is based on using these liquid securities as an index proxy. However, these positions run the risk of making losses owing to company–specific news; they they are not not pure purely ly focu focuse sed d upon upon the the inde index. x. The The seco second nd alte altern rnat ativ ive e is cumbersome and expensive in terms of transactions costs. Taking a position on the index is effortless using the index futures market. Using index futures, an investor can “buy” or “sell” the entire index by trading on one single security. Once a person is LONG NIFTY using the futures market, he gains if the index rises and loses if the index falls. Methodology
When you think the index will go up, buy the Nifty futures. The minimum market lot is 200 Nifties. Hence, if Nifty is at 1200, the investment is done in units of Rs.240,000. When the trade takes place, the investor is only required to pay up the initial margin, which is something like Rs.20,000. Hence, by paying an initial margin of Rs.20,000, the investor gets a claim on the index worth Rs.240,000. Similarly, by paying up Rs.200,000, the investor gets a claim on Nifty worth Rs.2.4 million. Futures are available at several different expirations. The investor can choose any any of them them to imple implemen mentt this this positi position. on. The choice choice is basica basically lly about about the the horizon of the investor. Longer dated futures go well with long–term forecasts about the movement of the index. Shorter dated futures tend to be more liquid. Example
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1.
On 1 Jul July y 200 2001, 1, a per perso son n fee feels ls the the ind index ex will will rise rise..
2.
He buys buys 200 200 Nif Nifti ties es with with expi expira rati tion on date date on 31st 31st July July 2001. 2001.
3. At this this tim time, e, the the Nif Nifty ty July July con contr trac actt cost costs s Rs.9 Rs.960 60 so so his his pos posit itio ion n is worth Rs.192,000. 4.
On 14 July July 2001, 001, Nifty fty has has risen isen to 967 967.3 .35. 5.
3.
The The Nift Nifty y July July cont contra ract ct has has rise risen n to Rs.9 Rs.980 80..
4.
He se sells of off hi his po position at at Rs Rs.980.
5.
His His pro profi fits ts from from the the po posit sition ion are are Rs.4 Rs.400 000. 0.
Speculation: Bearish index, short Nifty futures Sometimes we think that the market index is going to fall and that we can make profit by adopting a position position on the index. index. After a bad budget, or bad corporate corporate results, or the onset of a coalition government, many people feel that the index would go down. How does one implement a trading strategy to benefit from a downward movement in the index? Today a person has two choices: 1. Sell Sell sel selec ecte ted d liqu liquid id secu securi riti ties es whic which h move move with with the the ind index ex,, and and buy buy them at a later date: or, 2. Sell Sell the the ent entir ire e ind index ex por portf tfol olio io and and the then n buy buy it at a lat later er date date.. The first alternative is widely used – a lot of the trading volume on liquid securities is based on using these securities as an index proxy. However, these positions run the risk of making losses owing to company–specific news; they are not purely focused upon the index. The second alternative is hard to implement. This strategy is also cumbersome and expensive in terms of transactions costs. Taking a position on the index is effortless using the index futures market. Using index futures, an investor can “buy” or “sell” the entire index by trading on one single security. Once a person
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is SHORT NIFTY using the futures market, he gains if the index falls and loses if the index rises. Methodology
When you think the index will go down, sell the Nifty futures. The minimum market lot is 200 Nifties. Hence, if Nifty is at 1200, the investment is done in units of Rs.240,000. When the trade takes place, the investor is only required to pay up the initial margin, which is something like Rs.20,000. Hence, by paying an initial margin of Rs.20,000 the investor gets a claim on the index worth Rs.240,000. Similarly, by paying up Rs.200,000, the investor gets a claim on Nifty worth Rs.2.4 million. Futures are available at several different expirations. The investor can choose any any of them them to imple implemen mentt this this positi position. on. The choice choice is basica basically lly about about the the horizon of the investor. Longer dated futures go well with long–term forecasts about the movement of the index. Shorter dated futures tend to be more liquid. Example
1.
On 1 Jun June e 200 2001, 1, a per perso son n fee feels ls the the ind index ex will will fall fall..
2.
He sell sells s 200 200 Nift Niftie ies s wit with h a expi expira rati tion on date date of 26th 26th June June 2001 2001..
3. At this this tim time, e, the the Nift Nifty y June June con contr trac actt cos costs ts Rs.1 Rs.1,06 ,060 0 so so his his posi positi tion on is worth Rs.212,000. 4.
On 10 Jun June 200 2001 1, Nif Niftty ha has fa fallen llen to 96 962.90 2.90..
5. The The Nifty fty June con contrac tractt has has fall fallen to Rs. Rs.99 990 0. he squ squares res off his his position. His profits from the position work out to be Rs.14,000.
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Chapter 5
96
Applicabilit y of Derivative Instruments APPLICABILITY OF DERIVATIVE INSTRUMENTS 97
RISK MANAGEMENT: CONCEPT AND DEFINATION In rece recent nt year years s mange angers rs have have beco become me incr increa easi sing ngly ly awar aware e of how how thei theirr organizations can be affected by risks beyond their control. In many cases fluctu fluctuati ations ons in econom economic ic and and finan financia ciall variab variables les such such as exchan exchange ge rates, rates, interest rates and commodity prices have destabilizing affects on performance and corporate strategy.
WHAT IS RISK? Risks are defined as internal or external causes of and reasons for deviations in actual results and forecasts/budgets, or factors that can lead to changes in the the fore foreca cast st.. They They are are poss possib ibil ilit itie ies s not not incl includ uded ed in fore foreca cast st/b /bud udge gett and and represent an upside or downside to the forecast/ budget.
WHAT IS RISK MANAGEMENT? Risk management embraces the whole spectrum of activities and measures associated with the identification, evaluation and handling of opportunities and risks.
OBJECTIVES AND BENEFITS OF RISK MANAGEMENT The key objectives of Risk Management are: •
•
•
•
Providing a basis for informed decision making as a consequence of creating transparency in the company’s risk situation. Identi Identifyi fying ng threat threats s to the compan company, y, its assets assets and its financ financia iall and earning potential. Implem Implement enting ing proper proper mecha mechani nism sm for the the identi identific ficati ation, on, analy analysis sis and and mitigation of potential risks. Clearly prioritizing risks to the company and their mitigation strategies: and 98
•
Creating opportunities through improving risk mitigation capabilities. capabilities.
Effective and systematic Risk Management yields the following key benefits: Forward, rigorous, responsible thinking, so the organization is prepared for what might happen and is better prepared for making decisions to improve the effectiveness and efficiency of performance. Balance thinking – a trade – off must be struck between the cost of mana managi ging ng risk risk,, the the bene benefi fits ts to be gain gained ed,, and and what what leve levell of Risk Risk Management it is prudent to apply; and The The organi organizat zation ion is encou encourag raged ed to manage manage proact proactive ively ly rather rather than than reactively. It helps to speed up the decision making process, giving clear priorities to each type of activity or project requiring management attention and thus giving a clear cut advantage to the business. •
•
•
RISK MANAGEMENT PROCESS The objective of risk management process is to identify and evaluate the key risks, risks, treat treat and and monito monitorr these these risks risks effici efficient ently ly and and effecti effectivel vely, y, and ensure ensure ongo ongoin ing g repo report rtin ing g for for infor informe med d deci decisi sion on maki making ng.. It embr embrac aces es the the whol whole e spectrum of activities and measures concerned with systematic management of risks within the organization. The overall objective of the risk management process is to optimize the risk return relationship and reject unacceptable risks. The process contains four main stages: • • • •
Risk Identification Risk Evaluation Risk Handling; and Risk Controlling
Contro Controlli lling ng the the Risk Risk Manage Managemen mentt Proces Process s means means monito monitorin ring g wheth whether er the the mana manage geme ment nt proc proces ess s is acti active vely ly and and effe effect ctiv ivel ely y live lived d thro throug ugho hout ut the the 99
organization. The efficiency of the process is the responsibility of all managers within the organization and cannot be viewed as the sole responsibility of the Risk Manager. All levels of management should manage risks. The The risk risk mana manage geme ment nt proc proces ess s must must be esta establ blis ishe hed d as a perm perman anen entt and and integral part of business process if it to be fully effective. Furthermore, since risks and risk structures change continuously, the risk management process must remain sufficiently flexible to accommodate new situations as they arise.
Opportunity/Risk Opportunity/Risk Risk Risk RiskIdentification Evaluation Controlling Handling Risk Managemen Ma nagementt Process
Ongoing Evaluation M Eveasures easure aluation sreporting repo and ofrting risks ris mechanisms me kschanisms and an d for monitoring influencing of risks risks. and the concerni conc erning ng their impact imp act & of Identification of risks and Obje ctives, strate strat e gies, organization organization of the the company handling mechanism. their sources probability
RISK MANAGEMENT WITH FUTURES CONTRACT
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As the futures are exchange-traded, the clearing corporation of the exchange by granting credit guarantee nullifies the counter party risk. Also the strict margi marginin ning g syste system m follow followed ed in the future futures s marke markett worldw worldwide ide,, reduce reduces s the the default risk associated with the futures. The general margining system that is followed in the futures market is as follows. Depending on the position taken an initial margin is charged on the investor. This is determined by the exposure limit assigned to the investor. This can be inte interp rpre rete ted d as an adva advanc nce e paym paymen entt made made to take take a larg larger er posi positi tion on.. For For exam exampl ple, e, if the the expo exposu sure re limi limitt is 33 time times s the the base base capi capita tall give given n by the the investor, then it means that an initial margin of 3.33 is required. More than the initial margin collected, the net profit or loss on a position is paid out to or in by the investor on the very same day in the form of daily mark-to-market margins (MTM). The MTM is made compulsory to remove any defa defaul ultt on larg large e loss losses es if the the posi positi tion on is accu accumu mula late ted d for for seve severa rall days days.. Calculating Calculating the net loss associated with a position does the calculation of MTM margin. This is paid up each evening after trading ends. The focus is on calculating calculating the net loss on all contracts entered by the client.
ADVA ADVANT NTAG AGES ES AND AND RISK RISKS S OF TRAD TRADIN ING G IN FUTU FUTURE RES S OVER OVER CASH •
•
•
The biggest advantage of futures is that short selling is allowed without having stock and position can be carried for a long time, which is not possible in the cash segment because of rolling settlement. Conversely futu future res s can can be boug bought ht and and posi positi tion on can can be carr carrie ied d for for a long long time time without taking delivery, unlike in the cash segment where it delivery has to be taken because of rolling settlement. Further futures positions are leveraged positions, meaning a position can can be take taken n for for Rs10 Rs100 0 by payi paying ng Rs25 Rs25 marg margin in and and dail daily y mark mark-t -toomarket loss, if any. This can enhance the return on capital deployed. For example, the expectation for a Rs100 stock is to go up by Rs10. One way is to buy the stock in the cash segment by paying Rs100. In this way the profit will be Rs10 on investment of Rs100, giving about 10% 101
return returns. s. Alter Alternat native ively, ly, future futures s positi position on in the stock stock by payin paying g about about Rs30 toward initial and mark-to-market margin the same profit of Rs10 can be made on the investment of Rs30, i.e. about 33% returns. Please note that taking leveraged position is very risky, you can even lose your full capital in case the price moves against your position.
RISK MANAGEMENT WITH OPTIONS Risk is concerned with the unknown. Upside risk is the possibility of gain. Downside risk is the possibility of loss. One half the reasons to use options (like other derivatives) is to reduce risk. Certainty is exchanged with other players who assume the risk in hope of big gains. It is wrong to state that "options are risky." •
Reduce Reduce risk: The seller of a covered call exchanges his upside risk
(gains above the strike price) for the certainty of cash in hand (the premium). The buyer of a covered put limits his downside risk for a price - just like buying fire insurance for your house. •
Increase risk: The buyer of a call wants the upside risk of an asset, but
will only pay a small percentage of its current value, so his returns are leveraged. The seller of a put accepts the downside risk of locking in his purchase price of an asset, in exchange for the premium. To understand risk, look at the four standard graphs of options (put-call-buysell). The value of the options in the interim between purchase and expiration wil willl not not be exac exactl tly y like like thes these e grap graphs hs,, but but clos close e enou enough gh.. In all all case cases, s, the the premium was a certainty. •
Buyers start out-of-pocket. But going forward, the option buyer has no downside risk. The graph either flat lines or goes up on either side of the spot price.
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•
Sellers start with a gain. Going forward, they have no upside risk. These graphs either flat line or go down on either side of the spot price.
The extent of risk varies. Buyers/se /sellers of calls have unlimited upside/downside risk as the asset price increases. Buyers/sellers of puts have upside/downside risk limited to the spot price of the asset (less the premium). Long Call
A trader who believes that a stock's price will increase might buy the right to purchase the stock (a call option) option) rather than just buy the stock. He would have no obligation to buy the stock, only the right to do so until the expiry date. If the stock price increases over the exercise price by more than the premium paid, he will profit. If the stock price decreases, he will let the call contract expire worthless, and only lose the amount of the premium. A trader might buy the option instead of shares, because for the same amount of money, he can obtain a larger number of options than shares. If the stock rises, he will thus realize a larger gain than if he had purchased shares. This is an example of the principle of leverage of leverage..
Payoffs and profits from a long call. Short Call (Nak (Naked ed short sho rt call) cal l)
A trader who believes that a stock's price will decrease can short sell the stock or instead sell a call. Both tactics are generally considered inappropriate for small investors. The trader selling a call has an obligation to sell the stock to the call buyer at the buyer's option. If the stock price decreases, the short call position will make a profit in the amount of the premium.
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If the stock price increases over the exercise price by more than the amount of the premium, the short will lose money. Unless a trader already owns the shares which he may be required to provide, the potential loss is unlimited. However, such a trader who sells a call option for those shares he already owns has sold a covered call. call.
Payoffs and profits from a short call. Long Put
A trader who believes that a stock's price will decrease can buy the right to sell the stock at a fixed price. He will be under no obligation to sell the stock, but has the right to do so until the expiry date. If the stock price decreases below the exercise price by more than the premium paid, he will profit. If the stock price increases, he will just let the put contract expire worthless and only lose his premium paid.
Payoffs and profits from a long put. Short Put (Naked (Naked put) put)
A trader who believes that a stock's price will increase can sell the right to sell the stock at a fixed price. The trader now has the obligation to purchase the stock at a fixed price. The trader has sold insurance to the buyer of the put requiring the trader to insure the stockholder below the fixed price. This trade is generally considered inappropriate for a small investor. If the stock price 104
increases, the short put position will make a profit in the amount of the premium. If the stock price decreases below the exercise price by more than the premium, the short position will lose money.
Payoffs and profits from a short put.
INTRODUCTION TO OPTIONS STRATEGIES Bullish Strategies
Bullish options strategies are employed when the options trader expects the underlying stock price to move upwards. It is necessary to assess how high the stock price can go and the timeframe in which the rally will occur in order to select the optimum trading strategy. The most bullish of options trading strategies is the simple call buying strategy used by most novice options traders. In most cases, stocks seldom go up by leaps and bounds. Moderately bullish options traders usually set a target price for the Bull Run and utilize bull spreads to reduce risk. While maximum profit is capped for these strategies, they usually cost less to employ. The bull call spread and the bull put spread are common examples of moderately bullish strategies. Mildly bullish trading strategies are options strategies that make money as long as the underlying stock prices do not go down on options expiration date. These strategies usually provide a small downside protection as well. Writing out-of-the-money out-of-the-money covered calls is a good example of such a strategy.
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Bearish Strategies
Bearish options strategies are employed when the options trader expects the underlying stock price to move downwards. It is necessary to assess how low the stock price can go and the timeframe in which the decline will happen in order to select the optimum trading strategy. The The most most bear bearis ish h of opti option ons s trad tradin ing g stra strate tegi gies es is the the simp simple le put put buyi buying ng strategy utilized by most novice options traders. In most cases, stock price seldom make steep downward moves. Moderately bearish options traders usually set a target price for the expected decline and utilize bear spreads to reduce risk. While maximum profit is capped for these strategies, they usually cost less to employ. The bear call spread and the bear put spread are common examples of moderately bearish strategies. Mildly bearish trading strategies are options strategies that make money as long as the underlying stock prices do not go up on options expiration date. These strategies usually provide a small upside protection as well. Neutral or Non-Directional Non-Directional Strategies
Neutral strategies in options trading are employed when the options trader does not know whether the underlying stock price will rise or fall. Also known as non-directional strategies, they are so named because the potential to profit does not depend on whether the underlying stock price will go upwards or downwards. Rather, the correct neutral strategy to employ depends on the expected volatility of the underlying stock price. Bullish on Volatility
Neutra Neutrall tradin trading g strate strategie gies s those those are bullis bullish h on volati volatilit lity y profit profit when when the the underlying stock price experience big moves upwards or downwards. They include the long straddle, straddle, long strangle, strangle , and short condor and short butterfly.
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Bearish on Volatility
Neutra Neutrall tradin trading g strate strategie gies s those those are are bearis bearish h on volat volatili ility ty profit profit when when the the under underlyi lying ng stock stock price price experi experienc ences es littl little e or no moveme movement. nt. Such Such strate strategie gies s include the short straddle, straddle, short strangle, strangle, ratio spreads, long condor and long butterfly. Combining any of the four basic kinds of option trades (possibly with different exercise prices) and the two basic kinds of stock trades (long and short) allows a variety variety of options options strategie strategies. s. Simple Simple strategie strategies s usually usually combine only a few trades, while more complicated strategies can combine several.
OPTIONS TRADING STRATEGIES There are several basic Options Trading Strategies, but in order to execute any of them them succ succes essf sful ully ly an inve invest stor or new new to opti option ons s will will need need to know know some some elementary concepts. The most basic are the call and the put. Buying a call confers the right, but not the obligation, to buy at a pre-set price. Puts grant the buyer the right to sell at a pre-set price. But options are sold as well as bought. That seller grants the buyer the right, and takes on an obligation to fulfill the other side of the trade. There are several basic variations. Long Calls
The most basic, and easiest to understand, is the (long) call. MSFT (Microsoft), currently trading at $28, have June 31 options that expire on the third Friday of June, with a strike price (pre-set, 'if exercised, must-be-bought-at-price') of $31. Short ('Naked') Calls
When the option seller (the 'writer') doesn't own the underlying stock he's obligated to sell (if the option is exercised), he is said to be selling a 'naked' 107
call. Since he's on the selling side of the contract, his position is said to be 'short'. If the market price of the underlying asset decreases, the short call position will profit by the amount of the premium. The price rises above the strike price by more than the premium, the short position incurs a loss. Long Put
Traders who anticipate that the future market price of an asset, say a stock, will fall prior to expiration can buy the right to sell the stock at a fixed price. The put buyer has no obligation to sell the stock, but simply the right. If, in fact, the market price does fall below the strike price (prior to expiration of the the opti option on)) by more more than than the the prem premiu ium m paid paid,, he prof profit its. s. If the the pric price e increases, or doesn't fall enough to cover the premium, the trader lets the contract 'expire worthless'. Short Put
Traders who speculate that the future market price will increase, can sell the right to sell an asset at a pre-determined price. If the asset's market price rises, the short put position makes a profit equal to the the amou amount nt of the the prem premiu ium. m. (Exc (Exclu ludi ding ng any any tran transa sact ctio ion n cost costs, s, such such as comm commis issi sion ons. s.)) If the the pric price e fall falls s belo below w the the stri strike ke pric price e by more more than than the the premium, the 'writer' loses money. Several basic trading strategies utilize the characteristics of these four basc positions. These strategies are either pure profit plays - speculating on coming out on the plus side of the equation - or combinations of speculation and hedging. Hedging involves taking positions that tend to move in opposite directions.
They profit less than pure speculation, but make up for it by offloading some risk.
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for exa example, ple, use a long ong call call wit with a low low str strike ike pric price e in 'Bull spreads', spreads', for combination with a short call at a higher strike price and a short put with a higher strike price. 'Bear spreads', by contrast, involve a short call with a low strike price and a
long call with a higher strike price. An alternative method uses a short put with low strike price and a long put with a higher strike price. Options trading software can demonstrate several concrete examples of how any of these - under different assumptions about future prices, volume, etc in combination with different expiration dates and strike prices - can result in profit (or loss).
Current Strategies 1. LONG LO NG CALL CA LL Market View
Potential Profit
Potential Loss
Bullish
Unlimited
Limited
Purchasing calls has remained the most popular strategy with investors since listed options were first introduced. Before moving into more complex bullish and and bear bearis ish h stra strate tegi gies es,, an inve invest stor or shou should ld thor thorou ough ghly ly unde unders rsta tand nd the the fundamentals fundamentals about buying and holding call options. Situation: On 1 November, L&T is quoting at Rs 254 and the January 260
(strike price) call costs Rs 14 (premium). You expect the share price to rise significantly and want to profit from the increase
Action: Buy 1 L&T call at 14. Net outlay is Rs 14,000 If the L&T shares do go
up you can close your position either by selling the option back to the market or exercising your right to buy the underlying shares at the exercise price. Share Price
Option Market 109
1-Nov 20-Jan
Rs. 254 Rs. 300
Analysi Rises by Return 18% s
Buy 1 Jan 260 call at Rs 14, Cost =14,000 1. Sell 1Jan contract (Expiry) 2. Net Gain 40 (300 - 260 x 1000 units = 40,000) Your gain is:
Option sale = 40,000 Premium paid = (14,000) Net profit= 26,000 Return 186%
Possible Outcomes at expiry Share Price 300 Share price < 260 Stock price > 274
Option worth 40,000. Closing the position now will produce a net profit of 26,000 Option expires worthless. The loss is Rs. 14,000 (premium) Net profit = intrinsic value of (Break even = 260+14) option i.e. by whatever amount the share price exceeds 274
Although the profit is on expiry day, the investor is obviously able to sell his option at any time prior to expiry, and such sale will result in the receipt of time value in addition to any intrinsic value. 2. LONG PUT Market View
Potential Profit
Potential Loss
Bearish
Unlimited
Limited
A long put can be an ideal tool for an investor who wishes to participate profitably from a downward price move in the underlying stock. Before moving into into more more comp comple lex x bear bearis ish h stra strate tegi gies es,, an inve invest stor or shou should ld thor thorou ough ghly ly understand the fundamentals about buying and holding put options. Situation: An investor thinks L&T, currently trading at Rs 270, is overvalued
and may fall substantially. He therefore decides to buy Puts to gain exposure to its anticipated fall. 110
Action: Buy 1 L&T October 260 Put at Rs 8 for a total consideration of Rs
8,000. If the L&T shares do go down you can close your position either by sellin selling g the option option back back to the the marke markett or exerci exercisin sing g your your right right to buy the underlying shares at the exercise price. Share Price
1-Aug
Rs. 270
20-Oct
Rs. 240
Analysi Fall of prof profit it Rs 30 30 s
Option Market
Buy 1 L&T Oct 260 put at Rs 8 Total Outlay = 8,000 1. Sell 1 Oct contract. 2. Net gain 20 (260 - 240 x 1000 = 20,000) Effective profits Opti Option on purc purch hase (8,00 8,000) 0) Option sale 20,000 Net profit 12,000 or 150%
Possible Outcomes at expiry Share Price 240
The 260 put will be trading at Rs 20 which gives a profit of Rs 12 (20-8), if the position is closed out. Recover intrinsic value of premium.
Share price 240260 Stock price > 240 The 260 put will be trading at Rs 20 which gives a
profit of Rs 12 (20-8), if the position is closed out.
Although the profit is on expiry day, the investor is obviously able to sell his option at any time prior to expiry, and such sale will result in the receipt of time value in addition to any intrinsic value. 3. Short Call
Naked short call / Covered short call Market View
Potential Profit
Potential Loss
Bullish
Limited
Unlimited
111 111
The covered call is a strategy in which an investor writes a call option contract whi while le at the the same same time time owni owning ng an equi equiva vale lent nt numb number er of shar shares es of the the underlying stock. If this stock is purchased simultaneously with writing the call con-tract, the strategy is commonly referred to as a "buy-write." If the shares are already held from a previous purchase, it is commonly referred to an "overwrite." In either case, the stock is generally held in the same brokerage account from which the investor writes the call, and fully collateralizes, or "covers," the obligation conveyed by writing a call option contract. This strategy is the most basic and most widely used strategy combining the flexibility of listed options with stock ownership. Situation: It is 1 November and L&T share is trading at Rs 254. An investor
holds 10000 shares but does not expects their price to move very much over the next few months so decides to write call option against this shareholding. The Janu Januar ary y 260 260 call calls s are are trad tradin ing g at 14 and and inve invest stor or sell sells s 10 Action: The contracts (one contract is 1,000 shares). He receives an option premium equal to Rs 1,40,000 and takes on the obligation to deliver 10000 share at 260 each if the holder exercise the option. Share Price
1-Nov
Rs. 254
Option Market
Sell 10 Jan 260 calls @ Rs 14 Income 1,40,000 Option expire worthless
20-Jan Rs. 254 Analysi No change to E ective ro its shareh sharehold olding ing Profit Profit =1,40, =1,40,000 000 (opt (option ion val value ue of s
premium)
Possible Outcomes at expiry Share Price > 260
The holder will exercise his position and if called, the investor as a writer will sell shares originally purchased for Rs 254 at 274 (260+14), a return of 7.8% over 3 months.
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Share price < 240
The option expires worthless
4. Short Put Naked Short Put / Covered Short Put Market View
Potential Profit
Potential Loss
Bearish
Limited
Unlimited
According to the terms of a put contract, a put writer is obligated to purchase an equivalent number of underlying shares at the put's strike price if assigned an exercise notice on the written contract. Many investors write puts because they are willing to be assigned and acquire shares of the underlying stock in exchange for the premium received from the put's sale. For this discussion, a put writer will be considered "covered" if he has on deposit with his brokerage firm a cash amount (or other approved collateral) sufficient to cover such a purchase. Situation: An investor owns 10,000 shares and also has a cash holding of
around 60,00,000. In early March he feels that the share price of NIIT will either remain constant or, possibly, rise slightly. Investor or decide decides s to genera generate te some some additi additiona onall incom income e on his Action: The Invest portfolio and writes 10 NIIT 550 puts at Rs 40. Thus he received premium of 4,00,000. Possible Outcomes at expiry Share Price =/ > The investor's expectation is correct and the put will expire without being exercised. Initial income 550 Share price < 550
remains as profit. The put option will be exercised and the stock will have to be purchased, effectively for 51,00,000 (55,00,000- 4,00,000). 113
In rela relati tion on to the the Indi Indian an mark market ets, s, this this stra strate tegy gy requ requir ires es a subs substa tant ntia iall investment. The net outflow in this situation is: Future Margin – Option Premium. 5. Bull Call Spread Market View
Potential Profit
Potential Loss
Bullish
Limited
Limited
Establishing a bull call spread involves the purchase of a call option on a particular underlying stock, while simultaneously writing a call option on the same underlying stock with the same expiration month, at a higher strike price. Both the buy and the sell sides of this spread are opening transactions, and are always the same number of contracts. This spread is sometimes more broadly categorized as a "vertical spread": a family of spreads involving options of the same stock, same expiration month, but different strike prices. They can be created with either all calls or all puts, and be bullish or bearish. The bull call spread, as any spread, can be executed as a "unit" in one single transaction, not as separate buy and sell transactions. Situation: On 1 November, the share price of L&T is 204. Buy 1 L&T July 200
call option at Rs 16 and sell 1 July 220 call at Rs 8. Total outlay and maximum loss is 8. Break even is Rs 208 (200+8). Maximum profit is 12 (220200-8). Possible Outcomes at expiry Share Price < 200
Both the 200 and 220 calls are worthless and the maximum loss is equal to the net cost of establishing the spread i.e Rs 8
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Share price 200- The 200 call gains intrinsic value and profit is equal to the intrinsic value of the 200 calls less 220
Stock price > 220
the net debit of Rs 8. Maximum profit is therefore realized at 220, the point just before which the 220 calls may be exercised. The position can be closed for f or a maximum profit of Rs 12 above 220 i.e. difference in intrinsic value of two calls less than net debit (20-8).
Note: the long call position always covers the risk on the short call position. Eg. if the short option option is exercis exercised ed against against you, you, it is possib possible le to exercis exercise e the long position and acquire stock in order to satisfy the short position.
Advantages
Position established for less cost than a long call and breaks even more quickly. Limited loss.
6. Bear Put Spread Market View
Potential Profit
Potential Loss
Bullish
Limited
Limited
Establishing a bear put spread involves the purchase of a put option on a particular underlying stock, while simultaneously writing a put option on the same underlying stock with the same expiration month, but with a lower strike price. Both the buy and the sell sides of this spread are opening transactions, and are always the same number of contracts. This spread is sometimes more broadly categorized as a "vertical spread": a family of spreads involving options of the same stock, same expiration month, but different strike prices. They can be created with either all calls or all puts, and be bullish or bearish. The bear put spread, as any spread, can be executed as a "package" in one single transaction, not as separate buy and sell transactions. 115
Expectation: This strategy is appropriate when anticipating a fall in the price
of the underlying share. Situation: The share of Tata Tea is trading at 228. You buy 1 Tata Tea Oct
240 put at Rs 16 and sell 1 Tata 220 put at Rs 7. Maximum profit is Rs 11 and maximum loss Rs 9. Possible Outcomes at expiry Share Price > 240 Share price 240-220 Stock price 220 Stock price < 220
Both puts are worthless and the maximum loss is equal to the net co cost st of establishing the spread i.e Rs 9 The position can be closed out for the intrinsic value of the Rs. 240 put. The maximum potential profit of Rs 11 is realized just before the level at which the 220 put may be exercised by the holder The position can be closed for the difference in the intrinsic value of two puts, so the profit is 11 (240-220-9)
Advantages
Position established for less cost than a long put and breaks even more quickly. Limited loss. 7. Long Straddle Market View
Potential Profit
Potential Loss
Mixed
Unlimited
Limited
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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, expi expira rati tion on,, and and unde underl rlyi ying ng.. The The pote potent ntia iall loss loss is limi limite ted d to the the init initia iall investment. The potential profit is unlimited as the stock moves up or down. Purc Purcha hasi sing ng a stra stradd ddle le is appr approp opri riat ate e when when anti antici cipa pati ting ng significant volatility in the underlying but when uncertain about direction.
Expectation:
Situation: Buy 1 L&T Apr 260 call at Rs 21 and Buy 1 L&T Apr 260 Put at Rs
9. Upside breakeven = 290 (Exercise price 260 + net debit 30) Downside breakeven = 230 (260 - 30 net debit) Profit is unlimited, loss potential is limited, maximum loss Rs 30. Possible Outcomes at expiry
The call expires worthless and profit is equal to the the intr intrin insi sic c val valued of the 260 put put less ess the premium paid Profit is equal to the intrinsic value of the 260 Share price > Premium less the paid 260 Although profit opportunities are unlimited below Rs 230 and above Rs 290, the underlying share, in this example, has to move 11% before the strategy breaks even. Normally, however, once the direction of the underlying becomes clear the other 'leg' is closed which effectively reduces the break even. Share Price < 260
Advantages
Profit potential open ended in either direction. Maximum Loss limited to the premium paid. 8. Short Straddle Market View
Potential Profit 117
Potential Loss
Mixed
Unlimited
Unlimited
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. Generally lly undert undertake aken n with with a view view that that the underl underlyin ying g share share Expectation: Genera price will trade between break even points. Action: Sell 1 L&T April 260 call at Rs21, sell 1 L&T April 260 put at Rs 9.
Upside breakeven = 290 (Exercise price 260 + net credit 30) Downside breakeven = 230 (260 - 30 net credit) Maximum profit is 30, maximum loss unlimited. Possible Outcomes at expiry Share Price 260
Maximum profit potential is realized as both calls and put are worthless.
The risk is, of course, that if the underlying does prove to be volatile, the short straddle position exposes an investor in both direction it is important that the stock and cash should be in place to cover the call and put legs respectively. Alte Altern rnat ativ ivel ely, y, to prev preven entt such such expo exposu sure res s a stop stop loss loss faci facili lity ty coul could d be impl implem emen ente ted. d. In the the exam exampl ple e abov above, e, if the the inve invest stor or felt felt that that ther there e was was a possibility of a sharp downward movement the 240 puts could be purchased to protect downside. Conversely a sharp upward movement could be protected by buying the 280 calls. Normally a stop loss would only be implemented on one side leaving the other exposed. Nevertheless, the short straddle is particularly appropriate when taking the view that the underlying will trade in the range between the breakeven points and when prepared to deliver stock, in this example, at Rs 290 or alternatively take delivery of stock at Rs 230.
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Advantages
Generation of earnings from premium received. Secure known purchase and sale price. 9.Long Strangle Market View
Potential Profit
Potential Loss
Mixed
Unlimited
Limited
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 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. Situation: The share of L&T is currently standing at 247. Buy 1 L&T Oct 260
call at Rs 12, buy 1 Oct 240 put at Rs10. Upside breakeven = 282 (Exercise price 260 + net debit 22) Downside breakeven = 218 (240 - 22 net debit) Possible Outcomes at expiry Share Price > 260 Share price 240-260 Stock price < 240
Profit from the call is equal to its intrinsic value less the premium paid Both call and put are out of money. Maximum loss of 22 premium paid. Profit potential unlimited.
Advantages
Profit potential open ended in either direction. 119
Loss limited to total premium paid. 10.Short Strangle Market View
Potential Profit
Potential Loss
Mixed
Limited
Unlimited
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 sell sellin ing g outout-of of thethe-mo mone ney y puts puts and and call calls s with with the the same same expi expira rati tion on and 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. Situation: L&T shares are currently standing at Rs 247 and you sell 1 October
260 call at Rs 12 and sell 1 October 240 put at Rs 10. Upside breakeven = 282 (Exercise price 260 + net debit 22) Downside breakeven = 218 (240 - 22 net debit) Your maximum profit is Rs 22 and loss is unlimited. Possible Outcomes at expiry Share Price > 260 Share price 240-260 Stock price < 240
The call is exercisec by the holder and the seller delivers stock at 282. (260+22). Both the call and put would expire worthless. The 22 credit is retained The put is exercised. The seller takes delivery of the stock at 218.
Advantages
Generation of earnings from premium received. Secure know sale and purchase prices.
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Disadvantages
Loss is unlimited In the Indian Markets, the investment required for such a strategy is very high high and and shou should ld only only be atte attemp mpte ted d by peop people le with with huge huge fund funds s and and an appetite for large losses. 11.Butterfly Market View
Potential Profit
Potential Loss
Mixed
Limited
Unlimited
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 opti option ons, s, whic which h must must be all all call calls s or all all puts puts,, must ust also also have have the the same same expiration and underlying. Situation: L&T shares are currently trading at 240. You buy one Jan 220 call
at Rs. 40, sell two Jan 240 calls at Rs. 30, and buy one Jan 260 call at 25. This is called "buying a butterfly." The opposite would be to sell the butterfly. Upside breakeven = 255 Downside breakeven = 225 The maximum profit is 240-220-5 = Rs.15 Possible Outcomes at expiry Share Price >
The loss is Rs.5 i.e. net debit
260 Stock price 240 The maximum profit would be at this level. The
net profit would be 240-220-5 = Rs.15 Advantages
Potential loss is limited Disadvantages 121
Can be difficult to execute such strategies quickly. Requires big margin to execute this strategy. 12.Collar
A coll collar ar can can be esta establ blis ishe hed d by hold holdin ing g shar shares es of an unde underl rlyi ying ng stoc stock, k, purchasing a protective put and writing a covered call on that stock. The option portions of this strategy are referred to as a combination. Generally, the put put and and the the call call are are both both out out of-t of-the he-m -mon oney ey when when this this comb combin inat atio ion n is established, and have the same expiration month. Both the buy and the sell sides of this combination are opening transactions, and are always the same number of contracts. In other words, one collar equals one long put and one written call along with owning 100 shares of the underlying stock. Expectation: An investor will employ this strategy after accruing unrealized profits from the underlying shares, and wants to protect these gains with the purchase of a protective put. At the same time, the investor is willing to sell his stock at a price higher than the current market price so an out-of-the-money call contract is written, covered in this case by the underlying stock Situation: Suppose you purchased 100 shares of L&T ltd. at Rs.240 in may and would like a way to protect your downside with little or no cost. You would create a collar by buying one May 220 put at 10 and selling one May 260 call at 15. Net credit is Rs.5 Maximum profit: When share is at 260. Maximum loss: When the share is at or below 220. Possible Outcomes at expiry Share Price @220 Stock price @240 Stock price @260
The profit from the put offsets the loss from the stock. The profit would be equal to the net inflow i.e. Rs.5 The profit on the stock is exactly offset by the loss on the call option that was sold.
Advantages
122
The The collar collar strate strategy gy is best best used used for invest investors ors lookin looking g for a conser conservat vative ive strategy that can offer a reasonable rate of return with managed risk and potential tax advantages. Disadvantages
The primary concern in employing a collar is protection of profits accrued from underlying shares rather than increasing returns on the upside.
13. Condor Spread The Condor Spread strategy is a neutral strategy similar to the Butterfly. In the Iron Condor, an investor will combine a Bear-Call Credit Spread and a Bull-Put Credit Spread on the same underlying security. By doing this, an inves investor tor will will potent potential ially ly be able able to double double the credit credit obtain obtained ed over over a single single spread position. Since there are two spreads involved in the strategy (four options), there is an upper break even and a lower break even. A profit is made if the stock remains above the lower break even point or below the upper break even point. Expectation: The long condor can be a great strategy to use when your feeling on a stock is generally neutral because it's been trading in a narrow range. Like the butterfly, the condor is a limited risk, limited reward strategy that profits in stagnant markets. Situation: Imagine that L&T ltd. is trading at Rs. 240 and has been relatively flat for some time. If you think the situation is unlikely to change, Action
Sell 1 240 call @ 20 Sell 1 260 call @ 15 Buy 1 220 call @ 30& buy 1 280 @ 10 call as a hedge in case the market moved against you. Maximum profit: profit: When the stock price is between 240 & 260 Maximum loss: When the stock price is above 280 or below 220 Possible Outcomes at expiry Share Price <220
The loss would be of Rs. 5 (initial debit)
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Stock price 240-260 Stock price>260
The profit would be equal to 20-5= Rs.15 The loss would be Rs. 5 (initial debit)
Advantages:
The double credit achieved helps lower the potential risk. Losses are limited if the stock goes against you one way or the other. If you are facing a large gain or drop in the underlying you could only close one leg of the four legs in the position. Disadvantages:
Commission costs to open the position are higher since there are four trades, might be cost prohibitive to trade iron condors c ondors that are low net credits. 14. Calendar Spread
Calendar spreads take advantage of the different rates at which time value erodes. Since the time value element of an option’s premium erodes faster in the near month series than the far month series, a spread opens up between the the two. two. The The more more rapi rapid d eros erosio ion n in the the near near mont month h seri series es work works s to the the advantage of the writer and the strategy is therefore particularly appropriate when the near month series is overpriced. Expectation: A calendar spread involves the sale of a near dated call (put) and
the purchase of a longer dated call (put) at the same exercise price. Calls are used when market view is moderately bullish and puts are used when market view is moderately bearish. Situation: On 1 May the shares of L&T ltd. are trading at Rs.288 and the May
280 Call is available @ Rs.24 and the Jun Call is available @ Rs. 30 Action:
Sell 1 L&T Ltd. May 280 call @ Rs.24. Buy 1 L&T Ltd. Jun 280 call @ Rs.30. Net debit is Rs. 6 124
Possible Outcomes at expiry Share Price <280 Stock price @280 Stock price >280
The May 280 call expires worthless leaving the position long 1 Jun 280 call at a reduced cost of 6. Maximum profit potential is realized. The May 280 call expires worthless but the Jun 280 call will have 1 month time value remaining. Both calls will have intrinsic value, but the true value of the Jun 280 call is likely to be lower.
A calendar spread using puts could be established in the same way to suit a neutral to moderately bearish strategy. Alternatively, if the May calls were purc purcha hase sed d and and the the Jun Jun call calls s sold sold then then the the risks risks and and rewa reward rds s woul would d be reversed. This is generally known as a reverse calendar spread. Advantages
Limited loss, i.e. initial debit.
Disadvantages
Limited profit. Position may be disrupted by early exercise .
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Chapter 6
126
Achieveme nts in Future and Options Segment 127
ACHIEVEMENTS IN FUTURE AND OPTIONS SEGMENT
128
129
130
COMPARATIVE ANALYSIS OF F&O SEGMENT AND CASH SEGMENT
131
TOP 5 TRADED SYMBOL IN THE FUTURES SEGMENT FOR THE MONTH OF MAY 2008
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TOP 5 TRADED SYMBOL IN THE OPTIONS SEGMENT FOR THE MONTH OF MAY 2008
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134
Chapter 7
Conclusio n
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CONCLUSION
The Indian stock market witnesses both the good as well as the bad time. Most of the people keep them away from bad times that lead to low liquidity in the markets. But for the rest who want to remain in the markets without loosing much of their capital and take leverage of the market movements in both north and south directions, Derivatives Instruments are the tools to be with. By stud studyi ying ng and and appl applyi ying ng vari variou ous s Deri Deriva vati tive ve Inst Instru rume ment nts s like like Fu Futu ture res, s, Forwards and Option strategies, I came to a conclusion that these instruments are the best ones to turn the bad time into a good one i.e. to earn profits in any market direction. Therefore, Derivative Instruments are a very good tool that will help us to minimize our risk and maximize our returns so that one can have conviction in his portfolio in the hugely volatile stock market
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Finally, the objective of the study is accomplished and I recommend that one should use the Derivative Instruments, as it is very much applicable in the Indian Stock Market.
Chapter 8
137
Suggestions and Recommend ations
138
SUGGESTIONS AND RECOMMENDATIONS
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Chapter 9
140
The Reference Materials
THE REFERENCE MATERIALS GLOSSARY 141
ADJUSTED STRIKE PRICE: Strike price of an option, created as the result of
a special event such as stock split or a stock dividend. The adjusted strike price can differ from the regular intervals prescribed for strike prices. call or put put opti option on cont contra ract ct that that can can be AMERICAN AMERICAN STYLE STYLE OPTION: OPTION: A call exercised at any time before the expiration of the contract. ARBITRAGE: A trading technique that involves the simultaneous purchase
and sale of identical assets or of equivalent assets in two different markets with the intent of profiting by the price discrepancy. ASSIGNMENT: Notification by Stock Exchange Clearing to a clearing member
and the writer of an option that an owner of the option has exercised the option and that the terms of settlement must be met. Assignments are made on a random basis by the Stock Exchange Clearing. The writer of a call option is obligated to sell the underlying asset at the strike price of the call option; the writer of a put option is obligated to buy the underlying at the strike price of the put option. AT PRICE: When you enter a prospective trade into a trade parameter, the "At
Price" (At. Pr) is automatically computed and displayed. It is the price at which the program expects you can actually execute the trade, taking into account "slippage" and the current Bid/Ask, if available. AT-THE-MONEY (ATM): An at-the-money option is one whose strike price is
equal to (or, in practice, very close to) the current price of o f the underlying. AVERAGING DOWN: Buying more of a stock or an option at a lower price than
the original purchase so as to reduce the average cost. BACK MONTH: A back month contract is any exchange-traded derivatives
contract for a future period beyond the front month contract. Also called FAR MONTH. BEAR, BEARISH: A bear is someone with a pessimistic view on a market or
particular asset, e.g. believes that the price will fall. Such views are often described as bearish. 142
BINOMIAL PRICING MODEL: Methodology employed in some option pricing
models which assumes that the price of the underlying can either rise or fall by a certain amount at each pre-determined interval until expiration For more information, information, see COX-ROSS-RUBINSTEIN model. formula ula used to com compute pute the the BLACKBLACK-SCH SCHOLE OLES S PRICI PRICING NG MODEL MODEL:: A for theoretical value of European-style call and put options from the following inputs: stock price, strike price, interest rates, dividends, time of expiration, and volatiity. It was invented by Fischer Black and Myron Scholes. BOX SPREAD: A four-sided option spread that involves a long call and short
put at one strike price as well as a short call and long put at another strike price. In other words, this is a synthetic long stock position at one strike price and a synthetic short stock position at another strike price. BREAK-EVEN POINT: A stock price at option expiration at which an option
strategy results in neither a profit or a loss. BULL, BULLISH: A bull is someone with an optimistic view on a market or
particular CANCELED ORDER: A buy or sell order that is canceled before it has been
executed. In most cases, a limit order can be canceled at any time as long as it has not been executed. (A market order may be canceled if the order is placed after market hours and is then canceled before the market opens the following day). A request for cancel can be made at anytime before execution. CARRYING COST: The interest expense on money borrowed to finance a stock
or option position. CASH SETTLEMENT: The process by which the terms of an option contract
are fulfilled through the payment or receipt in Rupees of the amount by which the option is in-the-money as opposed to delivering or receiving the underlying stock. CLOSING TRANSACTION: To sell a previously purchased position or to buy
back a previously purchased position, effectively canceling out the position. 143
This is the the lega legall lly y requ requir ired ed amou amount nt of cash cash or secu securi riti ties es COLLATERAL: This deposited with a brokerage to insure that an investor can meet all potential obligations. Collateral (or margin) is required on investments with open-ended loss potential such as writing naked options. This is the the char charge ge paid paid to a brok broker er for for tran transa sact ctin ing g the the COMMISSION: This purchase or the sale of stock, options, or any other security. COMMODITY: A raw material or primary product used in manufacturing or
industrial processing or consumed in its natural form. The numb number er of unit units s of an unde underl rlyi ying ng spec specif ifie ied d in a CONTRACT CONTRACT SIZE: SIZE: The contract. In stock options the standard contract size is 100 shares of stock. In futures options the contract size is one futures contract. In index options the contract size is an amount of cash equal to parity times the multiplier. In the case of currency options it varies. COST OF CARRY: This is the interest cost of holding an asset for a period of
time. It is either the cost of funds to finance the purchase (real cost), or the loss of income because funds are diverted from one investment to another (opportunity (opportunity cost). DAY ORDER: An order to purchase or sell a security, usually at a specified
price, that is good for just the trading session on which it is given. It is automatically automatically cancelled on the close of the session if it is not executed. DAY TRADE: A position that is opened and closed on the same day. DEBIT: The amount you pay for placing a trade. A net outflow of cash from
your account as the result of a trade. DIRECTIONAL DIRECTIONAL TRADE: A trade designed to take advantage of an expected
movement in price. DISCOUNT: An adjective used to describe an option that is trading below its
intrinsic value.
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DYNAMIC HEDGING: A short-term trading strategy generally using futures
contra contracts cts to replic replicat ate e some some of the charac character terist istics ics of optio option n contra contracts cts.. The strategy takes into account the replicated option's delta and often requires adjusting. EARLY EXERCISE: A feature of American-style options that allows the owner
to exercise an option at any time prior to its expiration date. EQUITY OPTION: An option on shares of an individual common stock. Also
known as a stock option. EUROPEAN STYLE OPTION: An option that can only be exercised on the
expiration date of the contract. EX-DIVIDEND DATE: The day before which an investor must have purchased
the the stoc stock k in orde orderr to rece receiv ive e the the divi divide dend nd.. On the the ex-d ex-div ivid iden end d date date,, the the previous day's closing price is reduced by the amount of the dividend because purchasers of the stock on the ex-dividend date will not receive the dividend payment. EXCHANGE TRADED: The generic term used to describe futures, options and
other derivative instruments that are traded on an organized exchange. EXERCISE: The act by which the holder of an option takes up his rights to
buy or sell the underlying at the strike price. The demand of the owner of a call option that the number of units of the underlying specified in the contract be delivered to him at the specified price. The demand by the owner of a put option contract that the number of units of the underlying asset specified be bought from him at the specified price. EXOTIC OPTIONS: Various over-the-counter options whose terms are very
spec specif ific ic,, and and some someti time mes s uniq unique ue.. Exam Exampl ples es incl includ ude e Berm Bermud uda a opti option ons s (som (somew ewhe here re betw betwee een n Amer Americ ican an and and Eu Euro rope pean an type type,, this this opti option on can can be exercised only on certain dates) and look-back options (whose strike price is set at the option's expiration date and varies depending on the level reached by the underlying security).
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FILL: When an order has been completely executed, it is described as filled. FILL OR KILL (FOK) ORDER: This means do it now if the option (or stock) is
avai availa labl ble e in the the crow crowd d or from from the the spec specia iali list st,, other therwi wise se kill kill the the orde orderr alto altoge geth ther er.. Simi Simila larr to an allall-or or-n -non one e (AO AON) N) orde order, r, exce except pt it is "kil "kille led" d" immediately if it cannot be completely executed as soon as it is announced. Unlike an AON order, the FOK order cannot be used as part of a GTC order. FLEXIBLE EXCHANGE OPTIONS (FLEX): Customized equity and equity index
options. The user can specify, within certain limits, the terms of the options, such such as exrc exrcis ise e pric price, e, expi expira rati tion on date date,, exer exerci cise se type type,, and and sett settle leme ment nt calculation. Can only be traded in a minimum size, which makes FLEX an institutional institutional product. FRONT FRONT MONTH: MONTH: The first month of those listed by an exchange - this is
usually the most actively traded contract, but liquidity will move from this to the second month contract as the front month nears expiration. Also known as the NEAR MONTH. FRONTRUNNING: An illegal securities transaction based on prior nonpublic
knowledge of a forthcoming transaction that will affect the price of a stock. FOLLOW-UP ACTION: Term used to describe the trades an investor makes
subseq subsequen uentt to imple implemen mentin ting g a strat strategy egy.. Throug Through h these these adjust adjustmen ments, ts, the the inves investor tor transf transform orms s one one strat strategy egy into into a differ different ent one in respon response se to price price changes in the underlying. GUTS: The purchase (or sale) of both an in-the-money call and in-the-money
put. put. A box spread spread can be viewed viewed as the combina combinatio tion n of an in-the-m in-the-mone oney y strangle and an out-of-the-money strangle. To differentiate between these two strangles, the term guts refer to the in-the-money strangle. See box spread and strangle. HAIRCUT: Similar to margin required of public customers this term refers to
the equity required of floor traders on equity option exchanges. Generally, one of the advantages of being a floor trader is that the haircut is less than margin requirements for public customers. 146
positi tion on esta establ blis ishe hed d with with the the spec specif ific ic inte intent nt of prot protec ecti ting ng an HEDGE: A posi existing position. Example: an owner of common stock buys a put option to hedge against a possible stock price decline. option on orde orderr that that give gives s the the IMMEDIAT IMMEDIATE-OR E-OR-CAN -CANCEL CEL (IOC) (IOC) ORDER: ORDER: An opti trading floor an opportunity to partially or totally execute an order with any remaining balance immediately cancelled. ILLIQUID: An illiquid market is one that cannot be easily traded without even
relatively small orders tending to have a disproportionate impact on prices. This is usually due to a low volume of transactions and/or a small number of participants. INDEX: The compilation of stocks and their prices into a single number. E.g.
The BSE SENSEX / S&P CNX NSE NIFTY. INDEX OPTION: An option that has an index as the underlying. These are
usually cash-settled. IN-THE-MONEY (ITM): Term used when the strike price of an option is less
than the price of the underlying for a call option, or greater than the price of the underlying for a put option. In other words, the option has an intrinsic value greater than zero. INTRINSIC INTRINSIC VALUE: Amount of any favorable difference between the strike
price of an option and the current price of the underlying (i.e., the amount by which it is in-the-money). The intrinsic value of an out-of-the-money option is zero. LEAPS: Long-term Equity Anticipation Securities, also known as long-dated
options. Calls and puts with expiration as long as 2-5 years. Only about 10% of equities have LEAPs. Currently, equity LEAPS have two series at any time, always with January expirations. Some indexes also have LEAPs. LEGGING: Term used to describe a risky method of implementing or closing
out a spread strategy one side ("leg") at a time. Instead of utilizing a "spread order" to insure that both the written and the purchased options are filled 147
simultaneously, simultaneously, an investor gambles a better deal can be obtained on the price of the spread by implementing implementing it as two separate orders. means s of incr increa easi sing ng retu return rn or wort worth h with withou outt incr increa easi sing ng LEVERAGE: A mean investmen investment. t. Using Using borrowed borrowed funds to increase increase one's investmen investmentt return, return, for exampl example e buyin buying g stocks stocks on margi margin. n. Option Option contra contracts cts are levera leveraged ged as they they provide the prospect of a high return with little investment. MARGIN: The minimum equity required to support an investment position. To
buy on margin refers to borrowing part of the purchase price of a security from a brokerage firm. group p of comm common on stoc stocks ks whos whose e pric price e move moveme ment nt is MARKET MARKET BASKET: BASKET: A grou expected to closely correlate with an index. MARK TO MARKET: The revaluation of a position at its current market price. MARKET MAKER: A trader or institution that plays a leading role in a market
by being prepared to quote a two way price (Bid and Ask) on request - or constantly in the case of some screen based markets - during normal market hours. NAKED: An investment in which options sold short are not matched with a
long position in either the underlying or another option of the same type that expires at the same time or later than the options sold. The loss potential of naked strategies can be virtually unlimited. unlimited. NET MARGIN REQUIREMENT: The equity required in a margin account to
support an option position after deducting the premium received from sold options. NEUTRAL: An adjective describing the belief that a stock or the market in
general will neither rise nor decline significantly. ONE-CANCELS-THE-OTHER ONE-CANCELS-THE-OTHER (OCO) ORDER: Type of order which treats two or
more option orders as a package, whereby the execution of any one of the orders causes all the orders to be reduced by the same amount. Can be placed as a day or GTC order. 148
OPTION CHAIN: A list of the options available for a given underlying.
corporati ation on owned owned by the OPTIONS OPTIONS CLEARIN CLEARING G CORPORAT CORPORATION ION (OCC): (OCC): A corpor exchanges that trade listed stock options; OCC is an intermediary between option buyers and sellers. OCC issues and guarantees all option contracts. OUT-OF-THE-MONEY OUT-OF-THE-MONEY (OTM): An out-of-the-money option is one whose strike
price is unfavorable in comparison to the current price of the underlying. This mean means s when when the the stri strike ke pric price e of a call call is grea greate terr than than the the pric price e of the the underlying, or the strike price of a put is less than the price of the underlying. An out-of-the-money out-of-the-money option has no intrinsic value, only time value. OVERVALUED: An adjective used to describe an option that is trading at a
price higher that its theoretical value. It must be remembered that this is a subjectiv subjective e evaluatio evaluation, n, because because theoretic theoretical al value value depends depends on one subjectiv subjective e input - the volatility estimate. PARITY: An adjective used to describe the difference between the stock price
and the strike price of an in-the-money option. When an option is trading at its intrinsic value, it is said to be trading at parity. PUT/CALL RATIO: This ratio is used by many as a leading indicator. It is
computed by dividing the 4-day average of total put VOLUME by the 4-day average of total call VOLUME. term used used loos loosel ely y to desc descri ribe be any any RATIO RATIO CALENDAR CALENDAR COMBINAT COMBINATION: ION: A term varia variatio tion n on an inves investme tment nt strate strategy gy that that invol involves ves both both puts puts and and calls calls in unequal quantities and at least two different strike prices and two different expirations. REALIZED GAINS AND LOSSES: The profit or losses received or paid when a
clos closiing transa ansact ctiion is made and match tched toge togetther wit with an open pening ing transaction. ROLLOVER: Moving a position from one expiration date to another further
into the future. As the front month approaches expiration, traders wishing to
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maintain their positions will often move them to the next contract month. This is accomplished by a simultaneous sale of one and purchase of the other. SCALPER: A trader on the floor of an exchange who hopes to buy on the bid
pric price, e, sell sell on the the ask ask pric price, e, and and prof profit it from from mome moment nt to mom moment ent pric price e movements. Risk is limited by the very short time duration (usually 10 seconds to 3 minutes) of maintaining maintaining any one position. SEC: The Securities and Exchange Commission. The SEC is the United States
federal government agency that regulates the securities industry. SECTOR INDICES: Indices that measure the performance of a narrow market
segment, such as biotechnology or small capitalization stocks. SETTLEMENT SETTLEMENT PRICE: The official price at the end of a trading session. This
pric price e is esta establ blis ishe hed d by The The Opti Option ons s Clea Cleari ring ng Corp Corpor orat atio ion n and and is used used to determ determine ine change changes s in accoun accountt equity equity,, margi margin n requir requireme ements nts,, and and for other other purposes. See mark-to-market. mark-to-market. STRIKE PRICE: The price at which the holder of an option has the right to
buy or sell the underlying. This is a fixed price per unit and is specified in the option contract. Also known as striking price or exercise price. SYNTHETIC: A strategy that uses options to mimic the underlying asset. Both
long and short synthetics are strategies in the Trade Finder. The long synthetic comb combin ines es a long long call call and and a shor shortt put put to mimi mimic c a long long posi positi tion on in the the underlying. The short synthetic combines a short call and a long put to mimic a short position in the underlying. In both cases, both the call and put have the same strike price, the same expiration, and are on the same underlying. TECHNICAL ANALYSIS: Method of predicting future price movements based
on histor historica icall marke markett data data such such as (among (among others others)) the prices prices themse themselve lves, s, trading volume, open interest, the relation of advancing issues to declining issues, and short selling volume.
150
TICK: The smallest unit price change allowed in trading a specific security.
This varies by security, and can also be dependent on the current price of the security. TIME DECAY: Term used to describe how the theoretical value of an option
"erodes" or reduces with the passage of time. Time decay is quantified by Theta. specif ific ic loca locati tion on on the the trad tradin ing g floo floorr of an exch exchan ange ge TRADING TRADING PIT: A spec designated for the trading of a specific option class or stock. TRANSACTION TRANSACTION COSTS: All charges associated with executing a trade and
maintai maintaining ning a position, position, includin including g brokerage brokerage commissio commissions, ns, fees for exercise exercise and/or assignment, and margin interest. shortt opti option on posi positi tion on that that is not not full fully y coll collat ater eral aliz ized ed if UNCOVERED: A shor notification of assignment is received. See also NAKED. UNREALIZED GAIN OR LOSS: The difference between the original cost of an
open position and its current market price. Once the position is closed, it becomes a realized gain or loss. VOLATILITY: Volatility is a measure of the amount by which an asset has
fluctuated, or is expected to fluctuate, in a given period of time. Assets with greater volatility exhibit wider price swings and their options are higher in price than less volatile assets. Volatility is not equivalent to BETA. trade design designed ed to take take advant advantage age of an expect expected ed VOLATILITY VOLATILITY TRADE: A trade change in volatility. WASH SALE: When an investor repurchases an asset within 30 days of the
sale date and reports the original sale as a tax loss. The Internal Revenue Service prohibits wash sales since no change in ownership takes place. invest stme ment nt with with a fini finite te life life,, the the valu value e of whic which h WASTING WASTING ASSET: ASSET: An inve decreases over time if there is no price fluctuation f luctuation in the underlying asset.
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BIBLIOGRAPHY Books: •
•
Derivatives: Valuation and Risk Management By David A. Dubofsky and Thomas W. Miller, JR., Published by Oxford University Press. Financia Financiall Engineeri Engineering: ng: A Complete Complete Guide to Financia Financiall Innovati Innovation on By John F. Marshall and Vipul K. Bansal, Published by Printice Hall of India.
Newspapers:•
The Times of India
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•
The Economic Times
Internet: •
www.economictimes.com
•
www.moneycontrol.com
•
www.bseindia.com
•
www.nseindia.com
•
www.sebi.gov.in
•
www.investors.com
•
www.investopedia.com
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