Derivative Bhumi

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    Financial market:-

    securities (such as stocks and bonds), commodities (such as precious metals oragricultural goods), Financial markets have evolved significantly over several

    hundred years and are undergoing Financial market is a mechanism that allows

    people to easily buy and sell (trade) financial constant innovation to improve

    liquidity.

    A system that facilitates the exchange of money for financial assets. A security

    market such as the National Stock Exchange is an example of a financial

    market.

    Equity market:-

    A equity market is a public market for the trading ofcompany stockat an

    agreed price; these are securities listed on a stock exchange as well as those only traded

    privately.

    Derivative market: -

    Financial market

    Equity market Derivative market

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    The derivatives markets are the financial markets for derivatives. The market

    can be divided into two, that for exchange traded derivatives (ETD) and that for over-the-

    counter derivatives(OTC).

    Introduction of derivatives:-

    The word DERIVATIVES is derived from the word itself derived of an

    underlying asset. It is a future image or copy of an underlying asset which may be shares,

    stocks, commodities, stock index, etc.

    For example, wheat farmers may wish to sell their harvest at a future date to eliminate therisk of a change in prices by that date. Such a transaction is an example of a derivative. The

    price of this derivative is driven by the spot price of wheat which is the "underlying".

    Derivatives have become very important in the field finance. They are very

    important financial instruments for risk management as they allow risks to be separated and

    traded. Derivatives are used to shift risk and act as a form of insurance. This shift of risk

    means that each party involved in the contract should be able to identify all the risks involved

    before the contract is agreed.

    It is also important to remember that derivatives are derived from an underlying

    asset. This means that risks in trading derivatives may change depending on what happens to

    the underlying asset. The underlying asset can be equity, forex, commodity or any other asset.

    For example, if the settlement price of a derivative is based on the stock price of a stock for

    e.g. Infosys, which frequently changes on a daily basis, then the derivative risks are also

    changing on a daily basis. This means that derivative risks and positions must be monitored

    constantly.

    http://en.wikipedia.org/wiki/Financial_markethttp://en.wikipedia.org/wiki/Derivative_%28finance%29http://en.wikipedia.org/wiki/Derivative_%28finance%29#Exchange_traded_derivativeshttp://en.wikipedia.org/wiki/Derivative_%28finance%29#Over-the-counter_derivativeshttp://en.wikipedia.org/wiki/Derivative_%28finance%29#Over-the-counter_derivativeshttp://en.wikipedia.org/wiki/Derivative_%28finance%29#Over-the-counter_derivativeshttp://en.wikipedia.org/wiki/Derivative_%28finance%29#Over-the-counter_derivativeshttp://en.wikipedia.org/wiki/Derivative_%28finance%29#Exchange_traded_derivativeshttp://en.wikipedia.org/wiki/Derivative_%28finance%29http://en.wikipedia.org/wiki/Financial_market
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    History of derivatives:-

    Derivative products initially emerged as hedging devices against fluctuations in

    commodity prices, stock 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 grown tremendously in terms of variety

    of instruments available, their 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 Chicago Board of Trade (CBOT), the largest derivative exchange in the world,

    was established in 1848 where forward contracts on various commodities were standardized

    around 1865. From then on, futures contracts have remained more or less in the same form,

    as we know them today.

    Exchange traded financial derivatives were introduced in India in June 2000 at the

    two major stock exchanges, NSE and BSE. There are various contracts currently traded on

    these exchanges. The derivatives market in India has grown exponentially, especially at NSE.

    Stock Futures are the most highly traded contracts on NSE accounting for around 55% of the

    total turnover of derivatives at NSE, as on April 13, 2005.

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    CONCEPT OF BADLA SYSTEM

    Badla is nothing but a carry forward system which means getting something in

    return. The badla system was acceptable to be an important need for the investors in the stock

    market. Here in this system the investor feels that the price of a particular share is expected to

    go up or down, without giving or taking the delivery he can participate in the possible

    fluctuation of the share.

    In the badla system, a position is carried forward, be it a short sale or a long purchase. In the

    event of a long purchase, the market player may want to carry forward the transaction to thenext settlement cycle and for doing this he has to compensate the other party in the contract.

    While in case of a short sale, the market player wants tom carry forward the transaction to the

    next settlement cycle, he has to borrow the stocks to compensate the other party in the

    contract

    THUS BADLA IS PURELY A MEANS OF CASH & SHARE FINANCING

    ILLUSTRATION

    The investor has purchased the 100shares of INFOSYS COMPANY for

    Rs.7000 which is trading at Rs. 7300. After this the investor expects to rise further.

    Therefore he wishes to carry the contract forward to the next trading session by paying what

    are called badla charges.

    In any badla transaction there are two key elements, the hawala rate and the

    bald charge for the scrip. The badla charge is the interest payable by the investor for carrying

    forward the position. It is fixed individually for each scrip by the exchange every Saturday

    and it is calculated on what is called the heal rate. The hawala rate is the price at which a

    share is squared up in the current settlement and carried forward into the next settlement in

    the next trading session. The existing position is squared up against the hawala rate fixed and

    carried forward after factoring in the badla rate. The difference is paid to the broker

    (charges).

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    Thus if hawala rata Rs.7180 is lower than the initial margin the difference is paid to the

    broker. The badla charges vary from broker to broker and proper relationship with the broker

    If broker insists on a 25% margin, the investor get 400% leverage or four times the amount

    investor is ready to deposit as margin. Thus At the end of each settlement, investor carry

    forward the position at the hawala rate. This position will also be adjusted for badla. Thus

    investor can carry forward the transactions for settlement

    BADLA WAS BANNED ON 2nd

    JULY 2001

    The badla was banned because more exposure was given to the speculation

    and also the investor has to wait for 5days for the delivery of shares because the rolling

    settlement was T+5 days. As badla system is a combination of lending and borrowingmechanism of the stocks which further associated with risks. As badla was banned between

    the intermediator was not the exchanges but the brokers. This system was time consuming

    because it involves more Paper work. Thus if the broker becomes insolvent then they are not

    responsible for the investors funds.

    As carry forward were more a method of lending and borrowing of

    shares and Funds. Here the borrower of shares or funds pays a fee or badla charges for the

    borrowing and in the badla the futures prices were mixed up with the cash price.

    The badla charges include a default risk premium because of the counterparty

    risk inherent in the transaction. Further in the badla the position could break down if

    borrowing/lending also proved infeasible. There is no expiration date in the badla system

    which results into uncertainty. Finally in badla the net long (buy) positions would differ from

    the net short (sell) positions.

    Aims and objectives of derivatives:-

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    1. To explore the derivative market in India.

    2. To know what derivatives are available in India.

    3. To know derivatives trading mechanism of exchanges.

    4. To become aware of what strategies are followed by Indian Investors.

    5. To know how derivatives are used in covering risk

    6. To know how derivatives give a safe exposure.

    Need for derivative market:-

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

    2. They help in the discovery of future as well as current prices.

    3. They catalyze entrepreneurial activity.

    4.

    They increase the volume traded in markets because of participation of risk adverse

    people in greater numbers.

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

    Purpose and benefits of derivative market;-

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    1. Today's sophisticated international markets have helped foster the rapid growth in

    derivative instruments. In the hands of knowledgeable investors, derivatives can

    derive profit from:

    Changes in interest rates and equity markets around the world.

    Changes in price of assets.

    2. Help of hedge against inflation and deflation, and generate returns that are not

    correlated with more traditional investments. The two most widely recognized

    benefits attributed to derivative instruments are price discovery and risk

    management and others.

    3. Price discovery: -

    The kind of information and the way people absorb it constantly

    changes the price of a commodity. This process is known as price discovery. the price

    of all future contracts serve as prices that can be accepted by those who trade the

    contracts in lieu of facing the risk of uncertain future prices.

    4. Risk management: -

    This could be the most important purpose of the derivatives

    market. Risk management is the process of identifying the desired level of risk,

    identifying the actual level of risk and altering the latter to equal the former. This

    process can fall into the categories of hedging and speculation.

    5. Derivatives help in transferring risks from risk-averse people to risk-oriented people.

    6.

    By allowing transfer of unwanted risks, derivatives can promote more efficient

    allocation of capital across the economy and thus, increasing productivity in the

    economy.

    7. Derivatives increase the volume traded in markets because of participation of risk-

    averse people in greater numbers.

    Factors driving the growth of derivatives:-

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    Over the last three decades, the derivatives market has seen a

    phenomenal growth. A large variety of derivative contracts have been launched at

    exchanges across the world. Some of the factors driving the growth of financial

    derivatives are:

    1. Increased volatility in asset prices in financial markets,

    2. Increased integration of national financial markets with the international markets,

    3. Marked improvement in communication facilities and sharp decline in their costs,

    4. Development of more sophisticated risk management tools, providing economic

    agents a wider choice of risk management strategies, and

    5. Innovations in the derivatives markets, which optimally combine the risks and

    returns over a large number of financial assets leading to higher returns, reduced

    risk as well as transactions costs as compared to individual financial assets.

    Derivative market is divided in two markets:-

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    Over the counter:-

    Over the counter derivatives are contracts that are traded (and

    privately negotiated) directly between two parties, without going through an exchange or

    other intermediary. Products such as swaps and forward rate agreements are almost always

    traded in this way. The OTC derivative market is the largest market for derivatives, and is

    largely unregulated with respect to disclosure of information between the parties, since the

    OTC market is made up of banks and other highly sophisticated parties.

    Derivative market

    Over the counter (OTC) Exchange traded

    derivatives (ETD)

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    Because OTC derivatives are not traded on an exchange, there is no

    central counterparty. Therefore, they are subject to counterparty risk, like an ordinary

    contract, since each counter party relies on the other to perform.

    Features of over the counter derivatives:-

    1. The management of counter-party (credit) risk is decentralized and located within

    individual institutions.

    2.

    There are no formal centralized limits on individual positions, leverage, or margining.

    3. There are no formal rules for risk and burden-sharing.

    4. There are no formal rules or mechanisms for ensuring market stability and integrity,

    and for safeguarding the collective interests of market participants, and

    5.

    The OTC contracts are generally not regulated by a regulatory authority and theexchange's self-regulatory organization.

    6. When asset prices change rapidly, the size and configuration of counter-party

    exposures can become unsustainably large and provoke a rapid unwinding of

    positions.

    Exchange traded derivatives:-

    They are standardized ones where the exchange sets the

    standards for trading by providing the contract specifications and the clearing corporation

    provides the trade guarantee and the settlement activities. Futures and Options are the

    derivatives. Products like futures and options are traded in this way.

    In the exchange traded derivatives is the largest market for derivatives.

    In this type of derivatives a highly regulated exchange is involved which is Security

    Exchange Board of India (SEBI).

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    Features of Exchange Traded Derivatives:-

    1.

    The management of counter party risk is centralized and located with high

    institutions.

    2. There are formal centralized limits on individual positions, leverage, or

    margining

    3. There are formal rules for risk and burden-sharing.

    4.

    There are formal rules or mechanisms for ensuring market stability and

    integrity, and for safeguarding the collective interests of market participants,

    and

    5. The exchange traded contracts are generally regulated by a regulatory

    authority.

    Types of derivatives:-

    Derivative contracts have several types. The most common variants are forwards,

    futures, options and swaps.

    1. 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 pre-agreed price.

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    2. 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 special

    types of forward contracts in the sense that the former are standardized exchange-

    traded contracts.

    3. 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.

    4. Warrants:

    Options generally have lives of up to one year; the majority of options

    traded on options exchanges having a maximum maturity of nine months. Longer-

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

    5.

    LEAPS:The acronym LEAPS means Long-Term Equity Anticipation Securities.

    These are options having a maturity of up to three years.

    6. 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.

    7. 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:

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    Interest rate swaps:

    These entail swapping only the interest related cash flow between

    the parties in the same currency.

    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.

    8. 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.

    Forward contract:-

    It is an agreement between two parties to buy or sell an asset on a specified

    date for a specified price. A forward contract is a simple derivative. It is a type of market

    where buyer and seller predict the future for the underlying asset which may be stocks,

    currency, interest rate etc. One of the parties to the contract assumes a long position which

    agrees to buy underlying asset for a certain specified price. The other Party assumes a short

    position and agrees to sell at the same price. Forward contract can be 30days, 90days and

    180days

    The contract is usually between two financial institutions or between a

    financial institution and its corporate client. A forward contract is not normally traded on anexchange. It is traded on the OTC (over the counter) derivatives where the intermediator or

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    exchange has no role to play and contract is smoothly settled by the parties or normally

    traded outside the exchanges.

    At delivery, ownership of the good is transferred and payment is made. In

    other words, whereas the forward contract is executed today, and the price is agreed upon

    today, the actual transaction in which the underlying asset is traded does not take place until a

    later date. Typically, no money changes hands on the origination date of a forward contract.

    Forward contracts are not standardized unlike futures contracts. They are

    customized and each contract is unique in terms of contract size, expiration date and the asset

    type and quality. Terms of Forward contracts are negotiated between buyer and seller. As

    there is no exchange involved in it there is chance of default of either party.

    Forward contracts are very useful in hedging and speculation. Here the

    importer and exporter can hedge their risk exposure with respect to exchange rate fluctuations

    while entering into the currency forward market.

    The first formal commodities exchange in the United States for spot and

    forward contracting was formatted in 1848: the Chicago Board of Trade (CBOT).

    ILLUSTRATION

    On 1st

    march 2004 Mukesh has entered into a forward contract with Anil In this Mukesh

    takes a long position(buy) on the scrip and Anil takes a short position(short) on the scrip.

    Here Mukesh agrees to purchase 100 shares of RELIANCE ENERGY from the Anil for a

    predetermined price of Rs.400.The contract is three months forward. Thus on future Anil will

    deliver the shares to Mukesh while in return Mukesh will pay the amount of

    Rs.40,000(400*100).

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    Suppose during the maturity date Mukesh may default for the transaction he refuse to

    make the payment for the shares or Anil refuse to deliver the shares. Therefore in this there is

    a counter party risk one party may default due to this other party suffers because there is no

    standardized exchange between the parties and the contract is OTC in nature and also prices

    are decided by the buyers and sellers.

    Finally forward contract is settled at maturity. The holder of the short position delivers the

    asset to the holder of the long position in return for cash at the agreed upon rate. Therefore, a

    key determinant of the value of the contract is the market price of the underlying asset. A

    forward contract can therefore, assume a positive or negative value depending on themovements of the price of the asset. For example, if the price of the asset rises sharply after

    the two parties have entered into the contract, the party holding the long position stands to

    benefit, i.e. the value of the contract is positive for her. Conversely, the value of the contract

    becomes negative for the party holding the short position.

    Future contract:-

    A future contract is similar to a forward contract. It is a standardized

    forward contract that can be easily traded. In future contract default risk is lower on futures

    than on forwards for several reasons:-

    a) The counterparty to all futures trades is actually the clearing house of the futures

    exchange, which guarantees that all payments will be made.

    b)

    Future contracts are marked to market daily settled which means that any change

    in the value of the contract is realized as a profit or loss every day.

    c) Initial margin, which serves as a performance bond, is required when trading

    futures. In contrast, because they are not marked to market, forward contracts can

    build up large unrealized profits for one party and equally large unrealized losses

    for the other party.

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    There is a multilateral contract between the buyer and seller for an

    underlying asset which may be financial instrument or physical commodities. But unlike

    forward contracts the future contracts are standardized and exchange traded.

    The primary purpose of futures market is to provide an efficient and

    effective mechanism for management of inherent risks, without counter-party risk. As it is a

    future contract the buyer and seller has to pay the margin to trade in the futures market.

    The standardized items in a futures contract are:

    Quantity of the underlying

    Quality of the underlying

    The date and the month of delivery The units of price quotation and minimum price change.

    . Location of settlement.

    The current market price of INFOSYS COMPANY is Rs.1650.

    There are two parties in the contract i.e. Hitesh and Kishore. Hitesh is bullish and Kishore is

    bearish in the market. The initial margin is 10%. paid by the both parties. Here the Hitesh has

    purchased the one month contract of INFOSYS futures with the price of Rs.1650.The lot size

    of Infosys is 300 shares.

    Suppose the stock rises to 2200.

    Profit

    20

    2200

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    10

    0

    1400 1500 1600 1700 1800 1900

    -10

    -20

    Loss

    Unlimited profit for the buyer (Hitesh) = Rs.1, 65,000 [(2200-1650*3oo)] and notional profit

    for the buyer is 550.

    Unlimited loss for the buyer because the buyer is bearish in the market

    Suppose the stock falls to Rs.1400

    Profit

    20

    10

    0

    1400 1500 1600 1700 1800 1900

    -10

    -20

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    Loss

    Unlimited profit for the seller = Rs.75,000.[(1650-1400*300)] and notional profit for the

    seller is 250.

    Unlimited loss for the seller because the seller is bullish in the market.

    History of future derivatives:-

    Merton Miller, the 1990 Nobel laureate had said that 'financial

    futures represent the most significant financial innovation of the last twenty years." The first

    exchange that traded financial derivatives was launched in Chicago in the year 1972. A

    division of the Chicago Mercantile Exchange, it was called the International Monetary

    Market (IMM) and traded currency futures. The brain behind this was a man called Leo

    Melamed, acknowledged as the 'father of financial futures" who was then the Chairman of the

    Chicago Mercantile Exchange. Before IMM opened in 1972, the Chicago Mercantile

    Exchange sold contracts whose value was counted in millions. By 1990, the underlying value

    of all contracts traded at the Chicago Mercantile Exchange totaled 50 trillion dollar.

    FUTURES TERMINOLOGY:-

    a) Spot price: The price at which an asset trades in the spot market.

    b) Futures price: The price at which the futures contract trades in the futures

    market.

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    c) Contract cycle: The period over which a contract trades. The index futures

    contracts on the NSE have one- month, two-month and three months expiry

    cycles which expire on the last Thursday of the month. Thus a January expiration

    contract expires on the last Thursday 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.

    d) 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.

    e) Contract size: The amount of asset that has to be delivered under one contract.

    Also called as lot size.

    f) 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.

    g) 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.

    h)

    Initial margin: The amount that must be deposited in the margin account at the

    time a futures contract is first entered into is known as initial margin.

    i) 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.

    j)

    Maintenance margin: This is somewhat lower than the initial margin. This is set

    to ensure that the balance in the margin account never becomes negative. If the

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    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.

    Introduction to options:-

    It is an interesting tool for small retail investors. An option is a contract,

    which gives the buyer (holder) the right, but not the obligation, to buy or sell specified

    quantity of the underlying assets, at a specific (strike) price on or before a specified time

    (expiration date). The underlying may be physical commodities like wheat/ rice/ cotton/ gold/

    oil or financial instruments like equity stocks/ stock index/ bonds etc.

    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, 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. The options are also traded on stock exchange.

    Terminologies of options:-

    CALL OPTION

    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. To acquire this right the buyer pays a

    premium to the writer (seller) of the contract.

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    ILLUSTRATION

    Suppose in this option there are two parties one is Mahesh (call buyer) who is bullish in the

    market and other is Rakesh (call seller) who is bearish in the market.

    The current market price of RELIANCE COMPANY is Rs.600 and premium is Rs.25

    1. CALL BUYER

    Here the Mahesh has purchase the call option with a strike price of Rs.600.The option will be

    exercised once the price went above 600. The premium paid by the buyer is Rs.25.The buyerwill earn profit once the share price crossed to Rs.625 (strike price + premium). Suppose the

    stock has crossed Rs.660 the option will be exercised the buyer will purchase the RELIANCE

    scrip from the seller at Rs.600 and sell in the market at Rs.660.

    Profit

    30

    20

    10

    0 590 600 610 620 630 640

    -10

    -20

    -30

    Loss

    Unlimited profit for the buyer = Rs.35{(spot price strike price)

    premium}

    Limited loss for the buyer up to the premium paid.

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    2. CALL SELLER:

    In another scenario, if at the tie of expiry stock price falls below Rs. 600 say suppose the

    stock price fall to Rs.550 the buyer will choose not to exercise the option.

    Profit

    30

    20

    10

    0 590 600 610 620 630 640

    -10

    -20

    -30

    Loss

    Profit for the Seller limited to the premium received = Rs.25

    Loss unlimited for the seller if price touches above 600 say 630 then the loss of Rs.30

    Finally the stock price goes to Rs.610 the buyer will not exercise the option because he has

    the lost the premium of Rs.25.So he will buy the share from the seller at Rs.610.

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    Thus from the above example it shows that option contracts are formed so to avoid the

    unlimited losses and have limited losses to the certain extent

    Thus call option indicates two positions as follows:

    1) LONG POSITION

    If the investor expects price to rise i.e. bullish in the market he takes a long position by

    buying call option.

    2)

    SHORT POSITION

    If the investor expects price to fall i.e. bearish in the market he takes a short position by

    selling call option.

    PUT OPTION

    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.

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    ILLUSTRATION

    Suppose in this option there are two parties one is Dinesh (put buyer) who is bearish in the

    market and other is Amit (put seller) who is bullish in the market.

    The current market price of TISCO COMPANY is Rs.800 and premium is Rs.20.

    1) PUT BUYER (Dinesh):

    Here the Dinesh has purchase the put option with a strike price of Rs.800.The option will be

    exercised once the price went below 800. The premium paid by the buyer is Rs.20.The

    buyers breakeven point is Rs.780(Strike price Premium paid). The buyer will earn profit

    once the share price crossed below to Rs.780. Suppose the stock has crossed Rs.700 the

    option will be exercised the buyer will purchase the RELIANCE scrip from the market at

    Rs.700 and sell to the seller at Rs.800.

    Profit

    20

    10

    0 600 700 800 900 1000 1100

    10

    20

    Loss

    Unlimited profit for the buyer = Rs.80 {(Strike pricespot price)premium}

    Loss limited for the buyer up to the premium paid = 20.

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    2) PUT SELLER (Amit):

    In another scenario, if at the time of expiry, market price of TISCO is Rs. 900. 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.

    Profit

    20

    10

    0 600 700 800 900 1000 1100

    10

    20

    Loss

    Unlimited loses for the seller if stock price below 780 say 750 then unlimited losses for

    the seller because the seller is bullish in the market = 780 - 750 = 30

    Limited profit for the seller up to the premium received = 20

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    Thus Put option also indicates two positions as follows:

    LONG POSITION

    If the investor expects price to fall i.e. bearish in the market he takes

    a long position by buying Put option.

    SHORT POSITION

    If the investor expects price to rise i.e. bullish in the market he takes

    a short position by selling Put option.

    CALL OPTIONS PUT OPTIONS

    Option buyer or

    option holder

    Buys the right to buy the

    underlying asset at the

    specified price

    Buys the right to sell the

    underlying asset at the

    specified price

    Option seller or

    option writer

    Has the obligation to sell the

    underlying asset (to theoption holder) at the specified

    price

    Has the obligation to buy the

    underlying asset (from theoption holder) at the specified

    price.

    3)Index options:

    These options have the index as the underlying. Some options

    are European while others are American. Like index futures contracts, index

    options contracts are also cash settled.

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    4) 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.

    5)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.

    6) Writer of an option:

    The writer of a call/put option is the one who receive

    the option premium and is thereby obliged to sell/buy the asset if the buyer

    exercises on him. There are two basic types of options, call options and put

    options.

    7) Option price/premium:

    Option price is the price which the option buyer paysto the option seller. It is also referred to as the option premium.

    8)Expiration date:

    The date specified in the options contract is known as the

    expiration date, the exercise date, the strike date or the maturity.

    9) Strike price:

    The price specified in the options contract is known as the strike

    price or the exercise price.

    10) American options :

    American options are options that can be exercised at anytime up to the expiration date. Most exchange-traded options are American.

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    11)European options:

    European options are options that can be exercised only on

    the expiration date itself. European options are easier to analyze than Americanoptions, and properties of an American option are frequently deduced from those

    of its European counterpart.

    12) 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. A call

    option on the index is said to be in-the-money when the current index stands at alevel 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.

    13) 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).

    14) Out-of-the-money option:

    An out-of-the-money (OTM) option is an option thatwould lead to a negative cash flow if it were exercised immediately. A call option

    on the index is out-of-the-money when the 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.

    15) Time value of an option:

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    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.

    FACTORS AFFECTING OPTION PREMIUM

    THE PRICE OF THE UNDERLYING ASSET: (S)

    Changes in the underlying asset price can increase or decrease the premium of an option.

    These price changes have opposite effects on calls and puts.

    For instance, as the price of the underlying asset rises, the premium of a call will increase and

    the premium of a put will decrease. A decrease in the price of the underlying assets value

    will generally have the opposite effect.

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    THE SRIKE PRICE: (K)

    The strike price determines whether or not an option has any intrinsic value. An options

    premium generally increases as the option gets further in the money, and decreases as the

    option becomes more deeply out of the money.

    Time until expiration: (t)

    An expiration approaches, the level of an options time value, for puts and calls, decreases.

    Volatility:

    Volatility is simply a measure of risk (uncertainty), or variability of an options underlying.

    Higher volatility estimates reflect greater expected fluctuations (in either direction) in

    underlying price levels. This expectation generally results in higher option premiums for putsand calls alike, and is most noticeable with at- the- money options.

    Interest rate: (R1)

    This effect reflects the COST OF CARRY the interest that might be paid for margin, in

    case of an option seller or received from alternative investments in the case of an optionbuyer for the premium paid.

    Higher the interest rate, higher is the premium of the option as the cost of carry increases.

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    PLAYERS IN THE OPTION MARKET:-

    Developmental institutions

    Mutual Funds

    Domestic & Foreign Institutional Investors

    Brokers

    Retail Participants

    FUTURES V/S OPTIONS

    RIGHT OR OBLIGATION :

    Futures are agreements/contracts to buy or sell specified quantity of the underlying assets

    at a price agreed upon by the buyer & seller, on or before a specified time. Both the buyer

    and seller are obligated to buy/sell the underlying asset. In case of options the buyer enjoys the

    right & not the obligation, to buy or sell the underlying asset.

    RISK:

    Futures Contracts have symmetric risk profile for both the buyer as well as the seller. While

    options have asymmetric risk profile. In case of Options, for a buyer (or holder of the option),

    the downside is limited to the premium (option price) he has paid while the profits may be

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    unlimited. For a seller or writer of an option, however, the downside is unlimited while

    profits are limited to the premium he has received from the buyer.

    PRICES:

    The Futures contracts prices are affected mainly by the prices of the underlying asset. While

    the prices of options are however, affected by prices of the underlying asset, time remaining

    for expiry of the contract & volatility of the underlying asset.

    COST:

    It costs nothing to enter into a futures contract whereas there is a cost of entering into an

    options contract, termed as Premium.

    STRIKE PRICE:

    In the Futures contract the strike price moves while in the option contract the strike price

    remains constant.

    Liquidity:

    As Futures contract are more popular as compared to options. Also the premium charged is

    high in the options. So there is a limited Liquidity in the options as compared to Futures.

    There is no dedicated trading and investors in the options contract.

    Price behavior:

    The trading in future contract is one-dimensional as the price of future depends upon the

    price of the underlying only. While trading in option is two-dimensional as the price of the

    option depends upon the price and volatility of the underlying.

    PAY OFF:

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    As options contract are less active as compared to futures which results into non linear pay

    off. While futures are more active has linear pay off.

    FUTURES PAYOFFS

    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 potentiallyunlimited downside. Take the case of a speculator who buys a two month Nifty index

    futures contract when the Nifty stands at 2220. 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. Figure 4.1 shows the payoff

    diagram for the buyer of a futures contract.

    Payoff for a buyer of Nifty futures

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    The figure shows the profits/losses for a long futures position. The investor bought futures

    when the index was at 2220. If the index goes up, his futures position starts making profit. If

    the index falls, his futures position starts showing 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 2220. 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. Figure shows the payoff diagram for the seller of a futures

    contract.

    Payoff for a seller of Nifty futures

    The figure shows the profits/losses for a short futures position. The investor sold futures

    when the index was at 2220. If the index goes down, his futures position starts making profit.

    If the index rises, his futures position starts showing losses.

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    OPTIONS PAYOFFS

    The optionality characteristic of options results in a non-linear payoff for options. In simple

    words, it means that the losses for the buyer of an option are limited; however the profits are

    potentially unlimited. For a writer, the payoff is exactly the opposite. His profits are limited

    to the option premium; however his losses are potentially unlimited. These non-linear 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 2220, and sells it at a future date at an unknown price, St. Once it is

    purchased, the investor is said to be "long" the asset. Figure shows the payoff

    for a long position on the Nifty.

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    Payoff profile for seller of asset: Short asset

    In this basic position, an investor shorts the underlying asset, Nifty for instance, for 2220, and

    buys it back at a future date at an unknown price, St. Once it is sold, the investor is said to be

    "short" the asset. Figure shows the payoff for a short position on the Nifty.

    Payoff profile 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 lessthan the strike price, he lets his option expire un-exercised. His loss in this case is the

    premium he paid for buying the option. Figure 4.6 gives the payoff for the buyer of a three

    month call option (often referred to as long call) with strike of 2250 bought at a premium of

    86.60.

    Payoff for investor who went Long Nifty at 2220

    The figure shows the profits/losses from a long position on the index. The investor bought the

    index at 2220. If the index goes up, he profits. If the index falls he looses.

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    Payoff for investor who went Short Nifty at 2220

    The figure shows the profits/losses from a short position on the index. The investor sold the

    index at 2220. If the index falls, he profits. If the index rises, he looses.

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    Payoff for buyer of call option

    The figure shows the profits/losses for the buyer of a three-month Nifty 2250 call option. As

    can be seen, as the spot Nifty rises, the call option is in-the-money. If upon expiration, Nifty

    closes above the strike of 2250, the buyer would exercise his option and profit to the extent of

    the difference between the Nifty-close and the strike price. The profits possible on this option

    are potentially unlimited. However if Nifty falls below the strike of 2250, he lets the option

    expire. His losses are limited to the extent of the premium he paid for buying the option.

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    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 charges a premium. The

    profit/loss that the buyer makes on the option 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. 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 hisoption expire un-exercised and the writer gets to keep the premium. Figure gives the payoff

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    for the writer of a three month call option (often referred to as short call) with a strike of 2250

    sold at a premium of 86.60.

    Payoff for writer of call option

    The figure shows the profits/losses for the seller of a three-month Nifty 2250 call option. As

    the spot Nifty rises, the call option is in-the-money and the writer starts making losses. If

    upon expiration, Nifty closes above the strike of 2250, the buyer would exercise his option on

    the writer who would suffer a loss to the extent of the difference between the Nifty -close and

    the strike price. The loss that can be incurred by the writer of the option is potentially

    unlimited, whereas the maximum profit is limited to the extent of the up-front option

    premium of Rs.86.60 charged by him.

    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 price, he lets his option expire un-

    exercised. His loss in this case is the premium he paid for buying the option. Figure 4.8

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    gives the payoff for the buyer of a three month put option (often referred to as long put)

    with a strike of 2250 bought at a premium of 61.70.

    Payoff for buyer of put option

    The figure shows the profits/losses for the buyer of a three-month Nifty 2250 put option. As

    can be seen, as the spot Nifty falls, the put option is in-the-money. If upon expiration, Nifty

    closes below the strike of 2250, the buyer would exercise his option and profit to the extent of

    the difference between the strike price and Nifty-close. The profits possible on this option can

    be as high as the strike price. However if Nifty rises above the strike of 2250, he lets the

    option expire. His losses are limited to the extent of the premium he paid for buying the

    option.

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    o 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 charges a premium. The

    profit/loss that the buyer makes on the option 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 unexercised and the writer

    gets to keep the premium. Figure 4.9 gives the payoff for the writer of a three month putoption (often referred to as short put) with a strike of 2250 sold at a premium of 61.70.

    o Payoff for writer of put option

    The figure shows the profits/losses for the seller of a

    three-month Nifty 2250 put option. As the spot Nifty falls, the put option is in-the-money andthe writer starts making losses. If upon expiration, Nifty closes below the strike of 2250, the

    buyer would exercise his option on the writer who would suffer a loss to the extent of the

    difference between the strike price and Nifty-close. The loss that can be incurred by the

    writer of the option is a maximum extent of the strike price (Since the worst that can happen

    is that the asset price can fall to zero) whereas the maximum profit is limited to the extent of

    the up-front option premium of Rs.61.70 charged by him.

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    APPLICATION OF OPTIONS

    Since the index is nothing but a security whose price or level is a weighted average of

    securities constituting the index, all strategies that can be implemented using stock futures

    can also be implemented using index options.

    o Hedging: Have underlying buy puts

    Owners of stocks or equity portfolios often experience discomfort

    about the overall stock market movement. As an owner of stocks or an equity portfolio,

    sometimes you may have a view that stock prices will fall in the near future. At other times

    you may see that the market is in for a few days or weeks of massive volatility, and you 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. One way to protect

    your portfolio from potential downside due to a market drop is to buy insurance using put

    options.

    Index and stock options are a cheap and easily implementable way of seeking this insurance.

    The idea is simple. To protect the value of your portfolio from falling below a particular

    level, buy the right number of put options with the right strike price. If you are only

    concerned about the value of a particular stock that you hold, buy put options on that stock.

    If you are concerned about the overall portfolio, buy put options on the

    index. When the stock price falls your stock will lose value and the put options bought by you

    will gain, effectively ensuring that the total value of your stock plus put does not fall below a

    particular level. This level depends on the strike price of the stock options chosen by you.

    Similarly when the index falls, your portfolio will lose value and the put options bought by

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    you will gain, effectively ensuring that the value of your portfolio does not fall below a

    particular level. This level depends on the strike price of the index options chosen by you.

    Portfolio insurance using put options is of particular interest to mutual funds who already

    own well-diversified portfolios. By buying puts, the fund can limit its downside in case of a

    market fall.

    Speculation: Bullish security, buy calls or sell puts

    There are times when investors believe that security prices are going to rise.

    For instance, after a good budget, or good corporate results, or the onset of a stable

    government. How does one implement a trading strategy to benefit from an upward

    movement in the underlying security? Using options there are two ways one can do this:

    1. Buy call options; or

    2. Sell put options

    We have already seen the payoff of a call option. The downside to the

    buyer of the call option is limited to the option premium he pays for buying the option. His

    upside however is potentially unlimited. Suppose you have a hunch that the price of a

    particular security is going to rise in a months time. Your hunch proves correct and the price

    does indeed rise, it is this upside that you cash in on.

    However, if your hunch proves to be wrong and the security price

    plunges down, what you lose is only the option premium. Having decided to buy a call,

    which one should you buy? Table 4.1 gives the premium for one month calls and puts with

    different strikes. Given that there are a number of one-month calls trading, each with a

    different strike price, the obvious question is: which strike should you choose? Let us take a

    look at call options with different strike prices. Assume that the current price level is 1250,

    risk-free rate is 12% per year and volatility of the underlying security is 30%.

    The following options are available:

    1. A one month calls with a strike of 1200.

    2. A one month call with a strike of 1225.

    3. A one month call with a strike of 1250.

    4. A one month call with a strike of 1275.

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    5. A one month call with a strike of 1300.

    Which of these options you choose largely depends on how strongly you feel

    about the likelihood of the upward movement in the price, and how much you are willing to

    lose should this upward movement not come about. There are five one-month calls and five

    one-month puts trading in the market. The call with a strike of 1200 is deep in-the-money and

    hence trades at a higher premium. The call with a strike of 1275 is out-of-the-money and

    trades at a low premium.

    The call with a strike of 1300 is deep-out-of-money. Its execution depends

    on the unlikely event that the underlying will rise by more than 50 points on the expiration

    date. Hence buying this call is basically like buying a lottery. There is a small probability that

    it may be in-the-money by expiration, in which case the buyer will make profits. In the more

    likely event of the call expiring out-of-the-money, the buyer simply loses the small premium

    amount of Rs.27.50.

    As a person who wants to speculate on the hunch that prices may rise, you

    can also do so by selling or writing puts. As the writer of puts, you face a limited upside and

    an unlimited downside. If prices do rise, the buyer of the put will let the option expire and

    you will earn the premium. If however your hunch about an upward movement proves to be

    wrong and prices actually fall, then your losses directly increase with the falling price level.

    If for instance the price of the underlying falls to 1230 and you've sold a put with an exercise

    of 1300, the buyer

    Of the put will exercise the option and you'll end up losing Rs.70. Taking into account the

    premium earned by you when you sold the put, the net loss on the trade is Rs.5.20.

    Having decided to write a put, which one should you write? Given that there are a number of

    one-month puts trading, each with a different strike price, the obvious question is: which

    strike should you choose? This largely depends on how strongly you feel about the likelihood

    of the upward movement in the prices of the underlying. If you write an at-the-money put, the

    option premium earned by you will be higher than if you write an out-of-the-money put.

    However the chances of an at-the-money put being exercised on you are higher as well.

    o

    One month calls and puts trading at different strikes

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    The spot price is 1250. There are five one-month calls and five one-month puts trading in the

    market. The call with a strike of 1200 is deep in-the-money and hence trades at a higher

    premium. The call with a strike of 1275 is out-of-the-money and trades at a low premium.

    The call with a strike of 1300 is deep-out-of-money. Its execution depends on the unlikely

    event that the price of underlying will rise by more than 50 points on the expiration date.

    Hence buying this call is basically like buying a lottery. There is a small probability that it

    may be in-the-money by expiration in which case the buyer will profit. In the more likely

    event of the call expiring out-of-the-money, the buyer simply loses the small premium

    amount of Rs. 27.50. Figure 4.10 shows the payoffs from buying calls at different strikes.

    Similarly, the put with a strike of 1300 is deep in-the-money and trades at a higher premium

    than the at-the-money put at a strike of 1250. The put with a strike of 1200 is deep out-of-the-

    money and will only be exercised in the unlikely event that underlying falls by 50 points on

    the expiration date.

    Show the payoffs from writing puts at different strikes.

    Underlying Strike price of

    option

    Call premium

    (Rs.)

    Put premium (Rs.)

    1250 1200 80.10 18.15

    1250 1225 63.65 26.50

    1250 1250 49.45 37.00

    1250 1275 37.50 49.80

    1250 1300 27.50 64.80

    At a price level of 1250, one option is in-the-money and one is out-of-the-money. As

    expected, the in-the-money option fetches the highest premium of Rs.64.80 whereas the out-

    of-the-money option has the lowest premium of Rs. 18.15.

    o Speculation: Bearish security, sell calls or buy puts

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    Do you sometimes think that the market is going to drop? That you could

    make a profit by adopting a position on the market? Due to poor corporate results, or the

    instability of the government, many people feel that the stocks prices would go down. How

    does one implement a trading strategy to benefit from a downward movement in the market?

    Today, using options, you have two choices:

    1. Sell call options; or

    2. Buy put options

    We have already seen the payoff of a call option. The upside to the writer of the

    call option is limited to the option premium he receives upright for writing the option. His

    downside however is potentially unlimited. Suppose you have a hunch that the price of a

    particular security is going to fall in a months time. Your hunch proves correct and it does

    indeed fall, it is this downside that you cash in on. When the price falls, the buyer of the call

    lets the call expire and you get to keep the premium. However, if your hunch proves to be

    wrong and the market soars up instead, what you lose is directly proportional to the rise in the

    price of the security.

    REGULATORY FRAMEWORK

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    The trading of derivatives is governed by the provisions contained in the

    SC(R)A, the SEBI Act, the rules and regulations framed there under and the rules and bye

    laws of stock exchanges.

    SECURITIES CONTRACTS (REGULATION) ACT, 1956

    SC(R)A aims at preventing undesirable transactions in securities by

    regulating the business of dealing therein and by providing for certain other matters

    connected therewith. This is the principal Act, which governs the trading of securities in

    India. The term securities has been defined in the SC(R)A. As per Section 2(h), the

    Securities include:

    1.

    Shares, scrips, stocks, bonds, debentures, debenture stock or other marketable

    securities of a like nature in or of any incorporated company or other body corporate.

    2. Derivative

    3. Units or any other instrument issued by any collective investment scheme to the

    investors in such schemes.

    4. Government securities

    5. Such other instruments as may be declared by the Central Government to be

    securities.

    6. Rights or interests in securities.

    Derivative is defined to include:

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    A security derived from a debt instrument, share, loan whether secured or unsecured,

    risk instrument or contract for differences or any other form of security.

    A contract which derives its value from the prices, or index of prices, of underlying

    securities.

    Section 18A provides that notwithstanding anything contained in any other law for the time

    being in force, contracts in derivative shall be legal and valid if such contracts are:

    Traded on a recognized stock exchange Settled on the clearing house of the recognized stock

    exchange, in accordance with the rules and byelaws of such stock exchanges.

    SECURITIES AND EXCHANGE BOARD OF INDIA ACT, 1992

    SEBI Act, 1992 provides for establishment of Securities and Exchange Board

    of India(SEBI) with statutory powers for (a) protecting the interests of investors in securities

    (b) promoting the development of the securities market and (c) regulating the securities

    market. Its regulatory jurisdiction extends over corporates in the issuance of capital and

    transfer of securities, in addition to all intermediaries and persons associated with securities

    market. SEBI has been obligated to perform the aforesaid functions by such measures as it

    thinks fit. In particular, it has powers for:

    regulating the business in stock exchanges and any other securities markets.

    registering and regulating the working of stock brokers, subbrokers etc.

    promoting and regulating self-regulatory organizations.

    prohibiting fraudulent and unfair trade practices.

    calling for information from, undertaking inspection, conducting inquiries and audits of the

    stock exchanges, mutual funds and other persons associated with the securities market and

    intermediaries and selfregulatory organizations in the securities market.

    performing such functions and exercising according to Securities

    Contracts (Regulation) Act, 1956, as may be delegated to it by the Central Government.

    REGULATION FOR DERIVATIVES TRADING

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    SEBI set up a 24- member committee under the Chairmanship of Dr. L. C.

    Gupta to develop the appropriate regulatory framework for derivatives trading in India. On

    May 11, 1998 SEBI accepted the recommendations of the committee and approved the

    phased introduction of derivatives trading in India beginning with stock index futures. The

    provisions in the SC(R)A and the regulatory framework developed there under govern trading

    in securities. The amendment of the SC(R)A to include derivatives within the ambit of

    securities in the SC(R)A made trading in derivatives possible within the framework of that

    Act.

    1. Any Exchange fulfilling the eligibility criteria as prescribed in the L. C. Gupta

    committee report can apply to SEBI for grant of recognition under Section 4 of the SC(R)A,

    1956 to start trading derivatives.

    The derivatives exchange/segment should have a separate governing council and

    representation of trading/clearing members shall be limited to maximum of 40% of the total

    members of the governing council. The exchange would have to regulate the sales practices

    of its members and would have to obtain prior approval of SEBI before start of trading in

    any derivative contract.

    2.

    The Exchange should have minimum 50 members.

    3. The members of an existing segment of the exchange would not automatically

    become the members of derivative segment. The members of the derivative segment would

    need to fulfill the eligibility conditions as laid down by the L. C. Gupta committee.

    4. The clearing and settlement of derivatives trades would be through a

    SEBI approved clearing corporation/house. Clearing corporations/houses complying with the

    eligibility conditions as laid down by the committee have to apply to SEBI for grant of

    approval.

    5. Derivative brokers/dealers and clearing members are required to

    seek registration from SEBI. This is in addition to their registration as brokers of existing

    stock exchanges. The minimum net worth for clearing members of the derivatives clearing

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    corporation/house shall be Rs.300 Lakh. The networth of the member shall be computed as

    follows:

    Capital + Free reserves

    Less non-allowable assets viz.,

    (a) Fixed assets

    (b) Pledged securities

    (c) Members card

    (d) Non-allowable securities (unlisted securities)

    (e) Bad deliveries

    (f) Doubtful debts and advances

    (g) Prepaid expenses

    (h) Intangible assets

    (i) 30% marketable securities

    6.The minimum contract value shall not be less than Rs.2 Lakh. Exchanges have to

    submit details of the futures contract they propose to introduce.

    7. The initial margin requirement, exposure limits linked to capital adequacy and

    margin demands related to the risk of loss on the position will be prescribed by

    SEBI/Exchange from time to time.

    8. The L. C. Gupta committee report requires strict enforcement of Know your

    customer rule and requires that every client shall be registered with the derivatives broker.

    The members of the derivatives segment are also required to make their clients aware of the

    risks involved in derivatives trading by issuing to the client the Risk Disclosure Document

    and obtain a copy of the same duly signed by the client.