Effect of Derivatives Based Strategies-A study in S&P CNX Nifty Index

Done by,

M.MOHANA GANESH

1

CHAPTER 1

INTRODUCTION

1.1 Introduction To The Topic

Derivatives have widely been used as they facilitate hedging, that is, they enable fund

mangers of an underlying asset portfolio to transfer some parts of the risk of price

changes to others who are willing to bear such risk. Options are the specific derivative

instruments that give their owner the right to buy (call option holder) or to sell (put option

holder) a specific number of shares (assets) at a specified price (exercise price) of a given

underlying asset at or before a specified date (expiration date). In lieu of this privilege,

the holder of the option (long position) pays a market determined price (option premium)

to the writer or seller (short position) of the option.

The present study has used buy-and-hold strategies involving future & options and a

combination their-off, like Covered Call, Straddle and Strangle.

In an attempt to make appropriate investment decisions in particular under risk the

portfolio manager must be able to compare the hedging effectiveness of the strategies

involving the use of options under covered call and the pure option strategies like straddle

and strangle. The study also examines the risk and return associated to taking of future

position as buy-and-hold strategy vis-à-vis cash position.

The Indian equity market has widely been regarded as one of the best performing market

amongst the emerging markets of the world like China, Indonesia, Brazil, Russia,

Mexico, Korea etc. The first step towards introduction of derivatives trading in India was

the promulgation of the Securities Laws (Amendment) Ordinance, 1995. It withdrew the

prohibition on options in securities.

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

November 18, 1996 to develop regulatory framework for derivatives trading in India. In

its report, the committee prescribed necessary pre-conditions for introduction of

derivatives trading in India; it recommended that derivatives should be declared as

'securities' so that the regulatory framework applicable to trading of 'securities' could also

govern trading of securities.

SEBI also set up a group in June 1998 under the Chairmanship of Prof. J. R. Varma to

recommend measures for risk containment in derivatives market. The Report worked out

the operational details of margining system, methodology for charging initial margins,

broker net worth, deposit requirement and real-time monitoring requirements.

Derivatives trading commenced in India after SEBI granted the final approval to

commence trading and settlement in approved derivative contracts on the NSE and BSE.

This has also been proved beyond doubt across the financial world that the regulatory

norms in place governing the Indian Capital Market are one of the best in the world.

Recently NSE has been awarded “Derivative Exchange of the year” by Asia Risk

Magazine.

The derivatives trading on NSE commenced on June 12, 2000 with futures trading on

S&P CNX Nifty Index, options trading on the S&P CNX Nifty Index commenced on

June 4, 2001. Individual stock options were introduced on July 2, 2001 and Individual

stock futures were introduced on November 9, 2001 by the National stock Exchange of

India.

India’s experience with the launch of equity derivatives market has been extremely

positive. The derivatives turnover on the NSE has surpassed the equity market turnover.

The turnover of derivatives on the NSE increased from Rs. 23,654 million (US $ 207

million) in 2000-01 to Rs. 130,904,779 million (US $ 3,275,076 million) in 2007-08.

India is one of the most successful developing countries in terms of a vibrant market for

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exchange-traded derivatives. This reiterates the strengths of the modern development of

India’s securities markets, which are based on nationwide market access, anonymous

electronic trading, and a predominantly retail market. There is an increasing sense that

the equity derivatives market is playing a major role in shaping price discovery.

The factors that have been driving the growth of financial derivatives worldwide, as also

in India are increased volatility in asset prices in financial markets; increased integration

of national financial markets with international markets; development of more

sophisticated risk management tools, providing economic agents a wider choice of risk

management strategies and innovations in the derivatives markets, which optimally

combine the risks and returns over a large number of financial assets.

Subsequently, the product base has been increased to include trading in futures and

options on S&P CNX Nifty Index, CNX IT Index, Bank Nifty Index and Single securities

(188 stocks as stipulated by SEBI) and futures on interest rate. Futures and options

contracts were introduced on CNX Nifty Junior and CNX 100 indices for trading in F&O

segment on June 1, 2007.The turnover in the derivatives segment has witnessed

considerable growth since inception. In the global market, NSE ranks first (1st) in the

world in terms of number of contracts traded in the Single Stock Futures, second (2nd) in

Asia in terms of number of contracts traded in equity derivatives instrument. Since

inception, NSE established itself as the sole market leader in this segment in the country

with more than 98 % market share.

Following the implementation of reforms in the securities industry during the last decade,

Indian stock markets have stood out in the world ranking as well as in the developed and

emerging markets. India has a turnover ratio of 94.2%, which is quite comparable to the

other developed market like the US and UK which has turnover ratios of 129.1% and

141.9% respectively. As per Standard and Poor's Fact book India ranked 17th in terms of

market capitalization (18th in 2004) and 18th in terms of total value traded in stock

exchanges and 20th in terms of turnover ratio as on December 2005.

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NSE has been ranked 14th in the global futures and options volume in 2005 against its

rank of17th in the previous year. In the top 40 Futures Exchanges of the World, NSE

stands at the 7th position in 2005 as against 10th in the year 2004. (Source: ISMR-2006,

NSE). NSE faired very well in 2007 in terms of traded volumes in futures and options

taken together, improving its worldwide ranking from 15th in 2006 to 9th in 2007. The

traded volumes in the derivatives segment of the NSE saw an increase of 95% in 2007

over the figure in 2006.

National Stock Exchange of India Limited has been awarded ‘Derivatives Exchange of

the Year’ by Asia Risk Magazine. The award recognizes best practice, quality service and

innovation in derivatives and risk management in the Asia-Pacific region. The winning

institutions are those that, over the past year, have responded best in the needs of their

clients, both on the asset and liability side, along with the end-users that have

demonstrated outstanding trading and risk management strategies.

‘Asia Risk’ is the only publication dedicated solely to the business of financial risk

management and the derivatives market in the Asia-Pacific region since 1995.

Chart 1.1:Product-wise Distribution of Turnover of F&O Segment of NSE,

2007-08

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In terms of trading volumes in single stock futures, while the NSE was ranked first (1st)

in terms on number of contracts traded in 2006, it has shifted to second position as the

Johannesburg Stock Exchange (JSE) overtook NSE with a 265.49 million contracts

traded in 2007 at the JSE as against 179.33 contracts on the NSE.

Table 1.1: Futures on Individual Equities (Stock Futures)

(Number of Contracts- in millions)

EXCHANGE 2007 2006 %

JSE South Africa 265.49 69.67 281.06

NSE 179.32 100.29 78.81

Eurex 52.46 35.59 47.41

Liffe 75.27 29.52 155

MEFF 21.29 21.23 0.3

Source: WFE 2007 Annual Report and Statistics.

However, NSE faired very well in 2007 in terms of traded volumes in futures and options

taken together, improving its worldwide ranking from 15th in 2006 to 9th in 2007. The

traded volumes in the derivatives segment of the NSE saw an increase of 95% in 2007

over the figure in 2006.

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1.2. Literature Review

Thenmozhi M (2002) studied the impact of the introduction of index futures on

underlying index volatility in the Indian markets. Applying Variance Ratio Test,

Ordinary Least Square Multiple Regression Technique, she concluded that futures trading

have reduced the volatility in the spot markets. Further in a lead lag analysis. Thenmozhi

found that the futures market leads the spot index returns by one day. But this study

neglected inherent time varying characteristics and clustering of volatility and possible

autocorrelation. Therefore, the inferences drawn are unreliable. While analyzing the data

relating to Indian stock market from June 2000 till October 2002, M. T. Raju and Kiran

Karande (2003) concluded that introduction of futures has helped in reducing volatility in

the cash market. Premalatha Shenbagaraman (2003) examined the impact of introduction

of NSE Nifty index futures on Nifty index. Using an event study over the period from

October 1995 to December 2002, she tested for changes in the volatility before and after

the introduction. Using GARCH techniques to model the time series, she concluded that

futures trading have not led to a change in the volatility of the underlying stock index but

the structure of volatility seemed to have changed in post-futures period.

Nagaraj KS and Kotha Kiran Kumar (2004) studied the impact of Index futures trading

on spot market volatility using the data from June 12, 2000 to Feb. 27, 2003 of S&P CNX

Nifty. Using ARMA-GARCH Model, the study also examined the effect of the Sept. 11

terrorist attack on the nifty spot-futures relation. The study found that the post Sept. 11

attack, the relation between futures trading activity and spot volatility has strengthened,

implying that the market has become more efficient in assimilating the information into

its prices.

M Thenmozhi and M Sony Thomas (2004) analyzed the relationship between stock index

futures and corresponding stock market volatility of the NSE- Nifty using the GARCH

technique. Using the data from 1995 to 2003, the study concluded the reduction of

volatility in the underlying stock market and increased market efficiency.

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Gauri Mohan, Saurabh Kumar, and Sriharsha Pappu (2004) analyzed the data of NSE

NIFTY from 13th July 1998 to11th July 2002 to measure the impact of futures trading on

National Stock Exchange (NSE) of India and concluded that introduction of future had

increased the efficiency of market by quicker dissemination of information. But change

in volatility of the underlying stock market could not be completely attributed to the

introduction of futures trading.

Gupta (2003) tried to examine the impact of introduction of index futures on the

underlying stock market volatility in India and then compared the futures market

volatility with the spot market volatility. Analyzing the daily price data for BSE Sensex

and S&P CNX Nifty Index from June 1998 to June 2002, the empirical results reported

that the over-all volatility of the stock market has declined after the introduction of the

index futures for both of the indices. However, there was no conclusive evidence, which

suggested that, the futures volatility was higher (lower) in comparison to the underlying

stock market in terms of both the indices.

While analysing the data for S&P CNX Nifty for the period ranging form June 1999 to

December 2005, S V Ramana Rao (2007) concluded that the volatility has increased after

the introduction of index futures.

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1.3 OBJECTIVES OF THE STUDY

To examine the performance of various derivatives based investment strategies.

To examine the risk associated with different investment strategies

To examine whether derivatives can be used as an alternative to cash market

investing.

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1.4 SCOPE OF THE STUDY

This study helps to improve investment activities in securities.

It helps to give ideas about derivatives to students.

New strategies can be identified by the people who actively invest in derivatives.

Out of the money call and in the money put only selected to apply the strategies.

It may be further analysed in different dimensions. Some popular strategies only

taken in to analysis, it has a wide scope to add other derivatives based strategies.

The boundary of the study is that the collection of data is limited to a specific time

period Jan-2007 to march-2007.

1.6 LIMITATIONS

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Study was conducted during 2004 to 2008

Interest rate and time value of money factors are not considered.

The results of the present study are based on the prediction of volatility as per GARCH Model

CHAPTER 2

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RESEARCH METHODOLOGY

2.1 Research design

S&P CNX Nifty stock has constantly represented more than 55% of the total market

capitalization since March 2002 and it attained 56.78 % on 29th September 2007 (NSE

Fact-Book, 2008). During the last six months all the Nifty stocks had shared

approximately 41.16% of the traded value of all stocks on the NSE.

Therefore, the S&P CNX Nifty has been sampled as a portfolio that is the true

representative of the Indian Capital market to meet the objectives of the study.

In all, following strategies have been developed involving the Nifty futures and options

for empirical testing, namely;

Future

Covered Call (Long Future with Short Call);

Long Straddle;

Short Straddle;

Long Strangle; and

Short Strangle

Strip

Strap

Bull Spread

Bear Spread

Box Spread

Future Contract:

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A futures contract is a forward contract, which trades on an exchange. S&P CNX Nifty

futures are traded on National Stock Exchange. When only a long position is taken, it is

called long future.

Covered Call:

Under this strategy the long position on the Nifty futures is to be covered with short call

on the Nifty. In choosing the strike price of the call a distance from spot price of two

percent or more has been kept to factor in the historical growth rate of the Indian capital

market.

Straddle:

It involves taking instantaneous position (long or short) in call and as well as put with the

same strike price and expiration date. In case the position is long it is called long straddle,

in opposite case it is called short straddle.

Strangle:

It involves taking instantaneous position (long or short) in call and as well as put with the

same expiration date but different strike price of the call and option. In case the position

is long it is called long strangle, in opposite direction, it is called short strangle.

Strip

It involves taking long position in one call and as well as two puts with the same

expiration date and strike price of the call and option.

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Strap

It involves taking long position in two calls and as well as one put with the same

expiration dates and strike price of the call and option.

Bull Spread

It involves taking long position in one call and short in another call with the same

expiration date and higher strike price.

Bear Spread

It involves taking long position in one put and short in another put with the same

expiration date and lower strike price.

Box Spread

It is the combination of bull call spread and bear put spread.

Data:

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The data has been taken in different sets to meet the objectives of the study. Initially, the

first set of data comprises of daily closing price of the Nifty (January 1, 2004 to

December 31, 2008) comprising 1266 observations for assessing the daily volatility. For

predicting the volatility for the forth coming future contract, starting with effect from the

contract of January 2004, the average daily volatility of the immediate preceding

60months has been used.

Second set of data comprises of 1266 observations of daily future prices on Nifty

between January 1, 2004 and 31st December 2008 (60 months). This data has been used

in monitoring the value at risk involved due to changes in the value of portfolio taking

place because of frequent changes in price (volatility in prices).

Third set of data comprises of 251 observations of daily prices of call and put for

straddle. Fourth set of data comprises of 251 observations of each on call and put for

strangle. Fourth set of data comprises of 251 observations of each on call and put for

spreads. In case of strategies involving options, the data covered the period of 12 near

month contracts beginning 1st January 2008 to 31st December 2008.

Sources of Data:

The data have been sourced from the website of National Stock Exchange of India

(NSE). Needless to mention that to enrich the quality of the present study, other sources

of literature and relevant information have also been explored from various books,

journals, magazines, business news papers and various websites on financial planning

and investment management.

2.2 Research Tools

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Risk Adjusted Portfolio Performance:

William Sharpe (1966) suggested an alternative technique for performance evaluation.

Hence, Sharpe’s ratio to measure excess return per unit of risk undertaken has been used

to measure the performance of derivative based portfolio on S&P CNX Nifty. The

measure is the ratio of the risk premium of the portfolio, divided by the standard

deviation of the portfolio’s return:

Sharpe Ratio =(R − Rf)/ σ

Where, R = rate of return of the portfolio,

Rf = risk free rate of return over the same interval.

The risk free return has been the corresponding to the rate of return offered by National

Saving Certificates (NSCs) by Indian Post Office at the beginning of the calendar year

under study. Hence, the risk free rate of return taken for the calendar year 2001 was 11%,

for the year 2002 was 9.5%, for the year 2003 was 9% and 8% for the calendar years

2004 to 2008.

σ = standard deviation of the return of the portfolio.

In the present study, the actual daily log returns have been used to predict the daily

variance using the E-view software. The daily standard deviation is based on the average

of the daily SD of the 36 months immediately preceding the start of the monthly S&P

CNX Nifty Index future contract. Then this daily standard deviation has been converted

into monthly standard deviation by multiplying the square root of the actual number of

trading days during the forthcoming monthly future contract.

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GARCH Model:

Generalized Autoregressive Conditional Heteroscedasticity recognizes that volatilities are

not constant. During some period, a particular volatility may be relatively low or high.

This model attempts to keep track of the variations in the volatility through time.

σ^2= a0+ a1ε(n-1)^2 + a2σ (n-1)^2

σ^2= Variance rate

ε=Continuous compounding daily return

ai= The amount of weight given to the observation at i th day

a0=weight assigned to long run variance rate

Mechanism of Maintaining Derivative based Investment Strategies:

The future contract on the S&P CNX Nifty has been taken as one of the derivative

portfolio named Long Future (Naked) besides other five derivative based portfolios

namely Covered Call, Long Straddle, Short Straddle, Long Strangle and Short Strangle.

All the portfolios involving derivatives would thereafter be referred as Derivative

Portfolio.

For comparison purpose, a cash portfolio on the S&P CNX Nifty over the corresponding

period of time to that of derivative portfolios has also been considered.

The modus operandi used for derivative portfolio has also been of buy-and-hold, where

Nifty Future contracts have been rolled over from one month to another month on last

day of the expiry of the future contract during the entire period under study.

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However in the case of investment strategies involving options, the Straddle (long as well

as short) and Straddle (long as well as short), the following approach have been used

while deciding on the strike price.

While selecting the strike price of call option and put option, the normal historical growth

rate of the Indian capital market has been taken into account. The BSE Sensex, since its

inception in 1978-79 that has grown at a aggregate return of 21 percent (including two

percent for dividend) where as in case of S&P CNX Nifty the annual growth has been

about 21.6 percent (including two percent for dividend) during the last seven years

ending 31st December 2007.

The standard deviation of the Indian capital based on monthly returns for last nine

calendar years ending 31st December 2006 has been 7.36 percent. Taking into account

the normal rate of return and the volatility in the India capital market, in the present study

the researcher has opted, but not restricted, to choose out-of - money calls with strike

price higher by 1-2 percent and in- the- money put with strike price higher by 1-2 percent

of the spot price on the day of entering into the contracts amounting in the formation of

straddle for the purpose of empirically examining the performance of straddle. In case of

assessing the performance of strangle the out-of-money calls with strike price higher by

1-2 percent of the spot price and out-of-the money put with strike price lesser up-to 1-2

percent of the spot price on the day on entering into contract for the month under

consideration has been taken into account for examining the risk return dynamic of the

said strategy.

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Chapter 3

Analysis and Interpretation

It can be concluded from the descriptive statistics for the daily returns as presented in

Table- 3.1, that the data is not normally distributed, which seems to be a general

phenomenon worldwide for stock returns. The coefficient of kurtosis is greater than three

which characterize that the returns are distributed in the form of leptokurtosis exhibiting

fat tails and excess peakedness at the mean. From these characteristics thus it may

concluded that it is eligible for fitted in the form of GARCH model.

Table 3.1: Behaviour of Stock Returns

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0

100

200

300

400

-10 -5 0 5

Series: Daily ReturnSample 1/02/2004 12/31/2008Observations 1248

Mean 0.017914Median 0.139210Maximum 7.659829Minimum -13.94419Std. Dev. 1.887967Skewness -0.999814Kurtosis 9.678404

Jarque-Bera 2527.178Probability 0.000000

Table 3.2: Comparison of Long Futures and Cash Market

FUTURES CASHReturn SD Sharpe Return SD Sharpe

24.69 101.34 0.2428 2004 8.8 27.59 0.0289200.36 107.29 1.8667 2005 25.43 17.65 0.9879289.31 81.09 3.5667 2006 36.93 26.11 1.1082304.71 81.75 3.7263 2007 46.89 25.42 1.526

-153.48 84.64 -1.8142 2008 -63.25 44.31 -1.6079

Chart 3.2: Comparison of Long Futures and Cash Market

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Interpretation

The results of the derivative based portfolio on S&P CNX Nifty Index future and the cash

portfolio of the corresponding index have been presented in the Table-3.2 and shown in

Figure- 3.2.

The thorough analysis of the table, suggests that during the entire 60 months beginning 1st

Jan 2004 under study, the derivative portfolio based of S&P CNX Nifty Index future does

not at all amount in higher degree of risk when compared with the cash portfolio being

held in proportion to the index composition, rather compensates very smartly for higher

degree of risk under taken by the investors, as suggested by the Sharpe’s ratio (William

Sharpe, 1966). The Sharpe’s ratio was in favour of derivative portfolio to cash portfolio.

The examination of the table also suggest that, it is only during the calendar year 2008,

when Sharpe’s ratio (-1.8142 vs -1.6079) was slightly in favour of cash portfolio than

derivative portfolio, whereas during all remaining calendar years under study the

Sharpe’s ratio has been in favour of the derivative portfolio by huge margins of more

than 100 percent during 2006 and 2007.

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Table 3.3: Comparison of Covered call and Cash Market

COVERED CALL CASHReturn SD Sharpe Period Return SD Sharpe

-133.09 117.45 -1.1338442 Jan-08 -16.65 15.3 -1.132-54.63 55.48 -0.9861211 Feb-08 2.27 11.26 0.1419-84.01 20.77 -4.0486278 Mar-08 -9.01 13.93 0.694753.17 97.02 0.54720676 Apr-08 8.89 5.9 1.3946

-77.76 92.58 -0.8407863 May-08 -5.75 5.52 -1.1623-105.84 19.85 -5.3360202 Jun-08 -18.23 8.68 -2.1778

81.08 132.68 0.61049141 Jul-08 7.9 13.68 0.5342-74.28 109.8 -0.6772313 Aug-08 0.87 7.4 0.0274-79.19 35.24 -2.2494325 Sep-08 -10.04 10.69 -1.0018

-213.68 95.09 -2.2479756 Oct-08 -28.06 22.69 -1.2662-71.99 100.32 -0.7184011 Nov-08 -3.38 17.57 -0.23103.68 124.03 0.83528179 Dec-08 7.76 11.38 0.6239

Chart 3.3: Comparison of Covered call and Cash Market

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Interpretation

The results of the derivative portfolio (covered call on S&P CNX Nifty Index) and the

cash portfolio of the corresponding index have been presented in the Table- 3.3 and

shown in the Figure- 3.3. The period of study covered was 12 months ending on 31st

December 2008, The results indicate that in terms of aggregate return (-5.28%) the cash

portfolio has an edge over the derivative portfolio during the entire period of study, and

in terms of risk compensation as point out by Sharpe’s ratio, it is the cash portfolio that

has an edge over derivative portfolio.

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Table 3.4: Comparison of Long Straddle and Cash Market

LONG STRADDLE   CASHReturn SD Sharpe   Return SD Sharpe

172.211 78.91 2.18135851 Jan-08 -16.65 15.3 -1.132-177.86 247.23 -0.7197347 Feb-08 2.27 11.26 0.1419-169.42 115.59 -1.4663898 Mar-08 -9.01 13.93 0.6947-43.96 228.5 -0.1927352 Apr-08 8.89 5.9 1.394656.82 223.43 0.25394978 May-08 -5.75 5.52 -1.162333.29 17.65 1.8815864 Jun-08 -18.23 8.68 -2.177845.87 347.67 0.13170535 Jul-08 7.9 13.68 0.5342

-28.92 228.5 -0.1269147 Aug-08 0.87 7.4 0.0274-199.96 223.43 -0.895314 Sep-08 -10.04 10.69 -1.0018-37.25 228.5 -0.1633698 Oct-08 -28.06 22.69 -1.2662-48.85 223.43 -0.2189948 Nov-08 -3.38 17.57 -0.23-37.27 230.68 -0.1619126 Dec-08 7.76 11.38 0.6239

-17.1 -63.43

Chart 3.4: Comparison of Long Straddle and Cash Market

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Interpretation

The results of the option based strategy called Straddle on S&P CNX Nifty Index and the

cash portfolio of the corresponding index have been presented in the Table- 3.4 for long

straddle.

The through perusal of the tables shows that the Sharpe’s ratio favours the long straddle

only during January, May, June and July. Hence, results advocate that there is no use of

going in for the options based strategy called straddle (long).

In terms of aggregate return (-17.1% vs -63.43%) the derivative portfolio strategies of

Long Straddle has resulted in negative returns. Hence, in the present study, the proposed

methodology of selecting the strike price of the straddle only on the basis of long term

historical growth rate needs to be revisited, as it does not provide any evidence to support

such strategy for rational investors either in terms of risk, return or combination thereof.

Table 3.5: Comparison of Short Straddle and Cash Market

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SHORT STRADDLE   CASH  

Return SD Sharpe   Return SD Sharpe-172.21 48.41 -3.5590 Jan-08 -16.65 15.3 -1.132177.85 247.53 0.7181 Feb-08 2.27 11.26 0.1419169.42 115.96 2.4064 Mar-08 -9.01 13.93 0.6947138.33 21.98 6.2889 Apr-08 8.89 5.9 1.3946-56.81 137.99 -0.4123 May-08 -5.75 5.52 -1.1623-33.28 16.63 -2.0058 Jun-08 -18.23 8.68 -2.177854.13 61.81 0.8743 Jul-08 7.9 13.68 0.534228.92 17.82 1.6181 Aug-08 0.87 7.4 0.0274

199.96 120.94 1.6526 Sep-08 -10.04 10.69 -1.001837.25 115.05 0.3231 Oct-08 -28.06 22.69 -1.266248.85 8.19 5.9485 Nov-08 -3.38 17.57 -0.23

137.27 62.52 2.1942 Dec-08 7.76 11.38 0.6239             

-0.51       -63.43    

Chart 3.5: Comparison of Short Straddle and Cash Market

Interpretation

26

The results of the option based strategy called Short Straddle on S&P CNX Nifty Index

and the cash portfolio of the corresponding index have been presented in the table-3.5 for

short straddle.

The through perusal of the tables shows that the Sharpe’s ratio favours more than six

months in the entire period of 12 months under study. Hence, results advocate that there

is no use of going in for the options based strategy called straddle (short).

In terms of aggregate return (-0.5169) the derivative portfolio strategy of Straddle have

resulted in negative returns. Hence, in the present study, the proposed methodology of

selecting the strike price of the straddle only on the basis of long term historical growth

rate needs to be revisited, as it does not provide any evidence to support such strategy for

rational investors either in terms of risk, return or combination thereof.

Table 3.6: Comparison of Strip and Cash Market

 

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STRIP CASH

Return SD Sharpe   Return SD Sharpe36.11 34.67 1.0393 Jan-08 -16.65 15.3 -1.132

-386.44 298.79 -1.2936 Feb-08 2.27 11.26 0.1419-377.80 61.1 -6.1846 Mar-08 -9.01 13.93 0.6947

15.40 278.04 0.0551 Apr-08 8.89 5.9 1.3946-84.70 70.79 -1.1977 May-08 -5.75 5.52 -1.1623-72.16 8.87 -8.1432 Jun-08 -18.23 8.68 -2.177845.87 83.46 0.5486 Jul-08 7.9 13.68 0.5342

-30.85 54.25 -0.5701 Aug-08 0.87 7.4 0.0274-243.16 150.12 -1.6202 Sep-08 -10.04 10.69 -1.0018-90.14 108.20 -0.8338 Oct-08 -28.06 22.69 -1.2662-33.35 40.15 -0.8325 Nov-08 -3.38 17.57 -0.23-24.89 5.98 4.1727 Dec-08 7.76 11.38 0.6239

             -303.83       -63.43    

Chart 3.6: Comparison of Strip and Cash Market

Interpretation

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The results of the option based strategy called Straddle on S&P CNX Nifty Index and the

cash portfolio of the corresponding index have been presented in the Table- 3.6 for strip.

The through perusal of the tables shows that the Sharpe’s ratio (0.5486) favours the strip

only during July. Hence, results advocate that there is no use of going in for the options

based strategy called strip.

In terms of aggregate return the derivative portfolio strategies of strip has resulted in

negative returns. Hence, in the present study, the proposed methodology of selecting the

strike price of the straddle only on the basis of long term historical growth rate needs to

be revisited, as it does not provide any evidence to support such strategy for rational

investors either in terms of risk, return or combination thereof.

Table 3.7: Comparison of Strap and Cash Market

STRAP       CASH    

29

Return SD Sharpe   Return SD Sharpe172.20 107.64 1.5990 Jan-08 -16.65 15.3 -1.132

-223.04 279.48 -0.7983 Feb-08 2.27 11.26 0.1419-380.44 111.29 -3.4193 Mar-08 -9.01 13.93 0.6947167.06 387.15 0.4313 Apr-08 8.89 5.9 1.3946

-107.74 194.32 -0.5548 May-08 -5.75 5.52 -1.162344.10 107.37 0.4100 Jun-08 -18.23 8.68 -2.1778

-73.77 83.35 -0.8860 Jul-08 7.9 13.68 0.5342-38.93 24.63 -1.5835 Aug-08 0.87 7.4 0.0274-35.64 23.26 -1.5359 Sep-08 -10.04 10.69 -1.0018-12.74 16.19 -0.7923 Oct-08 -28.06 22.69 -1.266253.85 47.09 1.1418 Nov-08 -3.38 17.57 -0.230.39 37.80 0.0083 Dec-08 7.76 11.38 0.6239

             -231.31       -63.43    

Table 3.7: Comparison of Strap and Cash Market

Interpretation

30

The results of the option based strategy called Straddle on S&P CNX Nifty Index and the

cash portfolio of the corresponding index have been presented in the Table- 3.7 for strip.

The through perusal of the tables shows that the Sharpe’s ratio (1.5990 and 0.4100)

favours the strip only during January and June. Hence, results advocate that there is no

use of going in for the options based strategy called strap.

In terms of aggregate return the derivative portfolio strategies of strap has resulted in

negative returns. Hence, in the present study, the proposed methodology of selecting the

strike price of the straddle only on the basis of long term historical growth rate needs to

be revisited, as it does not provide any evidence to support such strategy for rational

investors either in terms of risk, return or combination thereof.

Table 3.8: Comparison of Long Strangle and Cash Market

31

LONG STRANGLE 

CASH

Return SD Sharpe   Return SD Sharpe-706.63 231.54 -3.0522 Jan-08 -16.65 15.3 -1.132-11.86 491.27 -0.0243 Feb-08 2.27 11.26 0.1419

-329.13 224.34 -1.4674 Mar-08 -9.01 13.93 0.6947323.11 461.21 0.7004 Apr-08 8.89 5.9 1.3946-44.69 260.08 -0.1721 May-08 -5.75 5.52 -1.1623

-593.46 388.03 -1.5295 Jun-08 -18.23 8.68 -2.1778491.69 767.32 0.6406 Jul-08 7.9 13.68 0.5342-84.36 407.33 -0.2073 Aug-08 0.87 7.4 0.0274

-376.85 206.82 -1.8224 Sep-08 -10.04 10.69 -1.0018-1018.98 454.04 -2.2443 Oct-08 -28.06 22.69 -1.2662-312.85 499.30 -0.6267 Nov-08 -3.38 17.57 -0.23325.38 451.30 0.7208 Dec-08 7.76 11.38 0.6239

             -322.93       -63.43    

Chart 3.8: Comparison of Long Strangle and Cash Market

Interpretation

32

The results of the yet another option based strategy called Strangle (long) on S&P CNX

Nifty Index and the cash portfolio of the corresponding index have been presented in the

Table- 3.8 for long strangle.

It has been found that in the case of option based strategy called Strangle (long), its

performance has further deteriorated as compared to straddle in terms of both (risk as

well as return).

In case of long strangle, the entire initial capital has been lost. The Sharpe ratio has been

lower during the entire period under study in case of short as well as long strangle.

Table 3.9: Comparison of Short Strangle and Cash Market

33

SHORT STRANGLE     CASH    Return SD Sharpe   Return SD Sharpe

706.63 190.78 3.7035 Jan-08 -16.65 15.3 -1.13211.86 491.27 0.0239 Feb-08 2.27 11.26 0.1419

329.13 224.34 1.4667 Mar-08 -9.01 13.93 0.6947-61.55 276.26 -0.2231 Apr-08 8.89 5.9 1.394644.69 75.13 0.5938 May-08 -5.75 5.52 -1.1623

593.46 388.03 1.5291 Jun-08 -18.23 8.68 -2.1778-291.69 625.90 -0.4661 Jul-08 7.9 13.68 0.5342

84.36 265.91 0.3169 Aug-08 0.87 7.4 0.0274376.85 206.82 1.8217 Sep-08 -10.04 10.69 -1.0018

1018.98 454.04 2.2440 Oct-08 -28.06 22.69 -1.2662312.85 499.30 0.6264 Nov-08 -3.38 17.57 -0.23-62.69 265.54 -0.2363 Dec-08 7.76 11.38 0.6239

             322.93       -63.43    

Chart 3.9: Comparison of Short Strangle and Cash Market

Interpretation

34

The results of the yet another option based strategy called Strangle on S&P CNX Nifty

Index and the cash portfolio of the corresponding index have been presented in the Table-

3.9 for short strangle.

It has been found that in the case of option based strategy called Strangle ( short), its

performance has show big positive return compared to straddle in terms of both (risk as

well as return).

In case of long strangle, the entire initial capital has been lost, where as in case of short

Strangle capital have been increased by more than three times. The Sharpe ratio has been

higher during the entire period under study in case of short as well as long strangle.

Table 3.10: Comparison of Bear Spread and Cash Market

35

BEAR SPREAD     CASH    Return SD Sharpe   Return SD Sharpe

1051.05 328.57 3.1986 Jan-08 -16.65 15.3 -1.132-331.97 977.95 -0.3395 Feb-08 2.27 11.26 0.1419

14.64 245.09 0.0594 Mar-08 -9.01 13.93 0.6947-49.90 45.64 -1.0951 Apr-08 8.89 5.9 1.3946

-105.24 39.13 -2.6916 May-08 -5.75 5.52 -1.1623146.78 178.21 0.8232 Jun-08 -18.23 8.68 -2.1778-49.95 139.11 -0.3596 Jul-08 7.9 13.68 0.5342

-107.76 40.88 -2.6380 Aug-08 0.87 7.4 0.027438.48 103.41 0.3713 Sep-08 -10.04 10.69 -1.0018

359.56 227.04 1.5833 Oct-08 -28.06 22.69 -1.2662-43.54 285.04 -0.1530 Nov-08 -3.38 17.57 -0.23-37.27 44.37 -0.8418 Dec-08 7.76 11.38 0.6239

             33.09       -63.43    

Chart 3.10: Comparison of Bear Spread and Cash Market

Interpretation

36

The results of the yet another option based strategy called Bear Spread on S&P CNX

Nifty Index and the cash portfolio of the corresponding index have been presented in the

Table- 3.10 for long strangle and in the Table- 3.8 for short strangle.

It has been found that in the case of option based strategy called Bear spread, its

performance has shown some positive compared to other derivatives strategies

In case of Bear Spread, Capital has been increased by more than 30%. The Sharpe ratio

has been average during the entire period under study in case of Bear Spread

Table 3.11: Comparison of Bull Spread and Cash Market

37

BULL SPREAD   

CASH

Return SD Sharpe   Return SD Sharpe0.54 33.67 0.0138 Jan-08 -16.65 15.3 -1.1320.07 0.33 -0.0057 Feb-08 2.27 11.26 0.14190.24 0.12 1.3976 Mar-08 -9.01 13.93 0.6947

178.17 125.82 1.4154 Apr-08 8.89 5.9 1.39460.99 125.29 0.0072 May-08 -5.75 5.52 -1.1623

-0.01 0.71 -0.1274 Jun-08 -18.23 8.68 -2.177893.46 66.09 1.4128 Jul-08 7.9 13.68 0.5342-0.03 66.09 -0.0012 Aug-08 0.87 7.4 0.0274-0.01 0.02 -3.6782 Sep-08 -10.04 10.69 -1.0018-0.02 0.01 -9.4867 Oct-08 -28.06 22.69 -1.26620.17 0.14 0.6757 Nov-08 -3.38 17.57 -0.23

190.22 134.38 1.4149 Dec-08 7.76 11.38 0.6239         

-23.75     -63.43    

Chart 3.11: Comparison of Bull Spread and Cash Market

Interpretation

38

The results of the yet another option based strategy called Bull Spread on S&P CNX

Nifty Index and the cash portfolio of the corresponding index have been presented in the

Table- 3.11

It has been found that in the case of option based strategy called Bull spread; its

performance has shown very negative compared to Bear spread.

In case of Bull Spread, Capital has been decreased by more than 23%. The Sharpe ratio

has been lower during the entire period under study in case of Bear Spread

Table 3.12: Comparison of Box Spread and Cash Market

39

BOX SPREAD   CASHReturn SD Sharpe   Return SD Sharpe

1051.59 453.56 2.3183 Jan-08 -16.65 15.3 -1.132-165.95 860.93 -0.1928 Feb-08 2.27 11.26 0.1419

14.88 127.87 0.1157 Mar-08 -9.01 13.93 0.694764.13 34.82 1.8392 Apr-08 8.89 5.9 1.3946

-52.12 82.20 -0.6350 May-08 -5.75 5.52 -1.162373.38 88.75 0.8259 Jun-08 -18.23 8.68 -2.177821.75 36.51 0.5936 Jul-08 7.9 13.68 0.5342

-53.89 53.49 -1.0090 Aug-08 0.87 7.4 0.027419.23 51.71 0.3704 Sep-08 -10.04 10.69 -1.0018

179.77 113.51 1.5829 Oct-08 -28.06 22.69 -1.2662-21.68 142.45 -0.1528 Nov-08 -3.38 17.57 -0.2376.47 69.41 1.10059 Dec-08 7.76 11.38 0.6239

         4.67     -63.43    

Chart 3.12: Comparison of Box Spread and Cash Market

Interpretation

40

The results of the yet another option based strategy called Box Spread on S&P CNX

Nifty Index and the cash portfolio of the corresponding index have been presented in the

Table- 3.12

It has been found that in the case of option based strategy called Box spread; its

performance has shown average compared to Bear spread and Bull Spread.

In case of Bull Spread, Capital has been decreased by more than 23%. The Sharpe ratio

has been lower during the entire period under study in case of Bear Spread. In case of

Bear Spread, Capital has been increased by more than 30%. The Sharpe ratio has been

average during the entire period under study in case of Bear Spread. Here, Capital has

been increased by more than 4%

Chapter 4

Findings

41

Futures

The results of the derivative based portfolio on S&P CNX Nifty Index future and the

cash portfolio of the corresponding index shown that during the entire 60 months

beginning 1st Jan 2004 under study, the derivative portfolio based of S&P CNX Nifty

Index future does not at all amount in higher degree of risk when compared with the

cash portfolio being held in proportion to the index composition, rather compensates

very smartly for higher degree of risk under taken by the investors.

Covered Call

The results of the derivative portfolio (covered call on S&P CNX Nifty Index) and

the cash portfolio of the corresponding index indicate s that in terms of aggregate

return, the cash portfolio has an edge over the derivative portfolio during the entire

period of study, and in terms of risk compensation as point out by Sharpe’s ratio, it is

the cash portfolio that has an edge over derivative portfolio.

Straddle

In terms of aggregate return the derivative portfolio strategy of Straddle have resulted

in negative returns. Hence, in the present study, the proposed methodology of

selecting the strike price of the straddle only on the basis of long term historical

growth rate needs to be revisited, as it does not provide any evidence to support such

strategy for rational investors either in terms of risk, return or combination thereof.

Strip

In terms of aggregate return the derivative portfolio strategies of strip has resulted in

negative returns. Hence, in the present study, the proposed methodology of selecting

the strike price of the straddle only on the basis of long term historical growth rate

needs to be revisited, as it does not provide any evidence to support such strategy for

rational investors either in terms of risk, return or combination thereof.

Strap

42

The through perusal of the tables shows that the Sharpe’s ratio favours the strip only

during January and June. Hence, results advocate that there is no use of going in for

the options based strategy called strap.

Strangle

In case of long strangle, the entire initial capital has been lost, where as in case of

short Strangle capital have been increased by more than three times. The Sharpe ratio

has been higher during the entire period under study in case of short as well as long

strangle.

Bear spread

It has been found that in the case of option based strategy called Bear spread, its

performance has shown some positive compared to other derivatives strategies. In

case of Bear Spread, Capital has been increased by more than 30%. The Sharpe ratio

has been average during the entire period under study in case of Bear Spread.

Bull Spread

In case of Bull Spread, Capital has been decreased by more than 23%. The Sharpe

ratio has been lower during the entire period under study in case of Bear Spread. In

case of Bear Spread, Capital has been increased by more than 30%. The Sharpe ratio

has been average during the entire period under study in case of Bear Spread. Here,

Capital has been increased by more than 4%.

Chapter 5

43

Conclusion

As Warren Buffet said, analysis on many of derivatives strategies proved to be “Weapons

for Mass Destruction”. The performance of derivative portfolio on S&P CNX Nifty

Future has be found to be exceptionally remunerative to the leveraged investors if

margins are maintained as suggested by the 99%. Of all 1529 trading days falling under

the present study, there has not been a single default for want of margins to be maintained

for derivative exposure.

Hence it may be concluded that both the derivative based strategies involving Future and

the Bear spread on the leading index S&P CNX Nifty of the Indian Capital Market has

proved to be better than a cash portfolio held on same Index. However, in case of pure

option based investment strategies on the leading Indian Indices (S&P CNX Nifty)

involving the Straddle (both long as well as short) and the Strangle (both long as well as

short) have lagged far behind in terms of both risk and return to the cash portfolio held on

the same index. Hence, option based strategies may be used, having understood the

dynamics of volatilities (risk), only over a short period of time to take advantage of price

swings/movements and cannot be used as a long term strategy.

Bibliography

44

1. Damodar N.Gujarati, “Basic Econometrics”, Pearson Education Inc, 2006

2. Jhon C. Hull,” Options, Futures and other Derivatives”, Tata McGraw-Hill, 2007

3. Fact Book (various issues), National Stock Exchange of India (NSE)

4. Gauri Mohan, Saurabh Kumar and Sriharsha Pappu, “Understanding volatility -

The Case of the Introduction of Futures Trading in the National Stock Exchange,

India”,http://papers.ssrn.com/sol3/papers.cfm?abstract_id=333520, 2004.

5. Indian security Market Review 2008, by NSE, India.

6. www.nseindia.com

45