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NISM-Series-VIII - Equity Derivatives - Wef - 22may2014
NISM-Series-VIII - Equity Derivatives - Wef - 22may2014
NISM-Series-VIII:
Equity Derivatives
Certification Examination
1
This workbook has been developed to assist candidates in preparing for the National
Institute of Securities Markets (NISM) NISM-Series-VIII: Equity Derivatives Certification
Examination (NISM-Series-VIII: ED Examination).
Published by:
National Institute of Securities Markets
© National Institute of Securities Markets, 2014
Plot 82, Sector 17, Vashi
Navi Mumbai – 400 703, India
All rights reserved. Reproduction of this publication in any form without prior
permission of the publishers is strictly prohibited.
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Disclaimer
The contents of this publication do not necessarily constitute or imply its endorsement,
recommendation, or favouring by the National Institute of Securities Market (NISM) or
the Securities and Exchange Board of India (SEBI). This publication is meant for general
reading and educational purpose only. It is not meant to serve as guide for investment.
The views and opinions and statements of authors or publishers expressed herein do
not constitute a personal recommendation or suggestion for any specific need of an
Individual. It shall not be used for advertising or product endorsement purposes.
The statements/explanations/concepts are of general nature and may not have taken
into account the particular objective/ move/ aim/ need/ circumstances of individual
user/ reader/ organization/ institute. Thus NISM and SEBI do not assume any
responsibility for any wrong move or action taken based on the information available in
this publication.
Therefore before acting on or following the steps suggested on any theme or before
following any recommendation given in this publication user/reader should
consider/seek professional advice.
The publication contains information, statements, opinions, statistics and materials that
have been obtained from sources believed to be reliable and the publishers of this title
have made best efforts to avoid any errors. However, publishers of this material offer no
guarantees and warranties of any kind to the readers/users of the information
contained in this publication.
NISM and SEBI do not warrant the totality and absolute accuracy, adequacy or
completeness of the information and material and expressly disclaim any liability for
errors or omissions in this information and material herein. NISM and SEBI do not accept
any legal liability what so ever based on any information contained herein.
While the NISM Certification examination will be largely based on material in this
workbook, NISM does not guarantee that all questions in the examination will be from
material covered herein.
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About NISM
In pursuance of the announcement made by the Finance Minister in his Budget Speech
in February 2005, Securities and Exchange Board of India (SEBI) has established the
National Institute of Securities Markets (NISM) in Mumbai.
SEBI, by establishing NISM, has articulated the desire expressed by the Indian
government to promote securities market education and research.
Towards accomplishing the desire of Government of India and vision of SEBI, NISM has
launched an effort to deliver financial and securities education at various levels and
across various segments in India and abroad. To implement its objectives, NISM has
established six distinct schools to cater the educational needs of various constituencies
such as investors, issuers, intermediaries, regulatory staff, policy makers, academia and
future professionals of securities markets.
NISM brings out various publications on securities markets with a view to enhance
knowledge levels of participants in the securities industry.
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Acknowledgement
This workbook has been developed by NISM in close cooperation with the Examination
Committee for NISM-Series-VIII: Equity Derivatives Certification Examination (NISM-
Series-VIII: ED Examination) consisting of representatives of National Stock Exchange
India Ltd. (NSE) and Bombay Stock Exchange Ltd. (BSE). NISM gratefully acknowledges
the contribution of all committee members.
This workbook has been developed for NISM by Mr. Manish Bansal and Mr. Ashutosh
Wakhare of Value Ideas Investment Services Pvt. Ltd.
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About the NISM-Series-VIII: Equity Derivatives Certification Examination
Examination Objectives
On successful completion of the examination the candidate should:
• Know the basics of the Indian equity derivatives market.
• Understand the various trading strategies that can be built using futures and
options on both stocks and stock indices.
• Understand the clearing, settlement and risk management as well as the
operational mechanism related to equity derivatives markets.
• Know the regulatory environment in which the equity derivatives markets
operate in India.
Assessment Structure
The NISM-Series-VIII: Equity Derivatives Certification Examination (NISM-Series-I: ED
Examination) will be of 100 marks consisting of 100 questions of 1 mark each, and
should be completed in 2 hours. There will be negative marking of 25% of the marks
assigned to each question. The passing score for the examination is 60%.
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Table of Contents
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Chapter 6: Introduction to Trading Systems ............................................................... 93
6.1 Trading System............................................................................................................ 93
6.2 Selection criteria of Stocks for trading ....................................................................... 97
6.3 Selection criteria of Index for trading ....................................................................... 100
6.4 Adjustments for Corporate Actions .......................................................................... 100
6.5 Position Limit ............................................................................................................ 102
6.6 Using Daily Newspapers to Track Futures and Options............................................ 104
Chapter 10: Sales Practices and Investors Protection Services .................................. 139
10.1 Understanding risk profile of the client .................................................................. 140
10.2 Investors Grievance Mechanism............................................................................. 147
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Chapter 1: Basics of Derivatives
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Both the contracting parties are committed and are obliged to honour the transaction
irrespective of price of the underlying asset at the time of delivery. Since forwards are
negotiated between two parties, the terms and conditions of contracts are customized.
These are Over-the-counter (OTC) contracts.
Futures
A futures contract is similar to a forward, except that the deal is made through an
organized and regulated exchange rather than being negotiated directly between two
parties. Indeed, we may say futures are exchange traded forward contracts.
Options
An Option is a contract that gives the right, but not an obligation, to buy or sell the
underlying on or before a stated date and at a stated price. While buyer of option pays
the premium and buys the right, writer/seller of option receives the premium with
obligation to sell/ buy the underlying asset, if the buyer exercises his right.
Swaps
A swap is an agreement made between two parties to exchange cash flows in the future
according to a prearranged formula. Swaps are, broadly speaking, series of forward
contracts. Swaps help market participants manage risk associated with volatile interest
rates, currency exchange rates and commodity prices.
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1.5 Types of Derivatives Market
In the modern world, there is a huge variety of derivative products available. They are
either traded on organised exchanges (called exchange traded derivatives) or agreed
directly between the contracting counterparties over the telephone or through
electronic media (called Over-the-counter (OTC) derivatives). Few complex products are
constructed on simple building blocks like forwards, futures, options and swaps to cater
to the specific requirements of customers.
Over-the-counter market is not a physical marketplace but a collection of broker-dealers
scattered across the country. Main idea of the market is more a way of doing business
than a place. Buying and selling of contracts is matched through negotiated bidding
process over a network of telephone or electronic media that link thousands of
intermediaries. OTC derivative markets have witnessed a substantial growth over the
past few years, very much contributed by the recent developments in information
technology. The OTC derivative markets have banks, financial institutions and
sophisticated market participants like hedge funds, corporations and high net-worth
individuals. OTC derivative market is less regulated market because these transactions
occur in private among qualified counterparties, who are supposed to be capable
enough to take care of themselves.
The OTC derivatives markets – transactions among the dealing counterparties, have
following features compared to exchange traded derivatives:
• Contracts are tailor made to fit in the specific requirements of dealing
counterparties.
• The management of counter-party (credit) risk is decentralized and located within
individual institutions.
• There are no formal centralized limits on individual positions, leverage, or
margining.
• There are no formal rules or mechanisms for risk management to ensure market
stability and integrity, and for safeguarding the collective interest of market
participants.
• Transactions are private with little or no disclosure to the entire market.
On the contrary, exchange-traded contracts are standardized, traded on organized
exchanges with prices determined by the interaction of buyers and sellers through
anonymous auction platform. A clearing house/ clearing corporation, guarantees
contract performance (settlement of transactions).
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example hedgers want to give away the risk where as traders are willing to take
risk.
• Derivatives market helps shift of speculative trades from unorganized market to
organized market. Risk management mechanism and surveillance of activities of
various participants in organized space provide stability to the financial system.
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Chapter 2: Understanding Index
2.1 Introduction to Index
Index is a statistical indicator that measures changes in the economy in general or in
particular areas. In case of financial markets, an index is a portfolio of securities that
represent a particular market or a portion of a market. Each Index has its own
calculation methodology and usually is expressed in terms of a change from a base
value. The base value might be as recent as the previous day or many years in the past.
Thus, the percentage change is more important than the actual numeric value. Financial
indices are created to measure price movement of stocks, bonds, T-bills and other type
of financial securities. More specifically, a stock index is created to provide market
participants with the information regarding average share price movement in the
market. Broad indices are expected to capture the overall behaviour of equity market
and need to represent the return obtained by typical portfolios in the country.
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Stock price as Number Today’s
Sr. Stock on January 1, of shares stock price
No. Name 1995 (in Rs.) in lakhs (in Rs.)
1 AZ 150 20 650
2 BY 300 12 450
3 CX 450 16 600
4 DW 100 30 350
5 EU 250 8 500
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Stock price as Number Today’s
Sr. Stock on January 1, of shares stock price
No. Name 1995 (in Rs.) in lakhs (in Rs.)
1 AZ 150 20 650
2 BY 300 12 450
3 CX 450 16 600
4 DW 100 30 350
5 EU 250 8 500
Computation of the index would be as follows:
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2.4 Attributes of an Index
A good market index should have following attributes:
• It should reflect the market behaviour
• It should be computed by independent third party and be free from influence of
any market participant
• It should be professionally maintained
Impact Cost
Liquidity in the context of stock market means a market where large orders are
executed without moving the prices.
Let us understand this with help of an example. The order book of a stock at a point in
time is as follows:
Buy Sell
Sr. No. Quantity Price (in Rs.) Price (in Rs.) Quantity Sr. No.
1 1000 4.00 4.50 2000 5
2 1000 3.90 4.55 1000 6
3 2000 3.80 4.70 500 7
4 1000 3.70 4.75 100 8
In the order book given above, there are four buy orders and four sell orders. The
difference between the best buy and the best sell orders is 0.50 - called bid-ask spread.
If a person places a market buy order for 100 shares, it would be matched against the
best available sell order at Rs. 4.50. He would buy 100 shares for Rs. 4.50. Similarly, if he
places a market sell order for 100 shares, it would be matched against the best available
buy order at Rs. 4 i.e. the shares would be sold at Rs.4.Hence, if a person buys 100
shares and sells them immediately, he is poorer by the bid-ask spread i.e. a loss of Rs 50.
This spread is regarded as the transaction cost which the market charges for the
privilege of trading (for a transaction size of 100 shares).
Now, suppose a person wants to buy and then sell 3000 shares. The sell order will hit
the following buy orders:
Sr. No. Quantity Price (in Rs.)
1 1000 4.00
2 1000 3.90
3 1000 3.80
While the buy order will hit the following sell orders:
Quantity Price (in Rs.) Sr. No.
2000 4.50 1
1000 4.55 2
There is increase in the transaction cost for an order size of 3000 shares in comparison
to the transaction cost for order for 100 shares. The “bid-ask spread” therefore conveys
transaction cost for small trade.
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Now, we come across the term called impact cost. We have to start by defining the ideal
price as the average of the best bid and offer price. In our example it is (4+4.50)/2, i.e.
Rs. 4.25. In an infinitely liquid market, it would be possible to execute large transactions
on both buy and sell at prices that are very close to the ideal price of Rs.4.25. However,
while actually trading, you will pay more than Rs.4.25 per share while buying and will
receive less than Rs.4.25 per share while selling. Percentage degradation, which is
experienced vis-à-vis the ideal price, when shares are bought or sold, is called impact
cost. Impact cost varies with transaction size. Also, it would be different for buy side and
sell side.
Buy Quantity Buy Price (in Rs.) Sell Price (in Rs.) Sell Quantity
1000 9.80 9.90 1000
2000 9.70 10.00 1500
3000 9.60 10.10 1000
To buy 1500 shares, Ideal price = (9.8+9.9)/ 2 = Rs.9.85
Actual buy price = [(1000*9.9)+(500*10.00)]/1500 = Rs.9.93
Impact cost for (1500 shares) = {(9.93 - 9.85)/9.85}*100 = 0.84 %
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Maintenance and Revision of the indices is done with the help of various mathematical
formulae. In order to keep the index comparable across time, the index needs to take
into account corporate actions such as stock splits, share issuance, dividends and
restructuring events. While index maintenance issue gets triggered by a corporate
action, index revision is an unabated phenomenon to ensure that index captures the
most vibrant lot of securities in the market and continues to correctly reflect the
market.
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Chapter 3: Introduction to Forward and Futures
3.1 Introduction to forward and futures Contracts
Forward contract is an agreement made directly between two parties to buy or sell an
asset on a specific date in the future, at the terms decided today. Forwards are widely
used in commodities, foreign exchange, equity and interest rate markets.
Let us understand with the help of an example. What is the basic difference between
cash market and forwards? Assume on March 9, 2009 you wanted to purchase gold
from a goldsmith. The market price for gold on March 9, 2009 was Rs. 15,425 for 10
gram and goldsmith agrees to sell you gold at market price. You paid him Rs.15, 425 for
10 gram of gold and took gold. This is a cash market transaction at a price (in this case
Rs.15, 425) referred to as spot price.
Now suppose you do not want to buy gold on March 9, 2009, but only after 1 month.
Goldsmith quotes you Rs.15, 450 for 10 grams of gold. You agree to the forward price
for 10 grams of gold and go away. Here, in this example, you have bought forward or
you are long forward, whereas the goldsmith has sold forwards or short forwards. There
is no exchange of money or gold at this point of time. After 1 month, you come back to
the goldsmith pay him Rs. 15,450 and collect your gold. This is a forward, where both
the parties are obliged to go through with the contract irrespective of the value of the
underlying asset (in this case gold) at the point of delivery.
Essential features of a forward are:
• It is a contract between two parties (Bilateral contract).
• All terms of the contract like price, quantity and quality of underlying, delivery
terms like place, settlement procedure etc. are fixed on the day of entering into
the contract.
In other words, Forwards are bilateral over-the-counter (OTC) transactions where the
terms of the contract, such as price, quantity, quality, time and place are negotiated
between two parties to the contract. Any alteration in the terms of the contract is
possible if both parties agree to it. Corporations, traders and investing institutions
extensively use OTC transactions to meet their specific requirements. The essential idea
of entering into a forward is to fix the price and thereby avoid the price risk. Thus, by
entering into forwards, one is assured of the price at which one can buy/sell an
underlying asset.
In the above-mentioned example, if on April 9, 2009 the gold trades at Rs. 15,500 in the
cash market, the forward contract becomes favourable to you because you can then
purchase gold at Rs. 15,450 under the contract and sell in cash market at Rs. 15,500 i.e.
net profit of Rs. 50. Similarly, if the spot price is 15,390 then you incur loss of Rs. 60 (buy
price – sell price).
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Major limitations of forwards
Liquidity Risk
Liquidity is nothing but the ability of the market participants to buy or sell the desired
quantity of an underlying asset. As forwards are tailor made contracts i.e. the terms of
the contract are according to the specific requirements of the parties, other market
participants may not be interested in these contracts. Forwards are not listed or traded
on exchanges, which makes it difficult for other market participants to easily access
these contracts or contracting parties. The tailor made contracts and their non-
availability on exchanges creates illiquidity in the contracts. Therefore, it is very difficult
for parties to exit from the forward contract before the contract’s maturity.
Counterparty risk
Counterparty risk is the risk of an economic loss from the failure of counterparty to fulfil
its contractual obligation. For example, A and B enter into a bilateral agreement, where
A will purchase 100 kg of rice at Rs.20 per kg from B after 6 months. Here, A is
counterparty to B and vice versa. After 6 months, if price of rice is Rs.30 in the market
then B may forego his obligation to deliver 100 kg of rice at Rs.20 to A. Similarly, if price
of rice falls to Rs.15 then A may purchase from the market at a lower price, instead of
honouring the contract. Thus, a party to the contract may default on his obligation if
there is incentive to default. This risk is also called default risk or credit risk.
In addition to the illiquidity and counterparty risks, there are several issues like lack of
transparency, settlement complications as it is to be done directly between the
contracting parties. Simple solution to all these issues lies in bringing these contracts to
the centralized trading platform. This is what futures contracts do.
Futures contract
Futures markets were innovated to overcome the limitations of forwards. A futures
contract is an agreement made through an organized exchange to buy or sell a fixed
amount of a commodity or a financial asset on a future date at an agreed price. Simply,
futures are standardised forward contracts that are traded on an exchange. The
clearinghouse associated with the exchange guarantees settlement of these trades. A
trader, who buys futures contract, takes a long position and the one, who sells futures,
takes a short position. The words buy and sell are figurative only because no money or
underlying asset changes hand, between buyer and seller, when the deal is signed.
Features of futures contract
In futures market, exchange decides all the contract terms of the contract other than
price. Accordingly, futures contracts have following features:
• Contract between two parties through Exchange
• Centralised trading platform i.e. exchange
• Price discovery through free interaction of buyers and sellers
• Margins are payable by both the parties
• Quality decided today (standardized )
• Quantity decided today (standardized)
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Futures terminologies
Let us understand various terms in the futures market with the help of quotes on Nifty
futures from NSE:
Quotes given on the NSE website for Nifty futures as on August 9, 2010
1. Instrument type : Future Index
2. Underlying asset : Nifty
3. Expiry date : August 26, 2010
4. Open price (in Rs.) : 5448
5. High price (in Rs.) : 5489.40
6. Low price (in Rs.) : 5436.75
7. Closing price (in Rs.) : 5482
8. Last Traded price (in Rs.) : 5478.50
9. No of contracts traded : 228447
10. Turnover in lakhs : 624319.03
11. Underlying value (in Rs.) : 5486.15
12. Open Interest : 32062850
Spot Price: The price at which an asset trades in the cash market. This is the underlying
value of Nifty on August 9, 2010 which is 5486.15.
Futures Price: The price of the futures contract in the futures market. The closing price
of Nifty in futures trading is Rs. 5482. Thus Rs. 5482 is the future price of Nifty, on a
closing basis.
Contract Cycle: It is a period over which a contract trades. On August 9, 2010, the
maximum number of index futures contracts is of 3 months contract cycle- the near
month (August 2010), the next month (September 2010) and the far month (October
2010). Every futures contract expires on last Thursday of respective month (in this case
August 26, 2010). And, a new contract (in this example - November 2010) is introduced
on the trading day following the expiry day of the near month contract (in this example
– on August 27, 2010).
Expiration Day: The day on which a derivative contract ceases to exist. It is last trading
day of the contract. The expiry date in the quotes given is August 26, 2010. It is the last
Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts
expire on the previous trading day. On expiry date, all the contracts are compulsorily
settled. If a contract is to be continued then it must be rolled to the near future
contract. For a long position, this means selling the expiring contract and buying the
next contract. Both the sides of a roll over should be executed at the same time.
Currently, all equity derivatives contracts (both on indices and individual stocks) on NSE
are cash settled whereas on BSE, derivative contracts on indices are cash settled while
the contracts on individual stocks are delivery settled.
Tick Size: It is minimum move allowed in the price quotations. Exchanges decide the tick
sizes on traded contracts as part of contract specification. Tick size for Nifty futures is 5
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paisa. Bid price is the price buyer is willing to pay and ask price is the price seller is
willing to sell.
Contract Size and contract value: Futures contracts are traded in lots and to arrive at
the contract value we have to multiply the price with contract multiplier or lot size or
contract size. For CNX Nifty, lot size is 50, for Sensex Index futures contract, it is 15 and
for SX40 futures contract on MCX-SX, it is 25. For individual stocks, it varies from one
stock to another. The lot size changes from time to time. In the Nifty quotes given
above, contract value would be equal to Nifty Futures Price * Lot Size = 5482 * 50 =
Rs.2,74,100.
Basis: The difference between the spot price and the futures price is called basis. If the
futures price is greater than spot price, basis for the asset is negative. Similarly, if the
spot price is greater than futures price, basis for the asset is positive. On August 9, 2010,
spot price > future price thus basis for nifty futures is positive i.e. (5486.15-5482 =
Rs.4.15).
Importantly, basis for one-month contract would be different from the basis for two or
three month contracts. Therefore, definition of basis is incomplete until we define the
basis vis-a-vis a futures contract i.e. basis for one month contract, two months contract
etc. It is also important to understand that the basis difference between say one month
and two months futures contract should essentially be equal to the cost of carrying the
underlying asset between first and second month. Indeed, this is the fundamental of
linking various futures and underlying cash market prices together.
During the life of the contract, the basis may become negative or positive, as there is a
movement in the futures price and spot price. Further, whatever the basis is, positive or
negative, it turns to zero at maturity of the futures contract i.e. there should not be any
difference between futures price and spot price at the time of maturity/ expiry of
contract. This happens because final settlement of futures contracts on last trading day
takes place at the closing price of the underlying asset.
It may be noted that we also have global indices being traded on BSE and NSE
denominated in Indian Rupees. For example, NSE has derivative contracts on S&P 500,
Dowjones & FTSE100 whereas BSE has derivative contracts on iBovespa (Brazilian
index), MICEX (Russian index), Hang Seng (Hongkong index) & FTSE / JSE Top40
(South African index).
The National Stock Exchange has also launched future contracts on India Volatility Index
(VIX) enabling traders to hedge market risk arising out of volatility in Feb. 2014. Other
exchanges are also working on introducing derivative contracts on volatility index.
Cost of Carry
Cost of Carry is the relationship between futures prices and spot prices. It measures the
storage cost (in commodity markets) plus the interest that is paid to finance or ‘carry’
the asset till delivery less the income earned on the asset during the holding period. For
equity derivatives, carrying cost is the interest paid to finance the purchase less (minus)
dividend earned.
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For example, assume the share of ABC Ltd is trading at Rs. 100 in the cash market. A
person wishes to buy the share, but does not have money. In that case he would have to
borrow Rs. 100 at the rate of, say, 6% per annum. Suppose that he holds this share for
one year and in that year he expects the company to give 200% dividend on its face
value of Rs. 1 i.e. dividend of Rs. 2. Thus his net cost of carry = Interest paid – dividend
received = 6 – 2 = Rs. 4. Therefore, break even futures price for him should be Rs.104.
It is important to note that cost of carry will be different for different participants.
Margin Account
As exchange guarantees the settlement of all the trades, to protect itself against default
by either counterparty, it charges various margins from brokers. Brokers in turn charge
margins from their customers. Brief about margins is as follows:
Initial Margin
The amount one needs to deposit in the margin account at the time entering a futures
contract is known as the initial margin. Let us take an example - On August 7, 2010 a
person decided to enter into a futures contract. He expects the market to go up so he
takes a long Nifty Futures position for August expiry. On August 7, 2010 Nifty closes at
5439.25.
The contract value = Nifty futures price * lot size = 5439.25 * 50 = Rs.2,71,962.50.
Therefore, Rs 2,71,962.50 is the contract value of one Nifty Future contract expiring on
August 26, 2010.
Assuming that the broker charges 10% of the contract value as initial margin, the person
has to pay him Rs. 27,196.25 as initial margin. Both buyers and sellers pay initial margin,
as there is an obligation on both the parties to honour the contract.
The initial margin is dependent on price movement of the underlying asset. As high
volatility assets carry more risk, exchange would charge higher initial margin on them.
Marking to Market (MTM)
In futures market, while contracts have maturity of several months, profits and losses
are settled on day-to-day basis – called mark to market (MTM) settlement. The
exchange collects these margins (MTM margins) from the loss making participants and
pays to the gainers on day-to-day basis.
Let us understand MTM with the help of the example. Suppose a person bought a
futures contract on August 7, 2010, when Nifty was 5439.25. He paid an initial margin of
Rs.27196.25 as calculated above. Next trading day i.e. August 8, 2010 Nifty futures
contract closes at 5482. This means that he benefits due to the 42.75 points gain on
Nifty futures contract. Thus, his net gain is of Rs. 2137.5 (42.75 * 50). This money will be
credited to his account and next day the position will start from 5482.
Open Interest and Volumes Traded
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An open interest is the total number of contracts outstanding (yet to be settled) for an
underlying asset. The quotes given above show us on August 9, 2010 Nifty futures has
an open Interest of 32062850. It is important to understand that number of long futures
as well as number of short futures is 32062850. This is because total number of long
futures will always be equal to total number of short futures. Only one side of contracts
is considered while calculating/ mentioning open interest. On August 8, 2010, the open
interest in Nifty futures was 30959200. This means that there is an increase of 1103650
in the open interest on August 9, 2010. The level of open interest indicates depth in the
market.
Volumes traded give us an idea about the market activity with regards to specific
contract over a given period – volume over a day, over a week or month or over entire
life of the contract.
Contract Specifications
Contract specifications include the salient features of a derivative contract like contract
maturity, contract multiplier also referred to as lot size, contract size, tick size etc. An
example contract specification is given below:
NSE’s Nifty Index Futures Contracts
Underlying index CNX Nifty
Contract Multiplier (Lot size) 50
Tick size or minimum price 0.05 index point (i.e., Re 0.05 or 5 paise)
difference
Last trading day/ Expiration day Last Thursday of the expiration month. If it
happens to be a holiday, the contract will expire
on the previous business day.
Contract months 3 contracts of 1, 2 and 3 month’s maturity. At the
expiry of the nearest month contract, a new
contract with 3 months maturity will start. Thus,
at any point of time, there will be 3 contracts
available for trading.
Daily settlement price Settlement price of the respective futures
contract.
Final settlement price Settlement price of the cash index on the expiry
date of the futures contract.
Price band
Price Band is essentially the price range within which a contract is permitted to trade
during a day. The band is calculated with regard to previous day closing price of a
specific contract. For example, previous day closing price of a contract is Rs.100 and
price band for the contract is 10% then the contract can trade between Rs.90 and
Rs.110 for next trading day. On the first trading day of the contract, the price band is
decided based on the closing price of the underlying asset in cash market. For example,
Today is first trading day of a futures contract for an underlying asset i.e. company A.
The price band for the contract is decided on the previous day’s closing price of
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company ‘A’ stock in cash market. Price band is clearly defined in the contract
specifications so that all market participants are aware of the same in advance.
Sometimes, bands are allowed to be expanded at the discretion of the exchanges with
specific trading halts.
Positions in derivatives market
As a market participant, you will always deal with certain terms like long, short and open
positions in the market. Let us understand the meanings of commonly used terms:
Long position
Outstanding/ unsettled buy position in a contract is called “Long Position”. For instance,
if Mr. X buys 5 contracts on Sensex futures then he would be long on 5 contracts on
Sensex futures. If Mr. Y buys 4 contracts on Pepper futures then he would be long on 4
contracts on pepper.
Short Position
Outstanding/ unsettled sell position in a contract is called “Short Position”. For instance,
if Mr. X sells 5 contracts on Sensex futures then he would be short on 5 contracts on
Sensex futures. If Mr. Y sells 4 contracts on Pepper futures then he would be short on 4
contracts on pepper.
Open position
Outstanding/ unsettled either long (buy) or short (sell) position in various derivative
contracts is called “Open Position”. For instance, if Mr. X shorts say 5 contracts on
Infosys futures and longs say 3 contracts on Reliance futures, he is said to be having
open position, which is equal to short on 5 contracts on Infosys and long on 3 contracts
of Reliance. If next day, he buys 2 Infosys contracts of same maturity, his open position
would be – short on 3 Infosys contracts and long on 3 Reliance contracts.
Naked and calendar spread positions
Naked position in futures market simply means a long or short position in any futures
contract without having any position in the underlying asset. Calendar spread position is
a combination of two positions in futures on the same underlying - long on one maturity
contract and short on a different maturity contract. For instance, a short position in near
month contract coupled with a long position in far month contract is a calendar spread
position. Calendar spread position is computed with respect to the near month series
and becomes an open position once the near month contract expires or either of the
offsetting positions is closed.
A calendar spread is always defined with regard to the relevant months i.e. spread
between August contract and September contract, August contract and October
contract and September contract and October contract etc.
Opening a position
Opening a position means either buying or selling a contract, which increases client’s
open position (long or short).
27
Closing a position
Closing a position means either buying or selling a contract, which essentially results in
reduction of client’s open position (long or short). A client is said to be closed a position
if he sells a contract which he had bought before or he buys a contract which he had
sold earlier.
Limitations of Futures Contract
As futures are standardized contracts introduced by the exchanges, they too have
certain limitations in the context of limited maturities, limited underlying set, lack of
flexibility in contract design and increased administrative costs on account of MTM
settlement etc.
Differences between Forwards and Futures
Feature Forward contracts Futures contracts
Operational It is not traded on the It is an exchange-traded
mechanism exchanges. contract.
Contract Terms of the contracts differ Terms of the contracts are
specifications from trade to trade (tailor made standardized.
contract) according to the need
of the participants.
Counter-party Exists, but at times gets reduced
Exists but the clearing agency
risk by a guarantor. associated with exchanges
becomes the counter-party to all
trades assuring guarantee on
their settlement.
Liquidation Low, as contracts are tailor High, as contracts are
profile made catering to the needs of standardised exchange-traded
the parties involved. Further, contracts.
contracts are not easily
accessible to other market
participants.
28
Examples Currency markets are an Commodities futures, Currency
example of forwards. Today futures, Index futures and
currency futures and options Individual stock futures in India.
have been introduced in India,
but yet a market for currency
forwards exists through banks.
29
110 10
120 20
130 30
140 40
150 50
60
Long Futures Payoff
40
20
Profit/Loss (Rs.)
0
50 60 70 80 90 100 110 120 130 140 150
CMP @ Expiry
-20
-40
30
60
Short Futures Payoff
40
20
Profit/Loss (Rs.)
0
50 60 70 80 90 100 110 120 130 140 150
CMP @ Expiry
-20
-40
As can be seen, a short futures position makes profits when prices fall. If prices fall to 60
at expiry, the person who has shorted at Rs.100 will buy from the market at 60 on expiry
and sell at 100, thereby making a profit of Rs. 40. This is shown in the above chart.
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• Create a synthetic forward/futures position by buying in the cash market and
carrying the asset to future date.
Price of acquiring the asset as on future date in both the cases should be same i.e. cost
of synthetic forward/ futures contract (spot price + cost of carrying the asset from today
to the future date) should be equivalent to the price of present forward/ futures
contract. If prices are not same then it will trigger arbitrage and will continue until prices
in both the markets are aligned.
The cost of creating a synthetic futures position is a fair price of futures contract. Fair
price of futures contract is nothing but addition of spot price of underlying asset and
cost of carrying the asset from today until delivery. Cost of carrying a financial asset
from today to the future date would entail different costs like transaction cost, custodial
charges, financing cost etc whereas for commodities, it would also include costs like
warehousing cost, insurance cost etc.
Let us take an example from Bullion Market. The spot price of gold is Rs 15000 per 10
grams. The cost of financing, storage and insurance for carrying the gold for three
months is Rs. 100 per 10 gram. Now you purchase 10 gram of gold from the market at
Rs 15000 and hold it for three months. We may now say that the value of the gold after
3 months would be Rs 15100 per 10 gram.
Assume the 3-month futures contract on gold is trading at Rs 15150 per 10 gram. What
should one do? Apparently, one should attempt to exploit the arbitrage opportunity
present in the gold market by buying gold in the cash market and sell 3-month gold
futures simultaneously. We borrow money to take delivery of gold in cash market today,
hold it for 3 months and deliver it in the futures market on the expiry of our futures
contract. Amount received on honouring the futures contract would be used to repay
the financer of our gold purchase. The net result will be a profit of Rs 50 without taking
any risk. (In the entire process, we have not considered any transaction cost-brokerage
etc.)
Because of this mispricing, as more and more people come to the cash market to buy
gold and sell in futures market, spot gold price will go up and gold futures price will
come down. This arbitrage opportunity continues until the prices between cash and
futures markets are aligned.
Therefore, if futures price is more than the future fair price of asset/ synthetic futures
price, it will trigger cash and carry arbitrage, which will continue until the prices in both
the markets are aligned.
Similarly, if futures prices is less than the future fair price of asset/ synthetic futures
price, it will trigger reverse cash and carry arbitrage i.e. market participants start buying
gold in futures markets and sell gold in cash market. Now people will borrow gold and
deliver it to honour the contract in the cash market and earn interest on the cash
market sales proceeds. After three months, they give gold back to the lender on receipt
of the same in futures market. This reverse arbitrage will result in reduction of gold’s
32
spot price and increase of its futures price, until these prices are aligned to leave no
money on the table.
Cost of transaction and non-arbitrage bound
Cost components of futures transaction like margins, transaction costs (commissions),
taxes etc. create distortions and take markets away from equilibrium. In fact, these cost
components create a non-arbitrage bound in the market i.e. if the futures price is within
that bound around the future fair value/ synthetic futures value, arbitrage will not take
place. In other words, because of the frictions in the market, for arbitrage to get
triggered, it is important for the futures price to fall beyond the non arbitrage bound in
either direction for the arbitragers to make profit from the arbitrage opportunities.
Fair Price
Practically, every component of carrying cost contributes towards widening this non-
arbitrage bound. Here, we should appreciate that wider the non-arbitrage bound,
farther the markets are from the equilibrium. In other words, for markets to be efficient,
different costs of operating in the markets should be as low as possible. Lower costs
would narrow down the non-arbitrage bound, which in-turn would ensure the efficient
price alignment across the markets.
Extension of cash & carry model to the assets generating returns
Let us extend the concept of cash and carry model by adding the inflows during the
holding period of underlying assets. For instance, underlying asset like securities (equity
or bonds) may have certain inflows, like dividend on equity and interest on debt
instruments, during the holding period. These inflows are adjusted in the future fair
price. Thus, modified formula of future fair price or synthetic futures price is:
Fair price = Spot price + Cost of carry - Inflows
In mathematical terms, F = S (1+r-q)T
Where F is fair price of the futures contract, S is the Spot price of the underlying asset, q
is expected return during holding period T (in years) and r is cost of carry.
If we use the continuous compounding, we may rewrite the formula as: F= Se(r-q)*T
Let us apply the above formula to the index futures market to find the synthetic futures
price/ future fair price of an index. Suppose , you buy index in cash market at 5000 level
i.e. purchase of all the stocks constituting the index in the same proportion as they are
in the index, cost of financing is 12% and the return on index is 4% per annum (spread
uniformly across the year). Given this statistics, fair price of index three months down
the line should be:
= Spot price (1+cost of financing – holding period return) ^ (time to expiration/365)
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= 5000 (1+0.12-0.04)^(90/365)
= Rs. 5095.79
[Alternatively, we could use exponential form for calculating the futures value as spot
price * e(r-q)T. Value in that case would have been 5000 * e((0.12-0.04)*90/365) = Rs. 5099.61].
If index futures is trading above 5099, we can buy index stocks in cash market and
simultaneously sell index futures to lock the gains equivalent to the difference between
futures price and future fair price (the cost of transaction, taxes, margins etc. are not
considered while calculating the future fair value).
Note: Cost of borrowing of funds and securities, return expectations on the held asset
etc. are different for the different market participants. The number of fair values of
futures can be equal to the number of market participants in the market. Perhaps the
difference among the fair values of futures contracts and non-arbitrage bound for
different market participants is what makes the market on continuous basis.
Assumptions in cash and carry model
Cash and carry model of futures pricing works under certain assumptions. The important
assumptions are stated below:*
• Underlying asset is available in abundance in cash market.
• Demand and supply in the underlying asset is not seasonal.
• Holding and maintaining of underlying asset is easy and feasible.
• Underlying asset can be sold short.
• No transaction costs.
• No taxes.
• No margin requirements.
[*This is not an exhaustive list of the assumptions of the model]
The assumption that underlying asset is available in abundance in the cash market i.e.
we can buy and/or sell as many units of the underlying assets as we want. This
assumption does not work especially when underlying asset has seasonal pattern of
demand and supply. The prices of seasonal assets (especially commodities) vary
drastically in different demand-supply environments. When supplies arrive to the
market place, prices are generally low whereas prices are generally high immediately
before the supply of the underlying.
When an underlying asset is not storable i.e. the asset is not easy to hold/maintain, then
one cannot carry the asset to the future. The cash and carry model is not applicable to
these types of underlying assets.
Similarly, many a times, the underlying may not be sold short. This is true in case of
seasonal commodities.
Even though this simple form of cash and carry model does not discount for transaction
cost, taxes etc. we can always upgrade the formula to reflect the impact of these factors
in the model. Margins are not considered while delivering the fair value/ synthetic
futures value. That is why this model is suitable for pricing forward contracts rather than
futures contracts.
34
Thus, no generalized statement can be made with regard to the use of cash and carry
model for pricing futures contracts. Assumptions of the model and characteristics of
underlying asset can help us in deciding whether a specific asset can be priced with the
help of this model or not. Further, suitable adjustments are made in the model to fit in
the specific requirements of the underlying assets.
Convenience Yield
Let us touch one more concept in futures market called Convenience Yield. We need to
go back and have a look at the formula for fair price of futures contract.
Fair price of futures contract = Spot price + Cost of carry – Inflows
As seen earlier inflows may be in the form of dividend (in case of equity) and interest (in
case of debt). However, sometimes inflows may also be intangibles. Intangible inflows
essentially mean values perceived by the market participants just by holding the asset.
These values may be in the form of just convenience or perceived mental comfort by
holding the asset.
For instance, in case of natural disaster like flood in a particular region, people start
storing essential commodities like grains, vegetables and energy products (heating oil)
etc. As a human tendency we store more than what is required for our real consumption
during a crisis. If every person behaves in similar way then suddenly a demand is
created for an underlying asset in the cash market. This indirectly increases the price of
underlying assets. In such situations people are deriving convenience, just by holding
the asset. This is termed as convenience return or convenience yield.
Convenience return for a commodity is likely to be different for different people,
depending on the way they use it. Further, it may vary over a period. In fact,
convenience is a subjective issue and may be very difficult to price.
Convenience yield sometimes may dominate the cost of carry, which leads futures to
trade at a discount to the cash market. In this case, reverse arbitrage is also not possible
because no one lends traders the assets to sell short in the cash market. In such
situations, practically, the cash and carry model breaks down and cannot be applied for
pricing the underlying assets.
Expectancy model of futures pricing
According to the expectancy model, it is not the relationship between spot and futures
prices but that of expected spot and futures prices, which moves the market, especially
in cases when the asset cannot be sold short or cannot be stored. It also argues that
futures price is nothing but the expected spot price of an asset in the future. This is why
market participants would enter futures contract and price the futures based upon their
estimates of the future spot prices of the underlying assets.
According to this model,
• Futures can trade at a premium or discount to the spot price of underlying asset.
• Futures price give market participants an indication of the expected direction of
movement of the spot price in the future.
35
For instance, if futures price is higher than spot price of an underlying asset, market
participants may expect the spot price to go up in near future. This expectedly rising
market is called “Contango market”. Similarly, if futures price are lower than spot price
of an asset, market participants may expect the spot price to come down in future. This
expectedly falling market is called “Backwardation market”.
Price discovery and convergence of cash and futures prices on the expiry
It is important to understand what actually futures prices indicate? For instance, if say
Jan. 2008 index futures contract is trading today (in December 2007) at 6200, what does
it mean. We can explain this by saying that that market expects the cash index to settle
at 6200 at the closure of the market on last Thursday (last trading day of the contract).
Point is that every participant in the market is trying to predict the cash index level at a
single point in time i.e. at the closure of the market on last trading day of the contract,
which is Thursday in our example. This results in price discovery of cash index at a
specific point in time. Now, we may also state that futures prices are essentially
expected spot price of the underlying asset, at the maturity of the futures contract.
Accordingly, both futures and spot prices converge at the maturity of futures contract,
as at that point in time there cannot be any difference between these two prices. This is
the reason why all futures contracts on expiry settle at the underlying cash market price.
This principal remains same for all the underlying assets.
6450
Nifty Basis
6250
6050
5850
Nifty Levels
5650
5450
5250
5050
4850
8
8
07
07
07
08
08
08
08
00
00
00
00
00
00
00
00
00
00
00
20
20
20
20
20
20
20
/2
/2
/2
/2
/2
/2
/2
/2
/2
/2
/2
7/
9/
1/
2/
4/
6/
8/
10
12
14
16
18
20
22
24
26
28
30
/2
/2
/3
1/
1/
1/
1/
1/
1/
1/
1/
1/
1/
1/
1/
1/
1/
1/
12
12
12
36
commodity derivatives, some contracts may settle with physical delivery. Even in the
case of physical settlement, financial assets are not bulky and do not need special
facility for storage, whereas in commodity market, due to the bulky nature of the
underlying assets, physical settlement in commodity derivatives creates the need for
warehousing. The varying quality of asset does not really exist as far as financial
underlying is concerned but in case of commodities, the quality of the asset underlying a
contract can vary significantly.
37
Traders take naked positions in the futures market i.e. they go long or short in various
futures contracts available in the market. Indeed, capacity of derivatives market to
absorb buying/selling by hedgers is directly dependent upon availability of traders, who
act as counter-party to hedgers. Accordingly, Traders form one of the most important
participants of the derivatives market, providing depth to the market. Hedgers will not
be able to hedge if traders were not present in the system. Therefore, for futures
market to click, presence of both hedgers and traders is a must.
For instance, assume, a farmer expects the price of wheat to fall in near future. He
wants to hedge his price risk on wheat produce for next 3 months till the time he has
actual produce in his hands and so would like to lock at the forward/ futures price now.
Accordingly, farmer can sell futures contracts on the expected quantity of produce. In
order to sell this futures contract, he needs a buyer. This buyer may be someone who
needs wheat after three months, may be a flour mill or a bakery. However, most of the
times, there is a demand supply mismatch in the market and the trader fills the gap
between demand and supply.
Here trader, counterparty to the farmer, is thinking in contrary i.e. this buyer would buy
only if he thinks that actual price of wheat is going to be higher than the contract price
for futures three months down the line. Further, the profit of trader would depend
upon actual wheat price being more than the contracted futures price at the maturity of
futures contract. If it is so, trader would make money otherwise he would lose money.
In addition to hedgers and traders, to establish a link between various markets like spot
and derivatives, we need a third party called arbitragers. These arbitragers continuously
hunt for the profit opportunities across the markets and products and seize those by
executing trades in different markets and products simultaneously. Importantly,
arbitragers generally lock in their profits unlike traders who trade naked contracts.
For example at the end of day (1st March 2012):
Market price of underlying asset (in Rs.) 100
March futures 110
Lot size 50
Here an arbitrageur will buy in the cash market at Rs. 100 and sell in the Futures market
at Rs. 110, thereby locking Rs. 10 as his profit on each share.
On the expiration date, suppose price (in Rs.) of the underlying asset is 108.
Cash Market Futures
Buy 100 Sell 110
Sell 108 Buy 108
+8 +2
Total profit would therefore be 10*50 = Rs. 500.
Suppose price (in Rs.) of the underlying asset is 95 on the expiration date.
Cash Market Futures
Buy 100 Sell 110
Sell 95 Buy 95
-5 +15
Total profit is 10*50 = Rs. 500.
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In the entire activity, the transaction cost and impact cost have not been considered. In
real life, the transaction cost has to be considered like the brokerage, service Tax,
Securities Service Tax etc.
Here, it may be interesting to look at the risks these arbitragers carry. As seen before,
arbitragers are executing positions in two or more markets/products simultaneously.
Even if the systems are seamless and electronic and both the legs of transaction are
liquid, there is a possibility of some gap between the executions of both the orders. If
either leg of the transaction is illiquid then the risk on the arbitrage deal is huge as only
one leg may get executed and another may not, which would open the arbitrager to the
naked exposure of a position. Similarly, if contracts are cash settled in both or one of the
markets, it would need reversal of trades in the respective markets, which would result
in additional risk on unwinding position with regard to simultaneous execution of the
trades.
These profit focused traders and arbitrageurs fetch enormous liquidity to the products
traded on the exchanges. This liquidity in turn results in better price discovery, lesser
cost of transaction and lesser manipulation in the market.
Uses of Index futures
Equity derivatives instruments facilitate trading of a component of price risk, which is
inherent to investment in securities. Price risk is nothing but change in the price
movement of asset, held by a market participant, in an unfavourable direction. This risk
broadly divided into two components - specific risk or unsystematic risk and market risk
or systematic risk.
Unsystematic Risk
Specific risk or unsystematic risk is the component of price risk that is unique to
particular events of the company and/or industry. This risk is inseparable from investing
in the securities. This risk could be reduced to a certain extent by diversifying the
portfolio.
Systematic Risk
An investor can diversify his portfolio and eliminate major part of price risk i.e. the
diversifiable/unsystematic risk but what is left is the non-diversifiable portion or the
market risk-called systematic risk. Variability in a security’s total returns that are directly
associated with overall movements in the general market or economy is called
systematic risk. Thus, every portfolio is exposed to market risk. This risk is separable
from investment and tradable in the market with the help of index-based derivatives.
When this particular risk is hedged perfectly with the help of index-based derivatives,
only specific risk of the portfolio remains.
Therefore, we may say that total price risk in investment in securities is the sum of
systematic risk or market risk and unsystematic risk or specific risk.
Before we get to management of systematic risk with index futures, we need to
understand Beta - a measure of systematic risk of a security that cannot be avoided
through diversification. It measures the sensitivity of a stock / portfolio vis-a-vis index
39
movement over a period of time, on the basis of historical prices. Suppose a stock has a
beta equal to 2. This means that historically a security has moved 20% when the index
moved 10%, indicating that the stock is more volatile than the index. Stocks / portfolios
having beta more than 1 are called aggressive and having beta less than 1 are called
conservative stocks / portfolios.
In order to calculate beta of a portfolio, betas of individual stocks are used. It is
calculated as weighted average of betas of individual stocks in the portfolio based on
their investment proportion. For example, if there are four stocks in a portfolio with
betas 0.5, 1.1, 1.30 and 0.90 having weights 35%, 15%, 20% and 30% respectively, the
beta of this portfolio would be 0.87 (0.5*0.35 +1.10*0.15 +1.30*0.20 +0.90*0.30).
A generalized formula for portfolio beta can be written as W1 β1+W2 β2+…+ Wn βn= βp
Where, W1 is weight of stock 1, β1 is the β of stock 1, W2 is weight of stock 2, β2 is the
β of stock 2, Wn is weight of stock n, βn is the β of stock n and βp is the β of portfolio.
Information on beta of individual stocks is readily available in various financial
newspapers, magazines and information vending networks like Bloomberg, Reuters etc.
Now, let us get to management of systematic risk. Assume you are having a portfolio
worth Rs.3,00,000 in cash market. You see the market may be volatile due to some
reasons. You are not comfortable with the market movement in the short run. At this
point of time, you have two options: (1) sell the entire portfolio and buy later and (2)
hedge by the use of Index futures to protect the value of this portfolio from the
expected fall in the market.
As an investor you are comfortable with the second option. If the prices fall, you make
loss in cash market but make profits in futures market. If prices rise, you make profits in
cash market but losses in futures market.
Now, the question arises how many contracts you have to sell to make a perfect hedge?
Perfect hedge means if you make Rs. 30,000 loss in cash market then you should make
Rs. 30,000 profit in futures market. To find the number of contracts for perfect hedge
‘hedge ratio’ is used. Hedge ratio is calculated as:
Number of contracts for perfect hedge = Vp * βp / Vi
Vp – Value of the portfolio
βp – Beta of the portfolio
Vi – Value of index futures contract
Value of index futures contract or contract size = futures index level * contract
multiplier. Readers may note that for simplification purpose, beta of futures index vis-a-
vis cash index is taken as one.
Let us assume, Beta of your portfolio is 1.3 and benchmark index level is 2608.65, then
hedge ratio will be (3, 00,000*1.3/2608.65) = 149.50 indices. Assume one Futures
contract has a lot size of 50. You will have to hedge using 149.5/ 50 = 2.99 contracts.
Since you cannot hedge 2.99 contracts, you will have to hedge by 3 futures contracts.
You have to pay the broker initial margin in order to take a position in futures.
40
Hedge against the systematic risk mainly depends upon the relationship of portfolio
with the index, which is measured by beta. A portfolio has different relationships with
different indices used for hedge hence the hedge ratio would change with the change in
the index. Further, there is an assumption that the past relationship between the stock’s
or portfolio’s movement and the index movement would continue in future. This may
result in some difference between actual and expected numbers.
Similarly, we can use single stock futures to manage the risk of the equity investment in
cash market. For instance, use of single stock futures would hedge the market
participant against the whole risk in the equity investment because these futures are
comparable with underlying positions. Only difference between an underlying position
and single stock futures is on settlement front; in case of cash transactions, settlement
takes place immediately and in case of single stock futures contracts, settlement is
deferred.
Important terms in hedging
Long hedge: Long hedge is the transaction when we hedge our position in cash market
by going long in futures market. For example, we expect to receive some funds in future
and want to invest the same amount in the securities market. We have not yet decided
the specific company/companies, where investment is to be made. We expect the
market to go up in near future and bear a risk of acquiring the securities at a higher
price. We can hedge by going long index futures today. On receipt of money, we may
invest in the cash market and simultaneously unwind corresponding index futures
positions. Any loss due to acquisition of securities at higher price, resulting from the
upward movement in the market over intermediate period, would be partially or fully
compensated by the profit made on our position in index futures.
Further, while investing, suitable securities at reasonable prices may not be immediately
available in sufficient quantity. Rushing to invest all money is likely to drive up the prices
to our disadvantage. This situation can also be taken care of by using the futures. We
may buy futures today; gradually invest money in the cash market and unwind
corresponding futures positions.
Similarly, we can take an example from the commodity market, if there is a flour mill
and it is expecting the price of wheat to go up in near future. It may buy wheat in
forwards/ futures market and protect itself against the upward movement in price of
wheat. This would also be an example of long hedge.
Short hedge: Short Hedge is a transaction when the hedge is accomplished by going
short in futures market. For instance, assume, we have a portfolio and want to liquidate
in near future but we expect the prices to go down in near future. This may go against
our plan and may result in reduction in the portfolio value. To protect our portfolio’s
value, today, we can short index futures of equivalent amount. The amount of loss
made in cash market will be partly or fully compensated by the profits on our futures
positions.
41
Let us take an example from currency market. Assume Company C is into export and
import business. Company expects some dollars to flow in after say 6 months. Director
Finance of the company is expecting the depreciation in dollar vis-a-vis local currency
over this period of time. To protect against this risk of adverse movement in exchange
rate of currency, company C may sell dollars in forward /futures market. This selling
would protect company against any fall of dollar against the local currency.
Cross hedge: When futures contract on an asset is not available, market participants
look forward to an asset that is closely associated with their underlying and trades in the
futures market of that closely associated asset, for hedging purpose. They may trade in
futures in this asset to protect the value of their asset in cash market. This is called cross
hedge.
For instance, if futures contracts on jet fuel are not available in the international
markets then hedgers may use contracts available on other energy products like crude
oil, heating oil or gasoline due to their close association with jet fuel for hedging
purpose. This is an example of cross hedge.
Indeed, in a crude sense, we may say that when we are using index futures to hedge
against the market risk on a portfolio, we are essentially establishing a cross hedge
because we are not using the exact underlying to hedge the risk against.
Hedge contract month: Hedge contract month is the maturity month of the contract
through which we hedge our position. For instance, if we use August 200X contract to
hedge our portfolio’s market risk, our hedge contract month would be August 200X
contract. Similarly, if we hedge say risk on crude oil price with the help of Mar. 200Y,
hedge contract month would be Mar. 200Y.
Trading in futures market
Traders are risk takers in the derivatives market. And they take positions in the futures
market without having position in the underlying cash market. These positions are
based upon their expectations on price movement of underlying asset. Traders either
take naked positions or spread positions.
A trader takes a naked long position when he expects the market to go up. Money
comes by reversing the position at higher price later. Similarly, he takes a short position
when he expects the market to go down to book profit by reversing his position at lower
price in the future. For instance, if one month Sensex futures contract is trading at
17900 and trader expects the cash index at the maturity of the one month contract
should settle at a level higher than this, he would take a long position in index futures at
a level of 17900. If his expectation comes true and index on maturity settles beyond
17900, this trader will make money to the extent of the difference between buy and
sell/settlement price of the index.
Traders may also take long/short positions in single stock futures. When they expect the
market to go up, they may take long position in these futures and when they expect the
market to go down, they may take short position in single stock futures.
42
Similarly, if someone wants to trade upon say steel prices, he may take long or short
position on steel futures depending upon his view – long position, if he expects the
market to move upwards and short position, if he expects the market to go downward.
If market moves in the expected direction, trader would end up making profit. Here, it
may be noted that if market does not move in the expected direction, trader may also
incur a loss. Because, a position is as exposed to loss as profit, it is called the speculative
position.
Naked position is long or short in any of the futures contracts but in case of a spread,
two opposite positions (one long and one short) are taken either in two contracts with
same maturity on different products or in two contracts with different maturities on the
same product. Former is inter-commodity or inter-product spread and latter is calendar
spread/time spread or horizontal spread. Exchanges need to provide the required inputs
to the system for it to recognize any kind of spread. At present, in equity market, the
system recognizes only calendar spreads. In commodities market, system recognizes
inter-commodity spread between specific commodities like Gold and Silver; Soybean,
Soybean meal and Soybean oil, etc.
Calendar spread position is always computed with respect to the near month series. For
instance, if Mr. A has say 3 contacts short in one month futures contract, 2 contracts
long in two months futures contract and 3 contracts long in three months futures
contract, he would be said to have 2 calendar spreads between first and second months
and 1 calendar spread between first and third month. Further, his position in remaining
2 three months contracts would be treated as naked. A calendar spread becomes a
naked/open position, when the near month contract expires or either of the legs of
spread is closed. As spread positions are hedged to a large extent because they are
combinations of two opposite positions, they are treated as conservatively speculative
positions.
Arbitrage opportunities in futures market
Arbitrage is simultaneous purchase and sale of an asset or replicating asset in the
market in an attempt to profit from discrepancies in their prices. Arbitrage involves
activity on one or several instruments/assets in one or different markets,
simultaneously. Important point to understand is that in an efficient market, arbitrage
opportunities may exist only for shorter period or none at all. The moment an arbitrager
spots an arbitrage opportunity, he would initiate the arbitrage to eliminate the arbitrage
opportunity.
Arbitrage occupies a prominent position in the futures world as a mechanism that keeps
the prices of futures contracts aligned properly with prices of the underlying assets. The
objective of arbitragers is to make profits without taking risk, but the complexity of
activity is such that it may result in losses as well. Well-informed and experienced
professional traders, equipped with powerful calculating and data processing tools,
normally undertake arbitrage.
Arbitrage in the futures market can typically be of three types:
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• Cash and carry arbitrage: Cash and carry arbitrage refers to a long position in the
cash or underlying market and a short position in futures market.
• Reverse cash and carry arbitrage: Reverse cash and carry arbitrage refers to long
position in futures market and short position in the underlying or cash market.
• Inter-Exchange arbitrage: This arbitrage entails two positions on the same
contract in two different markets/ exchanges.
These three positions are elaborated with the help of examples. To simplify the
calculations, it is assumed that there is no resistance like transaction costs, impact cost,
taxes etc., but in reality, arbitrage may not be as easy and costless as presumed in these
simplified examples. In a simplified world of the kind described by our assumptions,
actual futures prices are assumed to be exactly equal to the fair price or theoretical
price, which is spot price plus cost of carry.
In the language of simple mathematics, Fair futures price F = S + C
where S stands for Spot price and C stands for Holding costs/carrying costs.
If cost of carry is defined in the percentage terms, we may redefine the formula as:
F = S(1+r)T
Where r is the carrying cost (in percentage) and T is the Time to expiration (in years).
If we use continuous compounding for computation of the cost, the same formula
reduces to:
F= SerT
If futures price is higher than fair/theoretical price, there would exist profitable, risk-
free, cash and carry arbitrage opportunity. Thus, unless there are obstacles to such
arbitrage the activities of the arbitrageurs would cause spot-futures price relationships
to conform to that described by the cost of carry formula. On rare occasions, however,
there is an arbitrage opportunity that exists for some time. Practically, an arbitrage is
feasible and will be undertaken only if it provides net cash inflow after transaction costs,
brokerage, margin deposits etc.
Illustrations:
Cash and carry arbitrage
The following data is available on stock A as on August 1, 2008.
Cash market price Rs. 1500
December Futures Rs. 1520
Contract multiplier for stock 100 shares
Assume an implied cost of carry of 8% p.a. i.e. 0.75% per month.
Theoretically/ fair price of December futures is 1504.69 (= 1500 * e0.0075*5/12). Going by
the theoretical price, we may say that December futures on stock A are overvalued. To
take advantage of the mispricing, an arbitrageur may buy 100 shares of stock A and sell
1 futures contract on that at given prices. This would result in the arbitrage profit of Rs.
1531 (= 100 X 15.31), which is the difference between actual and fair prices for 100
shares. Position of the arbitrager in various scenarios of stock price would be as follows:
44
Case I: Stock rises to Rs. 1550
Profit on underlying = (1550 – 1500) x 100 = Rs. 5000
Loss on futures = (1550 - 1520) x 100 = Rs. 3000
Gain on Arbitrage = Rs. 2,000
Cost of Arbitrage in terms of financing (Rs. 4.69 for 100 shares) = Rs. 469
Net gain out of arbitrage = (2000 – 469)= Rs 1531
Case II: Stock falls to Rs.1480
Loss on underlying = (1500- 1480) x 100 = Rs. 2000
Profit on futures = (1520-1480) x 100 = Rs. 4000
Gain on Arbitrage = Rs. 2000
Cost of Arbitrage in terms of financing (Rs. 4.69 for 100 shares) = Rs. 469
Net gain out of arbitrage = (2000 – 469) = Rs. 1531
Reverse cash and carry arbitrage
The reverse cash and carry arbitrage is done when the futures are trading at a discount
to the cash market price. Let us look at the following data on stock A as on December 1.
Cash market price Rs. 100
December futures price Rs. 90
The prices trading in the market reflect a negative cost of carry, which offers an
opportunity to the traders to execute reverse cash and carry arbitrage as cost of carry is
expected to reverse to positive at some point in time during contract’s life. Otherwise,
also, if the trader carries his position till the expiry, it will yield him an arbitrage profit.
The assumption in implementing this arbitrage opportunity is that the arbitrager has got
the stock to sell in the cash market, which will be bought back at the time of reversing
the position. If stock is not available, arbitrager needs to borrow the stock to implement
the arbitrage. In that case, while analyzing the profitability from the transaction, cost of
borrowing of stock would also be taken into account.
Assuming the contract multiplier for futures contract on stock A is 200 shares. To
execute the reverse cost and carry, arbitrager would buy one December futures at Rs.90
and sell 200 shares of stock A at Rs.100 in cash market. This would result in the arbitrage
profit of Rs. 2000 (200 X Rs.10). Position of the arbitrager in various scenarios of stock
price would be as follows:
Case I: Stock rises to Rs. 110
Loss on underlying = (110 - 100) x 200 = Rs. 2000
Profit on futures = (110 - 90) x 200 = Rs. 4000
Net gain out of arbitrage = Rs. 2000
Case II: Stock falls to Rs. 85
Profit on underlying = (100 - 85) x 200 = Rs. 3000
Loss on futures = (90 - 85) x 200 = Rs. 1000
Net gain out of arbitrage = Rs. 2000
45
On maturity, when the futures price converges with the spot price of underlying, the
arbitrageur is in a position to buy the stock back at the closing price/ settlement price of
the day.
Our assumption in the above example is that both the positions (i.e. in cash and futures)
were held until maturity. However, one can always square off one’s position before the
expiry of the contract, whenever one feels that the market prices are favourable. Let us
understand this point with the help of an example. If in the above example of reverse
cost and carry, on any day in December before the maturity date, spot price of stock A is
Rs. 130 and December futures are at Rs. 135, arbitrager could reverse both his positions
i.e. buying the stock at Rs. 130 and selling futures at Rs. 135. This would result in the
following position:
Loss on underlying = (130 - 100) x 200 = Rs. 6000
Profit on futures = (135 - 90) x 200 = Rs. 9000
Net gain out of arbitrage = Rs. 3000
The above example on reverse cash and carry arbitrage can also be expanded to include
the interest income generated out of investing the sale proceeds of the stock.
Inter-market arbitrage
This arbitrage opportunity arises because of some price differences existing in same
underlying at two different exchanges. If August futures on stock Z are trading at Rs. 101
at NSE and Rs. 100 at BSE, the trader can buy a contract at BSE and sell at NSE. The
positions could be reversed over a period of time when difference between futures
prices squeeze. This would be profitable to an arbitrageur.
It is important to note that the cost of transaction and other incidental costs involved in
the deal must be analyzed properly by the arbitragers before entering into the
transaction.
In the light of above, we may conclude that futures provide market participants with a
quick and less expensive mode to alter their portfolio composition to arrive at the
desired level of risk. As they could be used to either add risk to the existing portfolios or
reduce risk of the existing portfolios, they are essentially risk management and portfolio
restructuring tool.
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Chapter 4: Introduction to Options
4.1 Basics of options
As seen in earlier section, forward/futures contract is a commitment to buy/sell the
underlying and has a linear pay off, which indicates unlimited losses and profits. Some
market participants desired to ride upside and restrict the losses. Accordingly, options
emerged as a financial instrument, which restricted the losses with a provision of
unlimited profits on buy or sell of underlying asset.
An Option is a contract that gives the right, but not an obligation, to buy or sell the
underlying asset on or before a stated date/day, at a stated price, for a price. The party
taking a long position i.e. buying the option is called buyer/ holder of the option and the
party taking a short position i.e. selling the option is called the seller/ writer of the
option.
The option buyer has the right but no obligation with regards to buying or selling the
underlying asset, while the option writer has the obligation in the contract. Therefore,
option buyer/ holder will exercise his option only when the situation is favourable to
him, but, when he decides to exercise, option writer would be legally bound to honour
the contract.
Options may be categorized into two main types:-
• Call Options
• Put Options
Option, which gives buyer a right to buy the underlying asset, is called Call option and
the option which gives buyer a right to sell the underlying asset, is called Put option.
Option terminology
There are several terms used in the options market. Let us comprehend on each of them
with the help of the following price:
Quote for Nifty Call option as on September 30, 2010
1. Instrument type : Option Index
2. Underlying asset : Nifty
3. Expiry date : October 28, 2010
4. Option type : Call European
5. Strike Price : 5900
6. Open price : 208.05
7. High price : 230
8. Low price : 183.9
9. Close price : 221.20
10. Traded Quantity : 700000
11. No of Contracts : 13539
12. Open Interest : 2700000
13. Underlying value : 6029.95
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Quote for Nifty Put option as on September 30, 2010
1. Instrument type : Option Index
2. Underlying asset : Nifty
3. Expiry date : October 28, 2010
4. Option type : Put European
5. Strike Price : 5900
6. Open price : 86.5
7. High price : 104
8. Low price : 84
9. Close price : 88.75
10. Traded Quantity : 3600000
11. No of Contracts : 71019
12. Open Interest : 3000000
13. Underlying value : 6029.95
Index option: These options have index as the underlying asset. For example options on
Nifty, Sensex, etc.
Stock option: These options have individual stocks as the underlying asset. For example,
option on ONGC, NTPC etc.
Buyer of an option: The buyer of an option is one who has a right but not the obligation
in the contract. For owning this right, he pays a price to the seller of this right called
‘option premium’ to the option seller.
Writer of an option: The writer of an option is one who receives the option premium
and is thereby obliged to sell/buy the asset if the buyer of option exercises his right.
American option: The owner of such option can exercise his right at any time on or
before the expiry date/day of the contract.
European option: The owner of such option can exercise his right only on the expiry
date/day of the contract. In India, Index options are European.
Option price/Premium: It is the price which the option buyer pays to the option seller.
In our examples, option price for call option is Rs. 221.20 and for put option is Rs. 88.75.
Premium traded is for single unit of nifty and to arrive at the total premium in a
contract, we need to multiply this premium with the lot size.
Lot size: Lot size is the number of units of underlying asset in a contract. Lot size of Nifty
option contracts is 50. Accordingly, in our examples, total premium for call option
contract would be Rs. 221.20*50= 11060 and total premium for put option contract
would be Rs. 88.75*50 = 4437.5.
Expiration Day: The day on which a derivative contract ceases to exist. It is the last
trading date/day of the contract. In our example, the expiration day of contracts is the
last Thursday of October month i.e. 28 October, 2010.
Spot price (S): It is the price at which the underlying asset trades in the spot market. In
our examples, it is the value of underlying viz. 6029.95.
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Strike price or Exercise price (X): Strike price is the price per share for which the
underlying security may be purchased or sold by the option holder. In our examples,
strike price for both call and put options is 5900.
In the money (ITM) option: This option would give holder a positive cash flow, if it were
exercised immediately. A call option is said to be ITM, when spot price is higher than
strike price. And, a put option is said to be ITM when spot price is lower than strike
price. In our examples, call option is in the money.
At the money (ATM) option: At the money option would lead to zero cash flow if it
were exercised immediately. Therefore, for both call and put ATM options, strike price is
equal to spot price.
Out of the money (OTM) option: Out of the money option is one with strike price worse
than the spot price for the holder of option. In other words, this option would give the
holder a negative cash flow if it were exercised immediately. A call option is said to be
OTM, when spot price is lower than strike price. And a put option is said to be OTM
when spot price is higher than strike price. In our examples, put option is out of the
money.
Intrinsic value: Option premium, defined above, consists of two components - intrinsic
value and time value.
For an option, intrinsic value refers to the amount by which option is in the money i.e.
the amount an option buyer will realize, before adjusting for premium paid, if he
exercises the option instantly. Therefore, only in-the-money options have intrinsic value
whereas at-the-money and out-of-the-money options have zero intrinsic value. The
intrinsic value of an option can never be negative.
Thus, for call option which is in-the-money, intrinsic value is the excess of spot price (S)
over the exercise price (X). Thus, intrinsic value of call option can be calculated as S-X,
with minimum value possible as zero because no one would like to exercise his right
under no advantage condition.
Similarly, for put option which is in-the-money, intrinsic value is the excess of exercise
price (X) over the spot price (S). Thus, intrinsic value of put option can be calculated as
X-S, with minimum value possible as zero.
Time value: It is the difference between premium and intrinsic value, if any, of an
option. ATM and OTM options will have only time value because the intrinsic value of
such options is zero.
Open Interest: As discussed in futures section, open interest is the total number of
option contracts outstanding for an underlying asset.
Exercise of Options
In case of American option, buyers can exercise their option any time before the
maturity of contract. All these options are exercised with respect to the settlement
value/ closing price of the stock on the day of exercise of option.
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Assignment of Options
Assignment of options means the allocation of exercised options to one or more option
sellers. The issue of assignment of options arises only in case of American options
because a buyer can exercise his options at any point of time.
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If Nifty were to close at 6318.35, you will exercise the option and buy Nifty @ 6200 and
make profit by selling it at 6318.5. In this transaction you will make a profit of Rs.
118.35, but you have already paid this much money to the option seller right at the
beginning, when you bought the option. So 6318.35 is the Break Even Point (BEP) for
this option contract. A general formula for calculating BEP for call options is strike price
plus premium (X + P).
If Nifty were to close at 6700, you will exercise the option and buy Nifty at 6200 and sell
it in the market at 6700, thereby making a profit of Rs. 500. But since you have already
paid Rs. 118.35 as option premium, your actual profit would be 500 – 118.35 = 381.65.
For profits/losses for other values, a table is given below. This table is used to draw the
pay off chart given in the next page.
Strike Price (X) 6200
Premium 118.35
51
500
Payoff for Long Call Position
400
300
200
Profit/ Loss
100
0
6100 6150 6200 6250 6300 6350 6400 6450 6500 6550 6600 6650 6700
-100
-200
Nifty Closing Price @ Expiry Payoff for Long Call Position
The contract value for a Nifty option with lot size of 50 and strike price of 6200 is 50 *
6200 = 310000.
The maximum loss for such an option buyer would be equal to 118.35 * 50 = 5917.5
As Nifty goes above 6318.35 you start making profit on exercising the option and if it
stays below 6318.35, you as a buyer always have the freedom not to exercise the
option. But as seen from table and chart you can reduce your losses as soon as nifty
goes above 6200. Long call position helps you to protect your loss to a maximum of Rs.
5917.5 with unlimited profit.
Short Call
Whenever someone buys a call option, there has to be a counterparty, who has sold
that call option. If the maximum loss for a long call position is equal to the premium
paid, it automatically means that the maximum gain for the short call position will be
equal to the premium received. Similarly, if maximum gain for long call position is
unlimited, then even maximum loss for the short call position has to be unlimited.
Lastly, whenever, the long call position is making losses, the short call position will make
profits and vice versa. Hence, if we have understood long call pay off, short call pay off
chart will be just the water image of the long call pay off. Thus at 6100 Nifty, When long
call position makes a loss of Rs. 118.35, short call position will make a profit of Rs.
118.35. Similarly for 6700, when long call makes a profit of 381.65, short call position
will lose 381.65. As Nifty starts rising, short call position will go deeper into losses.
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Strike Price (X) 6200
Premium 118.35
100
0
6100 6150 6200 6250 6300 6350 6400 6450 6500 6550 6600 6650 6700
-100
Profit/ Loss
-200
-300
-400
-500
Nifty Closing Price @ Expiry Payoff for Short Call Position
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For a lot size of 50, the contract value is 50 * 6200 = 310000.
Premium is received by the seller of the option. However he has to pay the margin. This
is because the option seller has an obligation and since his losses can be unlimited, he
can be a potential risk for the stability of the system.
Long Put
On October 1, 2010, Nifty is at 6143.40. You buy a put option with strike price of 6200 at
a premium of Rs. 141.50 with expiry date October 28, 2010. A put option gives the buyer
of the option the right, but not the obligation, to sell the underlying at the strike price.
In this example, you can sell Nifty at 6200. When will you do so? You will do so only
when Nifty is at a level lower than the strike price. So if Nifty goes below 6200 at expiry,
you will buy Nifty from market at lower price and sell at strike price. If Nifty stays above
6200, you will let the option expire. The maximum loss in this case as well (like in long
call position) will be equal to the premium paid; i.e. Rs. 141.50.
What can be the maximum profit? Theoretically, Nifty can fall only till zero. So maximum
profit will be when you buy Nifty at zero and sell it at strike price of 6200. The profit in
this case will be Rs. 6200, but since you have already paid Rs. 141.5 as premium, your
profit will reduce by that much to 6200 – 141.5 = 6058.5.
Breakeven point in this case will be equal to strike price – premium (X – P). In our
example breakeven point will be equal to 6200 – 141.5 = 6058.5. Thus when Nifty starts
moving below 6058.5, will you start making profits.
The pay off chart for long put position is drawn using the below table.
Strike Price (X) 6200
Premium 141.5
54
300
Payoff for Long Put Position
250
200
150
100
Profit/ Loss
50
0
5800 5850 5900 5950 6000 6050 6100 6150 6200 6250 6300 6350 6400
-50
-100
-150
-200
Nifty Closing Price @ Expiry Payoff for Long Put Position
The maximum loss for the option buyer is the premium paid, which is equal to 141.5 *
50 = 7075, where 50 is the lot size. Contract value for this put option is 6200 * 50 =
310000.
A put option buyer need not pay any margin. This is because he has already paid the
premium and there is no more risk that he can cause to the system. A margin is paid
only if there is any obligation. An option buyer (either buyer of a call option or a put
option) has no obligation.
Short Put
What will be the position of a put option seller/writer? Just the opposite of that of the
put option buyer. When long put makes profit, short put will make loss. If maximum loss
for long put is the premium paid, then maximum profit for the short put has to be equal
to the premium received. If maximum profit for long put is when price of underlying falls
to zero at expiry, then that also will be the time when short put position makes
maximum loss.
The table below shows the profit/ loss for short put position. An extra column is added
to the above table to show positions for short put. The pay off chart is drawn using this
table.
55
Strike Price (X) 6200
Premium 141.5
200
Payoff for Short Put Position
150
100
50
0
Profit/ Loss
5800 5850 5900 5950 6000 6050 6100 6150 6200 6250 6300 6350 6400
-50
-100
-150
-200
-250
-300
Nifty Closing Price @ Expiry Payoff for Short Put Position
Contract value in this case will be equal to 6200 * 50 = 310000 and margin received will
be equal to 141.5 * 50 = 7075.
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Seller of the put option receives the premium but he has to pay the margin on his
position as he has an obligation and his losses can be huge.
As can be seen above, options are products with asymmetric risk exposure i.e., the gains
when the underlying asset moves in one direction is significantly different from the
losses when the underlying asset moves in the opposite direction. For example, under a
call option, when a stock price goes down, the loss incurred by the buyer of this option
is limited to the purchase price of the option. But if the stock price goes up, the buyer of
the call gains in proportion to the rise in the stock’s value, thereby giving asymmetric
pay off. In contrast to this, futures have symmetric risk exposures (symmetric pay off).
Opening a Position
An opening transaction is one that adds to, or creates a new trading position. It can be
either a purchase or a sale. With respect to an option transaction, we will consider both:
• Opening purchase (Long on option) – A transaction in which the purchaser’s
intention is to create or increase a long position in a given series of options.
• Opening sale (Short on option) – A transaction in which the seller’s intention is to
create or increase a short position in a given series of options.
Closing a position
A closing transaction is one that reduces or eliminates an existing position by an
appropriate offsetting purchase or sale. This is also known as “squaring off” your
position. With respect to an option transaction:
• Closing purchase – A transaction in which the purchaser’s intention is to reduce
or eliminate a short position in a given series of options. This transaction is
frequently referred to as “covering” a short position.
• Closing sale – A transaction in which the seller’s intention is to reduce or
eliminate a long position in a given series of options.
Note: A trader does not close out a long call position by purchasing a put (or any other
similar transaction). A closing transaction for an option involves the purchase or sale of
an option contract with the same terms.
Leverage
An option buyer pays a relatively small premium for market exposure in relation to the
contract value. This is known as leverage. In our examples above (long call and long put),
we have seen that the premium paid (Rs.5,917.50 for long call and Rs.7,075 for long put)
was only a small percentage of the contract value (Rs.3,10,000 in both cases). A trader
can see large percentage gains from comparatively small, favourable percentage moves
in the underlying equity.
Leverage also has downside implications. If the underlying price does not rise/fall as
anticipated during the lifetime of the option, leverage can magnify the trader’s
percentage loss. Options offer their owners a predetermined, set risk. However, if the
owner’s options expire with no value, this loss can be the entire amount of the premium
paid for the option.
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Risk and return profile of option contracts
Risk Return
Long Premium paid Unlimited
Short Unlimited Premium received
A long option position has limited risk (premium paid) and unlimited profit potential. A
short option position has unlimited downside risk, but limited upside potential (to the
extent of premium received)
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Strike Price
If all the other factors remain constant but the strike price of option increases, intrinsic
value of the call option will decrease and hence its value will also decrease. On the other
hand, with all the other factors remaining constant, increase in strike price of option
increases the intrinsic value of the put option which in turn increases its option value.
Volatility
It is the magnitude of movement in the underlying asset’s price, either up or down. It
affects both call and put options in the same way. Higher the volatility of the underlying
stock, higher the premium because there is a greater possibility that the option will
move in-the-money during the life of the contract.
Higher volatility = Higher premium, Lower volatility = Lower premium (for both call and
put options).
Time to expiration
The effect of time to expiration on both call and put options is similar to that of volatility
on option premiums. Generally, longer the maturity of the option greater is the
uncertainty and hence the higher premiums. If all other factors affecting an option’s
price remain same, the time value portion of an option’s premium will decrease with
the passage of time. This is also known as time decay. Options are known as ‘wasting
assets’, due to this property where the time value gradually falls to zero.
It is also interesting to note that of the two component of option pricing (time value and
intrinsic value), one component is inherently biased towards reducing in value; i.e. time
value. So if all things remain constant throughout the contract period, the option price
will always fall in price by expiry. Thus option sellers are at a fundamental advantage as
compared to option buyers as there is an inherent tendency in the price to go down.
Interest Rates
Interest rates are slightly complicated because they affect different options, differently.
For example, interest rates have a greater impact on options with individual stocks and
indices compared to options on futures. To put it in simpler way high interest rates will
result in an increase in the value of a call option and a decrease in the value of a put
option.
Options Pricing Models
There are various option pricing models which traders use to arrive at the right value of
the option. Some of the most popular models are briefly discussed below:
The Binomial Pricing Model
The binomial option pricing model was developed by William Sharpe in 1978. It has
proved over time to be the most flexible, intuitive and popular approach to option
pricing.
The binomial model represents the price evolution of the option’s underlying asset as
the binomial tree of all possible prices at equally-spaced time steps from today under
the assumption that at each step, the price can only move up and down at fixed rates
and with respective simulated probabilities.
59
This is a very accurate model as it is iterative, but also very lengthy and time consuming.
The Black & Scholes Model
The Black & Scholes model was published in 1973 by Fisher Black and Myron Scholes. It
is one of the most popular, relative simple and fast modes of calculation. Unlike the
binomial model, it does not rely on calculation by iteration.
This model is used to calculate a theoretical call price (ignoring the dividends paid during
the life of the option) using the five key determinants of an option’s price: stock price,
strike price, volatility, time to expiration, and short-term (risk free) interest rate.
The original formula for calculating the theoretical Option Price (OP) is:
OP = SN(d 1 )-XertN(d 2 )
Where,
D 1 =[In(s/n)+(r+(v2/2)t]/ v√t
D 2 = d1-v√t
And the variables are
• S = stock price
• X = strike price
• t = time remaining until expiration, expressed in years
• r = current continuously compounded risk-free interest rate
• v = annual volatility of stock price (the standard deviation of the short-term
returns over one year)
• In = natural logarithm
• N(x) = standard normal cumulative distribution function
• e = the exponential function
Option Greeks
Option premiums change with changes in the factors that determine option pricing i.e.
factors such as strike price, volatility, term to maturity etc. The sensitivities most
commonly tracked in the market are known collectively as “Greeks” represented by
Delta, Gamma, Theta, Vega and Rho.
Delta (δ or ∆)
The most important of the ‘Greeks’ is the option’s “Delta”. This measures the sensitivity
of the option value to a given small change in the price of the underlying asset. It may
also be seen as the speed with which an option moves with respect to price of the
underlying asset.
Delta = Change in option premium/ Unit change in price of the underlying asset.
Delta for call option buyer is positive. This means that the value of the contract
increases as the share price rises. To that extent it is rather like a long or ‘bull’ position
in the underlying asset. Delta for call option seller will be same in magnitude but with
the opposite sign (negative).
60
Delta for put option buyer is negative. The value of the contract increases as the share
price falls. This is similar to a short or ‘bear’ position in the underlying asset. Delta for
put option seller will be same in magnitude but with the opposite sign (positive).
Therefore, delta is the degree to which an option price will move given a change in the
underlying stock or index price, all else being equal.
The knowledge of delta is of vital importance for option traders because this parameter
is heavily used in margining and risk management strategies. The delta is often called
the hedge ratio, e.g. if you have a portfolio of ‘n’ shares of a stock then ‘n’ divided by the
delta gives you the number of calls you would need to be short (i.e. need to write) to
create a hedge. In such a “delta neutral” portfolio, any gain in the value of the shares
held due to a rise in the share price would be exactly offset by a loss on the value of the
calls written, and vice versa.
Gamma (γ)
It measures change in delta with respect to change in price of the underlying asset. This
is called a second derivative option with regard to price of the underlying asset. It is
calculated as the ratio of change in delta for a unit change in market price of the
underlying asset.
Gamma = Change in an option delta/ Unit change in price of underlying asset
Gamma works as an acceleration of the delta, i.e. it signifies the speed with which an
option will go either in-the-money or out-of-the-money due to a change in price of the
underlying asset.
Theta (θ)
It is a measure of an option’s sensitivity to time decay. Theta is the change in option
price given a one-day decrease in time to expiration. It is a measure of time decay.
Theta is generally used to gain an idea of how time decay is affecting your option
positions.
Theta = Change in an option premium/ Change in time to expiry
Usually theta is negative for a long option, whether it is a call or a put. Other things
being equal, options tend to lose time value each day throughout their life. This is due
to the fact that the uncertainty element in the price decreases.
Vega (ν)
This is a measure of the sensitivity of an option price to changes in market volatility. It is
the change of an option premium for a given change (typically 1%) in the underlying
volatility.
Vega = Change in an option premium/ Change in volatility
Vega is positive for a long call and a long put. An increase in the assumed volatility of the
underlying increases the expected payout from a buy option, whether it is a call or a
put.
61
Rho (ρ)
Rho is the change in option price given a one percentage point change in the risk-free
interest rate. Rho measures the change in an option’s price per unit increase in the cost
of funding the underlying.
Rho = Change in an option premium/ Change in cost of funding the underlying
62
Pay offs for call options with different strikes and premiums
X 6000 6100 6200 6300
Nifty Closing
P 241.85 173.95 118.35 74.70
on Expiry
BEP 6241.85 6273.95 6318.35 6374.70
400
Payoff Charts for Calls with different Strikes
300
200
100
Profit/ Loss
0
5950 6000 6050 6100 6150 6200 6250 6300 6350 6400 6450 6500 6550 6600
-100
-200
If Nifty closes below 6000 at expiry i.e. on October 28, 2010, all options will expire out of
the money i.e. they are worthless. The greatest loss will be for option with strike price
6000 (Rs. 241.85) and least loss will be incurred on strike 6300 option (Rs 74.70).
63
Profitability for call options
As seen earlier when a buyer is bullish on nifty, he can buy call option with any strike
price. The choice of option would be better understood with return on investment
(ROI). In each case, ROI is defined as net profit as a percentage of premium paid by the
option buyer.
To illustrate, if Nifty goes up to 6500 at maturity, then ROI for all the four options will be
as below:
Profit on strike price 6000 option = 6500 – 6000 – 241.85 = 258.15
Return on investment = 258.15/ 241.85 = 1.067 times or 106.74 %
64
300
Payoff Charts for Short Calls with different Strikes
200
100
0
Profit/ Loss
5950 6000 6050 6100 6150 6200 6250 6300 6350 6400 6450 6500 6550 6600
-100
-200
-300
65
6000 -69 2 58.5
6050 -69 -48 8.5
6100 -69 -98 -41.5
6150 -69 -98 -91.5
6200 -69 -98 -141.5
6250 -69 -98 -141.5
6300 -69 -98 -141.5
6350 -69 -98 -141.5
6400 -69 -98 -141.5
350
Payoff Charts for Long Puts with different Strikes
300
250
200
150
Profit/ Loss
100
50
0
5750 5800 5850 5900 5950 6000 6050 6100 6150 6200 6250 6300 6350 6400
-50
-100
-150
The strike price of 6200 is in the money and hence the sellers are expecting a higher
premium of Rs. 141.50 for it. Similarly strike price 6000 is out of the money and so the
contract is selling at low premium of Rs. 69.
In terms of return on investment criterion, buyer of deep out of the money option will
gain the maximum return, if price of the Nifty falls drastically.
To illustrate if Nifty falls to 5800 at maturity then ROI for all the three options will be as
below:
Profit on strike price 6000 option = 6000 – 5800 – 69 = 131
Return on investment = 131/ 69 = 1.898 times or 189.86 %
Profit on strike price 6100 option = 6100 – 5800 – 98 = 202
Return on investment = 202/ 98 = 2.06 times or 206.12 %
66
Profit on strike price 6200 option = 6200 – 5800 – 141.50 = 258.5
Return on investment = 258.5/ 141.5 = 1.82 times or 182.69%
Seller of put option
Pay offs for put options with different strikes and premiums
X 6000 6100 6200
Nifty Closing
P 69 98 141.50
on Expiry
BEP 5931 6002 6058.50
200
Payoff Charts for Short Puts with different Strikes
150
100
50
0
5750 5800 5850 5900 5950 6000 6050 6100 6150 6200 6250 6300 6350 6400
Profit/ Loss
-50
-100
-150
-200
-250
-300
67
As per the table and charts, the seller of put option has more risk to sell deep in the
money put options even though they fetch higher returns in terms of option premiums.
On the other hand, selling deep out of the money put options is less risky but they come
with low premium.
Summary
From a trader’s perspective, we may say that he has the choice of futures of various
expiries and also options of various expiries and various strikes. Depending upon his
analysis of the then existing market conditions and his risk appetite, he can devise
various strategies, which we will see in the next chapter.
68
Chapter 5: Option Trading Strategies
Having understood the risk/ return profiles for vanilla call/ put options, now we turn to
using these products to our advantage – called option strategies. The only limiting factor
for strategies is the thought of the trader/ strategy designer. As long as the trader can
think of innovative combinations of various options, newer strategies will keep coming
to the market. Exotic products (or ‘exotics’) are nothing but a combination of different
derivative products. In this section, we will see some of the most commonly used
strategies.
Vertical Spreads
Vertical spreads are created by using options having same expiry but different strike
prices. Further, these can be created either using calls as combination or puts as
combination. These can be further classified as:
• Bullish Vertical Spread
o Using Calls
o Using Puts
• Bearish Vertical Spread
o Using Calls
o Using Puts
Bullish Vertical Spread using Calls
A bull spread is created when the underlying view on the market is positive but the
trader would also like to reduce his cost on position. So he takes one long call position
with lower strike and sells a call option with higher strike. As lower strike call will cost
more than the premium earned by selling a higher strike call, although the cost of
position reduces, the position is still a net cash outflow position to begin with. Secondly,
as higher strike call is shorted, all gains on long call beyond the strike price of short call
would get negated by losses of the short call. To take more profits from his long call,
trader can short as high strike call as possible, but this will result in his cost coming
down only marginally, as higher strike call will fetch lesser and lesser premium.
Say, for example, a trader is bullish on market, so he decides to go long on 5800 strike
call option by paying a premium of 300 and he expects market to go not above 6200, so
he shorts a 6200 call option and receives a premium of 145. His pay off for various price
moves will be as follows:
69
Option Call Call
Long/Short Long Short
Strike 5800 6200
Premium 300 145
Spot 6000
70
1000
Bull Call Spread Payoff
800
600
400
200
P/ L (Rs.)
0
5000 5100 5200 5300 5400 5500 5600 5700 5800 5900 6000 6100 6200 6300 6400 6500 6600 6700 6800 6900 7000
-200
-400
-600
As can be seen from the above pay off chart, it is a limited profit and limited loss
position. Maximum profit in this position is 245 and maximum loss is 155. BEP for this
spread is 5955.
Bullish Vertical Spread using Puts
Here again, the call on the market is bullish, hence, the trader would like to short a put
option. If prices go up, trader would end up with the premium on sold puts. However, in
case prices go down, the trader would be facing risk of unlimited losses. In order to put
a floor to his downside, he may buy a put option with a lower strike. While this would
reduce his overall upfront premium, benefit would be the embedded insurance against
unlimited potential loss on short put. This is a net premium receipt strategy.
Let us see this with the help of an example, where the trader goes short in a put option
of strike 6200 and receives a premium of 220 and goes long in a put option of strike
6000 and pays a premium of 170:
Option Put Put
Long/Short Short Long
Strike 6200 6000
Premium 220 170
Spot 6000
1000
Bull Put Spread Payoff
800
600
400
200
P/ L (Rs.)
0
5000 5100 5200 5300 5400 5500 5600 5700 5800 5900 6000 6100 6200 6300 6400 6500 6600 6700 6800 6900 7000
-200
-400
-600
-800
-1000
As can be seen from the picture above, it is a limited profit and limited loss position.
Maximum profit in this position is 50 and maximum loss is 150. BEP for this position is
6150.
72
Bearish Vertical Spread using calls
Here, the trader is bearish on the market and so he shorts a low strike high premium call
option. The risk in a naked short call is that if prices rise, losses could be unlimited. So,
to prevent his unlimited losses, he longs a high strike call and pays a lesser premium.
Thus in this strategy, he starts with a net inflow.
Let us see this with the help of the following table:
Option Call Call
Long/Short Long Short
Strike 6200 5800
Premium 145 300
Spot 6000
73
800
Bear Call Spread Payoff
600
400
200
0
P/ L (Rs.)
5000 5100 5200 5300 5400 5500 5600 5700 5800 5900 6000 6100 6200 6300 6400 6500 6600 6700 6800 6900 7000
-200
-400
-600
-800
As can be seen from the picture above, it is a limited profit and limited loss position.
Maximum profit in this position is 155 and maximum loss is 245. BEP for this position is
5955.
Bearish Vertical Spread using puts
Here, again the trader is bearish on the market and so goes long in one put option by
paying a premium. Further, to reduce his cost, he shorts another low strike put and
receives a premium.
For example, if a trader goes long in a put option of strike 6200 and pays a premium of
220 and at the same time to reduce his cost, shorts a 6000 strike put option and earns a
premium of 170, his profits/ losses and pay off would be as under:
Option Put Put
Long/Short Short Long
Strike 6000 6200
Premium 170 220
Spot 6000
74
5400 -430 580 150
5500 -330 480 150
5600 -230 380 150
5700 -130 280 150
5800 -30 180 150
5900 70 80 150
6000 170 -20 150
6100 170 -120 50
6200 170 -220 -50
6300 170 -220 -50
6400 170 -220 -50
6500 170 -220 -50
6600 170 -220 -50
6700 170 -220 -50
6800 170 -220 -50
6900 170 -220 -50
7000 170 -220 -50
1200
Bear Put Spread Payoff
1000
800
600
400
P/ L (Rs.)
200
-200
-400
-600
-800
As can be seen from the picture above, it is a limited profit and limited loss position.
Maximum profit in this position is 150 and maximum loss is 50. BEP for this position is
6150.
75
Horizontal Spread
Horizontal spread involves same strike, same type but different expiry options. This is
also known as time spread or calendar spread. Here, it is not possible to draw the pay
off chart as the expiries underlying the spread are different. Underlying reasoning
behind horizontal spreads is that these two options would have different time values
and the trader believes that difference between the time values of these two options
would shrink or widen. This is essentially a play on premium difference between two
options prices squeezing or widening.
Diagonal spread
Diagonal spread involves combination of options having same underlying but different
expiries as well as different strikes. Again, as the two legs in a spread are in different
maturities, it is not possible to draw pay offs here as well. These are much more
complicated in nature and in execution. These strategies are more suitable for the OTC
market than for the exchange traded markets.
5.2 Straddle
This strategy involves two options of same strike prices and same maturity. A long
straddle position is created by buying a call and a put option of same strike and same
expiry whereas a short straddle is created by shorting a call and a put option of same
strike and same expiry.
Let us say a stock is trading at Rs.6,000 and premiums for ATM call and put options are
257 and 136 respectively.
Long Straddle
If a person buys both a call and a put at these prices, then his maximum loss will be
equal to the sum of these two premiums paid, which is equal to 393. And, price
movement from here in either direction would first result in that person recovering his
premium and then making profit. This position is undertaken when trader’s view on
price of the underlying is uncertain but he thinks that in whatever direction the market
moves, it would move significantly in that direction.
Now, let us analyze his position on various market moves. Let us say the stock price falls
to 5300 at expiry. Then, his pay offs from position would be:
Long Call: - 257 (market price is below strike price, so option expires worthless)
Long Put: - 136 - 5300 + 6000 = 564
Net Flow: 564 – 257 = 307
As the stock price keeps moving down, loss on long call position is limited to premium
paid, whereas profit on long put position keeps increasing.
Now, consider that the stock price shoots up to 6700.
Long Call: -257 – 6000 + 6700 = 443
Long Put: -136
Net Flow: 443 – 136 = 307
76
As the stock price keeps moving up, loss on long put position is limited to premium paid,
whereas profit on long call position keeps increasing.
Thus, it can be seen that for huge swings in either direction the strategy yields profits.
However, there would be a band within which the position would result into losses. This
position would have two Break even points (BEPs) and they would lie at “Strike – Total
Premium” and “Strike + Total Premium”. Combined pay-off may be shown as follows:
Option Call Put
Long/Short Long Long
Strike 6000 6000
Premium 257 136
Spot 6000
77
1000
Straddle Payoff
800
600
400
P/ L (Rs.)
200
0
5000 5100 5200 5300 5400 5500 5600 5700 5800 5900 6000 6100 6200 6300 6400 6500 6600 6700 6800 6900 7000
-200
-400
It may be noted from the table and picture, that maximum loss of Rs. 393 would occur
to the trader if underlying expires at strike of option viz. 6000. Further, as long as
underlying expires between 6393 and 5607, he would always incur the loss and that
would depend on the level of underlying. His profit would start only after recovery of his
total premium of Rs. 393 in either direction and that is the reason there are two
breakeven points in this strategy.
Short Straddle
This would be the exact opposite of long straddle. Here, trader’s view is that the price of
underlying would not move much or remain stable. So, he sells a call and a put so that
he can profit from the premiums. As position of short straddle is just opposite of long
straddle, the pay off chart would be just inverted, so what was loss for long straddle
would become profit for short straddle. Position may be shown as follows:
Option Call Put
Long/Short Short Short
Strike 6000 6000
Premium 257 136
Spot 6000
78
5300 257 -564 -307
5400 257 -464 -207
5500 257 -364 -107
5600 257 -264 -7
5700 257 -164 93
5800 257 -64 193
5900 257 36 293
6000 257 136 393
6100 157 136 293
6200 57 136 193
6300 -43 136 93
6400 -143 136 -7
6500 -243 136 -107
6600 -343 136 -207
6700 -443 136 -307
6800 -543 136 -407
6900 -643 136 -507
7000 -743 136 -607
600
Short Straddle Payoff
400
200
0
5000 5100 5200 5300 5400 5500 5600 5700 5800 5900 6000 6100 6200 6300 6400 6500 6600 6700 6800 6900 7000
P/ L (Rs.)
-200
-400
-600
-800
It should be clear that this strategy is limited profit and unlimited loss strategy and
should be undertaken with significant care. Further, it would incur the loss for trader if
market moves significantly in either direction – up or down.
79
5.3 Strangle
This strategy is similar to straddle in outlook but different in implementation, aggression
and cost.
Long Strangle
As in case of straddle, the outlook here (for the long strangle position) is that the market
will move substantially in either direction, but while in straddle, both options have same
strike price, in case of a strangle, the strikes are different. Also, both the options (call
and put) in this case are out-of-the-money and hence the premium paid is low.
Let us say the cash market price of a stock is 6100. 6200 strike call is available at 145 and
6000 put is trading at a premium of 140. Both these options are out-of-the-money.
If a trader goes long on both these options, then his maximum cost would be equal to
the sum of the premiums of both these options. This would also be his maximum loss in
worst case situation. However, if market starts moving in either direction, his loss would
remain same for some time and then reduce. And, beyond a point (BEP) in either
direction, he would make money. Let us see this with various price points.
If spot price falls to 5700 on maturity, his long put would make profits while his long call
option would expire worthless.
Long Call: - 145
Long Put: -140 – 5700 + 6000 = 160
Net Position: 160 – 145 = 15
As price continues to go south, long put position will become more and more profitable
and long call’s loss would be maximum limited to the premium paid.
In case stock price goes to 6800 at expiry, long call would become profitable and long
put would expire worthless.
Long Call: -145 – 6200 + 6800 = 455
Long Put: -140
Net Position: 455 – 140 = 315
The pay off chart for long strangle is shown below:
Option Call Put
Long/Short Long Long
Strike 6200 6000
Premium 145 140
Spot 6100
80
5500 -145 360 215
5600 -145 260 115
5700 -145 160 15
5800 -145 60 -85
5900 -145 -40 -185
6000 -145 -140 -285
6100 -145 -140 -285
6200 -145 -140 -285
6300 -45 -140 -185
6400 55 -140 -85
6500 155 -140 15
6600 255 -140 115
6700 355 -140 215
6800 455 -140 315
6900 555 -140 415
7000 655 -140 515
7100 755 -140 615
1000
Long Strangle Payoff
800
600
400
P/ L (Rs.)
200
0
5100 5200 5300 5400 5500 5600 5700 5800 5900 6000 6100 6200 6300 6400 6500 6600 6700 6800 6900 7000 7100
-200
In this position, maximum profit for the trader would be unlimited in both the directions
– up or down and maximum loss would be limited to Rs. 285, which would occur if
underlying expires at any price between 6000 and 6200. Position would have two BEPs
at 5715 and 6485. Until underlying crosses either of these prices, trader would always
incur loss.
81
Short Strangle
This is exactly opposite to the long strangle with two out-of-the-money options (call and
put) shorted. Outlook, like short straddle, is that market will remain stable over the life
of options. Pay offs for this position will be exactly opposite to that of a long strangle
position. As always, the short position will make money, when the long position is in loss
and vice versa.
Option Call Put
Long/Short Short Short
Strike 6200 6000
Premium 145 140
Spot 6100
82
400
Short Strangle Payoff
200
0
5100 5200 5300 5400 5500 5600 5700 5800 5900 6000 6100 6200 6300 6400 6500 6600 6700 6800 6900 7000 7100
-200
P/ L (Rs.)
-400
-600
-800
In this position, maximum loss for the trader would be unlimited in both the directions –
up or down and maximum profit would be limited to Rs. 285, which would occur if
underlying expires at any price between 6000 and 6200. Position would have two BEPs
at 5715 and 6485. Until underlying crosses either of these prices, trader would always
make profit.
83
Long Cash: 1520 – 1590 = -70
Short Call: + 10 (Long call holder will not exercise his right as he can buy the stock from
the market at a price lower than strike, so he will let the option expire and the seller
gets to keep the premium)
Net Position: -70 + 10 = -60
Therefore, combined position of long stock and short call would generate the pay-off as
defined in the table and picture below:
Long Stock 1590
Strike Price 1600
Premium 10
84
150
Covered Call Payoff
100
50
P/ L (Rs.)
0
1490 1500 1510 1520 1530 1540 1550 1560 1570 1580 1590 1600 1610 1620 1630 1640 1650 1660 1670 1680 1690
-50
-100
From the table and the pay off chart we can see that the net position of a covered call
strategy looks like ‘short put’ with a strike of 1600. This is called synthetic short put
position.
If at that point of time, a 1600 strike put is available at any price other than Rs.20 (let us
say Rs.17), an arbitrage opportunity exists, where the trader can create a synthetic short
put position (covered call), earn a Rs. 20 premium and use the proceeds to buy a 1600
put for Rs.17, thereby making a risk free profit of Rs.3. Indeed, one needs to also
provide for frictions in the market like brokerage, taxes, administrative costs, funding
costs etc.
The most important factor in this strategy is the strike of the sold call option. If strike is
close to the prevailing price of underlying stock, it would fetch higher premium upfront
but would lock the potential gain from the stock early. And, if strike is too far from the
current price of underlying, while it would fetch low upfront premium, would provide
for longer ride of money on underlying stock. One has to decide on this subject based on
one’s view on the stock and choice between upfront premium from the option and
potential gain from underlying.
A simple perspective on strike choice for covered call is that, till the time the cash
market price does not reach the pre determined exit price, the long cash position can be
used to sell calls of that target strike price. As long as price stays below that target price
(let’s say 1600 in our case), we can write call option of 1600 strike and keep earning the
premium. The moment 1600 is reached in the spot market, we can sell in the cash
market and also cover the short call position.
85
5.5 Protective Put
Any investor, long in the cash market, always runs the risk of a fall in prices and thereby
reduction of portfolio value and MTM losses. A mutual fund manager, who is
anticipating a fall, can either sell his entire portfolio or short futures to hedge his
portfolio. In both cases, he is out of the market, as far as profits from upside are
concerned. What can be done to remain in the market, reduce losses but gain from the
upside? Buy insurance!
By buying put options, the fund manager is effectively taking a bearish view on the
market and if his view turns right, he will make profits on long put, which will be useful
to negate the MTM losses in the cash market portfolio.
Let us say an investor buys a stock in the cash market at 1600 and at the same time buys
a put option with strike of 1600 by paying a premium of Rs. 20.
Now, if prices fall to 1530 from here:
Long Cash: Loss of 1600 – 1530 = - 70
Long Put: Profit of – 20 – 1530 + 1600 = 50
Net Position: -20
For all falls in the market, the long put will turn profitable and the long cash will turn
loss making, thereby reducing the overall losses only to the extent of premium paid (if
strikes are different, losses will be different from premium paid)
In case prices rise to 1660
Long Cash: Profit of 1660 – 1600 = 60
Long Put: Loss of 20
Net Position: 60 – 20 = 40
As price keeps rising, the profits will keep rising as losses in long put will be maximum to
the extent of premium paid, but profits in long cash will keep increasing. Combined
position would look like as follows:
Long Cash 1600
Strike Price 1600
Premium 20
86
1600 0 -20 -20
1610 10 -20 -10
1620 20 -20 0
1630 30 -20 10
1640 40 -20 20
1650 50 -20 30
1660 60 -20 40
1670 70 -20 50
1680 80 -20 60
1690 90 -20 70
1700 100 -20 80
150
Protective Put Payoff
100
50
P/ L (Rs.)
0
1500 1510 1520 1530 1540 1550 1560 1570 1580 1590 1600 1610 1620 1630 1640 1650 1660 1670 1680 1690 1700
-50
-100
A protective put pay off is similar to that of long call. This is called synthetic long call
position.
5.6 Collar
A collar strategy is an extension of covered call strategy. Readers may recall that in case
of covered call, the downside risk remains for falling prices; i.e. if the stock price moves
down, losses keep increasing (covered call is similar to short put).To put a floor to this
downside, we long a put option, which essentially negates the downside of the short
underlying/futures (or the synthetic short put).
In our example, we had assumed that a trader longs a stock @ 1590 and shorts a call
option with a strike price of 1600 and receives Rs. 10 as premium. In this case, the BEP
87
was 1580. If price fell below 1580, loss could be unlimited whereas if price rose above
1600, the profit was capped at Rs. 20.
To prevent the downside, let us say, we now buy an out-of-the-money put option of
strike 1580 by paying a small premium of Rs. 7.
Now, if price of underlying falls to 1490 on maturity:
Long Stock: -1590 + 1490 = -100
Short Call: 10
Long Put: -7 – 1490 + 1580 = 83
Net Position: -100 + 10 + 83 = - 7 (in case of covered call this would have been -90)
If price rises to 1690 on maturity:
Long Stock: -1590 + 1690 = 100
Short Call: 10 – 1690 +1600 = - 80
Long Put: - 7
Net Position: 100 – 80 – 7 = 13 (in case of covered call this would have been + 20)
Combined position (i.e. long underlying, short call and long put) is as follows:
Long Stock 1590 Long Put 1580
Short Call 1600 Premium 7
Call Premium 10
88
150
Collar Payoff
100
50
P/ L (Rs.)
0
90
14
-50
-100
It is important to note here is that while the long put helps in reducing the downside
risk, it also reduces the maximum profit, which a covered call would have generated.
Also, the BEP has moved higher by the amount of premium paid for buying the out-of-
the-money put option.
CMP Long Call 1 Short Call 2 Long Call 3 Short Call 2 Net Flow
5100 -230 150 -100 150 -30
5200 -230 150 -100 150 -30
5300 -230 150 -100 150 -30
5400 -230 150 -100 150 -30
5500 -230 150 -100 150 -30
5600 -230 150 -100 150 -30
5700 -230 150 -100 150 -30
5800 -230 150 -100 150 -30
90
5900 -230 150 -100 150 -30
6000 -230 150 -100 150 -30
6100 -130 150 -100 150 70
6200 -30 50 -100 50 -30
6300 70 -50 0 -50 -30
6400 170 -150 100 -150 -30
6500 270 -250 200 -250 -30
6600 370 -350 300 -350 -30
6700 470 -450 400 -450 -30
6800 570 -550 500 -550 -30
6900 670 -650 600 -650 -30
7000 770 -750 700 -750 -30
7100 870 -850 800 -850 -30
1000
Butterfly Spread Payoff
800
600
400
200
P/ L (Rs.)
0
5100 5200 5300 5400 5500 5600 5700 5800 5900 6000 6100 6200 6300 6400 6500 6600 6700 6800 6900 7000 7100
-200
-400
-600
-800
CMP (Rs.) Long Call 1 Short Call 2 Long Call 3 Short Call 2 Net Flow
-1000
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Chapter 6: Introduction to Trading Systems
6.1 Trading System
In this chapter we shall take a brief look at the trading system of futures and options on
exchanges, including various types of orders. However, the best way to develop an
understanding of the trading system is to actually watch the screen and observe trading.
As stated earlier, futures and options are standardized contracts and like shares, they
are traded on exchanges. Markets around the world can be classified into two main
types based on the methods of booking a trade namely an “open outcry” market and
the “electronic” market. Open outcry is the way of communication between
professionals on an exchange, which involves shouting, or using hand signals to transfer
information about buy and sell orders. In an open outcry markets, usually the trading
takes place in a large hall known as “pit” where members are present and contracts are
traded through continuous bids and offers. Thus, such a market brings together the
buyers and sellers (through their brokers) on a platform for trading. In case of electronic
trading, there are screen based broker dealing terminals, instead of the trading pit.
Futures and options trading in India is electronic in nature, with the bids and offers, and
the acceptance being displayed on the terminal continuously.
All the exchanges in India (BSE, NSE and MCX-SX) provide a fully automated screen-
based trading platform for index futures, index options, stock futures and stock options.
These trading systems support an order driven market and simultaneously provide
complete transparency of trading operations. Derivative trading is similar to that of
trading of equities in the cash market segment.
All these exchanges have developed software for the F&O market to facilitate efficient
and transparent trading in futures and options instruments.
Entities in the trading system
Broadly there are four entities in the trading system
• Trading Members
• Trading cum Clearing Members (TM-CM)
• Professional Clearing Members (PCM)
• Self Clearing Member (SCM)
• Participants
Trading Members:
They are members of Stock Exchanges. They can trade either on behalf of their clients or
on their own account. The exchange assigns a trading member ID to each of its trading
member. A trading member can have more than one user.
The number of users allowed for each trading member is decided by the exchange from
time to time. A user must be registered with the exchange where he is assigned a
unique user ID.
The unique trading member ID is common for all the users of a particular trading
member. Therefore, it functions as a reference for all users of a particular trading
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member. Trading member is responsible to maintain adequate control over persons
having access to the firm’s User IDs.
Trading cum Clearing Members:
A Clearing Member (CM) who is also a Trading Member (TM) of the exchange. Such CMs
may clear and settle their own proprietary trades, their clients' trades as well as trades
of other TM's & Custodial Participants
Professional Clearing Member:
Professional clearing member clears the trades of his associate Trading Member and
institutional clients. PCM is not a Trading Member of the exchange. Typically banks or
custodians become a PCM and clear and settle for TM's as well as for Custodial
Participants
• Self Clearing Member (SCM)
A Self Clearing Member is also a Trading Member on the exchange. Such CMs may clear
and settle only their own proprietary trades and their clients' trades but cannot clear
and settle trades of other TM's.
Participants:
Participant is a client of a trading member. Clients may trade through various trading
members but settle through a single clearing member.
Market Timing of Derivative segment
Trading on the derivatives segment takes place on all working days of the week between
9:15 am and 3:30 pm.
Corporate Hierarchy
In the Futures and options trading software, trading member will have a provision of
defining the hierarchy amongst users of the system. This hierarchy comprises:
• Corporate Manager
• Branch Manager and
• Dealer
Corporate Manager:
As a user, it is the highest level in a trading firm. Corporate Manager can perform all the
functions such as order and trade related activities, receiving reports for all branches of
the trading member firm and also all dealers of the firm. Along with this he can also
define exposure limits for the branches of the firm. This facility is available only to the
corporate manager.
Branch Manager:
As a user, it is placed under the corporate manager. Branch Manager can perform and
view order and trade related activities for all dealers under that branch.
Dealer:
Dealer is at the lowest level of the user hierarchy. He can only view his own orders and
trades and does not have access to information on other dealers under either the same
branch or in other branches.
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Client Broker Relationship
A trading member would be responsible for various compliance related activities
including Know Your Client (KYC) form, execution of Client Broker agreement, timely
execution of orders given by clients, collection of adequate margins, maintain separate
client bank account for segregation of client money, ensure timely pay-in and pay-out of
funds, timely issue of contract notes, resolve clients’ complaints, sending periodical
statement of accounts, maintain unique client code, etc.
Order types and conditions
In the trading system, trading members are allowed to enter orders with various
conditions attached to them as per their requirements. These conditions are broadly
divided into the following categories:
• Time conditions
• Price conditions
• Various combinations of the above are allowed providing flexibility to the users.
Time conditions
Day order: A Day order is an order which is valid for a single day on which it is entered. If
the order is not executed during the day, the trading system cancels the order
automatically at the end of the day.
Immediate or cancel (IOC): User is allowed to buy/sell a contract as soon as the order is
released into the trading system. An unmatched order will be immediately cancelled.
Partial order match is possible in this order, and the unmatched portion of the order is
cancelled immediately.
Price condition
Limit order: It is an order to buy or sell a contract at a specified price. The user has to
specify this limit price while placing the order and the order gets executed only at this
specified limit price or at a better price than that (lower in case of buy order and higher
in case of a sell order).
Market order: A market order is an order to buy or sell a contract at the best bid/offer
price currently available in the market. Price is not specified at the time of placing this
order. The price will be the currently available price in the market i.e., a buy market
order will get executed at the best price at which the seller is ready to sell and a sell
market order will get executed at the best price at which the buyer is ready to buy.
Stop-loss order: A stop loss is an order to buy (or sell) a security once the price of the
security climbed above (or dropped below) a trigger price. The stop-loss order gets
activated when the trigger price is reached/crossed and enters the market as a market
order or as a limit order, as defined at the time of placing this stop-loss order. To
illustrate, suppose a trader buys ABC Ltd. shares at Rs 100 in expectation that the price
will rise. However, prices starts declining below his buy price, trader would like to limit
his losses. Trader may place a limit sell order specifying a trigger price of Rs 95 and a
limit price of Rs 92. The trigger price has to be between last traded price and limit price
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while placing the sell limit order. Once the market price of ABC breaches the trigger
price i.e. Rs 95, the order gets converted to a limit sell order at Rs 92. (Trigger Price is
the price at which the order gets triggered from the stop loss book.)
Order Matching Rules
In India, F&O platforms offer an order driven market, wherein orders match
automatically on price time priority basis.
Orders, as and when they are received, are first time stamped and then immediately
processed for potential match. If a match is not found, then the orders are stored in
different 'books'. Orders are stored in price-time priority in various books in the
following sequence:
• Best Price
• Within Price, by time priority.
The best buy order will match with the best sell order. An order may match partially
with another order resulting in multiple trades. For order matching, the best buy order
is the one with highest price and the best sell order is the one with lowest price. This is
because the computer views all buy orders available from the point of view of a seller
and all sell orders from the point of view of the buyers in the market.
Price Band
There are no price bands applicable in the derivatives segment. However, in order to
prevent erroneous order entry, operating ranges and day minimum/maximum ranges
are kept as below:
• For Index Futures: at 10% of the base price
• For Futures on Individual Securities: at 10% of the base price
• For Index and Stock Options: A contract specific price range based on its delta
value is computed and updated on a daily basis.
In view of this, orders placed at prices which are beyond the operating ranges would
reach the Exchange as a price freeze.
The Trader Workstation
The market watch window
The following windows are displayed on the trader workstation screen:
• Title bar
• Ticker window of futures and options market
• Ticker window of underlying (capital) market
• Toolbar
• Market watch window
• Inquiry window
• Snap quote
• Order/trade window
• System message window
The best way to familiarize oneself with the screen is to spend some time studying a live
screen.
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Placing orders on the trading system
While entering orders on the trading system for both the futures and the options
market, trading member are required to identify orders as being proprietary or clients.
‘Pro’ identifies proprietary orders while ‘Cli’ identifies client orders. Client account
number should be provided for client orders.
Futures and Options Market Instruments
The F&O segment of the derivatives exchanges provides trading facilities for the
following derivative Instruments:
• Index based futures (including futures on foreign stock indices)
• Index based options (including options on foreign stock indices)
• Individual stock options
• Individual stock futures
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Underlying Individual Securities
Contract Size (Lot Size) As specified by the exchange (minimum value of Rs 2,00,000)
Price Steps (Tick Size) Rs 0.05
Contract Period One, two and three months
Last Trading / Expiration Last Thursday of each contract maturity month. If expiry day is
Date a holiday, then the immediately preceding business day.
Delivery Based Settlement. On the last trading day, the closing
Final Settlement value of the underlying stock is the final settlement price of
the expiring futures contract.
Contract specifications for single stock options contracts on NSE and MCX-SX
Underlying Individual Security
Security Descriptor OPTSTK
Option Type European (CE/PE)
Strike Price Interval As specified by the exchange
As specified by the exchange (minimum value of Rs
Contract Size (Lot Size)
2,00,000)
Price Steps (Tick Size) Rs 0.05
3 month trading cycle - the near month (one), the next
month (two) and the far month (three). New contract is
Trading Cycle
introduced on the next trading day following the expiry of
near month contract.
Last Thursday of the expiry month. If the last Thursday is a
Last Trading /
trading holiday, then the expiry day is the previous trading
Expiration Date
day.
Mark-to-Mark and final settlement are cash settled on T+1
Settlement Basis
basis.
Premium settlement is cash settled with the pay-in and pay-
Daily settlement
out of the premium settlement is on T+1 day.
Closing price of such underlying security on the last trading
Final Settlement Price
day of the options contract.
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minimum of 3 strikes (1 in-the-money, 1 near-the-money, 1
out-of-the-money).
As specified by the exchange (minimum value of Rs
Contract Size (Lot Size) 2,00,000)
Price Steps (Tick Size) Rs 0.05
Contract Period One, two and three months, Weekly
Last Thursday of the expiry month. If the last Thursday is a
Last Trading / trading holiday, then the expiry day is the previous trading
Expiration Date day.
For further details on product specifications, please refer to the following websites of
exchanges:
www.nseindia.com
www.bseindia.com
www.mcx-sx.com
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Continued eligibility criteria for stocks in equity derivatives
The criteria for retention of stock in equity derivatives segment are as under:
a) The stock’s median quarter-sigma order size over last six months shall not be less
than Rs. 5 lakhs (Rupees Five Lakhs).
b) The market wide position limit (MWPL) of the stock shall not be less than Rs. 200
crores (Rupees Two Hundred crores).
c) The stock’s average monthly turnover in derivatives segment over last three
months shall not be less than Rs. 100 crores (Rupees Hundred crores).
If a stock fails to meet these retention criteria for three months consecutively, then no
fresh month contract shall be issued on that stock. However, the existing unexpired
contracts may be permitted to trade till expiry and new strikes may also be introduced
in the existing contract months.
Further, once the stock is excluded from the F&O list, it shall not be considered for re-
inclusion for a period of one year.
Re-introduction of dropped stocks
A stock which is dropped from derivatives trading may become eligible once again. In
such instances, the stock is required to fulfil the eligibility criteria for three consecutive
months to be re-introduced for derivatives trading. Derivative contracts on such stocks
may be re-introduced by the exchange subject to SEBI approval.
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2. Any adjustment for corporate actions shall be carried out on the last day on
which a security is traded on a ‘cum’ basis in the underlying cash market, after
the close of trading hours.
3. Adjustments shall mean modifications to positions and/or contract specifications
as listed below such that the basic premise of adjustment laid down in the above
paragraph is satisfied:
(a) Strike Price
(b) Position
(c) Market Lot/Multiplier
The adjustments shall be carried out on any or all of the above based on the nature of
the corporate action. The adjustments for corporate actions shall be carried out on all
open positions. The corporate actions may be broadly classified under stock benefits
and cash benefits as follows:
• Bonus
• Rights
• Merger/De-merger
• Amalgamation
• Splits
• Consolidations
• Hive-off
• Warrants
• Secured Premium Notes (SPNs)
• Extraordinary dividends
Following elaborates the adjustment for Bonus, Stock splits, consolidation and
extraordinary dividends
Bonus, Stock Splits and Consolidations
Strike Price: The new strike price shall be arrived at by dividing the old strike price by the
adjustment factor as under.
Market Lot / Multiplier: The new market lot/multiplier shall be arrived at by multiplying
the old market lot by the adjustment factor as under.
Position: The new position shall be arrived at by multiplying the old position by the
adjustment factor as under.
The adjustment factor for Bonus, Stock Splits and Consolidations is arrived at as follows:
Bonus
Ratio – A: B Adjustment factor: (A+B)/B
Stock Splits and Consolidations
Ratio – A: B Adjustment factor: A/B
The above methodology may result in fractions due to the corporate action e.g. a bonus
ratio of 3:7. With a view to minimizing fraction settlements, the following methodology
is proposed to be adopted:
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(a) Compute value of the position before adjustment
(b) Compute value of the position taking into account the exact adjustment factor
(c) Carry out rounding off for the Strike Price and Market Lot
(d) Compute value of the position based on the revised strike price and market lot
The difference between (a) and (d) above, if any, shall be decided in the manner laid
down by the group by adjusting Strike Price or Market Lot, so that no forced closure of
open position is mandated.
Dividends
Dividends which are below 10% of the market value of the underlying stock would be
deemed to be ordinary dividends and no adjustment in the Strike Price would be made
for ordinary dividends. For extra-ordinary dividends, above 10% of the market value of
the underlying stock, the Strike Price would be adjusted.
• To decide whether the dividend is "extra-ordinary" (i.e. over 10% of the market price of
the underlying stock.), the market price would mean the closing price of the stock on
the day previous to the date on which the announcement of the dividend is made by the
Company after the meeting of the Board of Directors. However, in cases where the
announcement of dividend is made after the close of market hours, the same day's
closing price would be taken as the market price. Further, if the shareholders of the
company in the AGM change the rate of dividend declared by the Board of Directors,
then to decide whether the dividend is extra-ordinary or not would be based on the rate
of dividend communicated to the exchange after AGM and the closing price of the stock
on the day previous to the date of the AGM.
• In case of declaration of "extra-ordinary " dividend by any company, the total dividend
amount (special and / or ordinary) would be reduced from all the strike prices of the
option contracts on that stock.
• The revised strike prices would be applicable from the ex-dividend date specified by the
exchange.
The basis for any adjustment for corporate actions shall be such that the value of the
position of the market participants, on the cum- and ex-dates for the corporate action,
shall continue to remain the same as far as possible. This will facilitate in retaining the
relative status of positions viz. in-the-money, at-the-money and out-of-money. This will
also address issues related to exercise and assignments.
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The trading member-wise position
limit in futures and options in
individual stocks is related to the
market-wide position limit for the
The trading The trading
individual stocks.
member position member position
For stocks having applicable
limits in equity limits in equity
market-wide position limit (MWPL)
index option index futures
of Rs. 500 crores or more, the
contracts is higher contracts is higher
combined futures and options
of Rs.500 crores or of Rs.500 crores or
Trading position limit is 20% of applicable
15% of the total 15% of the total
Member MWPL or Rs. 300 crores, whichever
open interest in the open interest in the
level / is lower and within which stock
market in equity market in equity
FII* / futures position cannot exceed 10%
index option index futures
Mutual of applicable MWPL or Rs. 150
contracts. This limit contracts. This limit
Fund* crores, whichever is lower.
would be would be
For stocks having applicable
applicable on open applicable on open
market-wide position limit (MWPL)
positions in all positions in all
less than Rs. 500 crores, the
option contracts on futures contracts
combined futures and options
a particular on a particular
position limit is 20% of applicable
underlying index underlying index.
MWPL and futures position cannot
exceed 20% of applicable MWPL or
Rs. 50 crore whichever is lower.
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6.6 Using Daily Newspapers to Track Futures and Options
The prices of both spot and F&O markets are published by many major business dailies
such as Economic Times, Mint, Business Standard, Financial Express, etc. They publish all
or some of the following details for the derivatives contracts being traded on the
exchanges.
Date: This gives the Trade date.
Symbol: This gives the underlying index or stock e.g. NIFTY, ACC, etc.
Instrument: This gives the contract descriptor for the various instruments available in
the derivatives segment e.g. FUTSTK, OPTIDX, etc.
Expiry date: The date on which the contract expires
Option Type: This gives the type of option for the contract. (CE- Call European, PE- Put
European, CA- Call American, PA - Put American)
Corporate Action level: This is the Corporate Action Flag. This flag changes when there is
a corporate action on a contract, which could either be a symbol change or a dividend
announced by the company.
Strike Price: This gives the Strike Price of the contract.
Opening price: This gives the price at which the contract opened for the day.
High price: This gives the highest price at which the contract was traded during the day.
Low price: This gives the lowest price at which the contract was traded during the day.
Closing price: This gives the price of the contract at the end of the day.
Last traded price: This gives the price at which the last contract of the day was traded.
Open Interest: For futures contracts open interest is equivalent to the open positions in
that futures contract multiplied by its last available closing price. For option contracts,
open interest is equivalent to the open positions multiplied by the notional value.
Notional value with respect to an option contract is computed as the product of the
open position in that option contract multiplied by the last available closing price of the
underlying.
Total Traded Quantity: This is the total no. of contracts on which business took place
during the day.
Total Traded Value: The total money value of the business which took place on the
contract during the day.
Number of Trades: The total no. of trades which took place on the instrument during the
day.
Information on trends in F&O markets:
• Positive trend: It gives information about the top gainers in the futures market.
• Negative trend: It gives information about the top losers in the futures market.
• Futures OI gainers: It lists those futures whose % increase in Open Interest is
among the highest on that day.
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• Futures OI losers: It lists those futures whose % decrease in Open Interest is
among the highest on that day.
• Active Calls: Calls with high trading volumes on that particular day.
• Active Puts: Puts with high trading volumes on that particular day.
• Put/ Call ratio (PCR): It gives the information about the ratio of trading volume of
put to call options.
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Chapter 7: Introduction to Clearing and Settlement
System
Clearing Corporation/ Clearing House is responsible for clearing and settlement of all
trades executed on the F&O Segment of the Exchange. Clearing Corporation acts as a
legal counterparty to all trades on this segment and also guarantees their financial
settlement. The Clearing and Settlement process comprises of three main activities, viz.,
Clearing, Settlement and Risk Management.
Clearing and settlement activities in the F&O segment are undertaken by Clearing
Corporation with the help of the following entities: Clearing Members and Clearing
Banks.
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which they have traded. While entering orders on the trading system, TMs identify
orders as either proprietary (Pro) or client (Cli). Proprietary positions are calculated on
net basis (buy-sell) for each contract and that of clients are arrived at by summing
together net positions of each individual client. A TM’s open position is the sum of
proprietary open position, client open long position and client open short position.
To illustrate, consider a clearing member ‘A’ with trading members clearing through him
‘PQR’ and ‘XYZ’.
Proprietary
Client 1 Client 2
Position Net
Buy Sell Net Buy Sell Net Buy Sell Net Member
TM Security
Qty Qty Qty Qty Qty Qty Qty Qty Qty
NIFTY
Long
PQR October 5000 3000 2000 3000 2000 1000 3000 1000 2000
5000
contract
Long
NIFTY
1000
XYZ October 1000 2000 (1000) 2000 1000 1000 3000 4000 (1000)
Short
contract
2000
Clearing member A’s open position for Nifty October contract is:
Member Long Position Short Position
PQR 5000 0
XYZ 1000 2000
Total for A 6000 2000
Here in the above example PQR’s Long Position is arrived by summing up net position of
his proprietary position i.e. 2000 and net positions of both his clients 1 & 2 i.e. 1000 and
2000 respectively. Similarly, we have calculated the long and short positions of XYZ.
Clearing member’s open position is arrived by adding long positions and short positions
of both the clients i.e. 6000 long open positions and 2000 short open positions.
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as the case may be, must be completed within six months. The settlement mechanism
shall be decided by the Stock Exchanges in consultation with the Depositories.
On expiry / exercise of physically settled stock derivatives, the risk management
framework (i.e., margins and default) of the cash segment shall be applicable.
Settlements of cash and equity derivative segments shall continue to remain separate.
The Stock Exchanges interested to introduce physical settlement should:
a. Put in place proper systems and procedures for smooth implementation of
physical settlement.
b. Make necessary amendments to the relevant bye-laws, rules and regulations for
implementation of physical settlement.
c. Bring the provisions of this circular to the notice of all categories of market
participants, including the general public, and also to disseminate the same on
their websites.
The Stock Exchanges interested to offer physical settlement should submit to SEBI for
approval, a detailed framework for implementation of physical settlement of stock
derivatives. After opting for a particular mode of settlement for stock derivatives, a
Stock Exchange may change to another mode of settlement after seeking prior approval
of SEBI.
At present, derivative contracts on both individual stocks and on stock indices are cash
settled on NSE and MCX-SX but on BSE, derivative contracts on stock indices are cash
settled while those on individual stocks are delivery based.
Settlement Schedule
The settlement of trades is on T+1 working day basis. Members with a funds pay-in
obligation are required to have clear funds in their primary clearing account on or
before 10.30 a.m. on the settlement day. The payout of funds is credited to the primary
clearing account of the members thereafter.
Settlement of Futures Contracts on Index or Individual Securities
In Futures contracts, both the parties to the contract have to deposit margin money
which is called as initial margin. Futures contract have two types of settlements, the
MTM settlement which happens on a continuous basis at the end of each day, and the
final settlement which happens on the last trading day of the futures contract.
Mark to Market (MTM) Settlement
Mark to Market is a process by which margins are adjusted on the basis of daily price
changes in the markets for underlying assets. The profits/ losses are computed as the
difference between:
1. The trade price and the day's settlement price for contracts executed during the
day but not squared up.
2. The previous day's settlement price and the current day's settlement price for
brought forward contracts.
3. The buy price and the sell price for contracts executed during the day and
squared up.
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The clearing member who suffers a loss is required to pay the MTM loss amount in cash
which is in turn passed on to the clearing member who has made a MTM profit. The
pay-in and pay-out of the mark-to-market settlement are affected on the day following
the trade day (T+1) where trading member is responsible to collect/ pay funds from/ to
clients by the next day. Clearing Members are responsible to collect and settle the daily
MTM profits/losses incurred by the TMs and their clients clearing and settling through
them. After completing day’s settlement process, all the open positions are reset to the
daily settlement price. These positions become the open positions for the next day.
Final Settlement
On expiration day of the futures contracts, after the close of trading hours, clearing
corporation marks all positions of a clearing member to the final settlement price and
the resulting profit/ loss is settled in cash. Final settlement loss/profit amount is
debited/ credited to the relevant clearing member’s clearing bank account on the day
following expiry day of the contract. All long positions are automatically assigned to
short positions in option contracts with the same series, on a random basis.
Settlement of Options Contracts on Index or Individual Securities
Options contracts have two types of settlements. These are as follows
1) Daily premium settlement,
2) Final settlement
Daily Premium Settlement
In options contract, buyer of an option pays premium while seller receives premium.
The amount payable and receivable as premium are netted to compute the net
premium payable or receivable amount for each client for each option contract.
The clearing members who have a premium payable position are required to pay the
premium amount to clearing corporation which in turn passed on to the members who
have a premium receivable position. This is known as daily premium settlement. The
pay-in and pay-out of the premium settlement is on T+1 day (T=Trade day). The
premium payable amount and premium receivable amount are directly credited/
debited to the clearing member’s clearing bank account.
Final Exercise Settlement
All the in the money stock options contracts shall get automatically exercised on the
expiry day. All the unclosed long/ short positions are automatically assigned to short/
long positions in option contracts with the same series, on the random basis.
Profit/ loss amount for options contract on index and individual securities on final
settlement is credited/debited to the relevant clearing members clearing bank account
on T+1 day i.e. a day after expiry day. Open positions, in option contracts, cease to exist
after their expiration day.
The pay-in/ pay-out of funds for a clearing member on a day is the net amount across
settlements and all trading members/ clients, in Future & Option Segment.
Settlement of Custodial Participant (CP) Deals
Clearing corporation provides a facility to entities like institutions to execute trades
through any trading member, which may be cleared and settled by their own CM. Such
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entities are called Custodial Participants (CP). A CP is required to register with clearing
corporation through this clearing member, which allots them a unique CP code. The CP
and the CM are required to enter into an agreement. All trades executed by such CP
through any TM are required to have the CP code in the relevant field on the F&O
trading system at the time of order entry. Without confirmation from CM, the
responsibility of settlement of such trade vests with the CM of the TM while such trades
form part of the obligations of the CM of the CP when they are confirmed from CM.
They shall be responsible for all obligations arising out of such trades including the
payment of margins and settlement of obligations.
Settlement Price
Settlement price for various contracts is determined as follows:
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based margining. Clearing member collects initial margin from the trading
members (TMs) and their respective clients.
• The open positions of the members are settled on an MTM basis for each
contract at the end of the day. The difference is settled in cash on a T+1 basis.
• Clearing corporation’s on-line position monitoring system monitors a CM’s open
position on a real-time basis. It sets limit for each CM based on his effective
deposits and simultaneously generates alert messages whenever a CM reaches
certain pre-determined benchmarks of the limit. Clearing corporation monitors
the CMs for Initial Margin violation, Exposure margin violation, while TMs are
monitored for Initial Margin violation and position limit violation.
• A trading terminal helps the CMs to monitor the open positions of all the TMs
clearing and settling through him. A CM may set limits for a TM clearing and
settling through him. Clearing corporation assists the CM to monitor the intra-
day limits set up by a CM and whenever a TM exceed the limits, it stops that
particular TM from further trading.
The most critical component of risk containment mechanism for F&O segment is the
margining system and on-line position monitoring. The actual position monitoring and
margining is carried out on-line through Parallel Risk Management System (PRISM) using
SPAN® (Standard Portfolio Analysis of Risk) system for the purpose of computation of
on-line margins, based on the parameters defined by SEBI.
7.5 Margining and mark to market under SPAN
In order to manage risk efficiently in the Indian securities market, exchanges have
adopted SPAN (Standard Portfolio Analysis of Risk), a risk management and margining
product designed by Chicago Mercantile Exchange (CME), Chicago, USA. This software
was developed for calculating initial margins on the various positions of market
participants.
The objective of SPAN is to identify overall potential risk in a portfolio. The program
treats futures and options uniformly, while recognizing the unique exposures associated
with options portfolios.
Since SPAN is used to determine initial margins/ performance bond requirements on
various positions, its basic objective is to determine the largest possible loss that a
portfolio might reasonably be expected to suffer from one day to the next. It then sets
the initial margins/ performance bond requirement at a level, which is sufficient to
cover this one-day potential loss.
The concept of risk array represents the extent to which a specific derivative instrument
will gain or lose value from the present time to a specific point in time in the near
future, over a specific set of market conditions. The time is set to one trading day i.e.
through the use of SPAN the maximum likely loss, which may reasonably occur over one
trading day is being evaluated.
Margins
The margining system for F&O segment is as below:
Initial margin
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Margins are computed by clearing corporation upto client level with the help of SPAN.
Clearing corporation collects initial margin for all the open positions of a Clearing
Member based on the margins computed. Margins are required to be paid up-front on
gross basis at individual client level for client positions and on net basis for proprietary
positions. A Clearing Member collects initial margin from TM whereas TM collects from
his clients.
Initial margin requirements are based on 99% value at risk over a one day time horizon.
However, in the case of futures contracts (on index or individual securities), where it
may not be possible to collect mark to market settlement value, before the
commencement of trading on the next day, the initial margin is computed over a two-
day time horizon, applying the appropriate statistical formula. The methodology for
computation of Value at Risk percentage is as per the recommendations of SEBI from
time to time.
Premium Margin
Along with Initial Margin, Premium Margin is also charged at client level. This margin is
required to be paid by a buyer of an option till the premium settlement is complete.
Assignment Margin for Options on Securities
Along with Initial Margin and Premium Margin, assignment margin is required to be
paid on assigned positions of Clearing Members towards final exercise settlement
obligations for option contracts on individual securities, till such obligations are fulfilled.
The margin is charged on the net exercise settlement value payable by a Clearing
Member towards final exercise settlement.
Exposure Margins
Clearing members are subject to exposure margins in addition to initial margins.
The exposure margins for options and futures contracts are as follows:
• For Index options and Index futures contracts: 3% of the notional value of a futures
contract. In case of options it is charged only on short positions and is 3% of the notional
value of open positions.
• For option contracts and Futures Contract on individual Securities:
The higher of 5% or 1.5 standard deviation of the notional value of gross open position
in futures on individual securities and gross short open positions in options on individual
securities in a particular underlying. The standard deviation of daily logarithmic returns
of prices in the underlying stock in the cash market in the last six months is computed
on a rolling and monthly basis at the end of each month.
For this purpose notional value means:
- For a futures contract - the contract value at last traded price/ closing price.
- For an options contract - the value of an equivalent number of shares as conveyed by
the options contract, in the underlying market, based on the last available closing price.
In case of calendar spread positions in futures contract, exposure margins are levied on
one third of the value of open position of the far month futures contract. The calendar
spread position is granted calendar spread treatment till the expiry of the near month
contract.
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Client Margins
Clearing corporation intimates all members of the margin liability of each of their client.
Additionally members are also required to report details of margins collected from
clients to clearing corporation, which holds in trust client margin monies to the extent
reported by the member as having been collected from their respective clients.
Cross Margin
Salient features of the cross margining available on exchanges are as follows:
1. Cross margining is available across Cash and Derivatives segment.
2. Cross margining is available to all categories of market participants.
3. When a Clearing Member clears for client/ entities in Cash and Derivatives
segments, he is then required to intimate client details through a Collateral Interface
for Members (CIM) to benefit from Cross margining.
4. When different Clearing Members clear for client/entities in Cash and Derivatives
segments they are required to enter into necessary agreements for availing cross
margining benefit.
5. Clients who wish to avail cross margining benefit in respect of positions in Index
Futures and Constituent Stock Futures only, their clearing member in the Derivatives
segment needs to provide the details of the clients.
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• At the end of each day the Exchange disseminates the aggregate open interest
across all Exchanges in the futures and options on individual stocks along with the
market wide position limit for that stock and tests whether the aggregate open
interest for any stock exceeds 95% of the market wide position limit for that stock. If
yes, the Exchange takes note of open positions of all client/ TMs as at the end of that
day in that stock, and from next day onwards the client/ TMs should trade only to
decrease their positions through offsetting positions till the normal trading in the
stock is resumed.
• The normal trading in the stock is resumed only after the aggregate open interest
across Exchanges comes down to 80% or below of the market wide position limit.
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exchange. The exchange monitors the FII position limits. The position limit for sub-
account is same as that of client level position limits.
Penalties
A penal charge will be levied on the amount in default as per the byelaws relating to
failure to meet obligations by any Clearing Member. The following penal charges are
levied for failure to pay funds/ settlement obligations:
Penalty Charge
Type of Default Chargeable to
per day
Overnight settlement
shortage of value more than 0.07% Clearing Member
Rs.5 lakhs
Security Deposit Shortage 0.07% Clearing Member
Shortage of Capital Cushion 0.07% Clearing Member
Any violations by the custodial participants shall be treated in line with those by the
trading member and as a result action shall be initiated against the concerned clearing
member.
Short Reporting of Margins in Client Margin Reporting Files
The following penalty shall be levied in case of short reporting by trading/clearing
member per instance.
Short collection for each client Penalty percentage
(< Rs 1 lakh) And (< 10% of applicable margin) 0.5%
(= Rs 1 lakh) Or (= 10% of applicable margin) 1.0%
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Instances of Disablement Penalty to be levied
1st instance 0.07% per day
0.07% per day + Rs.5,000/- per instance from 2nd
2nd to 5th instance of disablement
to 5th instance
0.07% per day + Rs.20,000/- ( for 2nd to 5th
6th to 10th instance of disablement instance) + Rs.10000/- per instance from 6th to
10th instance
0.07% per day + Rs.70,000/- (for 2nd to 10th
instance) + Rs.10,000/- per instance from 11th
11th instance onwards instance onwards.
Additionally, the member will be referred to the
Disciplinary Action Committee for suitable action
Instances as mentioned above refer to all disablements during market hours in a
calendar month. The penal charge of 0.07% per day is applicable on all disablements
due to margin violation anytime during the day.
FII/Mutual Fund position limit violation
In case of violation of FII/ Mutual Fund limits a penalty of Rs. 5,000/- would be levied for
each instance of violation.
Client wise/NRI/sub account of FII/scheme of MF position limit violation
In case of open position of any Client / NRI / sub-account of FII / scheme of MF
exceeding, the specified limit following penalty would be charged on the clearing
member for each day of violation:
1% of the value of the quantity in violation (i.e., excess quantity over the allowed
quantity, valued at the closing price of the security in the normal market of the Capital
Market segment of the Exchange) per client or Rs.1,00,000 per client, whichever is
lower, subject to a minimum penalty of Rs.5,000/- per violation / per client.
When the client level/NRI/sub-account of FII/scheme of mutual fund violation is on
account of open position exceeding 5% of the open interest, a penalty of Rs.5,000 per
instance would be levied to the clearing member.
Market wide Position Limit violation
At the end of each day during which the ban on fresh positions is in force for any
security, when any member or client has increased his existing positions or has created
a new position in that security the client/trading members will be subject to a penalty
1% of the value of increased position subject to a minimum of Rs.5000 and maximum of
Rs.100000. The positions, for this purpose, will be valued at the underlying close price.
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Chapter 8: Legal and Regulatory Environment
The trading of derivatives is governed by the provisions contained in the Securities
Contracts (Regulation) Act-1956, the Securities Exchange Board of India Act-1992, the
rules and regulations framed there under and other rules and bye–laws of stock
exchanges.
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• 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 self–regulatory 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.
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o Fixed assets
o Pledged securities
o Member’s card
o Non-allowable securities (unlisted securities)
o Bad deliveries
o Doubtful debts and advances
o Prepaid expenses
o Intangible assets
o 30% marketable securities
• The minimum contract value shall not be less than Rs. 2 Lakhs. Exchanges have to
submit details of the futures contract they propose to introduce.
• 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.
• 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.
• The trading members are required to have qualified approved user and sales person
who have passed a certification programme approved by SEBI.
Members and authorized dealer have to fulfil certain requirements and provide
collateral deposits to become members of the F&O segment. All collateral deposits are
segregated into cash component and non-cash component. Cash component means
cash, bank guarantee, fixed deposit receipts, T-bills and dated government securities.
Non-cash component mean all other forms of collateral deposits like deposit of
approved demat securities.
Net-worth criteria for Clearing Members has been provided by SEBI, while Net-worth
criteria for Trading Members and Limited Trading Members have been decided by stock
exchanges. Few exchanges have a special category of members called Limited Trading
Members, who are not cash market members of exchange.
The broker is required to get a Risk Disclosure Document signed by the client, at the
time of client registration. This document informs clients about the kind of risks that
derivatives can involve for the client. It makes the client aware and well informed.
Apart from other records, Trading Members are required to maintain trade confirmation
slips and exercise notices from the trading system for a period of 5 years.
All member brokers in the derivative segment should be inspected by the exchange at
least once a year.
A default by a member in the derivatives segment will be treated as default in all
segments of that exchange and as default on all exchanges where he is a member.
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The purpose of inspection of stock brokers’ records under the SEBI (Stock Broker & Sub-
Brokers) Regulations, 1992 is to ensure that the books of accounts and other books are
being maintained in the manner required.
The recognition to a stock exchange under the Securities Contract (Regulation) Act 1956
can be granted by the Central Government.
A penalty or suspension of registration of a stock - broker under the SEBI (Stock Broker
& Sub - Broker) Regulations, 1992 can be ordered if:
• The stock broker violates the provisions of the Act
• The stock broker does not follow the code of conduct
• The stock broker fails to resolve the complaints of the investors
• The stock broker indulges in manipulating, or price rigging or cornering of the
market
• The stock broker’s financial position deteriorates substantially
• The stock broker fails to pay fees
• The stock broker violates the conditions of registration
• The stock broker is suspended by the stock exchange
Position limits are the maximum exposure levels which the entire market can go up to
and each Clearing Member or investor can go up to. Position limits for the entire market
and Clearing Members and investors are defined by SEBI.
Each Clearing Member may have several Trading Members with him. The trading limits
for each such Trading Member are decided by Clearing Members on the computerized
trading system.
If the Trading Member reaches his position limit, he will not be able to enter any fresh
transactions which have the impact of increase his exposure. He will enter only those
transactions which have the impact of reducing his exposure. Thus, new positions will
not be permitted, but squaring up will be permitted.
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Table 1: Eligibility criteria for membership on F&O segment
CM and F&O CM, WDM
Particulars (all values in Rs. Lakhs) segment and F&O
1
Net-worth 100 200
Interest free security deposit (IFSD) 2 125 275
3
Collateral security deposit (CSD) 25 25
Annual subscription 1 2
1
No additional Net-worth is required for self clearing members. However, a Net-worth
of Rs. 300 Lakhs is required for TM-CM and PCM.
2 & 3
Additional Rs. 25 Lakhs is required for clearing memberships (SCM, TM-CM). In
addition, the clearing member is required to bring in IFSD of Rs. 2 Lakhs and CSD of
Rs. 8 Lakhs per trading member he undertakes to clear and settle.
Table 2: Requirements for professional clearing membership
Particulars (all values in Rs.
CM, F&O segment CM, WDM and F&O
Lakhs)
Trading members of Trading members of
Exchange / SEBI Exchange / SEBI
Eligibility registered registered
custodians / recognized custodians / recognized
banks banks
Net-worth 100 200
Interest free security deposit 125 275
Collateral security deposit 25 25
Annual subscription 1 2
Note: The PCM is required to bring in IFSD of Rs. 2 Lakhs and CSD of Rs. 8 Lakhs per
trading member whose trades he undertakes to clear and settle in the F&O segment.
The initial and exposure margin is payable upfront by Clearing Members. Initial margins
can be paid by members in the form of Cash, Bank Guarantee, Fixed Deposit Receipts
and approved securities.
Clearing members who are clearing and settling for other trading members can specify
the maximum collateral limit towards initial margins, for each trading member and
custodial participant clearing and settling through them.
Such limits can be set up by the clearing member, through the facility provided on the
trading system up to the time specified in this regard. Such collateral limits once set are
applicable to the trading members/custodial participants for that day, unless otherwise
modified by clearing member.
Non-fulfilment of either whole or part of the margin obligations will be treated as a
violation of the Rules, Bye-Laws and Regulations of clearing corporation and will attract
penalty.
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In addition clearing corporation may at its discretion and without any further notice to
the clearing member, initiate other disciplinary action, inter-alia including, withdrawal of
trading facilities and/ or clearing facility, close out of outstanding positions, imposing
penalties, collecting appropriate deposits, invoking bank guarantees/ fixed deposit
receipts, etc.
Liquid assets
Clearing member is required to provide liquid assets which adequately cover various
margins and liquid Net-worth requirements. He may deposit liquid assets in the form of
cash, bank guarantees, fixed deposit receipts, approved securities and any other form of
collateral as may be prescribed from time to time. The total liquid assets comprise of at
least 50% of the cash component and the rest is non cash component.
1. Cash Component:
• Cash
• Bank fixed deposits (FDRs) issued by approved banks and deposited with
approved custodians or Clearing Corporation.
• Bank Guarantees (BGs) in favour of clearing corporation from approved banks in
the specified format.
• Units of money market mutual fund and Gilt funds where applicable haircut is
10%.
• Government Securities and T-Bills
2. Non Cash Component:
• Liquid (Group I) Equity Shares as per Capital Market Segment which are in demat
form, as specified by clearing corporation from time to time deposited with
approved custodians.
• Mutual fund units other than those listed under cash component decided by
clearing corporation from time to time deposited with approved custodians.
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• Occasions when the 99% Value at Risk limit has been violated
• Defaults by broker-members
• Daily market activity report
• Daily market report
Main objectives of Trade Guarantee Fund (TGF):
• To guarantee settlement of bonafide transactions of the members of the
exchange.
• To inculcate confidence in the minds of market participants.
• To protect the interest of the investors in securities.
All active members of the Exchange are required to make initial contribution towards
Trade Guarantee Fund of the Exchange.
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• Members’ exposure should be linked to the amount of liquid assets maintained by
them with the clearing corporation.
• Cross margining (linking overall cash and derivative positions for margining) is not
permitted.
• All clients should pay margins. Brokers should not fund margins of clients.
• In the long run, India should have a national level clearing corporation.
• Clients should be provided with a Risk Disclosure Document by brokers.
• Brokers should keep margins collected from clients in a separate bank account.
• Brokers cannot use margins for any purpose except for payment of such margins to
the clearing corporation.
• Transactions should be entered in the trading system exclusive of brokerage.
• Brokerage should be charged separately in the Contract Note.
• In case of Clearing Member default, margins paid by the Clearing Member on his
own account alone would be used to settle his dues.
• All brokers in the derivatives segment should obtain SEBI Registration.
• The clearing function should be organized as a separate entity, preferably in the
form of a Clearing Corporation.
• The Clearing Corporation has powers to levy additional margins, special margins,
define maximum exposure limits and disable brokers from trading.
• At the time of entering into a transaction, the broker must indicate the client on
whose behalf the transaction is being entered into. Proprietary trading must also be
clearly identified.
• SEBI should create a Special Derivatives Cell within itself to understand and
supervise the market better.
• SEBI should constitute an Advisory Council for derivatives.
• Derivatives segment should have a separate Governing Council.
• No common members should be allowed between the Cash segment Governing
Board and the Derivatives segment Governing Council of the exchanges.
• The exchange should set up Arbitration and Investor Grievance Cells in at least 4
regions across the country.
• Derivatives trading must be through on-line systems.
• Disaster recovery site (in case of computer failure) is a must.
• Information about derivatives segment must be disseminated over at least two
information vending networks (e.g. Reuters, Bloomberg).
• All brokers of the Cash segment will not automatically become members of the
Derivative segment.
• An efficient cash market is a must for a healthy derivatives market.
• Delivery levels in the cash market should improve and increase.
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• Uniform settlement cycle across all exchanges is recommended.
• A separate Governing Board should be constituted for the Clearing Corporation of
the Derivatives segment.
• No broker members should be allowed to sit on the Governing Board of the Clearing
Corporation.
• If your client is a Trust or a Company, you (as a broker) must obtain authorization
from the Board of Trustees or Board of Directors for trading in derivatives on their
behalf
• Providing Client ID for every transaction is mandatory
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• Liquid Net-worth of all Clearing Members at all points of time (including intraday)
should be maintained at Rs 50 lakhs minimum level.
• Securities placed with the Clearing Corporation shall be marked to market on weekly
basis.
• Hair cut on equity securities is 15%.
• Hair cut on debt securities is 10%.
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Chapter 9: Accounting and Taxation
9.1 Accounting
Accounting for Forward Contract as per Accounting Standard - 11
When forward contract is for hedging
• The premium or discount (difference between the value at spot rate and forward
rate) should be amortized over the life of contract.
• Exchange difference (difference between the value of settlement date/ reporting
date and value at previous reporting date/ inception of the contract) is
recognized in Profit & Loss statement of the year.
• Profit/ loss on cancellation/ renewal of forward contract are recognized in P&L of
the year.
When forward contract is for trading/ speculation
• No premium or discount is recognized.
• A gain or loss i.e. the difference between the forward rate as per contract/
previous year end valuation rate and the forward rate available at the yearend
(reporting date) for remaining maturity period should be recognized in the P&L
of the period.
• Profit/ loss on cancellation / renewal of forward contract are recognized in P&L
of the year.
Accounting of Equity index and Equity stock futures in the books of the client
The Institute of Chartered Accountants of India (ICAI) has issued guidance notes on
accounting of index futures contracts from the view point of parties who enter into such
futures contracts as buyers or sellers. For other parties involved in the trading process,
like brokers, trading members, clearing members and clearing corporations, a trade in
equity index futures is similar to a trade in, say shares, and does not pose any peculiar
accounting problems. Hence in this section we shall largely focus on the accounting
treatment of equity index futures in the books of the client.
Accounting at the inception of the contract (Accounting for Initial Margin)
• Every client is required to pay to the Trading Member/ Clearing Member, initial
margin determined by the Clearing Corporation as per the bye-laws/ regulations
of the Exchange for entering into equity index/stock futures contracts.
• Such initial margin paid/ payable should be debited to "Initial Margin - Equity
Index/Equity stock Futures Account". Additional margins, if any, should also be
accounted for in the same manner.
• It may be mentioned that at the time when the contract is entered into for
purchase/ sale of equity index futures, no entry is passed for recording the
contract because no payment is made at that time except for the initial margin.
• At the balance sheet date, the balance in the "Initial Margin - Equity Index/
Equity Stock Futures Account' should be shown separately under the head
'Currency Assets'.
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• Where any amount has been paid in excess of the initial/ additional margin, the
excess should be disclosed separately as a deposit under the head 'Current
Assets'.
• Where instead of paying initial margin in cash, the Client provides bank
guarantees or lodges securities with the member, a disclosure should be made in
the notes to the financial statements of the Client. This will not require any
accounting entry.
Deposit for Initial Margin Kept
Deposit for Initial Margin a/c Dr.
To Bank a/c
Initial Margin paid / adjusted from deposit
Initial Margin a/c Dr.
To Bank a/c/ Deposit for initial Margin a/c
Initial margin returned /released
Bank a/c /Deposit for initial margin a/c Dr.
To Initial Margin a/c
Suppose Mr. X purchases a Futures Contract on October 5, 2009. The initial margin
calculated as per SPAN, is 50000. The margin for the subsequent days, calculated as per
the SPAN, is as follows:
On October 6, 2009 Rs. 55,000
On October 7, 2009 Rs. 45,000
On October 8, 2009 Rs. 47,000
1. On October 5, 2009
Initial Margin – Equity Futures a/c. Dr Rs 50,000
To Bank a/c Rs 50,000
(Being initial margin paid on Equity Futures Contracts)
2. On October 6, 2009
Initial Margin – Equity Futures a/c. Dr Rs 5,000
To Bank a/c Rs 5,000
(Being additional margin paid to the Exchange)
3. On October 7, 2009
Bank a/c. Dr Rs 10,000
To Initial Margin – Equity Futures a/c. Rs 10,000
(Being margin refunded by the Exchange)
4. On October 8, 2009
Initial Margin – Equity Futures a/c. Dr Rs 2,000
To Bank a/c Rs 2,000
(Being further margin paid to the Exchange)
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Accounting at the time of daily settlement - payment/receipt of mark-to-market
margin
• Payments made or received on account of Daily Settlement by the Client would be
debited or credited to an account titled as "Mark-to-Market Margin - Equity Index/
Equity Stock Futures Account".
• Mark-to-Market Margin a/c can be maintained Index/ stock-wise so as to facilitate
calculation of provision for loss.
• Such payment/receipt can be through a bank account or through a deposit kept with
clearing member (and debited to an appropriate account say, "Deposit for Mark-to-
Market Margin Account").
• At the year-end, any balance in the "Deposit for Mark-to-Market Margin Account"
should be shown as a deposit under the head "Current Assets".
M to M Margin received
Bank /Deposit for M to M Margin a/c Dr.
To M to M Margin a/c
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Provision for loss on Equity Stock/ Equity Index futures outstanding at Balance sheet
Opening provision was less hence increased
Profit & Loss a/c Dr
To Provision for loss on Equity Stock/Equity Index future a/c
To illustrate
Suppose Mr. A pays an amount of Rs 5000, as Mark-to-Market Margin on Equity Futures
Contract. The following accounting entry would be made in the books of accounts:
Profit & Loss a/c Dr. Rs 5000
To Provision for loss on Equity Futures a/c Rs 5000
(Being provision made for the amount paid to Clearing Member/Trading Member
because of movement in the prices of the futures contract)
Accounting at the time of final settlement or squaring-up of the contract
• At the expiry of a series of equity index futures, the profit/ loss, on final settlement
of the contracts in the series, should be calculated as the difference between final
settlement price and contract prices of all the contracts in the series.
• The profit/ loss, so computed, should be recognised in the profit and loss account by
corresponding debit/ credit to "Mark-to-Market Margin Account".
• Same accounting treatment should be made when a contract is squared-up by
entering into a reverse contract.
• If more than one contract in respect of the relevant series of Equity Index/ Equity
Stock futures contract to which the squared-up contract pertains is outstanding at
the time of the squaring up of the contract, the contract price of the contract so
squared-up should be determined using weighted average method for calculating
profit/ loss on squaring-up.
• On the settlement of an Equity Index/ Equity Stock futures contract, the initial
margin paid in respect of the contract is released which should be credited to Initial
Margin Account", and a corresponding debit should be given to the bank account or
the deposit account.
If profit on Settlement /Squaring off
M to M Margin a/c Dr
To P & L a/c
If Loss on Settlement/Squaring off
P & L a/c Dr -
To M to M Margin a/c
Entry for release of Initial Margin will be:
Bank a/c /Deposit for initial margin a/c Dr
To Initial Margin a/c
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Accounting in case of a default
• When a Client default in making payment in respect of Daily Settlement, the
contract is closed out
• The amount not paid by the Client is adjusted against the initial margin. Excess
margin if any is released and shortfall if any will be payable by the client.
• The accounting treatment in this regard will be the same as explained earlier
• The amount of profit or loss on the contract so closed out should be calculated and
recognised in the profit and loss account in the manner described earlier.
Disclosure
• The amount of bank guarantee, and book value as also the market value of securities
lodged should be disclosed in respect of outstanding contracts at the year end,
where initial margin money has been paid by way of bank guarantee and/or lodging
of securities, separately for each type of instruments.
• The number of futures contract not settled (open interests), number of contracts,
number of units pertaining to those contracts as of the balance sheet date should be
disclosed separately for Long and Short Positions, in respect of each of equity index/
futures i.e. index/ stock wise
Accounting for Equity Index Options in case of cash settled options
Accounting at the inception of the contract
• The seller/ writer of the option is required to pay initial margin for entering into the
option contract. It should be debited to an appropriate account, say, "Equity Index/
Stock Option Margin Account". In the balance sheet, such account should be shown
separately under the head "Current Assets".
• The buyer/ holder of the option is required to pay the premium. In the books of the
buyer/ holder, such premium should be debited to an appropriate account, say,
"Equity Index/ Stock Option Premium Account". In the books of the seller/ writer
such premium received should be credited to an appropriate account, say, "Equity
Index/ Stock Option Premium Account".
Accounting at the time of payment/ receipt of margin
• Payment made or received by the seller/ writer for the margin would be credited/
debited to the bank account and the corresponding debit or credit for the same
should be made to "Equity Index/ Stock Option Margin Account".
• Sometimes, the client may deposit a lump sum amount with the Trading/ Clearing
Member in respect of the margin instead of paying/ receiving margin on daily basis.
In such a case, the amount of margin paid/ received from/ into such account should
be debited/ credited to the "Deposit for margin account". At the year-end, any
balance in the "Deposit for margin account" should be shown as a deposit under the
head "Current Assets".
• Entries will be similar to initial margin on futures explained earlier.
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Accounting for open options as on the balance sheet date
• The "Equity Index/Stock Option Premium Account" should be shown under the
"head 'Current Asset' or 'Current Liabilities', as the case may be.
• In case of multiple options, entries recommended above may be made in one
“Equity Index/ Stock Option Premium Account”, in respect of options of all stocks.
The balance of this composite account should be shown under the head "Current
Assets' or "Current Liabilities", as the case may be.
• But for calculating provision for loss, Stock wise / index wise a/c is advisable.
• In the books of the buyer/ holder, a provision should be made for the amount by
which the premium paid for the option exceeds the premium prevailing on the
balance sheet date since the buyer/ holder can reduce his loss to the extent of the
premium prevailing in the market, by squaring off the transaction.
• The excess of premium prevailing in the market on the balance sheet date over the
premium paid is not recognised on the consideration of prudence,
• The provision so created should be credited to "Provision for Loss on Equity Index/
stock Option Account". The provision made as above should be shown as deduction
from "Equity Index/ stock Option Premium" which is shown under 'Current Assets'.
• In the books of the seller/ writer, the provision should be made for the amount by
which premium prevailing on the balance sheet date exceeds the premium received
for that option.
• The excess of premium received over the premium prevailing on the balance sheet
date is not recognised on the consideration of prudence.
• This provision should be credited to "Provision for Loss on Equity Index/ Stock
Option Account", with a corresponding debit to profit and loss account. "Equity
index/stock Options Premium Account" and "Provision for Loss on Equity Index/
Stock Options Account" should be shown under 'Current Liabilities and Provisions'.
• In case of multiple open options at the year-end, a Stockwise/ lndexwise provision
should be made considering all the open options of any strike price and any expiry
date under that stock/ Index taken together.
• Profit/Loss on bought and sold position of each stock be adjusted and if net result is
loss make provision and if net result is gain ignore it.
• The amount of provision required in respect of each stock or index should be
aggregated and a composite" Provision for Loss on Equity Stock/ Index Options
Account" should be credited by debiting P&L a/c.
• In case any opening balance in such provision account is there the same should be
adjusted against the provision required in the current year and the profit and loss
account be debited/ credited with the balance provision required to be made/excess
provision written back.
Accounting at the time of final settlement
In the books of the buyer/ holder:
• The buyer/ holder will recognise premium as an expense in the profit and loss
account
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• On exercise of the option, the buyer/ holder will receive favourable difference,
between the final settlement price as on the exercise/expiry date and the strike
price, which will be recognised as income.
In the books of the seller/writer:
• The seller/ writer will recognise premium as an income in the profit and loss account
• On exercise of the option, the seller/writer will pay the adverse difference, between
the final settlement price as on the exercise/ expiry date and the strike price. Such
payment will be recognised as a loss.
• As soon as an option gets exercised, margin paid towards such an option will be
released by the exchange, which should be credited to "Equity Index/ stock Option
Margin Account" and the bank account will be debited.
Accounting at the time of squaring off of an option contract
• The difference between the premium paid and received on the squared off
transactions should be transferred to the profit and loss account.
• Accounting treatment is the same as above in the books of the seller/ writer for
margin money released on the squaring off of an option contract. Method for
determination of profit/loss in multiple options situation:
• For working out profit or loss in case of outstanding multiple options of the same
stock / index with the same strike price and the same expiry date, weighted average
method should be followed on squaring off of transactions or is/ are exercised
before the expiry date.
Accounting treatment in respect of equity stock options in case of delivery settled
options
• The accounting entries at the time of inception, payment/receipt of margin and
open options at the balance sheet date will be the same as those in case of cash
settled options.
• At the time of final settlement, if an option expires unexercised then the accounting
entries will be the same as those in case of cash settled options.
• If the option is exercised then shares will be transferred in consideration for cash at
the strike price. In such a case, the accounting treatment will be as recommended in
the following paragraphs.
In case of buyer/holder:
• For a call option the buyer/ holder will receive equity shares for which the call
option was entered into. The buyer/ holder should debit the relevant equity shares
account and credit cash/ bank.
• For a put option buyer/ holder will deliver equity shares for which the put option
was entered into. The buyer/ holder should credit the relevant equity shares
account and debit cash/ bank.
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In case of seller/writer:
• For a call option the seller/ writer will deliver equity shares for which the call option
was entered into. The seller/ writer should credit the relevant equity shares account
and debit cash/ bank.
• For a put option the seller/ writer will receive equity shares for which the put option
was entered into. The seller/ writer should debit the relevant equity shares account
and credit cash/ bank.
• In addition to this entry, the premium paid/received will be transferred to the profit
and loss account, the accounting entries for which should be the same as those in
case of cash settled options.
Disclosure
• The enterprise should disclose the accounting policies and the methods adopted,
including criteria for recognition and the basis of measurement applied for equity
index options and equity stock options.
• Where initial margin is paid by way of bank guarantee and/or lodging of securities,
the amount of such bank guarantee/ book value and market value of securities in
respect of outstanding options at the year end.
• The buyer/holder and the seller/ writer of the option should give the following
details in respect of the option contracts outstanding as at the year-end for each
Equity Index/ Stock Option.
Accounting for Equity Stock Options
Accounting for Equity Stock Options which are settled in Cash
• Accounting entries for Equity Stock Options settled in cash will be the same as that in
the case of Equity Index Options.
• This is because in both the cases the settlement is done otherwise than by delivery
of the underlying assets.
Accounting for Equity Stock Options which are settled by delivery
Accounting entries at the time of inception, daily receipt/ payment of margin and open
options at the balance sheet date will be the same as that in the case of cash settled
options.
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Chapter 10: Sales Practices and Investors Protection
Services
The finance sector has an important role to play in an economy. It has responsibility to
ensure stable markets and support the real economy. The primary function of a financial
institution is to be responsible and provide sustainable financial services. Giving good
advice and having excellent customer service is a precondition for long-term success of
any financial institution.
Financial Institutions should have customer-oriented approach, where sales of products
are customer lead and always accompanied by correspondingly efficient and
appropriate advice. It can be summarily stated that: “Customers have the right to get
good advice; finance employees have the duty to give good advice.”
A favourable model should be developed in cooperation between company, its
employees and intermediaries in the finance sector to ensure the best possible
framework for increasing customer satisfaction.
In the recent past, naïve investors have increasingly become targets of financial abuse
and fraud. Investors should be cautious while investing in any of the financial products
in the market. Some of the areas where investor needs to be careful about his
investments are discussed below:
“High Return” or "Risk-Free" Investments
Investors should be careful of opportunities that promise spectacular profits or
"guaranteed" returns. The deal sounds too good to resist. An individual may claim that
unrealistic returns can be realized from "Low-Risk Investment Opportunities", but one
has to keep in mind no investment is risk-free. Returns are related to the risk taken and
hence there cannot be a product in the market that gives high return in risk free
manner.
Investment Advisor Services
Investment advisor is an individual or firm responsible for making investments on behalf
of, and/ or providing advice to, investors. He has a duty to act in the best interest of
their clients. Sometimes, however, investment advisors take advantage of their
positions of trust and use unauthorized and deceptive methods to misappropriate
money directly from their clients. Investors should be careful to review their monthly
account statements and to conduct annual reviews of their investment plans with their
investment adviser. Investors should be watchful for abnormal changes in their monthly
account statements.
Unsuitable Investment Recommendations
Some unscrupulous investment advisers convince clients to purchase investment
products that don’t meet the objectives of an investor. Unsuitable recommendations
can occur when a broker sells speculative transactions such as options, futures, or penny
stocks to say a senior citizen with low risk tolerance. Investors should be careful to
review the risk profile of each investment recommendation.
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Churning
“Churning” refers to when securities professionals making unnecessary and excessive
trades in customer accounts for the sole purpose of generating commissions. Investors
should be careful to review their monthly account statements and investigate any
abnormally high trading activity.
Investor Seminars
Investment advisers commonly invite investors to attend seminars. At these seminars,
advisers often use sales tactics to pitch unsuitable products. Investors should avoid
making rushed decisions at sales seminars and should seek objective third party advice
before committing their funds.
As sales become an integral part in financial services and proper advice to the customers
is important.
Contact with consumers
• Sales Agents must only make sales calls on consumers at reasonable times
recognizing that what is regarded as reasonable can vary in different locations
and in different types of households. Sales Agents will in any event only call
between 9 am and 8 pm, unless it is at the consumer’s request.
• Sales Agents will, as soon as possible on making contact, identify themselves, the
company they represent and their purpose.
• Sales Agents will take account of the consumer's personal circumstances and, as
a minimum, comply with diversity obligations.
• Sales Agents will end the discussion and leave the premises immediately at the
consumer’s request.
• Sales Agents will voluntarily cease contact with a consumer who clearly indicates
that contact is inconvenient, unwelcome or inappropriate.
• A contact number must be left with any consumer, on request.
• Sales Agents must not exploit a person’s inexperience, vulnerability, credulity or
loyalties.
• Members shall maintain records, including the date of contact with the
consumer to allow the subsequent identification of the Sales Agent involved.
This will assist in dealing with any complaint or query.
• Sales Agents must at all times:
o Be courteous and professional.
o Seek to avoid the consumer misunderstanding any information given or
making false assumptions, in particular over potential returns on their
savings.
o Avoid the use of high pressure/ luring tactics.
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desired return on an investment vehicle. People invest in various investment products
that generally comprise:
• Fixed Income Instruments, and
• Market oriented investments.
In the case of former, with a definite interest rate, there is little “risk” of not being able
to get the desired returns (credit or default risk exists though) but in the case of latter,
an investor goes with an expectation of a certain amount of return and the term “risk”
in this context refers to the probability of the investor not getting the desired /expected
returns.
Financial advisor should have thorough understanding of risk. There is a risk/ return
trade-off. That is, the greater risk accepted, the greater must be the potential return as
reward for committing one’s funds to an uncertain outcome. Generally, as the level of
risk rises, the expected rate of return should also rise, and vice versa.
A risk-averse investor would prefer investments that are more secure and thus would
have higher portfolio allocations to debt and fixed income instruments. On the other
hand an investor who is less risk averse would like to have greater exposure to equity
and other risky investments.
There is need to understand risk tolerance for a variety of reasons some of which are
specified below:
• To achieve level of financial independence that allows them to meet not only
their basic human needs, but also higher level needs for self development and
self improvement in their life.
• Willingness to accept a certain smaller return rather than a large but uncertain
profit from their financial decisions.
• Individual’s evaluations of their self-worth and their levels of self-esteem are
related to their levels of satisfaction with their financial situation.
• Individuals need to appreciate their personal comfort zone when they trade-off
what they are willing to accept in terms of possible losses versus possible gains.
• Investor’s objectives are often poorly developed and unrealistic in terms of
investments.
• It is often difficult for people to describe in their own words their attitudes about
risk.
• There is a good chance that new investors in particular will not understand many
of the financial and risk concepts presented by advisors.
• Communication is focused around an explicit and understandable score or
profile.
• Very difficult for the financial advisor to arrive at an accurate risk profile.
• Single Investment model will fit all- lifecycle approach does not work.
Some of the key parameters on which one’s risk tolerance can depend is age, personal
income, combined family income, sex, number of dependents, occupation, marital
status, education, access to other inherited sources of wealth.
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Financial advisors need to know about the time period for which investors plan to
invest. The objectives of the investors should be made clear to give a proper advice and
meet his short term as well as long term needs. Generally speaking, the longer the time
horizon, the more risk can be integrated into his financial expectations about the
investments.
Globally, as well as in India, it is well established, on the basis of track record of
performance that equities as a class of asset has outperformed other asset classes and
delivered superior returns over longer periods of time. With these statistics available,
why wouldn’t everyone at all times invest 100 percent in stocks? The answer is, of
course, that while over the long term stocks have outperformed, there have been many
short term periods in which they have underperformed, and in fact, have had negative
returns. Exactly when short term periods of underperformance occurs is unknown and
thus, there is more risk in owning stocks if one has a short term horizon than if there
exists a long term horizon.
The risk and complexity vary among derivative products. While some derivatives are
relatively simple, many others, especially options, could be highly complex and would
require additional safeguards from investors’ viewpoint. Options are a more complex
derivative product than index futures because evaluating the fairness of option
premium is a complex matter.
It is essential that broker-client relationship and sales practices for derivatives need
regulatory focus. The potential risk involved in trading (as opposed to hedging) with
derivatives is not understood widely. In the case of pricing of complex derivatives
contracts, there is a real danger of unethical sales practices. Clients may be fleeced or
induced to buy unsuitable derivative contracts at unfair prices and without properly
understanding the risks involved. That is why it has become a standard practice to
require a "risk disclosure document" to be provided by broker/ dealer to every client in
respect of the particular type of derivatives contracts being sold.
Also, derivatives brokers/ dealers are expected to know their clients and to exercise care
to ensure that the derivative product being sold by them to a particular client is suitable
to his understanding and financial capabilities. Derivatives may tempt many people
because of high leverage. The concept of "know-your-client" needs to be implemented
and every broker/ trader should obtain a client identity form.
Derivatives brokers/ dealers should avoid recommending opening futures/ options
transaction unless they have a reasonable basis for believing that the customer has such
knowledge and financial experience that he or she is capable of evaluating, and
financially able to bear, the risks of the transaction.
The broker-dealer must seek to obtain and verify specific categories of information
about its customers including, but not limited to, their Net-worth, annual income and
investment experience and knowledge. Brokers must ensure that investors are given a
detailed explanation of the special characteristics and risks applicable to the trading of
derivative products.
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The disclosure document about derivative products contains information describing the
mechanics and risks of derivatives trading, transaction costs, margin requirements and
tax consequences of margin trading.
Written Anti Money Laundering Procedures
Each registered intermediary should adopt written procedures to implement the anti
money laundering provisions as envisaged under the Anti Money Laundering Act, 2002.
Such procedures should include inter alia, the following three specific parameters which
are related to the overall ‘Client Due Diligence Process’:
• Policy for acceptance of clients
• Procedure for identifying the clients
• Transaction monitoring and reporting especially Suspicious Transactions
Reporting (STR)
Customer Due Diligence
The customer due diligence (“CDD”) measures comprises the following:
• Obtaining sufficient information in order to identify persons who beneficially
own or control securities account. Whenever it is apparent that the securities
acquired or maintained through an account are beneficially owned by a party
other than the client, that party should be identified using client identification
and verification procedures. The beneficial owner is the natural person or
persons who ultimately own, control or influence a client and/or persons on
whose behalf a transaction is being conducted. It also incorporates those
persons who exercise ultimate effective control over a legal person or
arrangement.
• Verify the customer’s identity using reliable, independent source documents,
data or information;
• Identify beneficial ownership and control, i.e. determine which individual(s)
ultimately own(s) or control(s) the customer and/ or the person on whose behalf
a transaction is being conducted;
• Verify the identity of the beneficial owner of the customer and/or the person on
whose behalf a transaction is being conducted, corroborating the information
provided in relation to person; and
• Conduct ongoing due diligence and scrutiny, i.e. perform ongoing scrutiny of the
transactions and account throughout the course of the business relationship to
ensure that the transactions being conducted are consistent with the registered
intermediary’s knowledge of the customer, its business and risk profile, taking
into account, where necessary, the customer’s source of funds.
Policy for acceptance of clients
All registered intermediaries should develop customer acceptance policies and
procedures that aim to identify the types of customers that are likely to pose a higher
than the average risk of money laundering or terrorist financing. By establishing such
policies and procedures, they will be in a better position to apply customer due
diligence on a risk sensitive basis depending on the type of customer business
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relationship or transaction. In a nutshell, the following safeguards are to be followed
while accepting the clients:
• No account is opened in a fictitious/benami name or on an anonymous basis.
• Factors of risk perception (in terms of monitoring suspicious transactions) of the
client are clearly defined having regard to client’s location (registered office
address, correspondence addresses and other addresses if applicable), nature of
business activity, trading turnover etc. and manner of making payment for
transactions undertaken. The parameters should enable classification of clients
into low, medium and high risk. Clients of special category may, if necessary, be
classified even higher. Such clients require higher degree of due diligence and
regular update of KYC profile.
• Documentation requirement and other information to be collected in respect of
different classes of clients depending on perceived risk and having regard to the
requirement to the Prevention of Money Laundering Act 2002, guidelines issued
by RBI and SEBI from time to time.
• Ensure that an account is not opened where the intermediary is unable to apply
appropriate clients due diligence measures/KYC policies. This may be applicable
in cases where it is not possible to ascertain the identity of the client,
information provided to the intermediary is suspected to be non genuine,
perceived non cooperation of the client in providing full and complete
information. The market intermediary should not continue to do business with
such a person and file a suspicious activity report. It should also evaluate
whether there is suspicious trading in determining in whether to freeze or close
the account. The market intermediary should be cautious to ensure that it does
not return securities of money that may be from suspicious trades. However, the
market intermediary should consult the relevant authorities in determining what
action it should take when it suspects suspicious trading.
• The circumstances under which the client is permitted to act on behalf of
another person/entity should be clearly laid down. It should be specified in what
manner the account should be operated, transaction limits for the operation,
additional authority required for transactions exceeding a specified
quantity/value and other appropriate details. Further the rights and
responsibilities of both the persons (i.e. the agent- client registered with the
intermediary, as well as the person on whose behalf the agent is acting should
be clearly laid down). Adequate verification of a person’s authority to act on
behalf the customer should also be carried out.
• Necessary checks and balance to be put into place before opening an account so
as to ensure that the identity of the client does not match with any person
having known criminal background or is not banned in any other manner,
whether in terms of criminal or civil proceedings by any enforcement agency
worldwide .
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Risk based approach
It is generally recognized that customers can be classified into a higher or lower risk
category depending on circumstances such as the customer’s background, type of
business relationship or transaction etc. As such, the registered intermediaries should
apply each of the customers due diligence measures on a risk sensitive basis. The basic
principle enshrined in this approach is that the registered intermediaries should adopt
an enhanced customer due diligence process for higher risk categories of customers.
Conversely, a simplified customer due diligence process may be adopted for lower risk
categories of customers. In line with the risk-based approach, the type and amount of
identification information and documents that registered intermediaries should obtain
necessarily depend on the risk category of a particular customer.
Clients of special categories (CSC)
Such clients include the following:
• Non resident clients.
• High Net-worth clients.
• Trust, Charities, NGOs and organizations receiving donations.
• Companies having close family shareholdings or beneficial ownership.
• Politically exposed persons (PEP) of foreign origin.
• Current / Former Head of State, Current or Former Senior High profile politicians
and connected persons (immediate family, Close advisors and companies in
which such individuals have interest or significant influence).
• Companies offering foreign exchange offerings.
• Clients in high risk countries (where existence / effectiveness of money
laundering controls is suspect, where there is unusual banking secrecy, Countries
active in narcotics production, Countries where corruption (as per Transparency
International Corruption Perception Index) is highly prevalent, Countries against
which government sanctions are applied, Countries reputed to be any of the
following – Havens / sponsors of international terrorism, offshore financial
centres, tax havens, countries where fraud is highly prevalent.
• Non face to face clients.
• Clients with dubious reputation as per public information available.etc.
The above mentioned list is only illustrative and the intermediary should exercise
independent judgment to ascertain whether new clients should be classified as CSC or
not.
Client Identification Procedure
• The ‘Know your Client’ (KYC) policy should clearly spell out the client
identification procedure to be carried out at different stages i.e. while
establishing the intermediary – client relationship, while carrying out
transactions for the client or when the intermediary has doubts regarding the
veracity or the adequacy of previously obtained client identification data.
• The client should be identified by the intermediary by using reliable sources
including documents/information. The intermediary should obtain adequate
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information to satisfactorily establish the identity of each new client and the
purpose of the intended nature of the relationship.
• The information should be adequate to satisfy competent authorities (regulatory
/ enforcement authorities) in future that due diligence was observed by the
intermediary in compliance with the Guidelines. Each original document should
be seen prior to acceptance of a copy.
• Failure by prospective client to provide satisfactory evidence of identity should
be noted and reported to the higher authority within the intermediary.
• SEBI has prescribed the minimum requirements relating to KYC for certain class
of the registered intermediaries from time to time. Taking into account the basic
principles enshrined in the KYC norms which have already been prescribed or
which are prescribed by SEBI from time to time, all registered intermediaries
should frame their own internal guidelines based on their experience in dealing
with their clients and legal requirements as per the established practices.
Further, the intermediary should also maintain continuous familiarity and follow-
up where it notices inconsistencies in the information provided. The underlying
principle should be to follow the principles enshrined in the PML Act, 2002 as
well as the SEBI Act, 1992 so that the intermediary is aware of the clients on
whose behalf it is dealing.
Documents to be obtained from customers for Customer Identification Procedure
under KYC
1. Accounts of Individuals
Legal name and any other names used supported by documents given below:
(i) Passport (ii) PAN card (iii) Voter’s Identity Card (iv) Driving License (v) Job Card issued
by NREGA duly signed by an officer of the State Govt (vi) The letter issued by the Unique
Identification Authority of India ( UIDAI) containing details of name, address and
Aadhaar number (vii) Identity card (subject to the bank’s satisfaction) (viii) Letter from a
recognized public authority or public servant verifying the identity and residence of the
customer to the satisfaction of bank
Correct Permanent Address supported by any of the following documents:
(i) Telephone bill (ii) Bank account statement (iii) Letter from any recognized public
authority (iv) Electricity bill (v) Ration card (vi) Letter from employer (subject to
satisfaction of the bank)
2. Accounts of Company
• Name of the company
• Principal place of business
• Mailing address of the company
• Telephone/Fax number
Documents Required:
(i) Certificate of incorporation and Memorandum & Articles of Association (ii) Resolution
of the Board of Directors to open an account and identification of those who have
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authority to operate the account (iii) Power of Attorney granted to its managers, officers
or employees to transact business on its behalf (iv) Copy of PAN allotment letter (v)
Copy of the telephone bill
3. Accounts of Partnership Firms
• Legal name
• Address
• Names of all partners and their addresses
• Telephone numbers of the firm and partners
Documents required:
(i) Registration certificate, if registered (ii) Partnership deed (iii) Power of Attorney
granted to a partner or an employee of the firm to transact business on its behalf (iv)
Any officially valid document identifying the partners and the persons holding the Power
of Attorney and their addresses (v) Telephone bill in the name of firm/partners
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within the set timeframe. Subsequently, the response received from the trading
member is reviewed.
• If the Trading Member has agreed with the contents of the complaint, he is
advised to settle the matter immediately and confirm
• If the Trading Member states that he has already settled the complaint, proof of
settlement is solicited and cross confirmation is obtained from the investor
• If the Trading Member raises issues from his side, the comments are analyzed
and forwarded to the investor for his views and comments. If differences persist
the Exchange holds meeting with the parties at the Exchange premises for
expeditious resolution of the complaints. In case differences still persist the
investor is informed that he may opt for Arbitration proceedings.
• If the Trading Member has justifiable reasons for his actions which are within the
regulatory framework, the investor is enlightened on the correct position on the
matter.
Nature of complaints
Exchanges provide assistance if the complaints fall within the purview of the Exchange
and are related to trades that are executed on the Exchange Platform. These may be of
the following types:
• Non-Receipt of Corporate Benefit (Dividend/Interest/Bonus etc.)
• Complaints against trading members on account of the following :
o Non-receipt of funds / securities
o Non- receipt of documents such as member client agreement, contract
notes, settlement of accounts, order trade log etc.
o Non-Receipt of Funds / Securities kept as margin
o Trades executed without adequate margins
o Delay /non – receipt of funds
o Squaring up of positions without consent
o Unauthorized transaction in the account
o Excess Brokerage charged by Trading Member / Sub-broker
o Unauthorized transfer of funds from commodities account to other
accounts etc.
• Complaints in cases where the member has surrendered his membership and
the complainant has approached the Exchange before expiry of the time
mentioned in the public notice
Exchanges may not take up the following types of complaints
a. Complaints in respect of transactions which are already subject matter of Arbitration
proceedings,
b. Complaints involving payment of funds and transfer of securities to entities other
than Trading Member,
c. Claims for mental agony/harassment and expenses incurred for pursuing the matter
with the ISC,
d. Claims for notional loss, opportunity loss for the disputed period or trade,
e. Complaints pertaining to trades not executed on the Exchange by the complainant,
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f. Claims of sub-broker/authorized persons for private commercial dealings with the
trading member,
g. Claims relating to transactions which are in the nature of loan or financing which are
not within the framework defined by the Exchange.
Arbitration
SEBI has instructed the exchange to have arbitration committees so that differences,
disputes and claims between trading members and investors can be settled effectively
and in a short time. Arbitration is also governed by Exchange Bye-laws.
Arbitration is a quasi judicial process of settlement of disputes between Trading
Members, Investors, Sub-brokers & Clearing Members and between Investors and
Issuers (Listed Companies). Generally the application for arbitration has to be filed at
the Arbitration Centres established by the exchanges.
The parties to arbitration are required to select the arbitrator from the panel of
arbitrators provided by the Exchange. The arbitrator conducts the arbitration
proceeding and passes the award normally within a period of four months from the date
of initial hearing.
The arbitration award is binding on both the parties. However, the aggrieved party,
within fifteen days of the receipt of the award from the arbitrator, can file an appeal to
the arbitration tribunal for re-hearing the whole case. On receipt of the appeal, the
Exchange appoints an Appellate Bench consisting of five arbitrators who re-hear the
case and then give the decision. The judgment of the Bench is by a ‘majority’ and is
binding on both the parties. The final award of the Bench is enforceable as if it were the
decree of the Court.
Any party who is dissatisfied with the Appellate Bench Award may challenge the same in
a Court of Law.
SEBI Complaints Redress System (SCORES) [http://scores.gov.in]
SEBI has launched a centralized web based complaints redress system (SCORES). This
would enable investors to lodge and follow up their complaints and track the status of
redressal of such complaints from anywhere. This would also enable the market
intermediaries and listed companies to receive the complaints from investors against
them, redress such complaints and report redressal. All the activities starting from
lodging of a complaint till its disposal by SEBI would be carried online in an automated
environment and the status of every complaint can be viewed online at any time. An
investor, who is not familiar with SCORES or does not have access to SCORES, can lodge
complaints in physical form. However, such complaints would be scanned and uploaded
in SCORES for processing. SCORES would expedite disposal of investors’ complaints as
this would obviate the need for physical movement of complaints and the possibility of
loss, damage or misdirection of the complaints would be avoided. It would facilitate
easy retrieval and tracking of complaints at any time.
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SCORES, which has been developed by National Informatics Centre, Government of
India, is web enabled and provides online access 24 x 7. This has the following salient
features:
• Complaints and reminders thereon are lodged online at anytime from anywhere;
• An email is generated instantaneously acknowledging the receipt of the complaint
and allotting a unique complaint registration number for future reference and
tracking;
• The complaint moves online to the entity (intermediary or listed company)
concerned for its redressal;
• The entity concerned uploads an Action Taken Report (ATR) on the complaint;
• SEBI peruses the ATR and disposes of the complaint if it is satisfied that the
complaint has been redressed adequately;
• The concerned investor can view the status of the complaint online;
• The entity concerned and the concerned investor can seek and provide
clarification(s) online to each other;
• The life cycle of a complaint has an audit trail; and
• All the complaints are saved in a central database which would generate relevant
MIS reports to enable SEBI to take appropriate policy decisions and or remedial
actions.
General Do's and Don’ts for Investors
Investors must follow some Do’s and Don’ts while transacting in the securities market.
Given below are some general Do’s and Don’ts for investors:
Do’s
Investors must:
• Always deal with the market intermediaries registered with SEBI / stock exchanges.
• Carry out due diligence before registering as client with any intermediary. Carefully
read and understand the contents stated in the Risk Disclosure Document, which
forms part of the investor registration requirement for dealing through brokers.
• Collect photocopies of all documents executed for registration as a client,
immediately on its execution.
• Ensure that the documents or forms for registration as Client are fully filled in.
• Give clear and unambiguous instructions to their broker / agent / depository
participant.
• Always insist on contract notes from their brokers/sub-brokers. In case of doubt in
respect of the transactions, verify the genuineness of the same from the exchange.
• Always settle the dues through the normal banking channels with the market
intermediaries.
• Adopt trading / investment strategies commensurate with their risk-bearing capacity
as all investments carry some risk, the degree of which varies according to the
investment strategy adopted.
• Be cautious about securities which show a sudden spurt in price or trading activity,
especially low price stocks.
• Remember that there are no guaranteed returns on investment in the stock market.
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• Read the terms and conditions and understand the risk factors associated with the
commodity market investment
• Always keep copies of all investment documentation (e.g. application forms,
acknowledgements slips, contract notes).
• Send important documents by a reliable mode (preferably through registered post)
to ensure delivery.
• Ensure that they have money and will be able to pay, before you buy.
• Ensure that they hold securities and will be able to deliver, before they sell.
• Follow up diligently and promptly e.g. If the required documentation is not received
within a reasonable time, investors must contact the concerned person at the
Trading Member immediately.
Don’ts
Investors must not:
• Deal with unregistered brokers / sub - brokers, or other unregistered intermediaries.
• Execute any documents with any intermediary without fully understanding its terms
and conditions.
• Leave the custody of their Demat Transaction slip book in the hands of any
intermediary.
• Make any payments in cash
• Accept unsigned/ duplicate or incomplete contract notes
• Deal based on rumours or 'tips'.
• Get swayed by promises of high returns.
• Fall prey to promises of guaranteed returns.
• Get misled by guarantees of repayment of their investments through post-dated
cheques.
• Get carried away by luring advertisements of any nature in print and electronic
media.
• Blindly follow media reports on corporate developments, as some of these could be
misleading.
• Blindly imitate investment decisions of others who may have profited from their
investment decisions.
• Forgo obtaining all documents of transactions, in good faith even from people whom
they ‘know’.
• Delay approaching concerned authorities in case of a dispute. Written complaints
must be filed with the Exchange as soon as possible.
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Appendix A: Sample Questions
1. An index option is a __________________.
(a) Debt instrument
(b) Derivative product
(c) Cash market product
(d) Money market instrument
2. The purchase of a share in one market and the simultaneous sale in a different
market to benefit from price differentials is known as ____________.
(a) Mortgage
(b) Arbitrage
(c) Hedging
(d) Speculation
6. You sold one XYZ Stock Futures contract at Rs. 278 and the lot size is 1,200. What is
your profit (+) or loss (-), if you purchase the contract back at Rs. 265?
(a) 16,600
(b) 15,600
(c) -15,600
(d) -16,600
7. You have taken a short position of one contract in June XYZ futures (contract
multiplier 50) at a price of Rs. 3,400. When you closed this position after a few days, you
realized that you made a profit of Rs. 10,000. Which of the following closing actions
would have enabled you to generate this profit? (You may ignore brokerage costs.)
(a) Selling 1 June XYZ futures contract at 3600
(b) Buying 1 June XYZ futures contract at 3600
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(c) Buying 1 June XYZ futures contract at 3200
(d) Selling 1 June XYZ futures contract at 3200
8. Which of the following is closest to the forward price of a share, if Cash Price =
Rs.750, Forward Contract Maturity = 6 months from date, Market Interest rate = 12%?
(a) 772.5
(b) 795
(c) 840
(d) 940.8
9. If you have sold a XYZ futures contract (contract multiplier 50) at 3100 and bought it
back at 3300, what is your gain/loss?
(a) A loss of Rs. 10,000
(b) A gain of Rs. 10,000
(c) A loss of Rs. 5,000
(d) A gain of Rs. 5,000
11. Client A has purchased 10 contracts of December series and sold 7 contracts of
January series of the NSE Nifty futures. How many lots will get categorized as regular
(non-spread) open positions?
(a) 10
(b) 7
(c) 3
(d) 17
12. In an equity scheme, fund can hedge its equity exposure by selling stock index
futures.
(a) True
(b) False
14. When the near leg of the calendar spread transaction on index futures expires, the
farther leg becomes a regular open position.
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(a) True
(b) False
16. The buyer of an option cannot lose more than the option premium paid.
(a) True only for European options
(b) True only for American options
(c) True for all options
(d) False for all options
19. You sold a Put option on a share. The strike price of the put was Rs.245 and you
received a premium of Rs.49 from the option buyer. Theoretically, what can be the
maximum loss on this position?
(a) 196
(b) 206
(c) 0
(d) 49
20. Current Price of XYZ Stock is Rs. 286. Rs. 260 strike call is quoted at Rs. 45. What is
the Intrinsic Value?
(a) 19
(b) 26
(c) 45
(d) 0
21. A European call option gives the buyer the right but not the obligation to buy from
the seller an underlying at the prevailing market price "on or before" the expiry date.
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(a) True
(b) False
22. A put option gives the buyer a right to sell how much of the underlying to the writer
of the option?
(a) Any quantity
(b) Only the specified quantity (lot size of the option contract)
(c) The specified quantity or less than the specified quantity
(d) The specified quantity or more than the specified quantity
24. An option with a delta of 0.5 will increase in value approximately by how much, if
the underlying share price increases by Rs 2?
(a) Rs 1
(b) Rs 2
(c) Rs 4
(d) There would be no change
26. Higher the price volatility of the underlying stock of the put option,
______________.
(a) Higher would be the premium
(b) Lower would be the premium
(c) Nil (zero) would be the premium
(d) Volatility does not effect put value
27. In which option is the strike price better than the market price (i.e., price difference
is advantageous to the option holder) and therefore it is profitable to exercise the
option?
(a) Out-of the money option
(b) In-the -money option
(c) At-the-money option
(d) Higher-the-money option
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28. Mr. X purchases 100 put option on stock S at Rs. 30 per call with strike price of Rs.
280. If on exercise date, stock price is Rs. 350, ignoring transaction cost, Mr. X will
choose _____________.
(a) To exercise the option
(b) Not to exercise the option
(c) May or may not exercise the option depending on whether he is in his hometown or
not at that time
(d) May or may not exercise the option depending on whether he like the company S or
not
29. Three Call series of XYZ stock - January, February and March are quoted. Which will
have the lowest Option Premium (same strikes)?
(a) January
(b) February
(c) March
(d) All will be equal
30. Which is the ratio of change in option premium for the unit change in interest rates?
(a) Vega
(b) Rho
(c) Theta
(d) Gamma
31. If you sell a put option with strike of Rs. 245 at a premium of Rs.40, how much is the
maximum gain that you may have on expiry of this position?
(a) 285
(b) 40
(c) 0
(d) 205
32. If an investor buys a call option with lower strike price and sells another call option
with higher strike price, both on the same underlying share and same expiration date,
the strategy is called ___________.
(a) Bullish spread
(b) Bearish spread
(c) Butterfly spread
(d) Calendar spread
33. On the derivative exchanges, all the orders entered on the Trading System are at
prices exclusive of brokerage.
(a) True
(b) False
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34. A trader has bought 100 shares of XYZ at Rs.780 per share. He expects the price to
go up but wants to protect himself if the price falls. He does not want to lose more than
Rs.1000 on this long position in XYZ. What should the trader do?
(a) Place a limit sell order for 100 shares of XYZ at Rs.770 per share
(b) Place a stop loss sell order for 100 shares of XYZ at Rs.770 per share
(c) Place a limit buy order for 100 shares of XYZ at Rs.790 per share
(d) Place a limit buy order for 100 shares of XYZ at Rs.770 per share
35. Trader A wants to sell 20 contracts of August series at Rs.4500 and Trader B wants to
sell 17 contracts of September series at Rs.4550. Lot size is 50 for both these contracts.
The Initial Margin is fixed at 6%. How much Initial Margin is required to be collected
from both these investors (sum of initial margins of A and B) by the broker?
(a) 2,70,000
(b) 5,02,050
(c) 2,32,050
(d) 4,10,000
36. A member has two clients C1 and C2. C1 has purchased 800 contracts and C2 has
sold 900 contracts in August XYZ futures series. What is the outstanding liability (open
position) of the member towards Clearing Corporation in number of contracts?
(a) 800
(b) 1700
(c) 900
(d) 100
38. Clients' positions cannot be netted off against each other while calculating initial
margin on the derivatives segment.
(a) True
(b) False
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40. Value-at-risk measures ___________.
(a) Value of proprietary portfolio
(b) Risk level of a financial portfolio
(c) Net-worth of an investor
(d) Credit rating of an investor
44. Liquid Assets maintained by Mr A (Clearing Member) are higher than that
maintained by Mr B (Clearing Member). Which of the following statements is true?
(a) Mr A can enjoy higher exposure levels in futures than Mr B
(b) Mr B can enjoy higher exposure levels in futures than Mr A
(c) Both Mr A and Mr B enjoy the same exposure levels
(d) No need to maintain liquid assets for exposure in derivatives markets
45. On the Clearing Council of the Clearing Corporation of the derivatives segment,
broker-members are allowed.
(a) True
(b) False
46. The main objective of Trade Guarantee Fund (TGF) at the exchanges is
_________________.
(a) To guarantee settlement of bonafide transactions of the members of the exchange
(b) To inculcate confidence in the minds of market participants
(c) To protect the interest of the investors in securities
(d) All of the above
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47. Value-at-risk provides the ______________.
(a) Expected maximum loss, which may be incurred by a portfolio over a given period of
time and specified confidence level
(b) Value of securities which are very risky
(c) Value of speculative stocks
(d) Theoretical value of illiquid stocks in a portfolio
49. If price of a futures contract decreases, the margin account of the buyer of this
futures contract is debited for the loss.
(a) True
(b) False
50. When establishing a relationship with a new client, the trading member takes
reasonable steps to assess the background, genuineness, beneficial identify, financial
soundness of such person and his investment/trading objectives.
(a) True
(b) False
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ANSWERS
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