8/14/2019 Dinesh Report
1/84
1.Introduction
TITLE
Derivatives are new concept to India market. The Indian capital market is
significant in terms of the degree of development, volume of trading and its tremendous
growth. With over 21 million shareholders, India has a third largest investor base the
world after USA and Japan. Over 9000 companies are listed on stock exchange, whish
are serviced by approximately 7500 stockbrokers.
Most of the investments are not taking place in under develop as economically
weak countries because of the risk of return attached with it. In any of the investment
there is a risk of loss. The risk may include earth quake, cyclone, storm and or monsoon
failure which are uncontrollable caused by nature.
Through our study we have attempted to know the planning program, and
system used by investor and individuals to manage the risk associated with future and
options. This is leads to study about futures and options in derivatives market.
1.1 OBJECTIVES OF THE RESEARCH
Understanding derivatives system in India.
Trading method and strategies in derivative market.
Rules and guidelines trading in futures and option.
SCOPE OF STUDY
With globalization of the financial sector, it's time to recast the architecture of the
financial market. To reduce this risk, the concept of derivatives comes into the picture.
The Project is about current scenario of derivatives market and also current
1
8/14/2019 Dinesh Report
2/84
developments of market. This project leads to complete understanding derivatives
market. In India we have different types of derivatives available like futures and
options. We are using different trading strategies used for futures and options. This
project is study complete design about the futures and options. What purpose is need
for derivatives market in India and practical concept behind that trading strategy used in
options. Derivatives are products whose values are derived from one or more basic
variables called bases. India is traditionally an agriculture country with strong
government intervention Rules and guidelines followed by SEBI
LIMITATIONS
The study is conducted in Bangalore only.
Since the study covers the overview of derivatives market, it cannot be
generalized.
The depth of study has not fulfilled
Respondents information is not reliable.
1.2 RESEARCH METHODOLOGY AND RESEARCH DESIGN:
The methodology is the plan, structure and strategy of the investigation process
that sets out to obtain answer to the study. The methodology followed for the collecting
information are using two sources of data namely
Primary Data
Secondary Data
Primary Data
2
8/14/2019 Dinesh Report
3/84
The data collected first hand by the researcher concerned with the research
problem refers to the Primary data.
Personal discussion was made with Unit manager and interaction with other
personnel in the organization for this purpose. There is no formal design of
questionnaire used in this study.
Secondary Data
The information available at various sources made for some other purpose but
facilitating the study undertaken is called as Secondary Data.
The various sources that were used for the collection of secondary data are
Various Text books were used to understand the concepts of portfolio
management.
Websites
Annual reports of different companies.
Newspapers such as Economic Times, Financial Express.
Magazines such as Business World, Business Today, Investors Guide, Capital
Market.
Sample Size
Sample size : 100 respondents
Sampling procedure : Non Probability Sampling Method
Sampling type : Convience sampling
3
8/14/2019 Dinesh Report
4/84
Sampling area : Bangalore
Sampling design : Exploratory Research Design
Research instrument : Structured Distinguished Questionnaire
Description of the research design
Achieve the objectives of the project all possible information relevant the investor
profile were collected. Taking the help of the theoretical mode, the most appropriate
methodology was decided.
SAMPLING PROCEDURE
Sample unit
Who is to be surveyed? The marketing researches must define the targeted
population that will be sampled. Once this unit is determine a sampling frame must be
developed so that every one in the targeted population has as equal of known chance
of being sampled.
Sample size
How many people should be surveyed? Sampled give more reliable results than
small samples. However it is necessary to sample the entire target population or even a
substation portion to achieve reliable results. Sample of less than 1% of population
often provide good reliability, given a credible sampling procedure.
Data collection instrument
The questionnaire is the most common instrument in collect primary data. A
questionnaire of a set of question presented to respondents for their answers. The
questionnaire very flexible in that there any number of way to ask questions.
4
8/14/2019 Dinesh Report
5/84
Questionnaire need to be carefully developed tested and debugged before they are
administrated on a large scale. Once a usually spot several errors a casually prepared
questionnaire.
In preparing a questionnaire the professional researcher carefully chooses the
questions and their form, working and sequence.
A common types of errors occurs in the questions asked , that is in including
question that cannot would not , or need to be answered and in omitting questions that
be answered each question should be checked to determine whether it contributes in
the research objectives.
The question should flow in a logical order on the respondents demographics come last
because they are more personal and less interesting to the respondents
Questionnaire design
Close ended question
Questions, which restrict the interviewees answer to pre-defined options,
are called close-ended questions. Close-ended questions give respondents a finite set
of specified responses to choose firm. Such questions are deemed appropriate when
the respondent has a specific answer to give a , when the researcher has a specified
answer in mind , when detailed narrative information is not needed or when there is a
finite numbers of ways to answer a question. These questions are common in survey
researches.
Analysis of Findings
Derivative market transaction volume is four times of the Spot market's volume
the allocation into derivatives is less than the investment into the Spot market
5
8/14/2019 Dinesh Report
6/84
Investors are not confident on the research report on various stocks mainly due
to its variance from the actual happenings in the market.
Traders mainly want to make short term gain by investing into Derivatives then
for using Derivative as an instrument to reduce the market risk.
The retail investors are reluctant to go by options mainly due to the low liquidity
in the Option's market
Meanings of derivatives
Derivatives are the financial instruments, which derive their value from some
other financial instruments, called the underlying. The foundation of all derivatives
market is the underlying market, which could be spot market for gold, or it could be a
pure number such as the level of the wholesale price index of a market price.
A derivative is a financial instrument whose value depends on the value
of other basic underlying variables
John c hull
According to the Securities Contract (Regulation) Act, 1956, derivatives include:
A security derived from a debt instrument, share, and loan whether secured or
unsecured, risk instrument or contract for differences or any other form of
security.
A contract, which derives its value from the prices or index of prices of underlying
securities.
6
8/14/2019 Dinesh Report
7/84
Therefore, derivatives are specialized contracts to facilitate temporarily for
hedging which is protection against losses resulting from unforeseen price or volatility
changes. Thus, derivatives are a very important tool of risk management.
Derivatives performs a number of economic functions like price discovery, risk transfer
and market completion. The simplest kind of derivative market is the forward market.
Here a buyer and seller write a contract for delivery at a specific future date and a
specified future price. In India, a forward market exists in the form of the dollar-rupee
market. But forward market suffers from two serious problems; counter party risk
resulting in comparatively high rate of contract non-compliance and poor liquidity.
Futures markets were invented to cope with these two difficulties of forward markets.
Futures are standardized forward contracts traded on an organized stock exchange. In
essence, a future contract is a derivative instrument whose value is derived from the
expected price of the underlying security or asset or index at a pre-determined future
date.
TYPES OF DERIVATIVES
The following are the popular and important derivatives:
7
DERIVATIVES
8/14/2019 Dinesh Report
8/84
One form of classification of derivatives is between commodity derivatives and financial
derivatives. Thus futures of option on gold sugar, jute, pepper etc are commodity
derivatives
While futures options or swaps on currencies, gilt-edged securities, stock and share
stock market indices etc are financial derivatives.
Forwards
Futures
Options and
Swaps
8
FORWARD
S
FUTURE OPTIONS
SWAPS
Derivatives
8/14/2019 Dinesh Report
9/84
Swap
i) Forward contract
A forward contract is a customized contract between the buyer and the seller where
settlement takes place on a specific date in future at a price agreed today. The rupee-
dollar exchange rate is a big forward contract market in India with banks, financial
institutions, corporate and exporters being the market participants.
The main features of a forward contract are:
Each contract is custom designed and hence unique in terms of contract size,
expiration date, asset type, asset quality etc.
A contract has to be settled in delivery or cash on expiration date.
In case one of the two parties wishes to reverse a contract, he has to compulsorily
go to the other party. The counter party being in a monopoly situation can command
the price he wants.
Traded in Over the Counter (OTC) markets. No down payment required.
Settlement is done on the date of maturity.
9
Forwards Future O tion Swap
Commodi
Security
Commodity Securit Call Put
Interest rate
Currency
8/14/2019 Dinesh Report
10/84
(ii) FUTURES
A future contract is very similar to a forward contract in all respects excepting the fact
that it is completely a standardized one. Hence, it is rightly said that a futures contract
is nothing but a standardized forward contract. It is legally enforceable and it is always
traded on an organized exchange.
A future is a contract to buy or sell an asset at a specified future date at a specified
price. These contracts are traded on the stock exchanges and it can change many
hands before final settlement is made.
Features of future contracts
1. Highly standardized in nature.
2. No down payment is required at the time of agreement.
3. Settlement: futures instruments are marked to the market and the exchange
records profit and loss on them on daily basis though held till maturity.
4. Hedging of price risk is most common in futures.
5. Non-linearity.
6. Non-delivery of asset: In future contracts generally parties simply exchange the
difference between the future and spot prices.
The advantage of a future is that it eliminates counterparty risk. Since there is an
exchange involved in between, and the exchange guarantees each trace, the buyer or
seller does not get affected with the opposite party defaulting.
10
8/14/2019 Dinesh Report
11/84
FUTURES V/S FORWARDS
Futures Forwards
Futures are traded on a stock
exchange.
Forwards are non-tradable, negotiated
instruments.
Futures are contracts having
standard terms and conditions.
Forwards are contracts customized by
the buyer and seller.
No default risk as the exchange
provides a counter guarantee.
High risk of default by either party.
Exit route is provided because ofhigh liquidity on the stock exchange.
No exit route for these contracts.
Highly regulated with strong
margining and surveillance systems.
No such systems are present in a
forward market.
a) Commodity futures
A commodity future is a futures contract in commodities like agriculture
products, metals and minerals etc. In organized commodity future markets, contracts
are standardized with standard quantities. Of course, this standard varies from
commodity to commodity. They also fixed delivery dates in each month or a few
months in a year. In India commodity futures in agricultural products are popular.
b) Financial futures
Financial futures refer to a futures contract in foreign exchange or financial
instruments like Treasury bill, commercial paper, and stock market index or interest
rate. It is an area where financial service companies can play a very dynamic role.
Financial futures are very popular in Western countries as hedging instruments to
11
8/14/2019 Dinesh Report
12/84
protect against exchange rate/interest rate fluctuations and for ensuring future interest
rates on loans.
The Stock Index Futures contract is a futures contract on major stock market
indices. This type of contract is very much useful for speculators, investors and
especially portfolio managers. They can hedge against future decline or increase in
prices of portfolios depending upon the situation.
Generally the asset will not be delivered on the maturity of the contract. The parties
simply exchange the difference between the future and spot prices on the date of
maturity. But, these kinds of financial futures are relatively new in India. may be larger
than the initial margin deposit.
For example, assume its now January. The July crude oil futures price is
presently quoted at $15 a barrel and over the coming month you expect the price to
increase. You decide to deposit the required initial margin of $2,000 and buy one July
crude oil futures contract. Further assume that by April the July crude oil futures price
has risen to $16 a barrel and you decide to take your profit by selling. Since each
contract is for 1,000 barrels, your $1 a barrel profit would be $1,000 less transaction
costs.
Price per barrel Value of 1,000
barrel contract
January Buy 1 July crude oil
futures contract
$15.00 $15,000
April Sell 1 July crude oil
futures contract
$16.00 $16,000
12
8/14/2019 Dinesh Report
13/84
Gain $1.00 $1,000
*
For simplicity, examples do not take into account commissions and other transaction
costs. These costs are important. You should be sure you understand them.
Suppose, instead, that rather than rising to $16 a barrel, the July crude oil price by April
has declined to $14 and that, to avoid the possibility of further loss, you elect to sell the
contract at that price. On the 1,000 barrel contract your loss would come to $1,000 plus
transaction costs.
Price per barrel Value of 1,000
barrel contract
January Buy 1 July crude oil
futures contract
$15.00 $15,000
April Sell 1 July crude oil
futures contract
$14.00 $14,000
Loss $1.00 $1,000
Note that if at any time the loss on the open position had reduced funds in your margin
account to below the maintenance margin level, you would have received a margin call
for whatever sum was needed to restore your account to the amount of the initial margin
requirement.
(iii) OPTIONS
In the volatile environment, risk of heavy fluctuations in the prices of assets is
very heavy. Option is yet another tool to manage such risks. Options are one better
13
8/14/2019 Dinesh Report
14/84
than futures. In option, as the name indicates, gives one party the option to take or
make delivery. But this option is given to only one party in the transaction while the
other party has an obligation to take or make delivery. The asset can be a stock, bond,
index, currency or a commodity.
But since the other party has an obligation and a risk associated with making
good the obligation, he receives a payment for that. This payment is called as
premium. The party that had the option or the right to buy/sell enjoys low risk. The cost
or this low risk is the premium amount that is paid to the other party.
The buyer of the right is called the option holder. The seller of the right (and
buyer of the obligation) is called the option writer. The cost of this transaction is the
premium.
In an options contract, the seller is usually referred to as a writer since he is
said to write the contract. It is similar to the seller who is said to be in Short position in
a forward contract. However, in a put option, the writer is in a different position. He is
obliged to buy shares. In an option contract, the buyer has to pay a certain amount at
the time of writing the contract for enjoying the right to buy or sell.
American Option Vs European Option
In an option contract, if the option can be exercised at any time between the
writing of the contract and its expiration, it is called as an American option. On other
hand, if it can be exercised only the time of maturity, it is termed as European option.
Types of options
Options may fall under any one of the following main categories:
Call Option
Put Option
14
8/14/2019 Dinesh Report
15/84
1) CALL OPTION
A call option is one which gives the option holder the right to buy a underlying asset
(commodities, foreign exchange, stocks, shares etc.) at a predetermined price called
exercise price or strike price on or before a specified date in future. In such a case, the
writer of a call option is under an obligation to sell the asset at the specified price, in
case the buyer exercises his option to buy. Thus, the obligation to sell arises only when
the option is exercised.
2) PUT OPTION
A put option is one, which gives the option holder the right to sell an underlying asset at
a predetermined price on or before a specified date in future. It means that the writer of
a put option is under an obligation to buy the asset at the exercise price provided the
option holder exercises his option to sell.
a. Option Premium
In an option contract, the option writer agrees to buy or sell an underlying asset
at a future date for an agreed price from/to the option buyer/seller at his option. This
contract, like any other contract must be supported by consideration. The consideration
for this contract is a sum of money called premium. The premium is nothing but the
price, which is required to be paid for the purchase of right to buy or sell.
The premium, one pays is the maximum amount to which he is exposed in the
market, since, in any case he can not lose more than that amount. Thus, his risk is
limited to that extent only. However, his gain potential is unlimited. In the case of a
double option, this premium money is also double.
b. Options Market
Options market refers to the market where option contracts are brought and sold. Once
an option contract is written, it can be bought or sold on the options market. The first
15
8/14/2019 Dinesh Report
16/84
option market namely the Chicago Board of Options Exchange was set up in 1973.
Thereafter, several options markets have been established.
Features of Option Market
1. Highly Flexible.
2. Down Payment.
3. Settlement.
4. Non-Linearity.
5. No Obligation to Buy or Sell.
For example :An investor buys one European Call option on one share of Reliance
Petroleum at a premium of Rs. 2 per share on 31 July . The strike price is Rs.60 and the
contract matures on 30 September . The payoffs for the investor on the basis of
fluctuating spot prices at any time are shown by the payoff table (Table 1). It may be
clear form the graph that even in the worst case scenario, the investor would only lose a
maximum of Rs.2 per share which he/she had paid for the premium. The upside to it
has an unlimited profits opportunity.
On the other hand the seller of the call option has a payoff chart completely reverse of
the call options buyer. The maximum loss that he can have is unlimited though a profit
of Rs.2 per share would be made on the premium payment by the buyer.
Payoff from Call Buying/Long (Rs.)S Xt C Payoff Net Profit
57 60 2 0 -258 60 2 0 -259 60 2 0 -260 60 2 0 -261 60 2 1 -1
16
8/14/2019 Dinesh Report
17/84
62 60 2 2 063 60 2 3 164 60 2 4 265 60 2 5 366 60 2 6 4
A European call option gives the following payoff to the investor: max (S - Xt, 0).
The seller gets a payoff of: -max (S - Xt,0) or min (Xt - S, 0).
Notes:
S - Stock Price
Xt - Exercise Price at time 't'
C - European Call Option Premium
iv) SWAPS
Swap is yet another exciting trading instrument. Infact, it is a combination of
forward by two counterparties. It is arranged to reap the benefits arising from the
fluctuations in the market either currency market or interest rate market or any other
market for that matter.
Features of Swaps
1. Basically a forward.
2. Double coincidence of wants.
3. Necessity of an intermediary.
4. Settlement.
5. Long term agreement.
Kinds of Swap
A swap can be arranged for the exchange of currencies, interest rates etc. A
swap in which two currencies are exchanged are exchanged is called cross-currency
swap. A swap in which a fixed rate of interest is exchanged for a floating rate is called
17
8/14/2019 Dinesh Report
18/84
interest rate swap. This interest rate swap can also be arranged in multi-currencies. A
swap in which on stream of floating interest rate is exchanged for another stream of
floating interest is called Basis swap. Thus, swap can be arranged according to the
requirements of the parties concerned and may innovative swap instruments can be
evolved like this.
Advantages
1. Borrowing at Lower Cost.
2. Access to New Financial Markets.
3. Hedging of Risk.
4. Tool to correct Asset-Liability Mismatch.
5. Additional Income.
Distinction between futures and options
Futures Options
Exchange traded, with novation Same as futures. Exchange defines the product Same as futures
Prize is zero, strike price moves Strike price is fixed, price moves.
Price is zero Price is always positive
Linear payoff Non linear payoff.
Both long and short at risk Only short at risk.
The Nifty index fund industry will find it very useful to make a bundle of a Nifty indexfund and a nifty put option to create a new kind of a Nifty index fund, which gives the
investor protection against extreme drop in Nifty. Selling put options is selling insurance,
18
8/14/2019 Dinesh Report
19/84
so any one who feels like earning revenues by selling insurance can set himself up to
do so on the index options market.
More generally, options offer "nonlinear payoffs" whereas futures only have
"linear payoffs". By combining futures and options, a wide variety of innovative and
useful pay off structures can be created
DERIVATIVES MARKET IN INDIA
Liberalization period:
In India financial markets, there were only a few financial products and the
stringent regulatory products and the stringent regulation environment also eluded any
possibility of development of a derivatives market in country. All Indian corporate were
mainly relying on term lending institution for meeting their project financing or any other
financing requirements and on commercial banks for meeting working capital finance
requirement. Commercial banks are on their assets and liabilities. The only derivative
product they were aware of is the foreign exchange forward contract. But this scenario
changed in the post liberalization period. Conservative Indian business practitioners
began to take a different view of various aspects of their operations to remain
competitive. Financial risks were given adequate attention and treasury function has
assumed a significance role in all major corporate since then.
Initially, banks were allowed to pass on gains arising out of cancellation of
forwards contracts to the customers and customers were permitted to cancel and re-
book the forward contracts. This remarkable change was followed by the introduction of
cross currency forward contacts. But the major milestone in developing forex derivatives
market in India was the introduction of cross currency options. The RBIs objective of
introducing cross currency options was to provide a complicated hedging strategy for
the corporate in their risk management activities.
19
8/14/2019 Dinesh Report
20/84
First traded in Mumbai in 1875:
The concept of derivatives is of course not new to the Indian market. Though
derivatives in the financial markets have nothing to talk about home, in the commodity
markets they have a long history of over hundred years. In 1875, the first commodity
futures exchange was set up in Mumbai under the guidance of Bombay Cotton Traders
Association. A clearinghouse for clearing and settlement of these traders was set up in
1918. Over a period of twenty years during 1900-1920, other futures markets were set
up in various places. Futures market in raw jute in Kolkata (1912), wheat futures market
in Hapur (1913), and bullion futures market in Mumbai (1920).
When it comes to financial markets, derivatives in equities claim a long
existence. The official history of Bombay Stock Exchange (then known as Native Share
and Stock Brokers Association) reveals that the concept of options existed since 1898
as is reflected from a quote given by one of the MPs-India being the original home of
options, a native broker would give a few points to the brokers of the other nations in
the manipulation of puts and calls
Approved by government of India
However, such an early expertise gained by Indian traders in derivatives trading has
come to an end with the Government of Indias ban on forward contract during the
1960s on the ground of their intrinsic undesirability. But ironically, the same were re-
introduced by the government in the 1980s as essential instruments for eliminating
wide fluctuations in prices and more so because of the World Bank UNCTAD report,
which strongly urged the Indian government to start futures trading in major cash crops,
especially in view of Indias entry to WTO.
With the world embracing the derivative trading on large scale, the Indian
market obviously cannot remain aloof, especially after liberalization has been set in
motion. Now we are in the threshold of introducing trading in derivatives, beginning with
20
8/14/2019 Dinesh Report
21/84
the stock index futures to be well set for the introduction of derivative trading. With L.C.
Gupta committee having recently submitted its report on the subject, SEBI is engaged
in the process of assessing the feasibility and desirability of introducing such trading.
The NSE and BSE are two exchanges on which financial derivatives are traded.
The combined notional value of the daily volumes on both the bourses stand at around
RS. 400 cr. In developed markets trading in the derivatives segment are thrice as large
as in the cash markets. In India, the figure is hardly 20% of cash markets. Quite clearly
our derivative markets have a long way to go.
Traded at NSE & BSE
According to the Executive Director of Association of NSE Member of India
(Amni), Vinod Jain, Volumes in derivatives segment are stagnating due to lack of
growth in the number of markets participants. Besides these products are still to catch
up with the masses who are keeping away from this segment due to lack of
understanding of the products and high contract price
Like our stock markets, the Indian derivatives markets are also becoming
heavily dependent on few instruments. For instance, futures in three blue chip
companies such as Satyam Computers, Reliance Industries and Infosys Technologies,have accounted for as 42% of the total turnover in the derivatives segment of
the National Stock Exchange in June 2002. Stock futures of Satyam Computers, Infosys
Technologies and HPCL accounted for 37% of the total turnover in May 2002, 35% in
April 2002 and 34% in March 2002 . These highly speculative stock futures instruments
accounted for about 69% of the total turnover. This may lead to price manipulations.
Meanwhile, options contracts are witnessing a decline in trading interest. The turnover
in individual stock options plunged to Rs. 4,642cr. In June compared with Rs. 5,133cr.
In May similarly, the turnover index options also declined from Rs. 463cr. in May to Rs.
389cr. in June.
21
8/14/2019 Dinesh Report
22/84
Division of Derivatives markets
a) COMMODITIES DERIVATIVES MARKETSIn order to give more thrust on agricultural sector, the National Agricultural Policy,
2000 has envisaged and domestic market reforms and dismantling of all controls and
regulations in agricultural commodity markets. It has also proposed to extend the
coverage of futures markets to minimize the wide fluctuations in commodity market
prices and for hedging the risk from price fluctuations.
As a result of these recommendations, there are presently, 15 exchanges
carrying out futures trading in as many as 30 commodity items. Out to these, twoexchanges viz. IPSTA, Cochin and the Bombay Commodity Exchange (BCE) Ltd.; have
been upgraded to international exchanged to deal international contracts in peeper and
castor oil respectively. Moreover, permission has been given to two more exchange viz.
the First Commodities Exchange of India Ltd., Kochi (for copra/coconut, its oil and
oilcake), and Keshave Commodity Exchange Ltd., Delhi (for potato), where futures
trading started very recently.
The government has also permitted four exchange viz., EICA, Mumbai. The
Central Gujarat Cotton Dealers Association, Vadodara; The South India cotton
Association Coimbatore; and the Ahmedabad Cotton Merchants Association,
Ahmedabad, for conducting forward (non-transferable specific delivery) contracts in
cotton. Lately as part of further liberalization of trade in agriculture and dismantling of
ECA, 1955 futures trade in sugar has been permitted and three new exchanges viz., E-
Commodities Limited, Mumbai; NCS InfoTech Ltd., Hyderabad; and E-Sugar India.com,
Mumbai have been given approval for conducting sugar futures (Ministry of Food and
Consumer Affairs, 1999).
In the recent past, the GOI has set up a committee to explore and appraise
matters important to the establishment and financing of the proposed national
22
8/14/2019 Dinesh Report
23/84
commodity exchange for the nationwide trading of commodity futures contracts. The
usage of warehouse receipts as a means for delivery of commodities under the
contracts is also being explored. The warehouse receipts system has been
operationalised in COFEI (coffee futures exchange of India) with effect from 1998. The
Government of India is on the move to establish a system of warehouse receipts in
other commodity stock exchanges at various places of the country.
Besides these domestic developments, during 1998, Reserve Bank of India
permitted the Indian Corporate Sector to access the exchanges subject to certain
conditions with a view to enable domestic metal manufacturers to compete with global
players. The de-regulation of oil-imports being on the cards, government should create
the right atmosphere for oil sector to participate in the international oil-derivatives
Markets.
Despite these developments, there are still many impediments that hold back the
farming community from entering the futures market and reap full benefits.
b) Currency Derivatives
Foreign exchange derivatives market is one of the oldest derivatives markets in
India. Presently, India has got a well-established dollar-rupee forward market with
contrast traded for one month, two months and three months expiration. Currency
derivatives markets have begun to evolve with the allowing of banks to pass on the
gains upon cancellation of a forward to the customer and permitting customer to cancel
and rebook forward contracts.
Introduction of cross currency options can be considered as another major step
towards developing forex derivatives markets in India. Today, Indian corporate are
permitted to purchase cross currency options to hedge exposures arising out of trade.
Authorized dealers who offer these products have to necessarily cover their exposure in
international markets i.e., they shall not carry the risk in their own books. Cross currency
23
8/14/2019 Dinesh Report
24/84
options are essentially meant for buying or selling any foreign currency in terms of US
dollar. They are therefore, useful only to those traders who invoice their exports and
imports in currencies other than US dollar or for corporate who borrow in currencies
other than US dollar. As against this, majority of Indian trade is invoiced in the US
dollars. Thus, they have almost no relevance in the Indian context.
Indian banks are allowed to use the foreign currency interest rate swaps,
forward rate agreements/interest rate options/swaps, and forward rate agreements/
interest rate option/swap/option/caps/floors to hedge interest rate and currency
mismatch in their balance sheets. Resident and the non-resident clients are also
permitted to use the above products as hedges for liabilities on their balance sheets.
Here it is worth remembering that globally, foreign exchange traders are
becoming as common as stock traders. But in India, forex dealers still play second
fiddle to stock traders and merely meet the needs of the exporters deposits. This may
be due to their risk averting behavior and perhaps lack of proper research. Such being
the position of the forex market, it is too premature to expect that once, foreign
currency-Indian rupee options are introduced, the market will pick up momentum.
This is all the more essential in a market where exchange rates though stated to
be market determined, are often found influenced by RBIs intervention in the exchange
market. As a result, exchange rate movements hardly obey the principle of interest rate
differentials. The incongruence in the domestic money rates as derived from the
USD/INR forwards yield curve supports this assertion. For example, the one-year
domestic term money is around 6-6.25% whereas that of the one-year implied forward
rate is around 5.40%. In such a scenario, it is difficult for a currency trader to take a firm
view on the exchange rate movement.
24
8/14/2019 Dinesh Report
25/84
c) Stock market derivatives
Today trading on the spot market for equity in India has always been a futures
market with weekly/fortnightly settlements. These markets features the risks and
difficulties of futures market, But without the gains in price discovery and hedging
services that come with separation the spot market from the futures market. Indias
primary market is acquainted with two types of derivatives
Convertible bonds
Warrants
As these warrants are listed and traded, it could be said that options market of a limited
sort already exist in our market.
Besides, a wide range of interesting derivatives markets exists in the informal sector.
Contracts such as bhav-bhav teji-mandietc. are traded in these markets. These
informal markets enjoy a very limited participation and have their presence outside the
conventional institutions of Indias financial system.
The first step towards introduction of derivatives trading in India in its current
format was the promulgation of the securities laws (Amendment) Ordinance, 1995 that
withdrew the prohibition on options in securities. The real push to derivatives market inIndia was however given by the SEBI. The security market watchdog, in November
1996 by setting up a committee under the chairmanship of Dr L C Gupta to develop
appropriate regulatory framework for derivatives trading in India.
In 2000, SEBI permitted NSE and BSE to commence trading in index futures
contracts based on S&P CNX Nifty and BSE 30 (sensex) index. This was followed by
approval for trading in options based on these two indexes and options on individual
securities. Futures contracts on Individual stocks were launched on November 9,2001.
Trading and settlement is done in accordance with the rules of the respective
exchanges. But the trading volumes were initially quite modest.
This could be due to -----
25
8/14/2019 Dinesh Report
26/84
Initially, few members have been permitted by SEBI to trade on
derivatives;
FIIS, MFS have been allowed to have a very limited participation;
Mandatory requirements for brokerage firms to have SEBI approved-
certification-test-passed brokers for undertaking derivatives trading and
Lack of clarity on taxation and accounting aspects under derivatives
trading.
The current trading behavior in the derivatives segments reveals that single stock
futures continues to account for sizeable proportion. A recent press report indicates that
futures in Indian exchanges have reached global volumes. One possible reason for
such skewed behavior of the traders could be that futures closely resemble the
erstwhile badla system. Such distortions are not however in the interest of the market.
SEBI has permitted trading in options and futures on individual stocks, but not on
all the listed stocks. It was very selective, stocks that are said to be highly volatile
with a low market capitalization are not allowed for option trading. This act of SEBI is
strongly resented by a section of the market. Their argument is that equity options are
indispensable to investors who need to protect their investment from volatility. The
higher the volatility of a stock the more necessary it is to list options on that stock. They
are highly vocal in arguing that SEBI should design an effective monitoring, surveillance
and risk management system at the level of the exchanges and clearing house to avert
and manage the default risks that are likely to arise owing to high volatility in low market
capital stocks instead of simply banning trading in options on them. SEBI needs to
examine these arguments. It may have to take a stand to nip in the bud all kinds of
manipulations by handling out severe punishments to all such erring companies.
Today, mutual funds are permitted to use equity derivatives products forhedging and portfolio rebalancing. However, such usage is not favored by fund
managers as they strongly apprehend that the dividing line between hedging and
26
8/14/2019 Dinesh Report
27/84
speculation being thin, they may always get exposed to the questioning by the
regulatory authorities.
d)CREDIT DERIVATIVES AND OTHERS
A credit derivative is a financial transaction whose pay-off depends on whether
or not a credit event occurs.
A credit event can be:
Bankruptcy
Default
Upgrade Downgrade
Interest rate movement
Mortgage defaults
Unforeseen pay-offs
A credit derivative, like any other derivative, derives its value from an case is the
credit. In the event of the underlying asset failing to perform as expected, credit
derivatives, ensures that someone other than the principal lender absorbs the resulting
financial loss. Credit derivatives market in India though could be said as non-existent
holds huge potential. Some of the important factors/situation such as opening up of the
insurance sector to foreign private players, relief to investors, tax benefits to corporate,
proxy hedgers etc., could provide the momentum to the credit derivatives market in
India, boosting yields and bringing down risk for both the corporate and banks.
Secondly, Indian banking system is saddled with huge NPAs, which it is of
course, eagerly trying to get rid off. The mounting pressure on profitability is making
banks more credit-averse. In such a situation, if markets can offer credit-insurance inthe form of derivatives, everyone would jump for it.
DERIVATIVES: Development in India
27
8/14/2019 Dinesh Report
28/84
The derivatives markets has existed for centuries as a result of the need for both
users and producers of natural resources to hedge against price fluctuations in the
underlying commodities. Although trading in agricultural and other commodities has
been the driving force behind the development of derivatives exchanges, the demand
for products based on financial instrumentssuch as bond, currencies, stocks and
stock indiceshave now far outstripped that for the commodities contracts.
India has been trading derivatives contracts in silver, gold, spices, coffee, cotton
and oil etc for decades in the gray market. Trading derivatives contracts in organized
market was legal before Morarji Desais government banned forward contracts.
Derivatives on stocks were traded in the form of Teji and Mandi in unorganized markets.
Recently futures contract in various commodities were allowed to trade on exchanges.
For example, now cotton and oil futures trade in Mumbai, soybean futures trade in
Bhopal, pepper futures in Kochi, coffee futures in Bangalore etc.
I n June 2000, National Stock Exchange and Bombay Stock Exchange started
trading in futures on Sensex and Nifty. Options trading on Sensex and Nifty
commenced in June 2001. Very soon thereafter trading began on options and futures in
31 prominent stocks in the month of July and November respectively. Currently thereare 41 stocks trading on NSE Derivative and the list keeps growing.
How many stocks are trading in Futures & Option? What is the minimum quantity
we need to trade?
The minimum quantity trade in is one market lot. The market lot is different for
different stocks/index. Time to time list will keep changing.
CNXIT 100 ICICI Bank 1400 Oriental Bank 1200
Nifty 200 Infosys 200 PNB 1200
28
8/14/2019 Dinesh Report
29/84
ACC 1500 IOC 600 Polaris 1400
Andhra Bank 4600 MTNL 1600 Ranbaxy 400
Bajaj Auto 400 ONGC 300 Wipro 600
Bank of Baroda 1400 Nalco 1150 REL 550
Bank of India 3800 Tisco 1350 Union Bank 4200
BEL 550 M&M 625 TCS 250
Bank of India 3800 Maruti 400 Tata Tea 550
Grasim Ind 350 BEL 550 ITC 300
BHEL 600 IPCL 1100 RIL 600
BPCL 550 Hero Honda 400 i-flex 300
Canada Bank 1600 HDFC Bank 800 HPCL 650
29
8/14/2019 Dinesh Report
30/84
Cipla 1000 HDFC 600 HLL 2000
Dr. Reddys 200 Gujarat Ambuja 1100 Hindalco 300
GAIL 1500 HCL Tech 1300 Tata Power 800
Evolution of derivatives
Development Prior to 1995
In the last few years there have been substantial improvements in the functioning
of the securities market. Requirements of adequate capitalization, margining and
establishment of clearing corporations have reduced market and credit risks. System
improvements have been effected through introduction of screen based trading system
and electronic transfer and maintenance of ownership records of securities. However,
there are inadequate advanced risk management tools. In order to provide such tools
and to deepen and strengthen cash market, a need was felt for trading of derivatives
like futures and options.
But it was not possible in view of prohibitions in the SCRA. Its preamble stated
that the Act is to prevent undesirable transactions in securities by prohibiting options
and by providing for certain others matters connected therewith. Section 20 of the Act
explicitly prohibited all options in securities. The Act empowered central Government to
prohibit by notification any type of transaction in any security. In exercise of this power,Government by its notification in 1969 prohibited all forward trading in securities. As the
need for derivatives was felt, it was thought that if these prohibitions were withdrawn,
trading in derivatives could commence. The securities laws (amendment) ordinance,
30
8/14/2019 Dinesh Report
31/84
1995, promulgated on 25th January 1995, lifted the ban by repealing section 20 of the
SCRA and amending its preamble.
From 1996 to 1997
The market for derivatives, however, did not take off, as there was no regulatory
framework to govern trading of derivatives. SEBI set up a 24 member committee under
the Chairmanship of Dr. L.C.Gupta on 18th November 1996 to develop appropriate
regulatory framework for derivatives trading in India. The Committee submitted its
report on March 17, 1998.
Market went ahead with preparation. It was soon realized that there was no law
under which the regulations could be framed for derivatives. It was felt that if
derivatives could be treated as securities under the SC(R) Act, trading in derivatives
would be possible within the framework of that Act. According to section 2(h) of the
SC(R) Act, securities includes shares, scrips, stocks bonds, debentures, debentures
stock, or other marketable securities of a like nature in or of any incorporated company
or other body corporate, government securities, such other instruments as may be
declared by the Central Government to be securities, and rights and interest in
securities.
SEBI felt that the definition of Securities under SC(R)A could be expanded by
declaring derivative contracts based on index of prices of securities and other derivative
contracts as securities. It was thought that Government could declare derivatives to be
securities under its delegated powers. Government, however did not declare
derivatives as securities, probably because its power was circumscribed by the words
such other. Only those instruments, which resemble the ones listed in the Act could be
declared.
EVENTS THAT MADE THE LAUNCH OF DERIVATIVES IN INDIA
31
8/14/2019 Dinesh Report
32/84
November 1996, SEBI set up a committee under the chairmanship of Dr. L C
Gupta, the well known economist and former SEBI Board Member.
The Committee submitted its report on the March 17 1998. It advocated the
introduction of derivatives in Indian market in a phased manner, starting with the
Index Futures.
SEBI accepted the report on May 11, 1998 and June 16, 1998, it issued a
circulation allowing exchanges to submit their proposals for introduction of Derivative
trading.
Government issued notification delineating the areas of responsibility between
RBI and Market Regulator SEBI.
On June 2000, derivative trading started in NSE and BSE.
Market players of Derivatives market:
Hedgers: The objective of these kind of traders is to reduce the risk. They are not in thederivatives market to make profits. They are in it to safeguard their existing positions.
Apart from equity markets, hedging is common in the foreign exchange markets where
fluctuations in the exchange rate have to be taken care of in the foreign currency
transactions or could be in the commodities market where spiraling oil prices have to be
tamed using the security in derivative instruments.
Speculators: They are traders with a view and objective of making profits. They are
willing to take risks and they bet upon whether the markets would go up or come down.
Arbitrageurs: Riskless Profit Making is the prime goal of Arbitrageurs. Buying in one
32
8/14/2019 Dinesh Report
33/84
market and selling in another, buying two products in the same market are common.
They could be making money even without putting there own money in and such
opportunities often come up in the market but last for very short timeframes. This is
because as soon as the situation arises arbitrageurs take advantage and demand-
supply forces drive the markets back to normal.
Derivatives Trading in Financial Markets
Derivatives were not traded in the financial markets of the world up to the period
about three decades back, though Stock Exchanges trading in securities in the cash
market came to be in vogue more than a century ago. In India the first Stock Exchange,
BSE was established in 1875. But BSE commenced trading in derivatives only from
2001. Even in the international financial/securities market the advent of derivatives as
trading products was a concurrent-effect with the process of globalization and
integration of the national economies of the developed countries beginning from the
Seventies of the last Century. As volumes traded increased and as competition turned
intense, trade & business became more complex in the new environment. The new
opportunities were matched by fresh challenges and unpredictable volatility of the
trading environment. Corporate for the first time sensed the formidable risks inherent inbusiness transactions and the unpredictability of the markets to which they are
exposed. Facing multiple risks the business organizations, were induced to search for
new remedies, i.e. risk containment devices/instruments. Derivatives came to be the
natural remedy in this context. To quote an international professional authority:
"As capital markets become increasingly integrated, shocks transmit easily from
one market to another. The proliferation of new instruments with complex features has
led to enhanced investment opportunities. One such instrument which has become
darling of corporate, banks, institutions alike is 'Derivatives'. To have a touch of the tree
top's view, Derivatives transaction is defined as a bilateral contract whose value is
derived, from the value of an underlying asset, or reference rate, or index. Derivative
33
8/14/2019 Dinesh Report
34/84
transactions have evolved in the past twenty years to cover a broad range of products
which include instruments like 'forwards', 'futures', 'options', 'swaps' covering a broad
spectrum of underlying assets including exchange rates, interest rates, commodities,
and equities."
Though recent in origin derivatives instruments issued over the years have
grown by leaps and bounds and the total amount issued globally is estimated to
approach $80 trillion by the advent of the new millennium.
Derivative positions have grown at a compounding rate of 20% since 1990. In
India though derivatives were introduced very recently in 2001, the trading turnover hasalready surpassed that of the equity segment. In NSE alone as per a report on its
website the total turnover of the derivatives segment for the month of May 2003 stood at
Rs. 53424 crores. During the month of May 2003, the percentage of derivatives
segment as a percentage of the cash segment was 97.68%. However in the earlier two
months the turnover of Derivatives was higher than that of the cash segment.
Trading process of derivatives
Detailed knowledge about derivatives market
Open a Demat Account with minimum balance
Starting process of Trading with help of demat account.
Create market watch and watching that particulars of derivatives market.
Buy commodities like oil and currency.
Select particulars buying & selling contract for derivatives market.
Minimum amount entering in to derivatives Rs.40000.
Incur Initial expense of transaction.
Buyers usually enter into lot size.
Decides whether states price at spot or futures prices
Waiting for increase price for contract
34
8/14/2019 Dinesh Report
35/84
Laterally square off transaction both futures & options.
Different types of derivatives products
Commodity
Oil
Currency
Agricultural commodities
Ornaments like gold.
Cattle
TRADING METHOD
Listed securities are traded on the floor of the recognized stock exchange where its
members trade. An investor is not permitted to enter the floor of the exchange and he
has to trust the broker to:
1. Negotiate the best price for the trade.
2. Settle the account, i.e. payment for securities sold due date.
3. Take delivery of securities purchased.
Trading in a stock exchange is conducted in two ways:
1. Ready delivery contracts.
2. Forward delivery contracts.
Ready delivery contracts or cash trading on cash transaction. These fulfill the following
criterion:
All listed securities can be traded.
Settlement within seven days.
35
8/14/2019 Dinesh Report
36/84
Carryover facilities not permitted.
Depository account:
A depository account is similar to the bank accounts. It gives a summary of an
investors holding of securities in the companies traded in the Indian Stock Exchanges
and records transaction details of securities bought and sold during the period. This
information of securities holding is maintained in the electric form. The securities in the
depository account do not have any numbers to distinguish them and are identified by
the total number of securities held for each company by the depository on the investors
account.
INTRODUCTION TO ONLINE TRADING
There is a world of difference in the way people trade these days. Gone are the
days when traders and brokers jostled, screaming their lungs out in a crowded bullring
to make various deals. With the advent of Internet trading there has come about a
drastic change in trading. It is now rather quite on the stock market front.
After online banking, online trading is probably the biggest revolution unleashed
by technological innovation. For the first time in a century and a half, trading power has
shifted from stockbrokers to individual investors. This revolution has advanced
significantly in the US and is being felt in Europe, Japan, Australia, China and South
Korea.
Online trading has become quite popular in the last couple of years because of
the convenience and ease of use. Online trading has basically replaced a phone call
with the Internet. Instead of interacting with the brokers over the phone, consumers are
now clicking the mouse. Online trading has given customers access to account
information, stock quotes, elaborate market research and interacting.
36
8/14/2019 Dinesh Report
37/84
Online trading is the perfect combination of the medium of the net catering to a
real life concept. Given that trading is all about having access to multiple information
sources, from the companys performance to the industrial and economic scenarios as
well as possessing the analytical tools to process this information, the net is the perfect
solution to investor needs. Online trading is all about bringing together under one site all
the relevant factors to enable an informed investment at cheaper rates.
Through online trading, the securities industry has, for the first time paved the
way for implementation of direct order placement, directly onto the broking firms trading
system via the Internet. Due to this price setting power for trading execution has shifted
from the brokers and traditional stock exchanges to the Electronic Communication
Networks (ECN).
ADVANTAGES
Internet trading has a variety of advantages, and below, a few of them are listed.
They are:
1. Easy access to information and research: Internet brokerage houses offer easily
accessible company information, investment advice, counseling on how to profitablyinvest and better manage an investors portfolio and verity the various portfolio and
verify the various tips got from various sources.
2. Markets on the desktop: Investors do not have to go take the trouble of going to
the stock exchange or to his brokers office, the investor has got all he requires on his
desktop.
3. Portfolio management: Investors can track their portfolio performance, that is, it is
faring in the market. If the portfolio is not performing well investors can get advice on
restructuring it.
4. Best prices: Online trading has resulted in a phenomenal reduction in the
transaction cost for the investor as online trading ensures a matching of buying and
37
8/14/2019 Dinesh Report
38/84
selling orders within an ENC without the intervention of market markets or traditional
stock exchanges.
5. Liquidity: The liquidity option available for investors has been considerably
stretched as the online trading offers 24 hours trading facilities.
6. Audit trial: Online trading has imparted greater transparency which is subject to
scrutiny, by providing an audit trial for an investor right at his desk, which earlier, used
to stop at his brokers trading terminal. The integrated electronic chain, starting with the
order-placement-clearing and settlement function and ending with the credit and
settlement function and ending with the credit to the depositary an account of the
investor is largely a transparent process.
7. Benefit of saving: Individual investors can save a lot more through online trading
as the cost per trade while trading online is less.
8. Variety: Individual invests in a variety of products, unlike earlier when investors
bought bonds, mutual funds and stocks for long-term basis and sat on term. Now
individuals can invest in stocks, stick options, mutual funds, individual, government,
corporate, municipal bonds, various types of IRA account mortgages and even
insurance.
DISADVANTAGES
A few of the possible disadvantages of online trading can be noted as follows:
1. Speedy net connection: One the most important requirements for any investor
while trading online is the need for fast internet connection as time is of essence while
trading. This has not yet been well established in India.
2. Guidance: Individuals are restricted to first hand guidance; the individual is the
one to make the own decision, online trading doesnt help investors while decision
making as a broker can.
3. Crashes: If the network crashes, there will be problems and delays due to large
influx of traffic and rapid online trading criteria.
38
8/14/2019 Dinesh Report
39/84
4. Communication links: There is need more effective communication links over the
internet and the ability of the server to deal with the volume of visitors.
Profit is ascertained
Payoff For Derivatives Contracts
A payoff is the likely profit/loss that would accrue to a market participant with
change in the price of the underlying asset. This is generally depicted in the form of
payoff diagrams which show the price of the underlying asset on the Xaxis and the
profits/losses on the Yaxis.
Payoff For A Buyer Of Nifty Futures
The figure shows the profits/losses for a long futures position. The investor
bought futures when the index was at 1220. If the index goes up, his futures position
starts making profit. If the index falls, his futures position starts showing losses.
39
Payoff For A Buyer Of Nifty Futures
8/14/2019 Dinesh Report
40/84
Futures contracts have linear payoffs. In simple words, it means that the losses
as well as profits for the buyer and the seller of a futures contract are unlimited. These
linear payoffs are fascinating as they can be combined with options and the underlying
to generate various complex payoffs.
Payoff For A Seller Of Nifty Futures
The figure shows the profits/losses for a short futures position. The investor sold
futures when the index was at 1220. If the index goes down, his futures position starts
making profit. If the index rises, his futures position starts showing losses.
The payoff for a person who sells a futures contract is similar to the payoff for a
person who shorts an asset. He has a potentially unlimited upside as well as a
potentially unlimited downside.
40
Payoff For A Seller Of NiftyFuture
8/14/2019 Dinesh Report
41/84
Payoff Profile For Buyer Of Call Options Long Call
A call
option gives the buyer the right to buy the underlying asset at the strike price specified
in the option. The profit/loss that the buyer makes on the option depends on the spot
price of the underlying. If upon expiration, the spot price exceeds the strike price, he
makes a profit.
Higher the spot price, more is the profit he makes. If the spot price of the underlying is
less than the strike price, he lets his option expire un-exercised. His loss in this case is
the premium he paid for buying the option. The figure shows the profits/losses for the
buyer of a three-month Nifty 1250 call option. As can be seen, as the spot Nifty rises,
the call option is in-the-money. If upon expiration, Nifty closes above the strike of 1250,
the buyer would exercise his option and profit to the extent of the difference between
the Nifty-close and the strike price. The profits possible on this option are potentially
unlimited. However if Nifty falls below the strike of 1250, he lets the option expire. His
losses are limited to the extent of the premium he paid for buying the option i.e. Rs.86.6
/-
Payoff Profile For Writer Of Call Options - Short Call
For selling the option, the writer of the option charges a premium. The profit/loss
that the buyer makes on the option depends on the spot price of the underlying.
41
Payoff For Buyer Of Call Option
8/14/2019 Dinesh Report
42/84
Whatever is the buyers profit is the sellers loss. If upon expiration, the spot price
exceeds the strike price, the buyer will exercise the option on the writer. Hence as the
spot price increases the writer of the option starts making losses. Higher the spot price,
more is the loss he makes. If upon expiration the spot price of the underlying is less
than the strike price, the buyer lets his option expire unexercised and the writer gets to
keep the premium.
The figure shows the profits/losses for the seller of a three-month Nifty 1250 call
option. As the spot Nifty rises, the call option is in-the-money and the writer starts
making losses . If upon expiration, Nifty closes above the strike of 1250, the buyer
would exercise his option on the writer who would suffer a loss to the extent of the
difference between the Nifty-close and the strike price. The loss that can be incurred by
the writer of the option is potentially unlimited, whereas the maximum profit is limited to
the extent of the up-front option premium of Rs.86.60 charged by him.
Payoff Profile For Buyer Of Put Options: Long Put
A put option gives the buyer the right to sell the underlying asset at the strike
price specified in the option. The profit/loss that the buyer makes on the option depends
on the spot price of the underlying. If upon expiration, the spot price is below the strike
42
Payoff For Writer Of Call Option
8/14/2019 Dinesh Report
43/84
price, he makes a profit. Lower the spot price, more is the profit he makes. If the spot
price of the underlying is higher than the strike price, he lets his option expire un-
exercised. His loss in this case is the premium he paid for buying the option.
The below figure shows the profits/losses for the buyer of a three-month Nifty
1250 put option. As can be seen, as the spot Nifty falls, the put option is in-the-money.
If upon expiration, Nifty closes below the strike of 1250, the buyer would exercise his
option and profit to the extent of the difference between the strike price and Nifty-close.
The profits possible on this option can be as high as the strike price. However if Nifty
rises above the strike of 1250, he lets the option expire. His losses are limited to the
extent of the premium he paid for buying the option i.e. Rs.61.70/-
Payoff Profile For Writer Of Put Options - Short Put
A put option gives the buyer the right to sell the underlying asset at the strike
price specified in the option. For selling the option, the writer of the option charges a
premium. The profit/loss that the buyer makes on the option depends on the spot price
of the underlying. Whatever is the buyers profit is the sellers loss. If upon expiration,
43
Payoff For Buyer Of Put Option
8/14/2019 Dinesh Report
44/84
the spot price happens to be below the strike price, the buyer will exercise the option on
the writer. If upon expiration the spot price of the underlying is more than the strike
price, the buyer lets his option expire un-exercised and the writer gets to keep the
premium.
The below figure shows the profits/losses for the seller of a three-month Nifty 1250 put
option. As the spot Nifty falls, the put option is in-the-money and the writer starts making
losses. If upon expiration, Nifty closes below the strike of 1250, the buyer would
exercise his option on the writer who would suffer a loss to the extent of the difference
between the strike price and Nifty-close.
The loss that can be incurred by the writer of the option is a maximum extent of
the strike price( Since the worst that can happen is that the asset price can fall to zero)
44
Payoff For Writer Of Put Option
8/14/2019 Dinesh Report
45/84
whereas the maximum profit is limited to the extent of the up-front option premium of
Rs.61.70 charged by him.
TRADING STRATEGIES
Single Option and Stock
These strategies involve using an option along with a position in a stock.
Strategy 1:
A Covered Call: A long position in stock and short position in a call option.
Illustration : An investor enters into writing a call option on one share of Rel. Petrol. At a
strike price of Rs.60 and a premium of Rs.6 per share. The maturity date is two months
form now and along with this option he/she buys a share of Rel.Petrol. in the spot
market at Rs. 58 per share.
By this the investor covers the position that he got in on the call option contract and if
the investor has to fulfill his/her obligation on the call option then can fulfill it using the
Rel.Petrol. share on which he/she entered into a long contract. The payoff table below
shows the Net Profit the investor would make on such a deal.
Writing a Covered Call Option
S Xt C Profit from
writing call
Net Profit from
Call Writing
Share
bought
Profit
from
stock
Total
Profit
50 60 6 0 6 58 -8 -2
52 60 6 0 6 58 -6 0
54 60 6 0 6 58 -4 2
56 60 6 0 6 58 -2 4
58 60 6 0 6 58 0 6
45
8/14/2019 Dinesh Report
46/84
60 60 6 0 6 58 2 8
62 60 6 -2 4 58 4 8
64 60 6 -4 2 58 6 8
66 60 6 -6 0 58 8 8
68 60 6 -8 -2 58 10 8
70 60 6 -10 -4 58 12 8
Strategy 2:
Reverse of Covered Call: This strategy is the reverse of writing a covered call. It is
applied by taking a long position or buying a call option and selling the stocks.
Illustration :
An investor enters into buying a call option on one share of Rel. Petrol. At a strike price
of Rs.60 and a premium of Rs.6 per share. The maturity date is two months from now
46
8/14/2019 Dinesh Report
47/84
and along with this option he/she sells a share of Rel.Petrol. in the spot market at Rs.
58 per share.
The payoff chart describes the payoff of buying the call option at the various spot rates
and the profit from selling the share at Rs.58 per share at various spot prices. The net
profit is shown by the thick line.
47
8/14/2019 Dinesh Report
48/84
Strategy 3:
Protective Put Strategy:
This strategy involves a long position in a stock and long position in a put. It is a
protective strategy reducing the downside heavily and much lower than the premium
paid to buy the put option. The upside is unlimited and arises after the price rises high
above the strike price.
Illustration 5:
An investor enters into buying a put option on one share of Rel. Petrol. At a strike price
of Rs.60 and a premium of Rs.6 per share. The maturity date is two months from now
and alongwith this option he/she buys a share of Rel.Petrol. in the spot market at Rs. 58
per share.
48
8/14/2019 Dinesh Report
49/84
Protective Put Strategy
S Xt p Profit from
buying put
option
Net Profit
from Buying
put option
Spot Price
of Buying
the stock
Profit from
stock
Total
Profit
50 60 -6 10 4 58 -8 -4
52 60 -6 8 2 58 -6 -4
54 60 -6 6 0 58 -4 -4
56 60 -6 4 -2 58 -2 -4
58 60 -6 2 -4 58 0 -4
60 60 -6 0 -6 58 2 -4
62 60 -6 0 -6 58 4 -2
64 60 -6 0 -6 58 6 0
66 60 -6 0 -6 58 8 2
68 60 -6 0 -6 58 10 4
70 60 -6 0 -6 58 12 6
49
8/14/2019 Dinesh Report
50/84
Strategy 4:
Reverse of Protective Put
This strategy is just the reverse of the above and looks at the case of taking short
positions on the tock as well as on the put option.
Illustration 6:
An investor enters into selling a put option on one share of Rel. Petrol. At a strike price
of Rs.60 and a premium of Rs.6 per share. The maturity date is two months from now
and alongwith this option he/she sells a share of Rel.Petrol. in the spot market at Rs. 58
per share.
Reverse of Protective Put Strategy
S Xt p Profit from
writing a put
option
Net Profit
from Put
Writing
Spot Price of
Selling the
stock
Profit
from
stock
Total Profit
50 60 6 -10 -4 58 8 4
50
8/14/2019 Dinesh Report
51/84
52 60 6 -8 -2 58 6 4
54 60 6 -6 0 58 4 4
56 60 6 -4 2 58 2 4
58 60 6 -2 4 58 0 4
60 60 6 0 6 58 -2 4
62 60 6 0 6 58 -4 2
64 60 6 0 6 58 -6 0
66 60 6 0 6 58 -8 -2
68 60 6 0 6 58 -10 -4
70 60 6 0 6 58 -12 -6
51
8/14/2019 Dinesh Report
52/84
All the four cases describe a single option with a position in a stock. Some of these
cases look similar to each other and these can be explained by Put-Call Parity.
Put Call Parity
P + S = c + Xe-r(T-t) + D ---------------------- (1)
Or
S - c = Xe-r(T-t) + D - p ---------------------- (2)
The second equation shows that a long position in a stock and a short position in a call
is equivalent to the short put position and cash equivalent to Xe -r(T-t) + D.
The first equation shows a long position in a stock combined with long put position is
equivalent to a long call position plus cash equivalent to Xe -r(T-t) + D.
SPREADS
The above involved positions in a single option and squaring them off in the spot
market. The spreads are a little different. They involve using two or more options of the
same type in the transaction.
Strategy 1:
Bull Spread:
The investor expects prices to increase in the future. This makes him purchase a
call option at X1 and sell a call option on the same stock at X2, where X1
8/14/2019 Dinesh Report
53/84
describes the net profit that one earns on the buy call option, sell call option and both
contracts together.
Payoff From a Bull Spread
S X1 X2 c1 c2 Profit from
X1
Net profit
from X1
Profit form
X2
Net
Profit
from X2
Total
Profit
4200 4300 4500 -450 400 0 -450 0 400 -50
4250 4300 4500 -450 400 0 -450 0 400 -50
4300 4300 4500 -450 400 0 -450 0 400 -50
4350 4300 4500 -450 400 50 -400 0 400 0
4400 4300 4500 -450 400 100 -350 0 400 50
4450 4300 4500 -450 400 150 -300 0 400 100
4500 4300 4500 -450 400 200 -250 0 400 150
4550 4300 4500 -450 400 250 -200 -50 350 150
4600 4300 4500 -450 400 300 -150 -100 300 150
4650 4300 4500 -450 400 350 -100 -150 250 150
4700 4300 4500 -450 400 400 -50 -200 200 150
4750 4300 4500 -450 400 450 0 -250 150 150
53
8/14/2019 Dinesh Report
54/84
The premium on call with X1 would be more than the premium on call with X2. This is
because as the strike price rises the call option becomes unfavourable for the buyer.
The payoffs could be generalised as follows.
Spot Rate Profit on
long call
Profit on
short call
Total
Payoff
Net Profit Which
option(s)
Exercised
S >= X2 S - X1 X2 - S X2 - X1 X2 - X1 - c1 +
c2
Both
X1 < S = X1 0 0 0 c2 - c1 None
The features of the Bull Spread:
54
8/14/2019 Dinesh Report
55/84
This requires an initial investment.
This reduces both the upside as well as the downside potential.
The spread could be in the money, on the money and out of money.
Another side of the Bull Spread is that on the Put Side. Buy at a low strike price and sell
the same stock put at a higher strike price.
This contract would involve an initial cash inflows unlike the Bull Spread based on the
Call Options. The premium on the low strike put option would be lower than the
premium on the higher strike put option as more the strike price more is favourability to
buy the put option on the part of the buyer.
Illustration
An investor purchases a put option on the BSE Sensex at premium of Rs.50 for a strike
price at 4300. The investor squares this off with a sell put option at Rs. 100 for a strike
price at 4500. The contracts mature on the same date. The payoff chart below
describes the net profit that one earns on the buy put option, sell put option and both
contracts together.
Payoff From a Bull Spread (Put Options)
S X1 X2 p1 p2 profit from
X1
Net profit
from X1
Profit
from X2
Net
Profit
from X2
Total
Profit
4200 4300 4500 -50 100 100 50 -300 -200 -150
4250 4300 4500 -50 100 50 0 -250 -150 -150
4300 4300 4500 -50 100 0 -50 -200 -100 -150
4350 4300 4500 -50 100 0 -50 -150 -50 -100
4400 4300 4500 -50 100 0 -50 -100 0 -50
55
8/14/2019 Dinesh Report
56/84
4450 4300 4500 -50 100 0 -50 -50 50 0
4500 4300 4500 -50 100 0 -50 0 100 50
4550 4300 4500 -50 100 0 -50 0 100 50
4600 4300 4500 -50 100 0 -50 0 100 50
4650 4300 4500 -50 100 0 -50 0 100 50
4700 4300 4500 -50 100 0 -50 0 100 50
4750 4300 4500 -50 100 0 -50 0 100 50
Spot Rate Profit on
long put
Profit on
short put
Total Payoff Net Profit Which option(s)
Exercised
S >= X2 0 0 0 p2 - p1 None
X1 < S
8/14/2019 Dinesh Report
57/84
1.3 Empirical analysis
TABLE NO.1
TABLE SHOWING DIFFERENT TYPE OF INVESTORS
investments
Frequency
Long term investor 47
Short term investor 24
Daily trader 29
Graph No.1
57
8/14/2019 Dinesh Report
58/84
GRAPH SHOWING DIFFERENT TYPE OF INVESTORS
Type of Investors
Analysis :
The above table shows the different type of investors long term short term
and day trade. As per the graph are 47%long term, 24% are short term and 29%
are day trader.
Interpretation :
Out of the 100 investors surveyed 47 investors are long term investors which
makes a percent of 47%. Here investors who have an investment of three months
or more than three months are called long term investors. Investors with an
investment period in between one to three months are called short term investors.
About 29 percent of the investors are day traders who buy and sell on the samedate.
TABLE NO.2
TABLE SHOWING THE PERCENTAGE OF INVESTMENT IN
DERIVATIVES
FrequencyLess than 20 % 37
20%-40% 28
40%-60% 19
58
8/14/2019 Dinesh Report
59/84
Above 60% 16
GRAPH NO.2
GRAPH SHOWING THE PERCENTAGE OF INVESTMENT IN
DERIVATIVES
Analysis :
The above table shows the percentage of investment in derivatives. As per the table
37% investors invest in less than 20% derivatives.
Interpretation :
Around 37 percent of the investors invest less than twenty percent of theirinvestment into derivatives. And around 28 percent allocate 20% to 40% into
derivatives.
TABLE NO.3
TABLE SHOWING THE INFORMATION USED FOR TRADE
IN DERIVATIVES
Frequency
Technical information 10
Market information 25
59
8/14/2019 Dinesh Report
60/84
Individual analysis 45
All the above 20
GRAPH NO.3
GRAPH SHOWING THE INFORMATION USED FOR TRADE IN
DERIVATIVES
Analysis :
The above table shows that different information used for derivatives trading
such as technical information, market information and individual analysis. As per
the graph 45% investor go by their by their individual analysis.
Interpretation :
On the question about the information used in order to trade in derivatives it
was found that around 45% of the investors go by their individual analysis before
investing.
TABLE NO.4
TABLE SHOWING THE INSTRUMENTS TRADED IN
DERIVATIVES
Frequency
60
8/14/2019 Dinesh Report
61/84
futures 69
options 31
GRAPH NO.4
GRAPH SHOWING THE INSTRUMENTS TRADED IN
DERIVATIVES
Analysis :
The above table shows the investors trading future and option. As per graph
investors in futures are more compared to the investors in option.
Interpretation :
69% of the investors have traded in Futures segment and around 31 percent
of the traders traded in options. So investors are favoring futures than options.
TABLE NO.5
TABLE SHOWING THE MOST INSTRUMENTS
Frequency
61
8/14/2019 Dinesh Report
62/84
Stock index futures 40
Futures on individual stocks 35
Stock index options 11Options on individual stocks 14
GRAPH NO.5
GRAPH SHOWING THE MOST FAVORED DERIVATIVES IN
INSTRUMENT
Analysis :
The above table shows the instruments traded in derivatives. out of 100
respondents 69 invest in futures and 31 invest in option.
Interpretation :
When asked about the most favored derivative instruments, forty percent of
the investors favored index futures and 35% of the investor went for futures on
individual stocks. So it is obvious that options are still not favored by investors.
TABLE NO.6
TABLE SHOWING THE DIFFERENT CONTRACTS ENTERED
Frequency
index futures 24
index options 14
stock futures 43
stock options 19
62
8/14/2019 Dinesh Report
63/84
GRAPH NO.6
GRAPH SHOWING THE DIFFERENT CONTRACTS ENTERED
Analysis :
The above table shows that 24 respondents invest in index futures , 43invest instock future and 19 in stock options.
Interpretation :
Around 43 percent of the respondents have entered into stock futures contract.
TABLE NO.7
TABLE SHOWING THE BEST DERIVATIVES
Frequency
Hedging 35
Speculation 65
GRAPH NO.7
GRAPH SHOWING THE BEST DERIVATIVES
Hedging vs. Speculations
63
8/14/2019 Dinesh Report
64/84
Analysis:
The above table shows the best for derivatives out of 100 respondents 65 investors
prefer hedging and 35 investors prefer speculation.
Interpretation:
More than 65% traders feel that Derivative is best for speculation than for hedging.
Out of 100 investors 35 were favoring derivative as a speculative instrument.
Traders mainly want to make short term gain by investing into Derivatives then for
using Derivative as an instrument to reduce the market risk.
TABLE NO.8
TABLE SHOWING STRATEGY USED FOR HEDGING
FrequencyLong & Short Futures 35
Short stock & Long Futures 14
Long & Shot Call 11
Short Stock & Long Call 15
Long Stock & Long Put 7
Short Stock & Short Put 7
Long Index futures & Short stock 6
Short Index Futures & Long Stock 5
GRAPH NO.8
GRAPH SHOWING STRATEGY USED FOR HEDGING
64
8/14/2019 Dinesh Report
65/84
Analysis:
The above table shows 35 respondents prefer long and short futures hedging, 14
prefer short and long futures, 11long and short call, 15short stock and long call, 7
long stock and long put, 7 in short stock and short put, 6 in long index future and
short stock, 5 in short index future and long stock.
Interpretation:
Among the strategies used for hedging Short Stock & Long Call have used as the
most used strategy.
TABLE NO.9
TABLE SHOWING THE STRATEGIES USED FOR HEDGING IN
A
BULLISH MARKET
Frequency
long futures 34
long call 23
long index futures 18
long index call 25
65
8/14/2019 Dinesh Report
66/84
GRAPH NO.9
GRAPH SHOWIN THE STRATEGOES USED FOR HEDGING INA BULLISH MARKET
Analysis :
The above table shows 34& respondents prefer long index future, 23% prefer
long index call, 18% prefer long call, 25% prefer long future.
Interpretation :
Among the strategies used for hedging in a bullish market, Long Index
Futures is being preferred by majority of the respondent
TABLE NO.10
TABLE SHOWING STRATEGIES USED IN A BEARISH MARKET
Frequency
short futures 36
short index futures 19
short call 29
short index call 16
Graph No.10
66
8/14/2019 Dinesh Report
67/84
GRAPH SHOWING STRATEGIES USED IN A BEARISH
MARKET
Analysis :
The above table shows 36%respondents prefer short futures in bearish
market, 19% prefers short calls, 29% prefers short index future and 16% prefer
short index call.
Interpretation :
In a bearish market, the most preferred strategy is Index Future short call
and its percentage is 29%.
TABLE NO.11
TABLE SOWING EXPECTED RISH REWARD RATIO
Frequency
1:0.2 32
1:0.4 23
1:0.6 221:0.8 10
1:1 13
67
8/14/2019 Dinesh Report
68/84
Graph No.11
GRAPH SHOWING EXPECTED RISK-REWARD RATIO
ANALYSIS:
The above table shows that out of total respondent 27 respondents expect 1:0.4
risk reward ratio, 21 expect 1:0.6, 8 expect 1:0.8, and the remaining 14 respondent
expects 1:1 ratio.
Interpretation :
Around 38 percent of the investors are looking out for an annual return of 40
percent from their investments. And 20 percent of the respondents have a high
expectation of 100 percent return.
TABLE NO.12
TABLE SHOWING GROWTH RATE IN OPTIONS IN INDIA
Frequency
Grow very fast 15
Grow Moderately 19
Not Much Growth 11
Can't Say anything 25
Graph No.12
GRAPH SHOWING GROWTH RATE IN OPTIONS IN INDIA
68
8/14/2019 Dinesh Report
69/84
Analysis :
The above table shows the growth rate in options in India. Fast growth frequency is
21%, moderate growth frequency is 27% , no much growth is 16% , no idea
frequency is 36%.
Interpretation.
More than 36 percent of the investors are still don't have any idea about the future
growth of the Option market in India, And 27% respondents feel that the option
market would grow moderately. And 21 percent expect the market to grow very
fast.
TABLE NO.13
TABLE SHOWING INTERESTED CONTRACT MATURITY
PERIOD FOR INDEX FUTURES & OPTIONS
Frequency
Current 45
Next month 35
Forward month 20
Graph No.13
GRAPH SHOWING INTERESTED CONTRACT MATURITY
P