CONTENTS

Derivatives an overview Futures contract Hedging in futures Speculating in futures Arbitrage in futures Options Options strategies Derivatives products Open interest Futures price = spot price + cost of carry

DERIVATIVES
The word DERIVATIVES is derived from the word itself derived of a underlying asset. It is a future image or copy of a underlying asset which may be shares, stocks, commodities, stock indices, etc. Derivatives is a financial product (shares, bonds) any act which is concerned with lending and borrowing (bank) does not have its value borrow the value from underlying asset/ basic variables. Derivatives is derived from the following products: A. B. C. D. E. F. G. Shares Debuntures Mutual funds Gold Steel Interest rate Currencies.

Derivatives is a type of market where two parties are entered into a contract one is bullish and other is bearish in the market having opposite views regarding the market. There cannot be a derivatives having same views about the market. In short it is like a INSURANCE market where investors cover their risk for a particular position. Derivatives are financial contracts of pre-determined fixed duration, whose values are derived from the value of an underlying primary financial instrument, commodity or index, such as: interest rates, exchange rates, commodities, and equities. Derivatives are risk shifting instruments. Initially, they were used to reduce exposure to changes in foreign exchange rates, interest rates, or stock indexes or commonly known as risk hedging. Hedging is the most important aspect of derivatives and also its basic economic purpose. There has to be counter party to hedgers and they are speculators. Speculators dont look at derivatives as means of reducing risk but its a business for them. Rather he accepts risks from the hedgers in pursuit of profits. Thus for a sound derivatives market, both hedgers and speculators are essential.

Derivatives trading has been a new introduction to the Indian markets. It is, in a sense promotion and acceptance of market economy, that has really contributed towards the growing awareness of risk and hence the gradual introduction of derivatives to hedge such risks. Initially derivatives was launched in America called Chicago. Then in 1999, RBI introduced derivatives in the local currency Interest Rate markets, which have not really developed, but with

the gradual acceptance of the ALM guidelines by banks, there should be an instrumental product in hedging their balance sheet liabilities. The first product which was launched by BSE and NSE in the derivatives market was index futures

BACKGROUND
Consider a hypothetical situation in which ABC trading company has to import a raw material for manufacturing goods. But this raw material is required only after 3 months. However in 3 months the prices of raw material may go up or go down due to foreign exchange fluctuations and at this point of time it can not be predicted whether the prices would go up or come down. Thus he is exposed to risks with fluctuations in forex rates. If he buys the goods in advance then he will incur heavy interest and storage charges. However, the availability of derivatives solves the problem of importer. He can buy currency derivatives. Now any loss due to rise in raw material prices would be offset by profits on the futures contract and vice versa. Hence the company can hedge its risk through the use of derivatives

DEFINATIONS
According to JOHN C. HUL A derivatives can be defined as a financial instrument whose value depends on (or derives from) the values of other, more basic underlying variables. According to ROBERT L. MCDONALD A derivative is simply a financial instrument (or even more simply an agreement between two people) which has a value determined by the price of something else.

With Securities Laws (Second Amendment) Act,1999, Derivatives has been included in the definition of Securities. The term Derivative has been defined in Securities Contracts (Regulations) Act, as:A Derivative includes: a. a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security; b. contract which derives its value from the prices, or index of prices, of securities. underlying

Derivatives were developed primarily to manage, offset or hedge against risk but some were developed primarily to provide the potential for high returns.

INTRODUCTION TO FUTURE MARKET

Futures markets were designed to solve the problems that exit in forward markets. A futures con tract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. There is a multilateral contract between the buyer and seller for a underlying asset which may be financial instrument or physical commodities. But unlike forward contracts the future contracts are standardized and exchange traded.

PURPOSE
The primary purpose of futures market is to provide an efficient and effective mechanism for management of inherent risks, without counter-party risk. It is a derivative instrument and a type of forward contract The future contracts are affected mainly by the prices of the underlying asset. As it is a future contract the buyer and seller has to pay the margin to trade in the futures market It is essential that both the parties compulsorily discharge their respective obligations on the settlement day only, even though the payoffs are on a daily marking to market basis to avoid default risk. Hence, the gains or losses are netted off on a daily basis and each morning starts with a fresh opening value. Here both the parties face an equal amount of risk and are also required to pay upfront margins to the exchange irrespective of whether they are buyers or sellers. Index based financial futures are settled in cash unlike futures on individual stocks which are very rare and yet to be launched even in the US. Most of the financial futures worldwide are index based and hence the buyer never comes to know who the seller is, both due to the presence of the clearing corporation of the stock exchange in between and also due to secrecy reasons EXAMPLE The current market price of INFOSYS COMPANY is Rs.1650. There are two parties in the contract i.e. Hitesh and Kishore. Hitesh is bullish and kishore is bearish in the market. The initial margin is 10%. paid by the both parties. Here the Hitesh has purchased the one month contract of INFOSYS futures with the price of Rs.1650.The lot size of infosys is 300 shares. Suppose the stock rises to 2200.

Profit

20 2200 10 0 1400 1500 1600 1700 1800 1900 -10 -20 Loss Unlimited profit for the buyer(Hitesh) = Rs.1,65,000 [(2200-1650*3oo)] and notional profit for the buyer is 500. Unlimited loss for the buyer because the buyer is bearish in the market

Suppose the stock falls to Rs.1400 Profit

20 10 0 1400 1500 1600 1700 1800 1900 -10 -20

Loss

Unlimited profit for the seller = Rs.75,000.[(1650-1400*300)] and notional profit for the seller is 250. Unlimited loss for the seller because the seller is bullish in the market. Finally, Futures contracts try to "bet" what the value of an index or commodity will be at some date in the future. Futures are often used by mutual funds and large institutions to hedge their positions when the markets are rocky. Also, Futures contracts offer a high degree of leverage, or the ability to control a sizable amount of an asset for a cash outlay, which is distantly small in proportion to the total value of contract

MARGIN Margin is money deposited by the buyer and the seller to ensure the integrity of the contract. Normally the margin requirement has been designed on the concept of VAR at 99% levels. Based on the value at risk of the stock/index margins are calculated. In general margin ranges between 10-50% of the contract value. PURPOSE The purpose of margin is to provide a financial safeguard to ensure that traders will perform on their contract obligations. TYPES OF MARGIN INITIAL MARGIN: It is a amount that a trader must deposit before trading any futures. The initial margin approximately equals the maximum daily price fluctuation permitted for the contract being traded. Upon proper completion of all obligations associated with a traders futures position, the initial margin is returned to the trader. OBJECTIVE The basic aim of Initial margin is to cover the largest potential loss in one day. Both buyer and seller have to deposit margins. The initial margin is deposited before the opening of the position in the Futures transaction. MAINTENANCE MARGIN: It is the minimum margin required to hold a position. Normally the maintenance is lower than initial margin. This is set to ensure that the balance in the margin account never becomes

negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call to top up the margin account to the initial level before trading commencing on the next level. ILLUSTRATION On MAY 15th two traders, one buyer and seller take a position on June NSE S and P CNX nifty futures at 1300 by depositing the initial margin of Rs.50,000with a maintenance margin of 12%. The lot size of nifty futures =200.suppose on MAY 16th The price of futures settled at Rs.1950. As the buyer is bullish and the seller is bearish in the market. The profit for the buyer will be 10,000 [(1350-1300)*200] Loss for the seller will be 10,000[(1300-1350)] Net Balance of Buyer = 60,000(50,000 is the margin +10,000 profit for the buyer) Net Balance of Seller = 40,000(50,000 is the margin -10,000 loss for the seller) Suppose on may 17th nifty futures settled at 1400. Profit of buyer will be 10,000[(1450-1350)*200] Loss of seller will be 10,000[(1350-1400)*200] Net balance of Buyer =70,000(50, 000 is the margin +20,000 profit for the buyer) Net Balance of Seller = 30,000(50,000 is the margin -20,000 loss for the seller) As the sellers balance dropped below the maintenance margin i.e. 12% of 1400*200=33600 While the initial margin was 50,000.Thus the seller must deposit Rs.20,000 as a margin call. Now the nifty futures settled at Rs.1390. Loss for Buyer will be 2,000 [(1390-1400)*200] Profit for Seller will be 2,000 [(1390-1400)*200] Net balance of Buyer =68,000(70,000 is the margin -2000 loss for the buyer) Net Balance of Seller = 52,000(50,000 is the margin +2000 profit for the seller) Therefore in this way each account each account is credited or debited according to the settlement price on a daily basis. Deficiencies in margin requirements are called for the broker, through margin calls. Till now the concept of maintenance margin is not used in India.

ADDITIONAL MARGIN: In case of sudden higher than expected volatility, additional margin may be called for by the exchange. This is generally imposed when the exchange fears that the markets have become too volatile and may result in some crisis, like payments crisis, etc. This is a preemptive move by exchange to prevent breakdown.

CROSS MARGINING: This is a method of calculating margin after taking into account combined positions in Futures, options, cash market etc. Hence, the total margin requirement reduces due to cross-Hedges. MARK-TO-MARKET MARGIN: It is a one day market which fluctuates on daily basis and on every scrip proper evaluation is done. E.g. Investor has purchase the SATYAM FUTURES. and pays the Initial margin. Suddenly script of SATYAM falls then the investor is required to pay the mark-to-market margin also called as variation margin for trading in the future contract

HEDGERS : Hedgers are the traders who wish to eliminate the risk of price change to which trhey are already exposed.It is a mechanism by which the participants in the physical/ cash markets can cover their price risk. Hedgers are those persons who dont want to take the risk therefore they hedge their risk while taking position in the contract. In short it is a way of reducing risks when the investor has the underlying security. PURPOSE: TO REDUCE THE VOLATILITY OF A PORTFOLIO, BY REDUCING THE RISK

Figure 1.1

Hedgers
Existing Approach SYSTEM Peril &Prize Approach New Peril &Prize

1) Difficult to 1) No Leverage 1)Fix price today to buy 1) Additional offload holding available risk latter by paying premium. cost is only during adverse reward dependant 2)For Long, buy ATM Put premium. market conditions on market prices Option. If market goes up, as circuit filters long position benefit else limit to curtail losses. exercise the option. 3)Sell deep OTM call option with underlying shares, earn premium + profit with increase prcie

Advantages
Availability of Leverage

STRATEGY:
The basic hedging strategy is to take an equal and opposite position in the futures market to the spot market. If the investor buys the scrip in the spot market but suddenly the market drops then the investor hedge their risk by taking the short position in the Index futures

HEDGING AND DIVERSIFICATION:

Hedging is one of the principal ways to manage risk, the other being diversification. Diversification and hedging do not have have cost in cash but have opportunity cost. Hedging is implemented by adding a negatively and perfectly correlated asset to an existing asset. Hedging eliminates both sides of risk: the potential profit and the potential loss. Diversification minimizes risk for a given amount of return (or, alternatively, maximizes return for a given amount of risk). Diversification is affected by choosing a group of assets instead of a single asset (technically, by adding positively and imperfectly correlated assets).

ILLUSTRATION Ram enters into a contract with Shyam that he sells 50 pens to Shyam for Rs.1000. The cost of manufacturing the pen for Ram is only Rs. 400 and he will make a profit of Rs 600 if the sale is completed. COST 400 SELLING PRICE 1000 PROFIT 600

However, Ram fears that Shyam may not honour his contract. So he inserts a new clause in the contract that if Shyam fails to honour the contract he will have to pay a penalty of Rs.400. And if Shyam honours the contract Ram will offer a discount of Rs 100 as incentive. Shyam defaults 400 (Initial Investment) 400 (penalty from Shyam - (No gain/loss) Shyam honors 600 (Initial profit) (-100) discount given to Shyam 500 (Net gain)

Finally if Shyam defaults Ram will get a penalty of Rs 400 but Ram will recover his initial investment. If Shyam honors the bill the ram will get a profit of 600 deducting the discount of Rs.100 and net profit for ram is Rs.500. Thus Ram has hedged his risk against default and protected his initial investment. Now lets see how investor hedge their risk in the market Example: Say you have bought 1000 shares of XYZ Company but in the short term you expect that the market would go down due to some news. Then, to minimize your downside risk you could hedge your position by buying a Put Option. This will hedge your downside risk in the market and your loss of value in XYZ will be set off by the purchase of the Put Option.

Therefore hedging does not remove losses .The best that can be achieved using hedging is the removal of unwanted exposure, i.e.unnessary risk. The hedging position will make less profits than the un-hedged position, half the time. One should not enter into a hedging strategy hoping to make excess profits for sure; all that can come out of hedging is reduce risk.

HEDGING WITH OPTIONS:

Options can be used to hedge the position of the underlying asset. Here the options buyers are not subject to margins as in hedging through futures. Options buyers are however required to pay premium which are sometimes so high that makes options unattractive.

ILLUSTRATION: With a market price of ACC Rs.600 the investor buys the 50 shares of ACC.Now the investor excepts that price will fall by 100.So he decided to buy the put Option b y paying the premium of Rs.25. Thus the investor has hedge their risk by purchasing the put Option. Finally stock falls by 100 the loss of investor is restricted t the premium paid of Rs.2500 as investor recovered Rs.75 a share by buying ACC put.

HEDGING STRATEGIES:

LONG SECURITY, SELL NIFTY FUTURES:

Under this investor takes a long position on the security and sell some amount of Nifty Futures. This offsets the hidden Nifty exposure that is inside every long- security position. Thus the position LONG SECURITY, SELL NIFTY is a pure play on the performance of the security, without any extra risk from fluctuations of the market index. Finally the investor has HEDGED AWAY his index exposure. EXAMPLE:

LONG SECURITY, SELL FUTURES Here stock futures can be used as an effective risk management tool. In this case the investor buys the shares of the company but suddenly the rally goes down. Thus to maximize the risk the Hedger enters into a future contract and takes a short position. However the losses suffers in the security will be offset by the profits he makes on his short future position.

Spot Price of ACC = 390 Market action = 350 Loss = 40 Strategy = BUY SECURITY, SELL FUTURES Two month Futures= 390 Premium = 12 Short position = 390 Future profit = 40(390-350) As the fall in the price of the security will result in a fall in the price of Futures. Now the Futures will trade at a price lower then the price at which the hedger entered into a short position.

Finally the loss of Rs.40 incurred on the security hedger holds, will be made up the profits made on his short futures position.

HAVE STOCK, BUY PUTS:

This is one of the simplest ways to take on hedge. Here the investor buys 100 shares of HLL.The spot price of HLL is 232 suddenly the investor worries about the fall of price. Therefore the solution is buy put options on HLL. The investor buys put option with a strike of Rs.240. The premium charged is Rs.10.Here the investor has two possible scenarios three months later. 1) IF PRICE RISES Market action: 215 Loss : 17(232-15) Strike price : 240 Premium : 08 Profit : 17(240-215-8) Thus loss he suffers on the stock will be offset by the profit the investor earns on the put option bought. 2) IF PRICE RISES: Market share : 250 Loss : 10 Short position : 250(spot market) Thus the investor has a limited loss(determined by the strike price investor chooses) and an unlimited profit.

HAVE PORTFOLIO, SHORT NIFTY FUTURES:

Here the investor are holding the portfolio of stocks and selling nifty futures. In the case of portfolios, most of the portfolio risk is accounted for by index fluctuations. Hence a position LONG PORTFOLIO+ SHORT NIFTY can often become one-tenth as risky as the LONG PORTFOLIO position.

Let us assume that an investor is holding a portfolio of following scrips as given below on 1 May, 2001.
st

Company Infosys Global Tele

Beta 1.55 2.06

Amount of Holding ( in Rs) 400,000.00 200,000.00

Satyam Comp HFCL Total Value of Portfolio

1.95 1.9

175,000.00 125,000.00 1,000,000.00

Trading Strategy to be followed The investor feels that the market will go down in the next two months and wants to protect him from any adverse movement. To achieve this the investor has to go short on 2 months NIFTY futures i.e he has to sell June Nifty. This strategy is called Short Hedge. Formula to calculate the number of futures for hedging purposes is Beta adjusted Value of Portfolio / Nifty Index level Beta of the above portfolio =(1.55*400,000)+(2.06*200,000)+(1.95*175,000)+(1.9*125, 000)/1,000,000 =1.61075 (round to 1.61) Applying the formula to calculate the number of futures contracts Assume NIFTY futures to be 1150 on 1st May 2001 = (1,000,000.00 * 1.61) / 1150 = 1400 Units Since one Nifty contract is 200 units, the investor has to sell 7 Nifty contracts. Short Hedge Stock Market Holds Rs 1,000,000.00 in stock portfolio Stock portfolio fall by 6% to Rs 940,000.00 Loss: -Rs 60,000.00 Net Profit: + Rs 15,450.00 Futures Market Sell 7 NIFTY futures contract at 1150. NIFTY futures falls by 4.5% to 1098.25 Profit: 72,450.00

1 May 25th June Profit / Loss

st

SPECULATORS:

If hedgers are the people who wish to avoid price risk, speculators are those who are willing to take such risk. speculators are those who do not have any position and simply play with the others money. They only have a particular view on the market, stock, commodity etc. In short, speculators put their money at risk in the hope of profiting from an anticipated price change. Here if speculators view is correct he earns profit. In the event of speculator not being covered, he will loose the position. They consider various factors such as demand supply, market positions, open interests, economic fundamentals and other data to take their positions. SPECULATION IN THE FUTURES MARKET

Speculation is all about taking position in the futures market without having the underlying. Speculators operate in the market with motive to make money. They take: Naked positions - Position in any future contract. Spread positions - Opposite positions in two future contracts. This is a conservative speculative strategy.

Speculators bring liquidity to the system, provide insurance to the hedgers and facilitate the price discovery in the market.

Figure 1.2

Speculators
Existing Approach
1) Deliver based Trading, margin trading& carry forward transactions.

SYSTEM Peril &Prize

1) Both profit & loss to extent of price change.

New Peril &Prize

1)Maximum loss possible to premium paid

Approach
1)Buy &Sell stocks on delivery basis 2) Buy Call &Put by paying

2) Buy Index Futures hold till expiry.

premium Greater Leverage as to pay only the premium. Greater variety of strike price options at a given time.

Advantages

ILLUSTRATION: Here the Speculator believes that stock market will going to appreciate. Current market price of PATNI COMPUTERS = 1500 Strategy: Buy February PATNI futures contract at 1500 Lot size = 100 shares Contract value = 1,50,000 (1500*100) Margin = 15000 (10% of 150000) Market action = rise to 1550 Future Gain:Rs. 5000 [(1550-1500)*100] Market action = fall to 1400 Future loss: Rs.-10000 [(1400-1500)*100] Thus the Speculator has a view on the market and accept the risk in anticipating of profiting from the view. He study the market and play the game with the stock market

TYPES: POSITION TRADERS:

These traders have a view on the market an hold positions over a period of as days until their target is met.

 DAY TRADERS:
. Day traders square off the position during the curse of the trading day and book the profits.

SCALPERS:
Scalpers in anticipation of making small profits trade a number of times throughout the day.

SPECULATING WITH OPTIONS:

A speculator has a definite outlook about future price, therefore he can buy put or call option depending upon his perception about future price. If speculator has a bullish outlook, he will buy calls or sell (write) put. In case of bearish perception, the speculator will put r write calls. If speculators view is correct he earns profit. In the event of speculator not being covered, he will loose the position. A Speculator will buy call or put if his price outlook in a particular direction is very strong but if is either neutral or not so strong. He would prefer writing call or put to earn premium in the event of price situations. ILLUSTRATION: Here if speculator excepts that ZEE TELEFILMS stock price will rise from present level of Rs.1050 then he buys call by paying premium. If prices have gone up then he earns profit otherwise he losses call premium which he pays to buy the call. if speculator sells that ZEE TELEFILMS stock will come down then he will buy put on the stale price until he can write either call or put. Finally Speculators provide depth an liquidity to the futures market an in their absence; the price protection sought the hedger would be very costly. STRATEGIES:

BULLISH SECURITY,SELL FUTURES:

Here the Speculator has a view on the market. The Speculator is bullish in the market. Speculator buys the shares of the company an makes the profit. At the same time the Speculator enters into the future contract i.e. buys futures and makes profit. Spot Price of RELIANCE = 1000 Value = 1000*100shares = 1,00,000 Market action = 1010 Profit = 1000 Initial margin = 20,000

Market action Profit

= 1010 = 400(investment of Rs.20,000)

This shows that with a investment of Rs.1,00,000 for a period of 2 months the speculator makes a profit of 1000 and got a annual return of 6% in the spot market but in the case of futures the Speculator makes a profit of Rs.400 on the investment of Rs.20,000 and got return of 12%. Thus because of leverage provided security futures form an attractive option for speculator.

BULLISH STOCK, BUY CALLS OR BUY PUTS:

Under this strategy the speculator is bullish in the market. He could do any of the following:

BUY STOCK
ACC spot price No of shares Price Market action Profit Return : 150 : 200 : 150*200 = 30,000 : 160 : 2,000 : 6.6% returns over 2months

BUY CALL OPTION:

Strike price Premium Lot size Market action Profit Return : 150 : 8 : 200 shares :160 : (160-150-8)*200 = 400 : 25% returns over 2months

This shows that investor can earn more in the call option because it gives 25% returns over a investment of 2months as compared to 6.6% returns over a investment in stocks

BEARISH SECURITY,SELL FUTURES:

In this case the stock futures is overvalued and is likely to see a fall in price. Here simple arbitrage ensures that futures on an individual securities more correspondingly with the

underlying security as long as there is sufficient liquidity in the market for the security. If the security price rises the future price will also rise and vice-versa.

Two month Futures on SBI Lot size Margin Market action Future profit

= = = = =

240 100shares 24 220 20(240-220)

Finally on the day of expiration the spot and future price converges the investor makes a profit because the speculator is bearish in the market and all the future stocks need to sell in the market.

BULLISH INDEX, LONG NIFTY FUTURES:

Here the investor is bullish in the index. Using index futures, an investor can BUY OR SELL the entire index trading on one single security. Once a person is LONG NIFTY using the futures market, the investor gains if the index rises and loss if the index falls.

1st July = Index will rise Buy nifty July contract = 960 Lot =200 14th July nifty risen= 967.35 Nifty July contract= 980 Short position Profit =980 = 4000(200*20)

ARBITRAGEURS:
Arbitrage is the concept of simultaneous buying of securities in one market where the price is low and selling in another market where the price is higher.

Arbitrageurs thrive on market imperfections. Arbitrageur is intelligent and knowledgeable person and ready to take the risk He is basically risk averse. He enters into those contracts were he can earn risk less profits. When markets are imperfect, buying in one market and simultaneously selling in other market gives risk less profit. Arbitrageurs are always in the look out for such imperfections. In the futures market one can take advantages of arbitrage opportunities by buying from lower priced market and selling at the higher priced market. JM Morgan introduced EQUITY DERIVATIVES FUND called as ARBITRAGE FUND where the investor buys the shares in the cash market and sell the shares in the future market.

ARBITRAGEURS IN FUTURES MARKET

Arbitrageurs facilitate the alignment of prices among different markets through operating in them simultaneously.

Figure 1.3

Arbitrageurs
Existing Approach SYSTEM Peril &Prize Approach New Peril &Prize

1) Buying Stocks in 1) Make money one and selling in whichever way the another exchange. Market moves. forward transactions. 2) If Future Contract more or less than Fair price

1) B Group more 1) Risk free promising as still game. in weekly settlement 2) Cash &Carry arbitrage continues

Fair Price = Cash Price + Cost of Carry.

Example: Current market price of ONGC in BSE= 500 Current market price of ONGC in NSE= 510 Lot size = 100 shares Thus the Arbitrageur earns the profit of Rs.1000(10*100)

STRATEGIES:

BUY SPOT, SELL FUTURES:

In this the investor observing that futures have been overpriced, how can the investor

cash in this opportunity to earn risk less profits. Say for instance ACC = 1000 and One month ACC futures = 1025. This shows that futures have been overpriced and therefore as an Arbitrageur, investor can make risk less profits entering into the following set f transactions. On day one, borrow funds, buy security on the spot market at 1000 Simultansely, sell the futures on the security at1025 Take delivery of the security purchased and hold the security for a month on the futures expiration date, the spot and futures converge . Now unwind the position Sa y the security closes at Rs.1015. Sell the security Futures position expires with the profit f Rs.10 The result is a risk less profit of Rs.15 on the spot position and Rs.10 on the futures position Return the Borrow funds.

Finally if the cost of borrowing funds to buy the security is less than the arbitrage profit possible, it makes sense for the investor to enter into the arbitrage. This is termed as cash andcarry arbitrage.

BUY FUTURES, SELL SPOT:

In this the investor observing that futures have been under priced, how can the

investor cash in this opportunity to earn risk less profits. Say for instance ACC = 1000 and One month ACC futures = 965. This shows that futures have been under priced and therefore as an Arbitrageur, investor can make risk less profits entering into the following set f transactions. On day one, sell the security on the spot market at 1000 Mae delivery of the security Simultansely, buy the futures on the security at 965 On the futures expiration date, the spot and futures converge . Now unwind the position Sa y the security closes at Rs.975. Sell the security Futures position expires with the profit f Rs.10 The result is a risk less profit of Rs.25 the spot position and Rs.10 on the futures position

Finally if the returns get investing in risk less instruments is less than the return from the arbitrage it makes sense for the investor to enter into the arbitrage. This is termed as reverse cash and- carry arbitrage.

ARBITRAGE WITH NIFTY FUTURES:

Arbitrage is the opportunity of taking advantage of the price difference between two markets. An arbitrageur will buy at the cheaper market and sell at the costlier market. It is possible to arbitraged between NIFTY in the futures market and the cash market. If the futures price is any of the prices given below other than the equilibrium price then the strategy to be followed is

CASE-1 Spot Price of INFOSEYS = 1650 Future Price Of INFOSEYS = 1675 In this case the arbitrageur will buy INFOSEYS in the cash market at Rs.1650 and sell in the futures at Rs.1675 and finally earn risk free profit Of Rs.25. CASE-2 Future Price Of ACC = 675 Spot Price of ACC = 700 In this case the arbitrageur will buy ACC in the Future market at Rs.675 and sell in the Spot at Rs.700 and finally earn risk free profit Of Rs.25.

INTRODUCTION TO OPTIONS It is a interesting tool for small retail investors. An option is a contract, which gives the buyer (holder) the right, but not the obligation, to buy or sell specified quantity of the underlying assets, at a specific (strike) price on or before a specified time (expiration date). The underlying may be physical commodities like wheat/ rice/ cotton/ gold/ oil or financial instruments like equity stocks/ stock index/ bonds etc. MONTHLY OPTIONS :

The exchange trade option with one month maturity and the contract usually expires on last Thursday of every month. PROBLEMS WITH MONTHLY OPTIONS Investors often face a problem when hedging using the three-monthly cycle options as the premium paid for hedging is very high. Also the trader has to pay more money to take a long or short position which results into iiliquidity in the market.Thus to overcome the problem the BSE introduced WEEKLY OPTIONS WEEKLY OPTIONS: The exchange trade option with one or weak maturity and the contract expires on last Friday of every weak ADVANTAGES

Weekly Options are advantageous to many to investors, hedgers and traders. The premium paid for buying options is also much lower as they have shorter time to maturity. The trader will also have to pay lesser money to take a long or short position. the trader can take a larger position in the market with limited loss. On account of low cost, the liquidity will improve, as more participants would come in. Weekly Options would lead to better price discovery and improvement in market depth, resulting in better price discovery and improvement in market efficiency

TYPES OF OPTION: CALL OPTION A call option gives the holder (buyer/ one who is long call), the right to buy specified quantity of the underlying asset at the strike price on or before expiration date. The seller (one who is short call) however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy. To acquire this right the buyer pays a premium to the writer (seller) of the contract. ILLUSTRATION Suppose in this option there are two parties one is Mahesh (call buyer) who is bullish in the market and other is Rakesh (call seller) who is bearish in the market. The current market price of RELIANCE COMPANY is Rs.600 and premium is Rs.25 1. CALL BUYER Here the Mahesh has purchase the call option with a strike price of Rs.600.The option will be excerised once the price went above 600. The premium paid by the buyer is Rs.25.The buyer will earn profit once the share price crossed to Rs.625(strike price + premium). Suppose the stock has

crossed Rs.660 the option will be exercised the buyer will purchase the RELIANCE scrip from the seller at Rs.600 and sell in the market at Rs.660.

Profit

30 20 10 0 590 600 610 620 630 640 -10 -20 -30 Loss

Unlimited profit for the buyer = Rs.35{(spot price strike price) premium} Limited loss for the buyer up to the premium paid. 2. CALL SELLER: In another scenario, if at the tie of expiry stock price falls below Rs. 600 say suppose the stock price fall to Rs.550 the buyer will choose not to exercise the option.

Profit 30 20 10

0 590 600 610 620 630 640 -10 -20 -30 Loss

Profit for the Seller limited to the premium received = Rs.25 Loss unlimited for the seller if price touches above 600 say 630 then the loss of Rs.30 Finally the stock price goes to Rs.610 the buyer will not exercise the option because he has the lost the premium of Rs.25.So he will buy the share from the seller at Rs.610. Thus from the above example it shows that option contracts are formed so to avoid the unlimited losses and have limited losses to the certain extent Thus call option indicates two positions as follows: LONG POSITION If the investor expects price to rise i.e. bullish in the market he takes a long position by buying call option. SHORT POSITION If the investor expects price to fall i.e. bearish in the market he takes a short position by selling call option. PUT OPTION A Put option gives the holder (buyer/ one who is long Put), the right to sell specified quantity of the underlying asset at the strike price on or before a expiry date. The seller of the put option (one who is short Put) however, has the obligation to buy the underlying asset at the strike price if the buyer decides to exercise his option to sell. ILLUSTRATION Suppose in this option there are two parties one is Dinesh (put buyer) who is bearish in the market and other is Amit(put seller) who is bullish in the market. The current market price of TISCO COMPANY is Rs.800 and premium is Rs.2 0 1) PUT BUYER(Dinesh):

Here the Dinesh has purchase the put option with a strike price of Rs.800.The option will be excerised once the price went below 800. The premium paid by the buyer is Rs.20.The buyers breakeven point is Rs.780(Strike price Premium paid). The buyer will earn profit once the share price crossed below to Rs.780. Suppose the stock has crossed Rs.700 the option will be exercised the buyer will purchase the RELIANCE scrip from the market at Rs.700and sell to the seller at Rs.800 Profit

20 10 0 600 700 800 900 1000 1100 -10 -20

Loss

Unlimited profit for the buyer = Rs.80 {(Strike price spot price) premium} Loss limited for the buyer up to the premium paid = 20 2). PUT SELLER(Amit):

In another scenario, if at the time of expiry, market price of TISCO is Rs. 900. the buyer of the Put option will choose not to exercise his option to sell as he can sell in the market at a higher rate.

profit

20 10 0 600 700 800 900 1000 1100 -10 -20

Loss

Unlimited loses for the seller if stock price below 780 say 750 then unlimited losses for the seller because the seller is bullish in the market = 780 - 750 = 30 Limited profit for the seller up to the premium received = 20

Thus Put option also indicates two positions as follows:

LONG POSITION If the investor expects price to fall i.e. bearish in the market he takes a long position by buying Put option. SHORT POSITION If the investor expects price to rise i.e. bullish in the market he takes a short position by selling Put option

Option buyer option holder

CALL OPTIONS PUT OPTIONS or Buys the right to buy the Buys the right to sell the underlying asset at the underlying asset at the specified price specified price

Option seller option writer

or Has the obligation to sell the underlying asset (to the option holder) at the specified price

Has the obligation to buy the underlying asset (from the option holder) at the specified price.

FACTORS AFFECTING OPTION PREMIUM

THE PRICE OF THE UNDERLYING ASSET: (S)

Changes in the underlying asset price can increase or decrease the premium of an option. These price changes have opposite effects on calls and puts. For instance, as the price of the underlying asset rises, the premium of a call will increase and the premium of a put will decrease. A decrease in the price of the underlying assets value will generally have the opposite effect

Premium of the Price of the CALL

Underlying asset Premium of the PUT

Premium of the
Price of CALL Underlying asset

Premium of the PUT

THE SRIKE PRICE: (K)

The strike price determines whether or not an option has any intrinsic value. An options premium generally increases as the option gets further in the money, and decreases as the option becomes more deeply out of the money.

Time until expiration: (t) Volatility:

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

Volatility is simply a measure of risk (uncertainty), or variability of an options underlying. Higher volatility estimates reflect greater expected fluctuations (in either direction) in underlying price levels. This expectation generally results in higher option premiums for puts and calls alike, and is most noticeable with at- the- money options.

Interest rate: (R1)

This effect reflects the COST OF CARRY the interest that might be paid for margin, in case of an option seller or received from alternative investments in the case of an option buyer for the premium paid. Higher the interest rate, higher is the premium of the option as the cost of carry increases.

PLAYERS IN THE OPTION MARKET: a) Developmental institutions b) Mutual Funds c) Domestic & Foreign Institutional Investors d) Brokers e) Retail Participants

FUTURES V/S OPTIONS

RIGHT OR OBLIGATION : Futures are agreements/contracts to buy or sell specified quantity of the underlying assets at a price agreed upon by the buyer & seller, on or before a specified time. Both the buyer and seller are obligated to buy/sell the underlying asset. In case of options the buyer enjoys the right & not the obligation, to buy or sell the underlying asset. RISK Futures Contracts have symmetric risk profile for both the buyer as well as the seller. While options have asymmetric risk profile. In case of Options, for a buyer (or holder of the option), the downside is limited to the premium (option price) he has paid while the profits may be unlimited. For a seller or writer of an option, however, the downside is unlimited while profits are limited to the premium he has received from the buyer. PRICES: The Futures contracts prices are affected mainly by the prices of the underlying asset. While the prices of options are however, affected by prices of the underlying asset, time remaining for expiry of the contract & volatility of the underlying asset.

COST:

It costs nothing to enter into a futures contract whereas there is a cost of entering into an options contract, termed as Premium.

STRIKE PRICE:

In the Futures contract the strike price moves while in the option contract the strike price remains constant .

Liquidity:

As Futures contract are more popular as compared to options. Also the premium charged is high in the options. So there is a limited Liquidity in the options as compared to Futures. There is no dedicated trading and investors in the options contract.

Price behaviour:

The trading in future contract is one-dimensional as the price of future depends upon the price of the underlying only. While trading in option is two-dimensional as the price of the option depends upon the price and volatility of the underlying.

PAY OFF:

As options contract are less active as compared to futures which results into non linear pay off. While futures are more active has linear pay off .

OPTION STRATAGIES:

1.

BULL CALL SPREAD:

This strategy is used when investor is bullish in the market but to a limited upside .The Bull Call Spread consists of the purchase of a lower strike price call an sale of a higher strike price call, of the same month. However, the total investment is usually far less than that required to purchase the stock. Current price of PATNI COMPUTERS is Rs. 1500 Here the investor buys one month call of 1490 at 25 ticks per contract and sell one month call of 1510 and receive 15 ticks per contract. Premium = 10 ticks per contract(25 paid- 15 received) Lot size = 600 shares BREAK- EVEN- POINT= 1490+10=1500

Possible outcomes at expiration: i. BREAK- EVEN- POINT:

On expiration if the stock of PATNI COMPUTERS is 1500 then the option will close at Breakeven. The call of 1490 will have an intrinsic value of 0 while the 1510 call option sold will expire worthless and also reduce the premium received.

ii.

BETWEEN STRIKE PRICE AND BREAK- EVEN- POINT :

If the index is between1490 an 1500 then the 1490 call option will have an intrinsic value of 5 which is less than premium paid result in loss of 5.While 1510 call option sold will not expire which will reduce the loss through receiving the net premium. If the index is between 1500 and 1510 then the 1490 call option will have an intrinsic value of 10 i.e. deep in the money While 1510 call option sold will have no intrinsic value the premium receive generate profit .

iii.

AT STRIKE:

If the index is at 1490, the 1490 call option will have no intrinsic value and expire worthless. While 1510 call sold result in Rs.10 loss i.e. deep out the money. If the index is at 1510, the 1490 call option will have an intrinsic value of 10 i.e. deep in the money. While 1510 call sold will have no intrinsic value and expire worthless and profit is the premium received of Rs. 10 iv. ABOVE HIGHER PRICE:

IF the PATNI COMPUTERS is above 1510, the 1490 call option will be in the money of Rs.10 while the 1510 option i.e. strike prices-premium paid. v. BELOW PRICE:

IF the underlying stock is below 1490, both the 1490 call option and 1510 option sold result in loss to the premium paid.

The pay-off table: PATNI COMPUTERS 1485 AT EXPIRATION (below lower price) 1490 1495 1500 1510

(At the (Between (At BEP) lower lower strike price) &BEP

Intrinsic value of 1490 long call at expiration (a) Premium paid (b) Intrinsic value of 1510 short call at expiration (c) Premium received (d) profit/loss(a-c)-(b- d)

0 25 0

0 25 0

5 25 0

10 25 0

20 25 0

15 -10

15 -10 1510

15 -5 1505

15 0 1500

15 10 1520 (Above BEP

PATNI COMPUTERS 1495 AT EXPIRATION (below higher price)

(At the (Between (At BEP) higher higher strike price) &BEP

Intrinsic value of 1510 short call at expiration (a) Premium paid (b) Intrinsic value of 1490 long call at expiration (c) Premium received (d) profit/loss(c-a)-( d - b)

10

15 5 25 -5

15 20 25 10

15 15 25 5

15 10 25 0

15 30 25 10

Profit

20 10 0 1490 1500 1510 1520 1530 1540 -10 -20

Loss

2. BEAR PUT SPREAD:

It is implemented in the bearish market with a limited downside. The Bear put Spread consists of the purchase a higher strike price put and sale of a lower strike price put, of the same month. It provides high leverage over a limited range of stock prices. However, the total investment is usually far less than that required to buy the stock shares. Current price of INFOSYS TECHNOLOGIES is Rs. 4500 Here the investor buys one month put of 5510(higher price) at 55 ticks per contract and sell one month put of 4490 (lower price) and receive 45 ticks per contract. Premium = 10 ticks per contract(55 paid- 45 received)

Lot size = 200 shares BREAK- EVEN- POINT= 5510-10 = 5500. Possible outcomes at expiration: i. BREAK- EVEN- POINT:

On expiration if the stock of PATNI COMPUTERS is 5500 then the option will close at Breakeven. The put purchase of 5510 is 10 result in no-profit no loss situation to the premium paid while the 4490 put option sold will expire worthless and also reduce the premium received. ii. BETWEEN STRIKE PRICE AND BREAK- EVEN- POINT :

If the index is between 5510 an 5500 then the 5510 put option will have an intrinsic value of 5 which is less than premium paid result in loss of 5.While 4490 call option sold will not expire which will reduce the loss of Rs.10 through receiving the net premium. If the index is between 5500 and 4490 then the 5510 put option will have an intrinsic value of 15 i.e. deep in the money While 4490 put option sold will have no intrinsic value the premium receive will generate profit . iii. AT STRIKE:

If the index is at 5510, the 5510 put option will have an intrinsic value of 0 and expire worthless. While 4490 will also have no intrinsic value an put sold result in reducing the loss as the premium received If the index is at 4490 the 5510 put option will have maximum profit deep in the money. While 4490 put sold will have no intrinsic value and expire worthless and profit is the premium received between the strike price an premium paid. iv. ABOVE STRIKE PRICE:

IF the INFOSYS TECHNOLOGIES is above 5510, the 5510 put option will have no intrinsic value. while the 4490 put option sold result in maximum loss to the premium received. If the underlying stock is above 4490 but below 5510, the 4490 put option will have no intrinsic value. while the 5510 put option sold result in the maximum profit strike price - premium v. BELOW STRIKE PRICE:

IF the underlying stock is below 5510, the 5510 option purchase while be in the money and 4490 option sold will be assigned (strike price premium paid) = profit .

The pay-off table: INFOSYS EXPIRATION AT 5520 5510 5505 5500 4480

(Above (At the (Between (At BEP) strike) strike) lower strike &BEP Intrinsic value of 5510 long put at expiration (a) Premium paid (b) Intrinsic value of 4490 short put at expiration (c) Premium received (d) profit/loss(a-c)-(b- d) 0 55 0 45 -10 0 55 0 45 -10 5 55 0 45 -5 10 55 0 45 0 30 55 10 45 10

INFOSYS EXPIRATION

AT 5505

4490

4495

5500

4480 (below strike price)

(Above (At the (Between (At BEP) strike) strike) strike &BEP

Intrinsic value of 4490 short put at expiration (a) Premium received (b) Intrinsic value of 5510 long put at expiration (c) Premium paid (d) profit/loss[(c-a)-( d - b)]

0 45 5 55 -5

0 45 30 55 20

0 45 15 55 15

0 45 10 55 0

10 45 30 55 10

Profit

20 10 0 3000 3500 4000 4500 5000 5500 6000 6500 7000 -10 -20 Loss

3. BULL PUT SPREAD.

This strategy is opposite of Bear put spread. Here the investor is moderately bullish in the market to provide high leverage over a limited range of stock prices. The investor buys a lower strike put and selling a higher strike put with the same expiration dates. The strategy has both limited profit potential and limited downside risk.

The current price of RELIANCE CAPITAL is Rs.1290

Here the investor buys one month put of 1300 (lower price) at 25 ticks per contract and sell one month put of 1310 (higher price) and receive 15 ticks per contract. Premium = 10 ticks per contract (25 paid- 15 received) Lot size = 600 shares BREAK- EVEN- POINT= 1300-10 = 1290 Possible outcomes at expiration: i. BREAK- EVEN- POINT:

On expiration if the stock of RELIANCE CAPITAL is 1290, the 1300 put option will have an intrinsic value of 10 while the 1310 put option sold will have an intrinsic value of 30. ii. BETWEEN STRIKE PRICE AND BREAK- EVEN- POINT:

If the underlying index is between 1290 an 1300, the 1300 put option the buyer will have an intrinsic value of 5 while the 1310 option sold will have an intrinsic value of 15 If the underlying index is between 1300 and 1310, the 1300 put option the buyer will have no intrinsic value and expire worthless, while the 1310 option sold will have an intrinsic value of 5. iii. AT STRIKE:

If the index is at1300, the 1300 put option will have an intrinsic value of 0 and expire worthless. While 1310 will have an intrinsic value of 10 If the index is at 1310 the 1300 put option will have an intrinsic value of 0 (deep out the money and expire worthless. While 1310 will also have no intrinsic value and profit of seller is limited t the premium received

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