OPTION TRADING IN INDIA AND ITS IMPACT ON

ECONOMY.





SUBMITTED BY
VITHAL .K
SURYANARAYANA MURTHY.
TEJEESH CHANDRA .P




INTRODUCTION TO OPTIONS:
Over the past three decades, option contract defined as a contract that gives the holder (known
as option buyer) the right to buy or sell an underlying asset in future at a pre-agreed price has
been widely accepted as one of the most useful derivative securities. While valuing the option
contracts, Black and Scholes (1973), in their seminal work, assume these securities as redundant
assets and value them with a no-arbitrage relation. They argue that a portfolio comprising of the
stock and (riskless) bond would replicate the option position. Does it mean that option contracts
are redundant securities? Several research studies have been conducted to examine the role of
option market and its contribution in improving the quality of underlying asset market.
Extending the argument of Black and Scholes (1973) and Black (1975), Manaster and
Rendleman (1982) contend that option market plays an important role as a trading vehicle which
provides high liquidity, low trading costs, leverage and least restrictions . Bhattacharya (1987)
adds upper bound on the loss if long in the option, as another factor that makes informed
investors prefer option market. All these studies have argued that prices of stock options may
reflect additional information not captured by observed stock prices leading to price discovery.
Grossman (1988) argues against the notion that a real security is redundant when it can be
synthesized by a dynamic trading strategy. He observes that such notion essentially ignores the
informational role of real securities markets. Further, he contends that the absence of put options
would prevent the transmittal of information to market participants about the future price
volatility leading to the higher volatility when market players resort to the dynamic hedging
strategies.
Detemple and Selden (1991) question the accuracy of arbitrage based option valuation
model, such as Black and Scholes Model, as there exists a robust interaction between option and
stock market. They conclude that, in an incomplete market, the valuation of derivative securities
cannot be treated independently from the valuation of primary securities, say equity shares. They
observe that the increase in stock prices consequent upon the introduction of option contracts is a
result of some economies with the diversity in preferences. Complementing these results,
Cassano (2001) concludes that the existence of option contracts reduces the gap between
incomplete and complete markets to negligible.
Extending the model of continuous insider trading given by Kyle (1985) to demonstrate
the role of options, Back (1993) concludes that option is not redundant when it is actually traded.
The existence of option market affects the prices of underlying assets and thus affects the flow of
information. He, further, contends that the volatility of underlying asset becomes stochastic when
the option is traded on such asset. Cao (1999) concludes that when the assumptions relating to
complete, competitive and frictionless markets are relaxed, the introduction of option contracts
effect the prices of underlying assets
Empirical studies, more often, involve investigation of options effects on stock prices
behaviour at two points in time separated by an event that might affect this behaviour. The
common event studies include option listing and option expiration effects. The volume of trading
witnessed in the option and stock market has been found to be of relevance in understanding the
price discovery function. The study conducted by Blume, Easley and OHara (1994) contends
that volume provides information about the quality of traders information that cannot be
deduced from the price statistic. They investigate the role of volume and trade information in
Brown and Jennings Model (1989) and Grundy and McNichols Model (1989), and emphasized
upon the changes that need to be brought about in these models. They support complementarity
in price and volume information and conclude that a trader who ignores volume would face
penalty because the price impounds information about the average level of traders private
information while volume captures signals relating to the quality of traders information.
Bhuyan and Chaudhury (2001) have examined the role of option markets open interest in
conveying information about the future movement of the underlying asset and have shown that
the trading strategies based on this predictor yields better results as compared to the buy-and-
hold and passive covered call strategies. Further, Bhuyan and Yan (2002) have developed several
price predictors from the open interests and volumes of individual stocks from the option market
and conclude that they exhibit significant explanatory and predictive power for the future stock
prices. Their results have been the driving force for the present study which is among one of the
earlier attempts to study the role of option market in determining the underlying share prices in
Indian context.
INTRODUCTION TO TRADING OPTIONS:
The options markets are booming; more traders are turning to options as their investment of
choice because of the many benefits option trading provides. Many traders turn to options
because they can get started with just a fraction of the money that would be required to trade the
underlying stocks or futures. And they like the fact that buying Calls or Puts offer unlimited
profit potential, with limited risk.
Experienced traders have always used options to hedge their portfolios, and to use the flexibility
of options to take advantage of market conditions that ca not be traded with just the underlying
stock or futures.
Leverage
Option trading has the advantage of leveraging capital by allowing a small amount of capital to
control a larger dollar value amount of the underlying asset. At the current price of $52 it would
cost $52,000 to purchase 1000 shares of Intel. Even on margin it would cost $26,000. However
you can control the same number of shares using options for a fraction of that amount. This
tremendous leverage means that for a smaller investment, the profit potential can be the same as
if you owned a much larger underlying asset position.

Flexibility
Options provide a very flexible investment tool. Options are available for many types of
underlying assets such as stocks, futures, indices, and other markets such as currencies. At any
given time, you can buy or sell options with a wide selection of strike prices and various contract
expiration periods. In fact, stocks and indices offer LEAPS, which are long duration options,
giving you flexible expiration dates that can be years away. Because of their unique risk/reward
structure, options can be bought and sold in many different combinations to take advantage of
almost any market condition. Option strategies can be created to make money in rising or
declining markets, markets with no price movement, explosive markets where the direction is
unclear, as a hedge to protect profits. When you only trade the underlying asset, you can only
benefit from directional movement. But with options you can benefit from other market
conditions.
Limited Risk - Unlimited Profits
Whenever you buy an option contract the maximum loss that you can incur is limited to the
amount of money you paid for the option contract. On the other hand, you have the potential for
unlimited profits. This limited risk, unlimited profit investment profile is very attractive to many
investors who want to know what their risk potential is at any point in time. Trading options also
gives you an extra edge in limiting the way you expose your investment to risk. Factors that can
affect the risk of an option position include asset price, volatility, time, and interest rates. Option
strategies can be created and adjusted to limit your risk for these factors when the market is
going against you.
Portfolio protection is also possible by hedging your stock or futures position by purchasing
options to protect your holdings from adverse asset movements. Individual options can be used
to hedge an individual asset, or index options can be used to hedge a basket of stocks in one
transaction.

Option
An option is the right either to buy or to sell a specified amount or value of a particular
underlying interest, at a fixed price, by exercising the option before its specified expiration date.
The options markets provide a mechanism where many different types of market players can
achieve their specific investment goals. An options investor may be looking for long term or
short term profits, or they may be looking to hedge an existing stock or commodity position.
Whatever your objectives may be, you need a thorough understanding of the markets you will be
trading, and the ability to communicate your objectives to others. An option is a financial
instrument, termed a derivative, and can be traded itself. It is termed a derivative because the
option contract derives its price and value from the underlying asset on which it is based, and the
option value can fluctuate as the price of the underlying asset rises or falls in price. The option
contract value can also affected by other market conditions, such as changes in; volatility, stock
splits, interest rates, and dividends.
Underlying Asset
Each option is based on an underlying asset, such as shares of stock or the value of an index, or a
Futures contract.
Two Types of Options
Call Option
A Call option is a contract that gives the buyer of the option the right, but not the obligation, to
purchase a fixed number of contracts or shares of the underlying asset at a fixed price, on or
before a set date.
Put Option
A Put option is a contract that gives the buyer of the option the right, but not the obligation, to
sell short a fixed number of contracts or shares of the underlying asset at a fixed price, on or
before a set date.
Contract Specifications
Strike Price
The strike price (or exercise price) is the price at which the underlying asset may be bought by
the holder of a call or sold by the holder of a put.
Expiration Date
This is the date on which an option expires. Options held to this date and not yet exercised cease
to exist.
Two Styles of Options
American style
American style options may be exercised anytime until their expiration. Generally, US-traded
equity options are American style.
European style
European style options may be exercised only in a defined period at expiration. Some UStraded
index and currency options are European style.
Settlement
Physical Delivery
Physical delivery options entitle the holder to receive actual delivery (for a call) or to make
actual delivery (for a put) of the underlying asset upon exercise.
Cash Settlement
Cash settlement options do not permit actual delivery of the underlying asset. Instead, if held to
term, they culminate in a cash credit or debit for the difference in value from purchase to
expiration.
LEAPS
LEAPS (Long-term Equity Anticipation Securities) are long term options with expiration dates
that can be up to 3 years away. Not all optionable stocks and indices have LEAPS available. Like
any product in the market place, the exchanges only create LEAPS for a stock if they feel there is
a market demand for them. This is the same reason why not all stocks have trading options.
LEAPS can be used for long term speculation or hedging. LEAPS on many of the index option
markets like SPX, OEX, and NDX are now available as well. LEAPS symbols are given their
own option root symbol designation, which is usually very different from the option or asset root
symbol. For example, Intels stock symbol is INTC, its option root symbol is INQ, and its
LEAPS symbols are LNL and ZNL.
Option Premiums and Pricing
The price paid for an option is called the premium, it is the price paid by the buying, and the
price received by the writer or seller of the option. The premium is determined by various pricing
factors and open market transactions.
Options Pricing
If you are going to trade options, you should understand all of the factors that can affect the price
of an option and therefore the performance of your trades. We are not going to explore the exact
details of the various pricing formulas for options, but there are many good references on the
subject. Many factors impact the value of an option premium. Intrinsic value and time value are
the primary components that determine the price/premium of an option.
I ntrinsic value
This Is the portion of the premium equal to the amount an option is in-the-money, or intrinsically
profitable, if at all. The terms, in-the-money, out-of-the-money, and at-the-money describe the
relationship of the price of the underlying asset to the strike price of the option contract
Time Value
Option time value includes factors such as volatility, days to expiration, and interest rates that
impact intrinsic and time value.
In-the-Money, Out-of-the-Money, and At-the-Money
These terms are key to understanding the value of your option contract at any point in time over
the period of the contract. These terms describe the relationship of the underlying asset relative
to the strike price of the option. This is true for any kind of option A Call option is said to be in-
the-money (ITM) if the underlying asset price is higher than the strike price. This is because the
Call option becomes profitable when the underlying asset price rises above the strike price.
Remember, Call options are bullish and benefit from an increase in the price of the underlying
asset. Conversely, a Call option is considered out-of-the-money if the underlying asset price is
lower than the strike price.
Time
Days to Expiration
The time remaining in days to expiration is an important time factor. An option is considered a
wasting asset, and as the option's expiration date gets closer, the value of the option decreases.
The more time remaining until expiration, the more time value the option contract has. If the
underlying asset price falls far below or far above the strike price of the option, the underlying
asset becomes more dominant in determining the price of the option. On the day the option
expires, the only value the option contract has is its intrinsic value; that is, the amount by which
the option contract is in-the-money.

Volatility
Volatility of the Underlying Asset
Volatility refers to the price fluctuations exhibited by the underlying asset. An options premium
will be influenced by the likelihood, in the eyes of the market participants, that the underlying
asset will move above or below the various strike prices. Generally, higher volatility means
higher option premiums. Volatility is the amount in annual percent terms that the underlying
asset has moved or is expected to move, from its current price, on an annual basis. This number
can help us forecast short-term price ranges and can also help us determine the relative value for
an option price.
There are two types of volatility that we can work with in our options analysis:
Historical Volatility
The first is historical or sometimes called statistical volatility, which is volatility based on the
historical price movement of the underlying asset. This volatility number measures what the
volatility has been in the past. Historical volatility is generally based on daily bars looking back
20, 30, and 60 days.
I mplied Volatility
The second kind of volatility we work with is implied volatility, which is an implied value based
on the current option prices for an underlying asset. This kind of volatility is much more valuable
in trading, because it gives us an insight to what the market is saying about the potential asset
price movement. When option prices rise because of increased volatility or nervousness in the
market, this may tell us that something important may about to be announced. So when option
prices rise independently of asset prices, higher implied volatility is driving the options prices up.
Therefore, implied volatility can be seen as a measurement of risk; higher implied volatility
generally means higher risk for the option seller, and that sellers are trying to mitigate that risk.
Interest Rates
The cost of money, as reflected by market interest rates, also affects option premiums. As one of
the inputs into the option pricing formula, it is the risk-free interest rate for the remaining time
until expiration. In most cases you can use the 90-day T-Bill rate. For longer term options or
LEAPS, you can find a suitable substitute in the 180-day and 1 or 2 year Bonds.
Dividends
Dividends are payments made to holders of shares of stock. Neither option holders nor writers,
of either calls or puts, receive or pay dividends. As such, dividends reflect a difference in the
cash flow of the underlying asset vs. an option. These differences are generally recognized in the
option premiums.
Corporate Actions
Corporate actions is a general name for a variety of actions a corporation may take that affect
its capital structure. These include special cash distributions, stock dividends, stock splits, pin
offs and many others. In most cases, the terms of an option will be adjusted to make such a
corporate action neutral to the option holder and writer. This may mean adjusting the strike price
of the option or quantity of the underlying asset.
Greeks
Options analysts use several Greek (and pseudo-Greek) letters to represent the risk factors
affecting an option premium. Known collectively as the Greeks, these variables represent the
estimated impact of changes in price, time volatility, and interest rates on the premium of an
option.
Delta
Delta is the expected change in an option premium for a 1-point change in the price of an asset.
For example, an option with a delta of .5 may be expected to move .50 for a 1-point move in the
asset.
In-the-money options have higher delta values than out-of the money options. At-the money
options generally have a delta of .5.


HISTORICAL DEVELOPMENT OF DERIVATIVE MARKET IN INDIA:
Derivative markets in India have been in existence in one form or the other for a long time. In the
area of commodities, the Bombay Cotton Trade Association started future trading way back in
1875. This was the first organized futures market. Then Bombay Cotton Exchange Ltd. in 1893,
Gujarat Vyapari Mandall in 1900, Calcutta Hesstan Exchange Ltd. in 1919 had started future
market.
After the country attained independence, derivative market came through a full circle from
prohibition of all sorts of derivative trades to their recent reintroduction. In 1952, the government
of India banned cash settlement and options trading, derivatives trading shifted to informal
forwards markets. In recent years government policy has shifted in favour of an increased role at
market based pricing and less suspicious derivatives trading. The first step towards introduction
of financial derivatives trading in India was the promulgation at the securities laws
(Amendment) ordinance 1995. It provided for withdrawal at prohibition on options in securities.
The last decade, beginning the year 2000, saw lifting of ban of futures trading in many
commodities.
Derivatives trading, primarily the exchange traded variety started in India, in June 2000 with the
introduction of index futures trading on the Bombay Stock Exchange and the National Stock
Exchange. This was followed up in July 2001 by the introduction of index options, options on
individual securities and futures on individual securities on both NSE and BSE. Interest rate
futures trading were introduced on the NSE in June 2003 (Hull, 2010). Derivative is a financial
instrument where price of the instrument depends on the price of underlying asset. Concept of
derivative is comparatively new in India. Once insurance policy is being considered, quite
similarity is observed between insurance and derivative though insurance is not at all a derivative
instrument.
A very small percentage of Indian population actively invests in equity market. Facts presented
by the Minister of State for Finance to the Upper House of Parliament recently showed more
than half of the NSEs trading account in the Futures and Options segment was contributed by
just 169 PAN card identities of which 95 were propriety traders. During the time period
January2012-September 2012, NSEs top 25 trading members are accounted for about 47% of its
daily turnover on the cash market
Percentage (%) Number of investors
contributing to the total
turnover in cash segment
Number of investors
contributing to the total
turnover in Futures and
Options segment
50 638 169
60 1600 376
70 7026 1143
80 31430 5167
90 125283 29050
SEBI had launched currency derivatives in the form of currency futures in India in August 2008,
a month before the global financial crisis hit the world. The Reserve bank of INDIA allowed
trading of currency options in June 2010.
Initially, the currency futures were limited to rupee- dollar only, but later they were extended to
other pairs. RBI and SEBI jointly regulate these products. While RBI approves the products,
SEBI decides on the trading platforms.














JUSTIFICATION OF YOUR STUDY
To study the options trading in India. Its impact on Indian economy. Since options are being used
extensively all over the world we are trying to find out what are these options and how they
impact the economy.
LITERATURE REVIEW
In Grossmann (1976), Grossman provided some of the most influential insights into the role of
information in markets. He constructed a simple model of a market with a single risky asset and
traders who can be either uninformed or become informed by incurring some cost. He reasoned
that, in a perfect market with costly information, there must be noise so that agents can earn a
return on their investment in information gathering. Otherwise the market will break down
because it lacks both an equilibrium where agents earn a return on their information and one
where agents do not gather information.
In reality, markets are not characterized by perfect information and noise is an ever-present fact
in real-world financial exchanges. Recognizing this, in the 1970s finance research began asking
the question of which markets are the first choice of traders who are in the possession of new or
superior information. The results pointed away from spot, and toward derivatives exchanges.
Several studies documented the propensity of information traders not to trade on their
Progress
Date
Progress of Financial Derivatives
Feb. 2010

Launch of currency future on additional
currency pairs at NSE
Oct. 2010 Introduction of European style stock option at
NSE
Oct. 2010 Introduction of Currency options on USD INR
by NSE
30th March
2012
BSE launched trading in BRICSMART indices
derivatives
information in traditional stock markets. They are rather shown to take their business to options
and futures markets, since these markets offer larger absolute returns with lower capital
investment than the markets for the respective underlying. The major findings from these studies
are summarized in the following paragraphs. Manaster and Rendleman (1982) argued that in the
long run, the instrument providing the greatest liquidity paired with the lowest trading costs and
restrictions would be likely to play the predominant role in the markets determination of
equilibrium stock prices. To support their conjecture that options are such an instrument, they
argued that options entail relatively low trading costs compared to the underlying stocks. They
are furthermore not subject to an uptick rule for the purpose of short-selling, may enable
investors to reinvest the proceeds from such transactions, and come with lower margin
requirements due to the higher leverage for a given investment amount.
In their empirical analysis, they calculated Black/Scholes-implied stock prices from option
prices, using option price data from the CRSP tapes from April 26, 1973, to June 30, 1976, and
weekly interest rate data from 91-day Treasury Bills. If options were priced according to the
Black/Scholes model, these implied stock prices would be the option markets assessment of
equilibrium stock values. They found that the difference between the implied and the observed
stock prices (on day t) was positively related to returns on the stock on the following day (t 1).
Furthermore, the y could reject the hypothesis that the previous days (t _ 1) implied stock prices
contained no information concerning the following days (t 1) return at the 1%-level. In their
own words, there did appear to be evidence that closing option prices contained information
that was not reflected in stock prices for a period of up to 24 h. Chern et al. (2008) used an
event study approach of stock split announcements to compare stocks that were the underlying of
an option (optioned stocks) to stocks that had no such accompanying option. They found a
significantly greater anticipation of stock split announcements for optioned than for non-
optioned stocks at the NYSE, AMEX and NASDAQ exchanges, conditional on there having
been significant evidence of an anticipation of a particular stock split. They also reported a
significantly smaller price reaction on the announcement day and on the following day for
optioned NYSE and AMEX stocks. Taken together, this evidence supported their hypothesis that
the announcement of a stock split conveys less new information in the case of optioned stocks
than for non-optioned stocks, and that the former adjust more quickly to this information than the
latter. Figlewski and Webb (1993) echoed the arguments of Manaster and Rendleman (1982) in
reasoning that option markets give traders who cannot or will not engage in short sales (e.g., due
to transaction costs) an opportunity to sell short indirectly. They argued that the option market
maker who is the counterparty of such a transaction will usually hedge by performing a short sale
herself, subject to lower transaction costs and fewer constraints. Starting from this assumed
mechanism, the authors conjectured that the existence of options should be positively related to
the average level of short interest. They tested this hypothesis empirically using a sample of 342
stocks with uninterrupted data from 1969 to 1985 from the Standard & Poors 500 index (S&P
500), taken from the CRSP tapes. The results show that relative short interest was significantly
higher for stocks that had traded options than for those without, in each year of the sample.
Jennings and Starks (1986) examined quarterly earnings announcements from NYSE-listed
stocks of the S&P 500 from June 15 to August 21, 1981, and from October 4 to December 31,
1982, to find what effect the trading of options on a stock had on the price impact of earnings
announcements. They found that the prices of non-option companies took longer to adjust
following earnings announcements than that of companies which were the underlying of option
trading, supporting the notion that the latter were more efficient. Skinner (1990) arrived at
similar results when he found that optioned stocks at the Chicago Board Options Exchange
(CBOE) and the American Stock Exchange (AMEX) were being followed by a larger number of
analysts than stocks without options written on them. He took that as an explanation for his
second finding, namely that the stock price reaction upon the release of accounting earnings
information for newly optioned stocks, as compared to levels prior to options being written on
their shares, declined both in absolute terms and conditional on unexpected earnings, with
significance at the 1%-level. Easley et al. (1998) showed that option volumes led stock price
changes and carried information about future stock price changes, an interdependence that was
later complemented by the results of Jayaraman et al. (2001). The latter reported that, for their
sample period of 19861996, the CBOE led equity markets in terms of volume. Pan and
Poteshman (2003) came to the same conclusion and reported that the effect was particularly
evident for small stocks (which can generally be assumed to be less informational efficient) and
remained consistent at the annual level over a period of 12 years. Lee and Yi (2001) found that
informed traders preferred trading on the CBOE to trading on the NYSE, but not for all volumes.
They calculated that large-volume informed trades were more frequent at the NYSE and argued
that the reason for this observation may have been that large trades at the CBOE tended not to be
anonymous, while they were more so at the NYSE. They argued that, since market makers at the
CBOE could distinguish between informed and uninformed traders for larger orders, they
increased the spread for informed traders, thus making the CBOE less attractive for such large
informed orders. Furthermore, their results suggested that informed investors were attracted to
options with lower option deltas, i.e., larger leverage. Chakravarty et al. (2004) focused on a
slightly different aspect of the topic and argued that informed insiders sometimes trade in option
markets, a conjecture that they arrived at after reviewing insider trading convictions in option
markets. They employed an approach first applied by Hasbrouck (1995), which allowed them to
measure directly the share of price discovery across 60 stocks listed at the NYSE that possessed
options exclusively at the CBOE over a period from 1988 to 1992. With this method, they
calculated implied stock prices from call option prices and compared them to actual prices in the
stock market. The results showed that an average of between 17% and 18% of the price
discovery occurred in the option market, with estimates for individual stocks ranging from close
to 1223% numbers that they found to be significantly different from zero at the 1%-level.
They also observed that the information share of out-of-the-money options seemed to be higher
than for in- or at-the-money options, and that option market price discovery appeared to be an
increasing function of volume evidence that is consistent with informed traders who value both
leverage and liquidity. Schlag and Stoll (2005) broadened the research focus by analyzing both
options and futures, again finding that (signed) options and futures volumes had a
contemporaneous effect on the DAX price index in 1998. They investigated the source of price
discovery in this market and found that futures traders possessed information about the index that
was not reflected in the quotes, while the price effect of signed options volumes was largely
temporary, which points to a liquidity (as opposed to an information-based) explanation.
Interestingly, they also reported that signed futures volume led signed options volume. In an
earlier article that focused only on futures markets, Cox (1976) developed a model to relate the
effect of organized futures trading on spot market prices. Applying it to data from six different
commodities over the years 19281971, he found evidence for more informed traders and a
disappearance of spot price autocorrelation during periods of futures trading. Cao (1999)
proposed a model which implied that the introduction of options caused an increase in the prices
of the underlying asset and the market index, decreased the price response of the asset upon new
public information, and increased the number of analysts following the underlying asset
(consistent with Skinner (1990)). His empirical evidence backed up the predictions of the model,
supporting his hypothesis that the installation of an options market induced investors to acquire
more precise information, because it gave them additional opportunities to profit from trading on
it.

A CRITICAL MISSING LINK
While options trading is found in most developed commodity markets and many more are yet to
offer such an instrument, the use of commodity contracts with features of options is not a modern
development. In ancient times, transactions contracts with embedded option features were
important for commerce and not uncommon. Because trading on samples was common in
medieval goods markets, an agreement for a future sale would typically have a provision that
would permit the purchaser to refuse delivery if the delivered goods were found to be of
inadequate quality when compared with the original sample. Evidence of the use of option
contracts in ancient times appears during the Greek civilization. Present-day options trading on
the floor of an exchange began in April 1973 when the Chicago Board of Trade (CBOT) created
the Chicago Board Options Exchange (CBOE) for trading only options on a few New York
Stock Exchange-listed equities. Options on futures contracts were introduced at the CBOT in
October 1982, when the exchange began trading options on U.S. Treasury Bond futures. In the
same year, options trading on gold futures and sugar futures commenced on exchanges in the
U.S. Over the years, trading in commodity options has spread both across sectors and across
geographies. By 2012, trading in commodity options is found on about 20 commodity exchanges
across the globe that includes exchanges from developing nations of Africa and South America.
Exchange-traded commodity derivative futures were re-started only in the early 2000s after a
hiatus of about four decades, do not allow trading in commodity options. As a result, commodity
stakeholders, especially the risk-averse, and the Indian economy as a whole are bereft of many
spill-over benefits of commodity options trading.
COMMODITY OPTIONS: A RISK MANAGEMENT TOOL, ESPECIALLY FOR RISK-
AVERSE STAKEHOLDERS:
Commodity option, a financial derivative contract, is better suited for risk-averse groups like
farmers and SMEs as there is limited and known downside risk and there are no margin calls for
buying options. It is a cost-effective tool, which smaller players like SMEs and farmers would be
more comfortable with, with their risk management strategies. Apart from the certainty in
economic operations, deployment of risk management strategies by economic agents also helps
in reducing their risk perception among lending institutions, that is banks, leading to larger credit
flow. Additionally, availability of options creates opportunities for banks and other facilitating
financial market agents to offer new, innovative, and customized risk management products that
suit the specific hedging requirements of commodity players. Such growth-promoting, self-
reinforcing factors affect SMEs, and significant positive outcomes await the farming sector in
higher incomes, exports, employment generation, and growth of the overall economy.
MSP MODEL IN INDIA AKIN TO AN OPTIONS CONTRACT
In India the government procures mainly wheat and rice at the minimum support price (MSP),
which, willy-nilly, acts as an option contract for farmers. Although MSP has great significance in
protecting a farmers interest (indirect price risk management), it is also a big burden on the
governments finances. The Food Corporation of Indias open-ended purchase puts undue
pressure on food subsidy, which is expected to touch `1,30,000 crores in 2013-14, as against
`81,798 crores incurred in 201213 (as on January 11, 2013).This burden can be greatly reduced
if a market-oriented approach through exchange-traded instruments is used to replicate the MSP
model. For example, X suggests that an appropriate use of exchange-traded options can replicate
the governments minimum-support-price mechanism for wheat at a saving between $35 and
$151 per tonne, depending on the structure and ambition of the scheme.
OPTION CONTRACTS: MUCH MORE THAN JUST PRICE RISK MANAGEMENT
Effectiveness of the use of options for hedging has been well documented and empirically
proven in various studies over the years. Many studies also bring out the fact that, in addition to
options being just used as a tool for price risk management, the presence of active commodity
options trading in an economy brings about a lot of other benefitsserving not only the market
participants but also the economy at large. A few of the benefits are:
Improved information transmission. Smaller transaction cost and similarity to pure insurance
products of options attract vast and diverse participation, including small participants. As a
result, options assumes a leading and critical role for a robust price discovery and information
transmission between derivatives and underlying markets. This is corroborated by Chan and
Lein. Their study, covering a number of currency markets, reveals that each market maintains
some distinct characteristics after the introduction of options; nevertheless, these markets exhibit
a common pattern: after the introduction of options, the instantaneous feedback between spot and
futures markets improve drastically.
Hedging production risk. While commodity price risks, especially in the agricultural sector,
can be hedged using futures contracts, the quantum of exposure that requires to be hedged
sometimes becomes difficult to quantify, given the agricultural yield risks. Options have been
found to offer a solution. Apart from managing price risks, the presence of options helps craft a
hedging strategy that manages production risks too. Simulation results by Sakong, et al. on
maximizing expected utility functions establish the superiority of a hedging strategy that hedges
the minimum expected yield on the futures market, and hedges the remaining expected
production against downside price risk using put options. Their results are strengthened if risk
aversion is higher at low incomes, which is what one actually finds in a developing economy like
India.
Complementing futures trading. While futures contract can enable price risk management; the
combination of futures and options contracts can add to the effectiveness of the combined
derivatives position. The combined derivatives position can take advantage of various scenarios,
given the difference in the pay-offs of futures (linear) and options contracts (non-linear).
Vercammen demonstrated that using options in conjunction with futures allows the hedge to
reduce variability in the distribution of returns while maintaining an open position. On similar
lines, Lien and Wong showed that in scenarios where there are two distinct sources of
uncertainty, hedgers require at least two different hedging instruments (that is, options in
addition to futures contract) to meet their hedging needs.
Improved market liquidity leads to associated benefits. With increased market liquidity,
commodity options also brings in various associated benefits upon market participants, such as
lower impact cost, improved market stability, reduced volatility, improved price discovery,
reduced risk of market cornering, and so on. Shastri, Sultan, and Tandon in their study on the
effect of introducing foreign currency options and options on foreign currency futures on the
underlying currencies found that the volatility of exchange rates decreases following the listing
of options for a majority of the currencies. Further, the increase in derivatives trading volume
after the introduction of options is consistent with the notion that derivatives are important
innovations for stabilizing and increasing liquidity in the market for the underlying assets. On a
broader note, Camerer inferred that an organized exchange-traded commodity options market
could attract many more participants than a private firm market. The research further stressed
that commodity options not only allow farmers to hedge production risks, but also reflect the
quick dissemination of information in their prices. Finally, it can be concluded that exchange
trading of commodity options bring in large social benefits as they dramatically reduce ignorance
about commodity markets.
Commodity options: More accessible, more inclusive
Given the above socio-economic benefits to the economy at large, besides serving market
participants (including government agencies), the commencement of commodity options trading
in India is highly desirable. It will be pertinent to note that even China, whose tightly regulated
commodity derivatives market has evolved alongside Indias, is demonstrably contemplating to
allow commodity options trading. The immediate need therefore is to amend the Forward
Contracts (Regulation) Act or FCRA, 1952, and enable commodity options trading along with
the existing commodity futures trading. The broadened commodity derivatives market will not
only make the market more accessible to commodity stakeholders, especially the small players,
but will also bring about a more inclusive development of the commodity economy.
BINARY TRADING
India is one of the emerging economies in todays world with its growing manufacturing and service
industries. Binary options trading has also been welcome into the Indian community, helping Indians trade
on domestic assets as well as assets from across the globe. With India being a prime growth economy, there
are a number of individuals residing in India who see trading binary options as an accessible and easy way
to earn sizeable profits.
There are three primary reasons for the growing popularity of binary options in India. This includes the
rising usage of smartphones and online technology across the country, the growing interest of the financial
markets amongst Indians and the number of Indian assets that are available on binary trading platforms such
as many online service providers.
The Rise in Smartphone & Online Access
India has become one of the global leaders of technological advancements. Indians have grown a foothold
in providing information technology (IT) services to a range of Westernized countries. In doing so, they
have enabled their country to gain access to the online world. Binary trading has grown in popularity as
many Indians now have access to the internet through their mobile devices or personal computers. Whats
interesting about this rise in usage is that much of this is still untapped. As of 2012, India had the 3rd largest
number of internet users worldwide after China and the US. However, this only represents 11.4% of Indias
overall population. Right now, the growth in internet usage in India is rising at an exponential rate on a daily
basis as networks are expanding and the price of mobile devices becomes more affordable. This creates a
situation where there are major opportunities for Indian traders to access binary options through their
newfound online usage. Not only can they gain access to information quickly online to perform their trades,
traders can also take action through the use of online binary trading platforms and mobile apps.
A Rising Interest in the Financial Markets
As Indias domestic economy continues to contribute more to the global economy, many Indian consumers
are becoming more interested in the stock market. Since a number of Indians are learning more about their
primary sectors such as manufacturing and IT through their day-to-day work, they are dabbling with
trades. This presents opportunities for binary trading as they can trade on stocks and indices from India or
other global markets but also manage their risk easily online. They can also trade on assets across a range of
categories as well as in markets outside of India since these are available through the online platform.
The Accessibility of Indian Stocks and Indices for Binary Trading
On the OSP platform, all of our traders can place trades across a range of global assets, including the Indian
market. Our Indian traders find trading on domestic stocks and indices useful so they can make a prediction
on a stock or index they have local insight on. This local knowledge can help them to understand how the
asset will move upon expiration. Indian assets available include
SENSEX a stock market index that consists of 30 well-established and financially sound
companies that are listed on the Bombay Stock Exchange (BSE). These 30 firms represent the
largest and most actively traded stocks and span across a range of industries such as the financial
services, pharmaceutical and oil and gas sectors. The value of the SENSEX is said to provide a
good indication of the stability of the Indian economy overall.
Nifty 50 - the Nifty is a market index comprised of 50 major stocks, measured by market capital
status, that are traded on the National Stock Exchange of India (NSE). The index maintains 22
Indian economy sectors and provides the trading community with a single portfolio for all of
these markets. The index includes companies that represent an overall picture of Indias
developing economy.
Reliance Industries Limited (RIL) - an Indian conglomerate company that operates three primary
business segments petrochemicals, refining and oil and gas. As a company, it also has other
diversified divisions related to textiles, telecommunications and retail.
Tata Motors a multinational automotive company who has grown to become one of the largest
motor vehicle manufacturers in the world by volume. The organization is a member of the Tata
Group, which currently manages a range of businesses across India. The company expanded its
operations into production of commercial vehicles in 1954 when it formed a joint venture with
Daimler-Benz AG of Germany.
Tata Steel - a multinational steel company that can trace its roots back to 1907, it is one of
Indias largest companies. Headquartered in Mumbai, India and a subsidiary of the Tata Group,
it is the 10th largest steel-producing company in the world.
Whether you are based in India or have an understanding of the Indian market, binary trading continues to
be a growth area for the Indian trading community. As India continues to expand its influence in todays
global economy, there is no doubt that the popularity of binary trading in India will continue to grow as
traders seek to improve their profit potential.

Traders are always trying to understand the factors that cause the market to rise and fall. The
truth is that there are a multitude of factors, and millions of investors make decisions that impact
the market every day. Corporate earnings and news, political news, and general market sentiment
can all move the market. But economic factors have the most influence on long-term market
performance.

There is a lot of economic data available on the US economy, and almost every day some
economic report or another is being released. When reading these releases I always try to assess
the importance of each item and how it fits into the current economic situation. For the most
important reports, especially those that may impact an industry that contains companies you are
trading, it is often better to not rely solely on the analysis offered by financial journalists but to
look at and try to understand the original sources.

Of all the economic indicators, the three most significant for the overall stock market are
inflation, gross domestic product (GDP), and labor market data. I always try to keep in mind
where these three are in relation to the current stage of the economic cycle. That gives me a
framework to work with that allows me to estimate how any individual piece of economic data
may affect these three indicators, and to then project its probable effect on the stock market as a
whole.

INFLATION

Inflation is a significant indicator for securities markets because it determines how much of the
real value of an investment is being lost, and the rate of return you need to compensate for that
erosion. For example, if inflation is at 3% this year, and your investment also increases by 3%, in
real terms you have just managed to stay even. And to take on market risk, you should receive a
risk premium above and beyond the inflation rate. So investors who buy stocks do so
expecting they will get a return equal to (or better than) that risk premium adjusted by the
inflation rate. So a higher rate of inflation means you should get a higher return for investments
in the equity markets.

But the effect inflation has on the stock market is more complicated than that. The main impact
of inflation on stock prices actually comes from the effect it has on a companys earnings. Low
inflation keeps a companys costs down, and increases profits. So all other things being equal, (a
favorite phrase of all economists), low inflation is better for the market than high inflation.

There are many causes of inflation. From a supply-demand standpoint, it can be due to increased
demand for a particular product, from an increase in a companys cost of supplies, or from
limited supplies (like OPEC members restricting oil supplies), or even just due to fear that
supplies might be limited at some point in the future. But the single most important determinant
of inflation is the output gap, which is the balance between supply and demand in the economy.

The output gap measures the difference between the economys potential, where all capital and
labor resources are in use, and the actual level of output. When actual output is below its
potential, inflation should be low because excess workers and unused plant and equipment are
available. The actual level of output is easy to get, and is measured by GDP. But potential output
is harder to calculate and requires estimates to determine its value. So while the output gap is
important to always keep in mind when interpreting economic data, its exact amount is never
known. For that reason it is not a realistic indicator for investors to use. That is why a proxy is
needed, so that you have a single number to estimate it. In the US it is the Consumer Price Index
(CPI) that is the most widely followed measure of inflation.

The Labor Department issues a CPI figure every month, measuring the increase in the price of a
given "basket" of goods and services purchased by the average consumer. That basket
supposedly includes a number of items commonly purchased by all or most consumers, such as
food, housing, clothes, transportation, medical care, and entertainment. The total value of that
basket is then compared to the same basket of goods a year later. The percentage increase in the
price for these goods in one year is the inflation rate or, if the value drops as happened in Japan
over much of the past decade, the deflation rate. That gives you a measured percentage such as
3%, which means that the basic necessities of life cost 3% more today than they did last year.

There are of course some problems with this measure. For one thing, the products rarely remain
exactly the same, and it can be difficult to strip out how much of an increase is due to inflation,
and how much is due to other factors such as improvements in quality. Also, the composition of
what people buy changes over time. In fact, many of the goods now included were not even
invented 20 or 30 years ago. Still remains the single best proxy available and, at least in the
short- to medium-term, is the number that investors focus on when making their decisions.

GROSS DOMESTIC PRODUCT (GDP)

While GDP is an important component in inflation, it is also important as an economic indicator
in its own right. When compared to the previous years reading, it tells you how fast the
economy is growing (or contracting). GDP is the dollar value of all goods and services produced
by a given country during a certain period. It is measured by either adding all of the income
earned in an economy, or by all the spending in an economy. Both measures should be roughly
equal.

Gross domestic income includes wages and salaries, corporate profits, interest collected by
lenders, and taxes collected by governments. GDP domestic expenditures includes consumer
spending, housing investment, government spending, business spending (investment in factories,
equipment, and inventory), as well as foreign spending on our exports minus our spending on
their imports. With so many individual components affecting GDP (and through the output gap,
inflation) you can see how easy it is for the number of economic reports to mushroom.

GDP affects the stock market through its effect on inflation, as well as through its use as a key
indicator of economic activity and future economic prospects by investors. Any significant
change in the GDP, either up or down, can have a big effect on investing sentiment. If investors
believe the economy is improving (and corporate earnings along with it) they are likely to be
willing to pay more for any given stock. If there is a decline in GDP (or investors expect a
decline) they would only be willing to buy a given stock for less, leading to a decline in the stock
market.

On top of this effect, there is also an economic theory that suggests the stock market itself exerts
a reverse effect on economic activity, usually called the wealth effect. This theory says that a
fall in the stock market makes an individuals personal wealth (or perceived wealth) fall. They
consequently stop spending as much. Since consumer spending represents around two-thirds of
GDP, a small change in consumption exerts a significant effect on GDP. This means that as the
stock market falls, it causes GDP to fall even further, which further intensifies the downward
pressure on the stock market.

THE LABOR MARKET

The last major factor influencing the economy is the labor market. The key indicators most
investors focus on here are total employment and the unemployment rate. US citizens who are
already working represent the employed, while those who are actively looking for work, but
havent found it yet, are the unemployed. The unemployment rate does not include people
without jobs who are not looking for jobs, such as students, retirees, or people who are
discouraged and have simply given up trying to find a job.

The Employment Report is published monthly by the US Department of Labor, and provides
both the employment and unemployment numbers. There is always some unemployment. As the
allocation of resources change in the economy, based on what people are buying, some
companies go out of business while others that produce the things that are in demand will be
expanding. This allows a flow of labor from losing to winning industries but it is not an
instantaneous process. Others may leave their jobs by choice. That means there is always some
amount of unemployment built into the economic structure, which is often termed the natural
level of unemployment.

The natural level of unemployment is the point where any drop below that figure creates
conditions that will drive up inflation (as companies bid up wages to attract the scarce
workers). There is always some disagreement as to what the natural level of unemployment is
for the US economy. For one thing, it changes over time as the nature of the economy
changes. For most of the 1980s, it was often estimated at about 6%, although most economists
now feel it is probably around 5%, or even the high 4s.

What might cause this kind of change? A paper a couple years ago from the Brookings Institute
cited some factors that they estimated have reduced the natural rate by about 1%. Accounting for
about 0.4% of that is the aging of the population; older people tend to be more fully
employed. The growth of temporary staffing firms that rapidly match job-seekers with employers
could account for 0.2-0.4%. Finally, the doubling of the prison population probably accounts for
about 0.2% of the reduction, by removing from the labor force people who are less likely to be
employed.

CONCLUSION: PUTTING IT ALL TOGETHER

There are many components that are used to calculate each of the major economic indicators, and
rarely all point in the same direction. To make it even more complicated, each of these indicators
are closely linked with one another. That is what makes it difficult to interpret what impact any
individual economic report is likely to have on the stock market. To make things even more
difficult, whether a certain reading is good or bad can also depend on what part of the economic
cycle the economy is currently at.

There are many institutions and safeguards within an economy that are designed to mitigate or
increase any of these effects that you also need to take into account. Their probable reaction to
news and events must be factored into any predictions for the future behavior of the
economy. Monetary policy and fiscal policy are the two primary ways that the government
influences the economy. Following the actions of the Federal Reserve, analyzing the comments
made by its members (particularly the Chairman), and trying to predict what their future moves
will be keep many economists employed. And actions taken by the Federal Open Market
Committee often do move the stock market.

The economic evidence right now seems to indicate that the current output gap is still large
enough to allow for additional expansion without increasing the rate of inflation. Therefore
reports showing an increase in GDP, or unemployment decreasing, are good news and the market
should go up. Any report that shows inflation is higher than expected is bad, because it may
indicate that we are overestimating the size of the output gap, and that should cause the stock
market to drop. But in a later stage of the economic cycle, when the output gap is smaller or non-
existent, those same news items could have the opposite effect on the stock market.

Lets work through one last example and explain the chain of reasoning that can lead to what
may seem, on the surface, a counterintuitive result. Consider how a report that unemployment is
low might be bad for the stock market. When labor market data shows that the unemployment
rate is low, the stock market is usually expected to go up. Since more people are employed,
consumer spending will increase, which leads to an increase in GDP. But as mentioned earlier, if
the output gap is small or nonexistent an increase in GDP means the output gap will decrease
even more which means the economy stands a greater risk of inflation. And inflation is bad for
the stock market so it goes down on what would normally be considered good news.

Inflation, GDP, and employment data all exert a significant influence on the stock market. All
three are closely interrelated and a change in any single factor can have a significant trickle-
down effect. And since interpretation is as much an art as science, it can also be helpful to try
and look at the original source reports on occasion, if only to see what the headlines, business
articles, and pundits may be leaving out.