A

PROJECT REPORT

ON

“INDIAN CAPITAL AND TRADING TECHNIQUES”

AT

PRUDENT BROKING CORPORATE LIMLITED

(A project submitted in the partial fulfilment of the requirement for the

degree of Post Graduate of Diploma in Management(PGDM))

SUBMITTED BY

DANDAPATI DHARMARAJU

Regd No:-B31820765

USBM,BHUBANESWAR

Guided By:-

INTERAL GUIDE :- EXTERNAL GUIDE :-

Mrs.SMITA DAS Mr.RAJENDRA DANG

FACULITY IN FINANCE USBM DGM FINANCE,PRUDENT

1
 UNITED SCHOOL OF BUSINESS MANAGEMENT,BHUBANESAR

ORGANIZATION CERTIFICATE

This is to certify that DANDAPATI DHARMARAJU student of SCHOL OF

BUSINESS MANAGEMENT,BHUBANESWAR has carried out his project Titled
" INDIAN CAPITAL AND TRADING TECHNIQUES " on PRUDENT for partial
fulfilment of the requirement for the award of POST GRADUATE DEPLOMA
MANAGEMENT at BHUBANESWAR. I also certify the matter embedded in
this project is original and has not submitted for the award of any other
degree.

I wish his professional success in the future.

Date: Mr.Rajendra Dang

Place:Bhubaneswar D.G.M (Finance),PRUDENT

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 DECLARATION
I do here by declare that the factor of findings presented in this
study entitled “INDIAN CAPITAL MAKET AND TRADING
TECHNIQUES” in PRUDENT CORPORATE LIMITED is a report of
independent work submitted by me under the guidance of Mr
Smita Das (Lecture ,USBM College , Bhubaneswar). This report
has not previously submitted by anyone to be awarded with any
degree for any other certificate purpose.

This project has been prepaired on the

basis of collected data from my field work and secondary source
and materials embodied in it are not borrowed from any other
sources without due acknowledgement.

Place: Dandapati Dharmaraju

Date: Student of PGDM(Fiinance),USBM

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 ACKNOWLEDGEMENT

I express my gratitude to the management of PRUDENT BROKING

CORPRATE LIMITED for kindly allowing me to do this project on financing in
PRUDENT.
I express my gratitude to this institute of UNITED SCHOOL OF BUSINESS
MANAGEMENT for allowing me to undertake this summer training in
PRUDENT.
As a part of my curriculum my training during the project work in PRUDENT
was a nice experience as I learn a lot new things.
me to complete the project,

I am very thankful to Mr. RAJENDRA DANG D.G.M (FINANCE),PRUDENT Ltd.

Who has guided me during the entire period of training. They provided me a
lot of data materials and information related to the topic which helped I am
also thankful to the staff of PRUDENT and other persons of PRUDENT for this
cooperation.

DANDAPATI DHARMARAJU
Regd No:- B31820765

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 PREFACE

This project has been prepared in partial fulfilment of the requirement for the
subject: The summer internship program on the topic "INDIAN CAPITAL AND
TRADING TECHNIQUES" on PRUDENT in PGDM during year 2018-2020.
For preparing the project report, I have completed my internship from
PRUDENT under MR.RAJENDRA DANG, during the suggested duration for the
period of 45 days to enhance my knowledge. The blend of learning and
knowledge acquired during my summer
internship at he company is presented in this project report.
The rationale behind doing summer internship and preparing project report is
INDIAN CAPITAL AND TRADING TECHNIQUES, what is company, what is capital
market, why it is necessary for a company, and how does it help its investors
for taking investing decision.

5
TABLE CONTANTS page
1.1Financial markets 7

1.2Capital market and money market 9

1.3Corporate security 11

1.4 Debt instrument 11

1.5 Debentures/Bonds 12

1.6 Derivatives 17

*Derivatives product 18

*index derivatives 22

1.7Commodity derivates 25

2. fundamental analysis

*introduction of fundamental analysis 29

*Stock market capitalization GDP ratio 31

*Analyzing India using Maslow’s hierarchy of needs 37

* Correlation between Sensex and Nifty 38
3. Technical Analysis
*Introduction to Technical Analysis 40
*Key Technical Indicators 42
4.Trading strategy 48
5.conclusion 50

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Financial markets

Financial market is a market where financial instruments are exchanged or traded and helps in
determining the prices of the assets that are traded in and is also called the price discovery process.

1. Organizations that facilitate the trade in financial products. For e.g. Stock exchanges (NYSE,
Nasdaq) facilitate the trade in stocks, bonds and warrants.

2. Coming together of buyer and sellers at a common platform to trade financial products is
termed as financial markets, i.e. stocks and shares are traded between buyers and sellers in a
number of ways including: the use of stock exchanges; directly between buyers and sellers etc.

Financial markets may be classified on the basis of

• types of claims – debt and equity markets

• maturity – money market and capital market
• trade – spot market and delivery market
• deals in financial claims – primary market and secondary market

Indian Financial Market consists of the following markets:

• Capital Market/ Securities Market o Primary capital market o Secondary capital market
• Money Market
• Debt Market

Primary capital market- A market where new securities are bought and sold for the first time

Types of issues in Primary market

• Initial public offer (IPO) (in case of an unlisted company),

• Follow-on public offer (FPO),
• Rights offer such that securities are offered to existing shareholders,
• Preferential issue/ bonus issue/ QIB placement
• Composite issue, that is, mixture of a rights and public offer, or offer for sale (offer of
securities by existing shareholders to the public for subscription).

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 Difference between

Primary market Secondary market

Deals with new securities Market for existing securities, which are
already listed
Provides additional to issuer No additional capital generated. Provides
capital companies liquidity to existing stock

Leading stock exchanges:

• Bombay Stock Exchange Limited o Oldest in Asia

o Presence in 417 cities and towns in India o Trading in
equity, debt instrument and derivatives

• National Stock Exchange

• New York Stock Exchange NYSE)
• NASDAQ
• London Stock Exchange

Functions of Stock Exchanges

• Liquidity and marketability of securities
• Fair price determination
• Source of long-tern funds
• Helps in capital formation
• Reflects general state of economy

Basics of Stock Market Indices:

A stock market index is the reflection of the market as a whole. It is a representative of the entire
stock market. Movements in the index represent the average returns obtained by the investors.
Stock market index is sensitive to the news of:
• Company specific
• Country specific
Thus the movement in the stock index is also the reflection of the expectation of the future
performance of the companies listed on the exchange

Index Calculation:
Step 1: Calculate the weightage of each scrip

Weightage = (Mcapit / total market cap)*100

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Step 2: Value of index n

∑ {Mcapit * Weightit}/ Wb

I=1

Where;

Mcapit = market cap of scrip “i” at time “t”

= price of the share * number of outstanding shares

Wb = Sum of all the market cap of all the scrips in the index during the base year

Settlement cycles:

Settlement is the process whereby the trader who has made purchases of scrip makes payment and
the seller selling the scrip delivers the securities. This settlement process is carried out by Clearing
Houses for the stock exchanges. The Clearing House acts like an intermediary in every transaction
and acts as a seller to all buyers and buyer to all sellers.

Capital market and money market:

Financial markets can broadly be divided into money and capital market.

Money Market: Money market is a market for debt securities that pay off in the short term usually
less than one year, for example the market for 90-days treasury bills. This market encompasses the
trading and issuance of short term non equity debt instruments including treasury bills, commercial
papers, bankers acceptance, certificates of deposits, etc.

Capital Market: Capital market is a market for long-term debt and equity shares. In this market, the
capital funds comprising of both equity and debt are issued and traded. This also includes private
placement sources of debt and equity as well as organized markets like stock exchanges. Capital
market includes financial instruments with more than one year maturity

Significance of Capital Markets

A well functioning stock market may help the development process in an economy through the
following channels:

1. Growth of savings,
2. Efficient allocation of investment resources,

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 3. Better utilization of the existing resources.

In market economy like India, financial market institutions provide the avenue by which long-term
savings are mobilized and channelled into investments. Confidence of the investors in the market is
imperative for the growth and development of the market. For any stock market, the market
Indices is the barometer of its performance and reflects the prevailing sentiments of the entire
economy. Stock index is created to provide investors with the information regarding the average
share price in the stock market. The ups and downs in the index represent the movement of the
equity market. These indices need to represent the return obtained by typical portfolios in the
country.

Generally, the stock price of any company is vulnerable to three types of news:

• Company specific
• Industry specific
• Economy specific

An all share index includes stocks from all the sectors of the economy and thus cancels out the stock
and sector specific news and events that affect stock prices, (law of portfolio diversification) and
reflect the overall performance of the company/equity market and the news affecting it.

The most important use of an equity market index is as a benchmark for a portfolio of stocks. All
diversified portfolios, belonging either to retail investors or mutual funds, use the common stock
index as a yardstick for their returns. Indices are useful in modern financial application of
derivatives.

Capital Market Instruments – some of the capital market instruments are:

• Equity
• Preference shares
• Debenture/ Bonds
• ADRs/ GDRs
• Derivatives

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Corporate securities

Shares
The total capital of a company may be divided into small units called shares. For example, if the
required capital of a company is US $5,00,000 and is divided into 50,000 units of US $10 each, each
unit is called a share of face value US $10. A share may be of any face value depending upon the
capital required and the number of shares into which it is divided. The holders of the shares are
called share holders. The shares can be purchased or sold only in integral multiples.

Equity shares signify ownership in a corporation and represent claim over the financial assets and
earnings of the corporation. Shareholders enjoy voting rights and the right to receive dividends;
however in case of liquidation they will receive residuals, after all the creditors of the company are
settled in full. A company may invite investors to subscribe for the shares by the way of:
• Public issue through prospectus
• Tender/ book building process
• Offer for sale
• Placement method
• Rights issue

Stocks
The word stock refers to the old English law tradition where a share in the capital of the company
was not divided into “shares” of fixed denomination but was issued as one chunk. This concept is no
more prevalent, but the word “stock” continues. The word “joint stock companies” also refers to
this tradition.

Debt Instruments

A contractual arrangement in which the issuer agrees to pay interest and repay the borrowed
amount after a specified period of time is a debt instrument. Certain features common to all debt
instruments are:
• Maturity – the number of years over which the issuer agrees to meet the contractual
obligations is the term to maturity. Debt instruments are classified on the basis of the time
remaining to maturity
• Par value – the face value or principal value of the debt instrument is called the par value.
• Coupon rate – agreed rate of interest that is paid periodically to the investor and is
calculated as a percentage of the face value. Some of the debt instruments may not have an
explicit coupon rate, for instance zero coupon bonds. These bonds are issued on discount
and redeemed at par. Thus the difference between the investor’s investment and return is
the interest earned. Coupon rates may be fixed for the term or may be variable.
• Call option – option available to the issuer, specified in the trust indenture, to ‘call in’ the
bonds and repay them at pre determined price before maturity. Call feature acts like a
ceiling f or payments. The issuer may call the bonds before the stated maturity as it may
recognize that the interest rates may fall below the coupon rate and redeeming the bonds
and replacing them with securities of lower coupon rates will be economically beneficial. It

11
 is the same as the prepayment option, where the borrower prepays before scheduled
payments or slated maturity o Some bonds are issued with ‘call protection feature, i.e they
would not be called for a specified period of time
o Similar to the call option of the issuer there is a put option for the investor, to sell the
securities back to the issuer at a predetermined price and date. The investor may
do so anticipating rise in the interest rates wherein the investor would liquidate the
funds and alternatively invest in place of higher interest
• Refunding provisions – in case where the issuer may not have cash to redeem the debt
instruments the issuer may issue new debt instrument and use the proceeds to repay the
securities or to exercise the call option.

Debt instruments may be of various kinds depending on the repayment:

• Bullet payment – instruments where the issuer agrees to repay the entire amount at the
maturity date, i.e lumpsum payment is called bullet payment
• Sinking fund payment – instruments where the issuer agrees to retire a specified portion of
the debt each year is called sinking fund requirement
• Amortization – instruments where there are scheduled principal repayments before
maturity date are called amortizing instruments

Debentures/ Bonds
The term Debenture is derived from the Latin word ‘debere’ which means ‘to owe a debt’. A
debenture is an acknowledgment of debt, taken either from the public or a particular source. A
debenture may be viewed as a loan, represented as marketable security. The word “bond” may be
used interchangeably with debentures.

Debt instruments with maturity more than 5 years are called ‘bonds’

Yields

Most common method of calculating the yields on debt instrument is the ‘yield to maturity’
method, the formula is as under:

YTM = coupon rate + prorated discount / (face value + purchase price)/2

Main differences between shares and debentures

• Share money forms a part of the capital of the company. The share holders are part
proprietors of the company, whereas debentures are mere debt, and debenture holders are
just creditors.
• Share holders get dividend only out of profits and in case of insufficient or no profits they
get nothing and debenture holders being creditors get guaranteed interest, as agreed,
whether the company makes profit or not.
• Share holders are paid after the debenture holders are paid their due first

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 • The dividend on shares depends upon the profit of the company but the interest on
debentures is very well fixed at the time of issue itself.
• Shares are not to be paid back by the company whereas debentures have to be paid back at
the end of a fixed period.
• In case the company is wound up, the share holders may lose a part or full of their capital
but he debenture holders invariably get back their investment.
• Investment in shares is riskier, as it represents residual interest in the company.
Debenture, being debt, is senior.

• Debentures are quite often secured, that is, a security interest is created on some assets to
back up debentures. There is no question of any security in case of shares.
• Share holders have a right to attend and vote at the meetings of the share holders whereas
debenture holders have no such rights.

Quasi debt instruments

Preference shares
Preference shares are different from ordinary equity shares. Preference share holders have the
following preferential rights

(i) The right to get a fixed rate of dividend before the payment of dividend to the equity
holders.
(ii) The right to get back their capital before the equity holders in case of winding up of the
company.

Eligibility norms for public issue: ICDR Regulations

IPO

Conditions for IPO: (all conditions listed below to be satisfied)

• Net tangible assets of 3 crore in each of the preceding 3 full years, of which not more than
50% are held in monetary assets:
• Track record of distributable profits for 3 out of the immediately preceding 5 years:
• Net worth of 1 crore in each of the preceding three full years;
• Issue size of proposed issue + all previous issues made in the same financial year does not
exceed 5 times its pre-issue net worth as per the audited balance sheet of the preceding
financial year;
• In case of change of name within the last one year, 50% of the revenue for the preceding 1
full year earned by it from the activity indicated by the new name.

If the issuer does not satisfy any of the condition listed above, issuer may make IPO by satisfying
the following:

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 1. Issue through book building subject
to allotment of 50% of net offer to
public to QIB failing which full
subscription monies to be refunded
• 15% of the cost of the project to
be contributed by SCB or PFI of
which not less than 10% from the
O appraisers + allotment of 10% of
R • the net offer to public to QIB
failing which full subscription
monies to be refunded

2. Minimum post-issue face value OR Issuer to provide market-making for 2 yrs

capital of the issuer is 10 crores from the date of listing of the specified
securities

• Promoters’ contribution:
o Cannot be less than 20% of the post issue capital
o Maximum not defined, but in view of the required minimum public offer as per Rule 19
(2) (b) of Securities Contracts Regulations, promoters contribution plus any firm
allotments cannot exceed 90% or 75% of the issue size as the case may be (see below).
• Minimum Public offer: By public offer is meant the securities being offered to public by
advertisement, exclusive of promoters’ contribution and firm allotments. o Rule 19(2)(b) of
the Securities Contracts (Regulations) Rules, 1957 requires that the minimum public offer
should be 25% of total issued securities should be offered to public through advertisement.
o However, a lower public offer of 10% is allowed if the following conditions are satisfied:
 The minimum public offer is Rs 100 crores ,and the number of securities being
offered to public is at least 20 lakh securities.
 The offer is made through mandatory book-building route, with minimum
allocation of 60% to QIBs.
• Firm allotment/ reservations: Subject to the minimum public offer norms, issuers are free
to make reservations on competitive basis (as defined hereinafter) and/or firm allotments
(as defined hereinafter) to various categories of persons for the remaining part of the issue
size.

Firm allotment: This implies allotment on a firm basis in public issues by an issuing company.
Specified Categories for Firm allotment in public issues can be made to the following:
1. Indian and Multilateral Development Financial Institutions
2. Indian Mutual Funds
3. Foreign Institutional Investors (including non resident Indians and overseas corporate
bodies)
4. Permanent / regular employees of the issuer company – maximum 10 % of total proposed
issue amount 5. Scheduled Banks
6. Lead Merchant Banker- subject to a ceiling of 5 % of the proposed issue.

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FPO

• Promoters’ contribution:
o In case of FPO, the promoters should ensure participation either to the extent of 20% of
the proposed issue or their post-issue share holding must be to the extent of 20% of the
post issue capital. Requirement to bring in contribution from promoters shall be
optional for a company listed on a stock exchange for
at least 3 years and having a track record of dividend payment of 3 years immediately
preceding the year of issue. o As for maximum promoters’ contribution, Rule 19 (2) (b)
stated above shall be applicable. o Participation by promoters in excess of above shall be
treated as preferential allotment, to which preferential allotment rules will be applicable.
As for preferential allotment rules, see Notes under sec. 81.

• Net Public offer:

o The minimum net public offer shall be as per Rule 19 (2) (b) – see above..
• Firm allotment / reservations:
o The issuer companies are free to make reservations on competitive basis (as defined
above) and/or firm allotments to various categories of persons enumerated above, for
the remaining issue size, that is, after considering promoters’ contribution and public
offer.. o The reservation on competitive basis may also be made for retail individual
shareholders (RIS). For meaning of the term RIS, see under ‘categories of investors’
below.

Composite Issue

• Promoters’ contribution:
o promoters have option to contribute either 20% of the proposed issue or 20% of post
issue capital
o the right issue component to be excluded while computing the post-issue capital
• Others:
o The right issue component to be offered to the existing shareholders o Except the
above, the rules of allotment under IPO as above shall apply

Qualified Institutional Placement

Another class of issue, not being a rights issue, which calls for resolution under sec. 81 (1A).

Condition for issue-

• The equity shares of the same class were listed on a stock exchange having nation-wide
trading terminals for a period of at least one year as on the date of issuance of notice for
issue of shares to QIBs
• The issue should not violate the prescribed minimum public shareholding requirements
specified by the listing agreement.

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Reservation
• Minimum of 10 percent of specified securities issued shall be allotted to mutual funds.
• In case the mutual funds do not agree to take shares issued under this chapter, such shares
may be allotted to other QIBs.
• However, no allotment shall be made under this chapter, either directly or indirectly, to any
QIB being a promoter or any person related to promoters.

Withdrawal of bid not permitted.- Investors shall not be allowed to withdraw their bids after the
closure of issue.

Number of allottees.-
• minimum number of allottees shall not be less than:
o Two, where the issue size is less than or equal to Rs. 250 crores; o Five,
where the issue size is greater than Rs. 250 crores. • No single allottee shall be
allotted more than 50% of the issue size.

Restrictions.-
• Amount raised through the proposed placement + all previous placements made in the
same financial year shall not exceed five times the net worth of the issuer as per the audited
balance sheet of the previous financial year.
• Lock-in-period of one year from the date of allotment, except when sold on a recognised
stock exchange.

Investments by Non- resident Investors

Provisions about investments by non-residents, non resident Indians, overseas bodies corporates
and other foreign investors are made by the RBI in pursuance of FEMA provisions. An overview is as
follows:

Foreign investment is freely permitted in almost all sectors in India. Under Foreign Direct
Investments (FDI) Scheme, investments can be made by non-residents in the shares / convertible
debentures of an Indian Company under two routes;

• Automatic Route; and

• Government Route.

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Derivatives
What are derivatives? A derivative picks a risk or volatility in a financial asset, transaction, market
rate, or contingency, and creates a product the value of which will change as per changes in the
underlying risk or volatility. The idea is that someone may either try to safeguard against such risk
(hedging), or someone may take the risk, or may engage in a trade on the derivative, based on the
view that they want to execute. The risk that a derivative intends to trade is called underlying.

A derivative is a financial instrument, whose value depends on the values of basic underlying
variable. In the sense, derivatives is a financial instrument that offers return based on the return of
some other underlying asset, i.e the return is derived from another instrument.
The best way will be take examples of uncertainties and the derivatives that can be structured
around the same.

• Stock prices are uncertain - Lot of forwards, options or futures contracts are based on
movements in prices of individual stocks or groups of stocks.

• Prices of commodities are uncertain - There are forwards, futures and options on
commodities.

• Interest rates are uncertain - There are interest rate swaps and futures.
• Foreign exchange rates are uncertain - There are exchange rate derivatives.
• Weather is uncertain - There are weather derivatives, and so on.

Derivative products initially emerged as a hedging device against fluctuations in commodity prices,
and commodity linked derivatives remained the sole form of such products for almost three
hundred years. It was primarily used by the farmers to protect themselves against fluctuations in
the price of their crops. From the time it was sown to the time it was ready for harvest, farmers
would face price uncertainties. Through the use of simple derivative products, it was possible for
the farmers to partially or fully transfer price risks by locking in asset prices.

From hedging devices, derivatives have grown as major trading tool. Traders may execute their
views on various underlyings by going long or short on derivatives of different types.

Financial derivatives:
Financial derivatives are financial instruments whose prices are derived from the prices of other
financial instruments. Although financial derivatives have existed for a considerable period of time,
they have become a major force in financial markets only since the early 1970s. In the class of
equity derivatives, futures and options on stock indices have gained more popularity than on
individual stocks, especially among institutional investors, who are major users of index-linked
derivatives.

17
Even small investors find these useful due to high correlation of the popular indices with various
portfolios and ease of use.

DERIVATIVES PRODUCTS
Some significant derivatives that are of interest to us are depicted in the accompanying graph:

Major types of derivatives

Derivative contracts have several variants. Depending upon the market in which they are
traded, derivatives are classified as 1) exchange traded and 2) over the counter.

The most common variants are forwards, futures, options and swaps.

Forwards:
A forward contract is a customized contract between two entities, where settlement takes place as
a specific date in the future at today’s predetermined price.
Ex: On 1st June, X enters into an agreement to buy 50 bales of cotton for 1st December at
Rs.1000 per bale from Y, a cotton dealer. It is a case of a forward contract where X has to pay
Rs.50000 on 1st December to Y and Y has to supply 50 bales of cotton.

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Options:
Options are of two types – call and put. Calls give the buyer the right but not the obligation
to buy a given quantity of the underlying asset, at a given price on or before a given future date.
Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset
at a given price on or before a given date.

Warrants:
Options generally have maturity period of three months, majority of options that are traded on
exchanges have maximum maturity of nine months. Longer-traded options are called warrants and
are generally traded over-the-counter.

Leaps:
The acronym LEAPS means Long-term Equity Anticipation Securities. These are options having a
maturity of up to three years.

Baskets:
Basket Options are currency-protected options and its return-profile is based on the average
performance of a pre-set basket of underlying assets. The basket can be interest rate, equity or
commodity related. A basket of options is made by purchasing different options. The payout is
therefore the addition of each individual option payout

Swaps:
Swaps are private agreement between two parties to exchange cash flows in the future according
to a pre-arranged formula. They can be regarded as portfolio of forward contracts. The two
commonly used Swaps are

i) Interest Rate Swaps: - A interest rate swap entails swapping only the interest
related cash flows between the parties in the same currency.
ii) Currency Swaps: - A currency swap is a foreign exchange agreement between two
parties to exchange a given amount of one currency for another and after a specified period
of time, to give back the original amount swapped.

FUTURES, FORWARDS AND OPTIONS

An option is different from futures in several ways. At practical level, the option buyer faces an
interesting situation. He pays for the options in full at the time it is purchased. After this, he only
has an upside. There is no possibility of the options position generating any further losses to him.
This is different from futures, where one is free to enter, but can generate huge losses. This
characteristic makes options attractive to many market participants who trade occasionally, who
cannot put in the time to closely monitor their futures position.

19
Buying put options is like buying insurance. To buy a put option on Nifty is to buy insurance which
reimburses the full amount to which Nifty drops below the strike price of the put option. This is
attractive to traders, and to mutual funds creating “guaranteed return products”.

FORWARDS
A forward contract is an agreement to buy or sell an asset on a specified date for a specified
price. One of the parties to the contract assumes a long position and agrees to buy the underlying
asset on a certain specified future date for a certain specified price. The other party assumes a short
position and agrees to sell the asset on the same date for the same price, other contract details like
delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The
forward contracts are normally traded outside the exchange.

The salient features of forward contracts are:

 They are bilateral contracts and hence exposed to counter-party risk
 Each contract is custom designed, and hence is unique in terms of contract size, expiration
date and the asset type and quality.
 The contract price is generally not available in public domain
 On the expiration date, the contract has to be settled by delivery of the asset, or net
settlement.

The forward markets face certain limitations such as:

 Lack of centralization of trading
 Illiquidity and
 Counterparty risk

FUTURES
Futures contract is a standardized transaction taking place on the futures exchange. Futures
market was designed to solve the problems that exist in forward market. A futures contract is an
agreement between two parties, to buy or sell an asset at a certain time in the future at a certain
price, but unlike forward contracts, the futures contracts are standardized and exchange traded To
facilitate liquidity in the futures contracts, the exchange specifies certain standard quantity and
quality of the underlying instrument that can be delivered, and a standard time for such a
settlement. Futures’ exchange has a division or subsidiary called a clearing house that performs the
specific responsibilities of paying and collecting daily gains and losses as well as guaranteeing

20
performance of one party to other. A futures' contract can be offset prior to maturity by entering
into an equal and opposite transaction. More than 99% of futures transactions are offset this way.

Yet another feature is that in a futures contract gains and losses on each party’s position is credited
or charged on a daily basis, this process is called daily settlement or marking to market. Any person
entering into a futures contract assumes a long or short position, by a small amount to the clearing
house called the margin money

The standardized items in a futures contract are:

 Quantity of the underlying
 Quality of the underlying
 The date and month of delivery
 The units of price quotation and minimum price change
 Location of settlement

FUTURES TERMINOLOGY
1. SPOT PRICE: The price at which an asset trades in the spot market.
2. FUTURES PRICE: The price at which the futures contract trades in the futures market.
3. CONTRACT CYCLE: The period over which a contract trades. The index futures contracts on
the NSE have one month, two months and three months expiry cycles that expires on the
last Thursday of the month. Thus a contract which is to expire in January will expire on the
last Thursday of January.
4. EXPIRY DATE: It is the date specified in the futures contract. This is the last day on which the
contract will be traded, at the end of which it will cease to exist.
5. CONTRACT SIZE: It is the quantity of asset that has to be delivered under one contract. For
instance, the contract size on NSE’s futures market is 200 Nifties.
6. BASIS: In the context of financial futures, basis can be defined as the futures price minus the
spot price. There will be different basis for each delivery month,
for each contract. In a normal market, basis will be positive; this reflects that the futures
price exceeds the spot prices.
7. COST OF CARRY: The relationship between futures price and spot price can be summarized
in terms of what is known as the cost of carry. This measures the storage cost plus the
interest paid to finance the asset less the income earned on the asset.

21
 8. INITIAL MARGIN: The amount that must be deposited in the margin account at the time
when a futures contract is first entered into is known as initial margin.
9. MARK TO MARKET: In the futures market, at the end of each trading day, the margin
account is adjusted to reflect the investor’s gain or loss depending upon the futures closing
price. This is called Marking-to-market.
10. MAINTENANCE MARGIN: This is somewhat lower than the 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 and
is expected to top up the margin account to the initial margin level before trading
commences on the next day.

Stock futures contract

It is a contractual agreement to trade in stock/ shares of a company on a future date. Some of the
basic things in a futures trade as specified by the exchange are:
• Contract size
• Expiration cycle
• Trading hours
• Last trading day
• Margin requirement

Advantages of stock futures trading

• Investing in futures is less costly as there is only initial margin money to be deposited
• A large array of strategies can be used to hedge and speculate, with smaller cash outlay
there is greater liquidity

Disadvantages of stock futures trading

• The risk of losses is greater than the initial investment of margin money
• The futures contract does not give ownership or voting rights in the equity in which it is
trading
• There is greater vigilance required because futures trades are marked to market daily
INDEX DERIVATIVES
Index derivatives are derivative contracts that has index as the underlying. The most
popular index derivatives contract is index futures and index options. NSE’s market index - the S&P
CNX Nifty are examples of exchange traded index futures.

An index is a broad-based weighted average of prices of selected constituents that form

part of the index. The rules for construction of the index are defined by the body that creates the
index. Trading in stock index futures was first introduced by the Kansas City Board of Trade in 1982.

22
Advantages of investing in stock index futures
• Diversification of the risks as the investor is not investing in a particular stock
• Flexibility of changing the portfolio and adjusting the exposures to particular stock index,
market or industry

OPTIONS
An option is a contract, or a provision of a contract, that gives one party (the option holder)
the right, but not the obligation, to perform a specified transaction with another party (the option
issuer or option writer) according to the specified terms. The owner of a property might sell another
party an option to purchase the property any time during the next three months at a specified
price. For every buyer of an option there must be a seller. The seller is often referred to as the
writer. As with futures, options are brought into existence by being traded, if none is traded, none
exists; conversely, there is no limit to the number of option contracts that can be in existence at any
time. As with futures, the process of closing out options positions will cause contracts to cease to
exist, diminishing the total number.

Thus an option is the right to buy or sell a specified amount of a financial instrument at a
pre-arranged price on or before a particular date.

There are two options which can be exercised:

 Call option, the right to buy is referred to as a call option.  Put
option, the right to sell is referred as a put option.

OPTION TERMINOLOGY
1. INDEX OPTION: These options have the index as the underlying. Some options are
European while others are American. European style options can be exercised only
on the maturity date of the option, which is known as the expiry date. An American
style option can be exercised at any time upto, and including, the expiry date. It is
to be noted that the distinction has nothing to do with geography. Both type of the
option are traded all over the world
2. STOCK OPTION: Stock options are options on individual stocks. A contract gives the
holder the right to buy or sell shares at the specified price.
3. BUYER OF AN OPTION: The buyer of an option is the one who by paying the option
premium buys the right but not the obligation to exercise the options on the
seller/writer.
4. WRITER OF AN OPTION: The writer of a call/put option is the one who receives the
option premium and is thereby obliged to sell/buy the asset if the buyer exercised
on him.
5. STRIKE PRICE: The price specified in the option contract is known as the strike price
or the exercise price.
6. ‘IN THE MONEY’ OPTION: An ‘in the money’ option is an option that would lead to a
positive cash flow to the holder if it was exercised immediately. A call option on the
index is said to be in-the-money (ITM) when the current index stands at a level

23
 higher than the strike price (i.e. spot price> strike price). If the index is much higher
than the strike price, the call is said to be deep ITM. In the case of a put, the put is
ITM if the index is below the strike price.
7. ‘AT THE MONEY’ OPTION: An ‘at the money’ option is an option that would lead to
zero cash flow to the holder if it were exercised immediately. An option on the
index is at the money when the current index equals the strike price(i.e. spot price =
strike price).
8. ‘OUT OF THE MONEY’ OPTION: An ‘out of the money’(OTM) option is an option that
would lead to a negative cash flow for the holder if it were exercised immediately. A
call option on the index is out of the money when the current index stands at a level
lower than the strike price(i.e. spot price < strike price). If the index is much lower
than the strike price, the call is said to be deep OTM. In the case of a put, the put is
OTM if the index is above the strike price.
9. INTRINSIC VALUE OF AN OPTION: The option premium can be broken down into
two components - intrinsic value and time value. The intrinsic value of a call is the
ITM value of the option that is if the call is OTM, its intrinsic value will be zero.
10. TIME VALUE OF AN OPTION: The time value of an option is the difference between
its premium and its intrinsic value. Usually maximum time value exists when the
option is ATM. The longer the time to expiration, the greater is an option’s time
value, or else equal. At expiration, an option should have no time value.

Factors affecting value of options – you would understand this while using the
valuation techniques, but the terms are introduced below:

• Price – value of the call option is directly proportionate to the change in the price of the
underlying. Say for example
• Time – as options expire in future, time has an effect on the value of the options.
• Interest rates and Volatility – in case where the underlying asset is a bond or interest rate,
interest rate volatility would have an impact on the option prices. The statistical or historical
volatility (SV) helps measure the past price movements of the stock and helps in
understanding the future volatility of the stock during the life of the option

24
 Commodity Derivatives

Commodity Derivatives are the first of the derivatives contracts that emerged to hedge against the
risk of the value of the agricultural crops going below the cost of production. Chicago Board of
Trade was the first organized exchange, established in 1848 to have started trading in various
commodities. Chicago Board of Trade and Chicago Mercantile Exchange are the largest
commodities exchanges in the world

It is important to understand the attributes necessary in a commodity derivative contract:

a) Commodity should have a high shelf life – only if the commodity has storability, durability
will the carriers of the stock feel the need for hedging against the price risks or price
fluctuations involved
b) Units should be homogenous – the underlying commodity as defined in the commodity
derivative contract should be the same as traded in the cash market to facilitate actual
delivery in the cash market. Thus the units of the commodity should be homogenous
c) Wide and frequent fluctuations in the commodity prices – if the price fluctuations in the
cash market are small, people would feel less incentivised to hedge or insure against the
price fluctuations and derivatives market would be of no significance. Also if by the inherent
attributes of the cash market of the commodity, the cash market of the commodity was
such that it would eliminate the risks of volatility or price fluctuations, derivatives market
would be of no significance. Taking an oversimplified example, if an investor had purchased
100 tons of rice @ Rs. 10/ kg in the cash market and is of the view that the prices may fall in
the future, he may short a rice future at Rs. 10/ kg to hedge against the fall in prices. Now if
the prices fall to Rs. 2/ kg, the loss that the investor makes in the cash market may be
compensated by squaring of the short position thus eliminating the risk of price fluctuations
in the commodity market

Commodity derivative contracts are standardized contracts and are traded as per the investors
needs. The needs of the investor may be instrumental or convenience, depending upon the needs,
the investor would trade in a derivative product. Instrumental risks would relate to price risk
reduction and convenience needs would relate to flexibility in trade or efficient clearing process.

Commodity Derivatives in India

Commodity derivatives in India were established by the Cotton Trade Association in 1875, since
then the market has suffered from liquidity problems and several regulatory dogmas. However in
the recent times the commodity trade has grown significantly and today there are 25 derivatives
exchanges in India which include four national commodity exchanges; National Commodity and
Derivatives Exchange (NCDEX), National MultiCommodity Exchange of India (NCME), National Board
of Trade (NBOT) and Multi

25
Commodity Exchange (MCX)

NCDEX
It is the largest commodity derivatives exchange in India and is the only commodity exchange
promoted by national level institutions. NCDEX was incorporated in 2003 under the Companies Act,
1956 and is regulated by the Forward Market Commission in respect of the futures trading in
commodities. NCDEX is located in Mumbai

MCX is recognised by the government of India and is amongst the world’s top three bullion
exchanges and top four energy exchanges. MCX’s headquarter is in Mumbai and facilitates online
trading, clearing and settlement operations for the commodoties futures market in the country.

26
Over the Counter Derivatives (OTC Derivatives)

Derivatives that are privately negotiated and not traded on the stock exchange are called OTC
Derivatives.

Interest Rate Derivatives (IRD)

In the OTC derivatives segment, interest rate derivatives (IRDs) are easily the largest and therefore
the most significant globally. In markets with complex risk exposures and high volatility Interest
Rate Derivatives are an effective tool for management of financial risks. In IRDs, the parties are
trying to trade in the volatility of interest rates. Interest rates affect a whole spectrum of financial
assets – loans, bonds, fixed income securities, government treasuries, and so on. In fact, changes in
interest rates have major macro economic implications for various economic parameters –
exchange rates, state of the economy, and thereby, the entire spectrum of the financial sector.

Definition of IRDs
Interest Rate Derivatives (IRD) are derivatives where the underlying risk interest rates. Hence,
depending on the type of the transaction, parties either swap interest at a fixed or floating rate on a
notional amount, or trade in interest rate futures, or engage in forward rate agreements. As in case
of all derivatives, the contract is mostly settled by net settlement, that is payment of difference
amount.

Types:
The basic IRDs are simple and mostly liquid and are called vanilla products, whereas derivatives
belonging to the least liquid category are termed as exotic interest rate derivatives. Some vanilla
products are:
1) Interest Rate Swaps
2) Interest Rate Futures
3) Forward Rate Agreements
4) Interest rate caps/floors

Interest Rate Swaps – These are derivatives where one party exchanges or swaps the fixed or the
floating rates of interest with the other party. The interest rates are calculated on the notional
principal amount which is not exchanged but used to determine the quantum of cashflow in the
transaction. Interest rate swaps are typically used by corporations to typically alter the exposure to
fluctuations on interest rates by swapping fixed rate obligations for floating and vice-a-versa or to
obtain lower rates of interest than otherwise available.

Interest rate swaps can be a) fixed-for-fixed rate swap, b) fixed-for-floating rate swap, c) floating-
for-floating rate swap and so on. As the names suggest interest rates are being swapped, either in

27
the same currency or different currency and there could be as many customized variations of the
swaps, as desired.

This can be further explained simply. For instance if there are two borrowers in the market where
Borrower A has borrowed at a fixed rate but wants a floating rate of interest and Borrower B has
borrowed with floating and wants a fixed rate of interest. IN such a scenario they can swap their
existing interest rates without any further borrowing.

This would make the transaction of the two borrowers independent of the underlying borrowings.
For instance if a company has investments with a floating rate of interest of 4.7% and can obtain
fixed interest rate of 4.5% then the company may enter into a fixedfor-floating swap and earn a
profit of 20 basis points.

Forward Rate Agreements (FRAs) – These are cash settled for ward contracts on interest rate
traded among international banks active in the Eurodollar market.

These are contracts between two parties where the interest rates are to be paid/ received on an
obligation at a future date. The rate of interest, notional amount and expiry date is fixed at the time
of entering the contract and only difference in the amount is paid/ received at the end of the
period. The principal is called notional because while it determines the amount of payment, actual
exchange of principal never takes place. For instance if A enters an FRA with B and receives a fixed
rate of interest say 6% on principal, say P for three years and B receives floating rate on P. If at the
end of contract period of C the LIBOR rate is 6.5% then A will make a payment of the differential
amount, (that is .5% on the principal P) to B. The settlement mechanism can be further explained as
follows:

For instance at a notional principal of USD 1 million where the borrower buys an FRA for 3 months
that carries an interest rate of 6% and the contract run is 6 months. At the settlement date the
settlement rate is at 6.5%. Then the settlement amount will be calculated in the following manner:

Settlement amount = [(Difference between settlement rate and agreed rate)* contract run*
principal amount]/[(36,000 or 36500) + (settlement rate*contract period)]

That is, in the above problem

Settlement amount = [(6.5-6)*180*USD 1 million]/[36,000 + (6.5%* 90)

(Note: 36,000 is used for currencies where the basis of calculation is actual/360 days and
36,500 is used for currencies where the basis of calculation of interest is actual/365 days)

Interest Rate Caps/Floors: Interest rate caps/floors are basically hedging instruments that can give
the investor both benefits of fixed rate interest and fluctuating rate interest. The person providing

28
an interest rate cap is the protection seller. The seller assures the borrower or the buyer that in
case of high volatility in the interest rates, if interest rate moves beyond the cap the borrower will
be paid amount beyond the cap. In case the market rates do not go beyond the cap limit, the seller
need not pay anything to the borrower. In such a situation as long as the interest rates are within
the cap limit borrower enjoys the floating rates and if rates move above the cap limit he will be
compensated with the requisite amount by the protection seller and the borrower will pay fixed to
the capped rate of interest. The same is the case when a person enters a Interest Rate Floor
transaction.

In case of Interest Rate Cap transaction the borrower is expects the market interest rates to go up in
the future and hedge against the movement of the market rates. Interest Rate Caps/Floors
transactions are ideally of one, two, five or ten years and the desired level of protection the buyer
seeks are 6%, 8% or 10%.

Fundamental Analysis
Introduction to Fundamental Analysis

Fundamental analysis is a process of looking at a business at the basic or fundamental financial

level. The primary assumption of fundamental analysis is that the all the factors are not discounted
in the current market price. There is something called the intrinsic value of the stock which is its
true value. Fundamental analysis also assumes that the market will reach its true intrinsic value in
the long term and hence the market value and the intrinsic value will reach equilibrium. Hence if
the market value at present is lower than its intrinsic value, then it is good time to invest and vice
versa.

The steps involved in fundamental analysis are:

1. Macroeconomic analysis, which involves considering currencies, commodities and
indices.
2. Industry sector analysis, which involves the analysis of companies that are a part of the
sector.
3. Situational analysis of a company.
4. Financial analysis of the company.
5. Valuation

29
Fundamental Analysis Tools

There are several tools used for fundamental analysis. Some of the most popular are:

1. Earnings per Share

2. Price to Earnings
3. Projected Earning Growth (PEG)
4. Price to Sales (P/S)
5. Price to Book (P/B)
6. Dividend Payout ratio
7. Dividend yield
8. Book value
9. Return on Equity (ROE)
10. Ratio analysis
Stock Market Capitalization to GDP ratio

Market Capitalization - Market capitalization of a company is determined by multiplying the price

of its stock by the number of shares issued by the company. Similarly, market capitalization of an
index is calculated by adding the individual market capitalization of the companies in the index.
Free float market capitalization method is used to calculate the market capitalization of SENSEX.
Free float market capitalization is defined as that proportion of total shares issued by the company
that are readily available for trading in the market. It excludes promoter’s holding, government
holding, etc.

Gross Domestic product - GDP is defined as the total market value of all final goods and services
produced within the country in a given period of time.

GDP = C + I + G + NX

C – Consumption expenditure

I – Investment expenditure

G – Government expenditure

NX – Net exports = Exports –Imports

30
Stock Market Capitalization to GDP ratio - The stock market cap to GDP ratio is used to
measure whether a market is overvalued or undervalued. Usually a value of over 100% indicates
that the market is overvalued and best not to invest. A value of below 100% is considered
undervalued and hence the right time to invest. Warren buffet said that if the ratio is around 80% it
is a good time to invest and if it is more than 200% then it is better to stay away from investing in
that market.

Calculation of the ratio - It is calculated as:

31
Quarterly stock market capitalization to GDP ratios of India

SL NO YEAR PERCENTGE
1 1998 27
2 1999 30
3 2000 35
4 2001 26
5 2002 22
6 2003 46
7 2004 49
8 2005 54
9 2006 66
10 2007 110
11 2008 91
12 2009 80
13 2010 89
14 2011 71
15 2012 60
16 2013 62
17 2014 67
18 2015 70
19 2016 68
20 2017 87
21 2018 76

120

100

80

60

40

20

0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

percent

32
Analysis of ratio
The stock market capitalization to GDP ratio is used to determine whether an overall market is
undervalued or overvalued. the can used to focus on specific market, such as the Indian market, or it
can be applied to the world market depending on what values are used in the calculation.

For the first time on Indian’s history the market capitalization of the BSE crossed the country’s
domestic GD, this statistic can be observed in the graph as well, where market capitalization to GDP
ratio crossed 100 for the first time.

As the chart suggest, for India, the average market cap to GDP number over the past decades has
been 52% Indian market were trading near the ratio in march 2009 (when the downward started
rally started). And as we stand currently, the markets are back at almost their 2008 peak.

As per Buffett, a 70-80% range on this ratio indicates that market are somewhere between
moderate valuation and fair valuation. If the ratio exceeds 115% the markets are in the overvalued
zone where odds of investing are not in the favor of investor.

33
Price To Earnings Ratio of the SENSEX

P/E ratio - The price to earnings ratio is an important indicator used by several fundamental
analysts. The P/E of a company tells us how much the investor is willing to pay, based on the
earnings of the company. The P/E ratio also tells us how much the market is willing to pay the
investor per rupee earning of the company.

The P/E ratio is calculated as

P/E= Stock price/Earnings per share

The stock price is the current market value of the stock.

The EPS can be calculated in three ways. EPS is calculated as the net earnings divided by the
outstanding shares. If the EPS is calculated based on the net earnings of the previous four quarters,
it is called trailing P/E. If the EPS is calculated based on the estimated earnings of the next four
quarters, it is called a forward P/E. Sometimes the EPS is calculated using the net earnings of the
previous two quarters and the next two quarters. Hence there are types of P/E ratio.

Significance of the ratio - The P/E ratio cannot be the only indicator to base one’s investment.

There are two ways to read the P/E ratio. One method is to compare the P/E of the company to the
industry P/E. If the P/E of the company is higher than the P/E of the industry it means that the
market is expecting some positive events from the company as far as earnings are concerned. This
can be interpreted in two ways. It could mean that the company is outperforming the market and
hence is overheated or it could mean that there are some positive events associated with the
company and hence a good time to invest. The second method to read the P/E is to compare the
P/E of the company with its competitors in the same industry. This gives a general idea as to
whether the stock price is undervalued or overvalued.

Significance of the ratio - The P/E ratio cannot be the only indicator to base one’s investment.

There are two ways to read the P/E ratio. One method is to compare the P/E of the company to the
industry P/E. If the P/E of the company is higher than the P/E of the industry it means that the
market is expecting some positive events from the company as far as earnings are concerned. This
can be interpreted in two ways. It could mean that the company is outperforming the market and
hence is overheated or it could mean that there are some positive events associated with the
company and hence a good time to invest. The second method to read the P/E is to compare the

34
P/E of the company with its competitors in the same industry. This gives a general idea as to
whether the stock price is undervalued or overvalued.

Quarterly P/E ratios of SENSEX

SL NO YEAR RETURN
1 1995 4400
2 1996 4900
3 1997 5000
4 1998 4300
5 1999 5100
6 2000 5000
7 2001 4100
8 2002 4300
9 2003 4700
10 2004 5200
11 2005 8000
12 2006 10000
13 2007 14800
14 2008 15000
15 2009 15200
16 2010 20000
17 2011 17000
18 2012 16000
19 2013 20000
20 2014 26000
21 2015 27000
22 2016 26000
23 2017 46000
24 2018 56000
25 2019 51000

35
 BSE SENSEX
60000

50000

40000

30000

20000

10000

Analysis of the ratio

The P/E ratio of the BSE Sensex had been fluctuating till 1994-95. It has been relatively stable from
then on shifting between 15- 20 levels which is good P/E for a growing economy.

The P/E of the Sensex as of June 2010 is 20.5. This when compared to the emerging and developed
market is quite high. Except the US Nasdaq, the P/E ratios of the major indices are between 12 and
17.

36
Analyzing India Using Maslow’s Hierarchy of Needs

Physiological needs- These are the basic needs that are required to sustain life. They include food,
water, air, etc. According to Maslow’s theory, if these fundamental needs are not satisfied then one
will surely be motivated to satisfy them. Higher needs such as social needs and esteem needs are
not recognized until one satisfies the needs basic to existence.

Safety needs- Once basic needs are satisfied the attention turns to safety and security needs of the
individual. The various safety and security needs include housing security, insurance, job security,
financial security, etc.

Social needs- This, according to Maslow’s, is the first level of higher level needs. Social needs are
those related to interaction with others and they include friendship, belonging to a group, etc.

Esteem needs- Esteem needs can be internal esteem needs or external esteem needs. The esteem
needs include self-respect, achievement, attention, recognition and reputation. The first two are
internal esteem needs where as the last three are external esteem needs.

Self-actualization- Self-actualization is the summit of Maslow’s hierarchy of needs. It is the quest of

reaching one’s full potential as a person. The needs associated with self-actualization include truth,
justice, wisdom, etc.

37
Correlation between SENSEX and Nifty
SENSEX is the sensitive Index of Bombay Stock Exchange (BSE), India, a Market Capitalization
Weighted average of 30 large and financially stable companies’ BSE stock prices. These 30
companies account for a half of the total market capitalization of BSE. Started since 1986, SENSEX is
monitored by most of the global markets as well.

NIFTY is Standard & Poor’s CRISIL NSE Index 50, is the index for large and financially sound
companies whose stocks are being traded on National of National Stock Exchange (NSE) of India.
Started since November 1995, nifty is most widely used for benchmarking index funds, index based
derivatives and to evaluate the overall performance of the nation’s stock market over time.

On plotting the daily closing values of Sensex and Nifty for about last three and a half years (2nd Jan
2007 to 31st May 2010), with the hypothesis that SENSEX is independent variable and Nifty is
dependent on SENSEX, by performing ANOVA or Analysis of variables test in MS-Excel, the
coefficient of correlation or R-square comes out to be 85% and the hypothesis proves to be correct
with 95% confidence. The inference from above mathematical analysis is that even though both
indices belong to separate markets, their performance/daily movement is almost identical, which
can be spotted visually as well, because both the curves fit very well and mostly give identical
information.

The war between the two has intensified due to the ever rising competition between NSE and BSE.
Both of them have their own USPs. The market Capitalization of NSE is almost twice of BSE, but, the
BSE is the oldest stock exchange in Asia and has its own history. The fact that both are having many
independent powers & separate entities worsens the situation. So, the only common link between
them now is SEBI, which has a totally different role, as it’s a regulatory authority to watch and
control the legal and ethical aspects of the market and protect the interests of shareholders. Hence,
no one, not even the SEBI is an intermediary between the two, thereby, intensifying the

38
competition between them to become the preferred exchange for top companies. Even though the
competition is healthy for any company to emerge stronger, provide more value added services and
work smarter, it becomes totally unhealthy and destructive when there are price wars and a red
ocean causing them to put their riches in advertising and other undue marketing/brand building
expenses.

So, whom to track? Whom to believe and follow? Which of them is a better indicator of the
market? Who is better in gauging the Indian stocks? Ironically, it doesn’t matter at all. Both SENSEX
and Nifty are well diversified and contains many similar companies’ stocks. So, even though Nifty
has got 20 more companies, that’s 67% more variety, both SENSEX and Nifty moves in the same
direction and the trend seems like totally correlated. There is a definite difference in scale or
magnitude, but, after scaling and equalizing both to similar bases, there will be hardly any
difference in both indices. So, the choice is based only on convenience and not on the performance.
The global markets prefer SENSEX because that was the only option with them earlier and they
don’t want to switch to other without any clear reason for that sudden change.

39
Technical Analysis
Introduction to Technical Analysis
Technical analysis is the study of market action, primarily through the use of charts, for the purpose
of forecasting future price trends. For technical analysts, the term market action includes three
sources of information. They are price, volume and open interest. Open interest is used only in
futures and options.

There are three premises on which technical analysis is based. They are

1) Market action discounts everything - Anything and everything that affects the price is
actually reflected in the price of that market. Hence a technical analyst will only study the price
action and not the reasons behind the change in the price.

2) Prices move in trends - There are three types of trends. They are uptrend, downtrend
and sideways trend. The assumption of technical analysis is that a trend in motion is more likely to
continue than reverse or a trend in motion will continue in the same direction until it reverses.

3) History repeats itself - The meaning of the phrase history repeats itself is that the key to
understanding the future lies in the study of the past, or that the future is just a repetition of the
past.

Usually the following tools & instruments are used to do the technical analysis:

Price Fields
Technical analysis is based almost entirely on the analysis of price and volume. The fields which
define a security's price and volume are explained below.

Open - This is the price of the first trade for the period (e.g., the first trade of the day). When
analyzing daily data, the Open is especially important as it is the consensus price after all interested
parties were able to "sleep on it."

High - This is the highest price that the security traded during the period. It is the point at which
there were more sellers than buyers (i.e., there are always sellers willing to sell at higher prices, but
the High represents the highest price buyers were willing to pay).

Low - This is the lowest price that the security traded during the period. It is the point at which
there were more buyers than sellers (i.e., there are always buyers willing to buy at lower prices, but
the Low represents the lowest price sellers were willing to accept).

Close - This is the last price that the security traded during the period. Due to its availability, the
Close is the most often used price for analysis. The relationship between the Open (the first price)
and the Close (the last price) are considered significant by most technicians. This relationship is
emphasized in candlestick charts.

40
Volume - This is the number of shares (or contracts) that were traded during the period. The
relationship between prices and volume (e.g., increasing prices accompanied with increasing
volume) is important.

Open Interest - This is the total number of outstanding contracts (i.e., those that have not been
exercised, closed, or expired) of a future or option. Open interest is often used as an indicator.

Bid - This is the price a market maker is willing to pay for a security (i.e., the price you will receive if
you sell).

Ask - This is the price a market maker is willing to accept (i.e., the price you will pay to buy the
security).

Chart Styles
Price in a chart can be displayed in following styles:

1. Bar Chart.
2. Line Chart.
3. Candlestick Chart.

1) Bar Charts:

The highs and lows of a stock are plotted in a diagram and the points are joined with vertical lines
(bars). A small horizontal tick to the left denotes the opening level while a small horizontal tick to
the right represents the closing price of each interval.

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Key Technical Indicators
There are several indicators that are used in technical analysis. But I have chosen to highlight the
following indicators as I have used some of these further in the project.

1. Moving average
2. Relative Strength Index (RSI)
3. Larry William’s % R
4. Moving average Convergence Divergence (MACD)
5. Fibonacci tools

1) Moving average - The moving average essentially a trend following indicator or a lagging
indicator as it is formed after the price movement occurs. Its purpose is to identify or signal that a
new trend has begun or that an old trend has ended or reversed. Its purpose is to track the progress
of the trend.

There are three types of moving averages that are used by technical analysts. They are

a) Simple moving average - It is calculated by taking the average of the previous 10 or 15

closing prices. The weights given to each day is the same i.e. in a 10 day simple moving average, the
weight given for the 10th day closing price is the same as the weight given for the 1st day closing

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price. The disadvantage of the simple moving average is that it reacts slower to the price movement
when compared to an exponential moving average.

b) Linearly weighted moving average - In this type of moving average weights are given in a
linear proportion to each day’s closing price i.e. the 10th day closing price is multiplied with 10, the
9th day with 9, and so on. The greater weight is given to the most recent closing.

c) Exponential moving average - The exponential moving average assigns greater weight to
more recent data and it includes in its calculation all of the data in the life of the instrument. The
advantage of using exponential moving averages is that it reacts quicker to the price movement
than a simple moving average.

Analyzing moving averages - There are two ways to analyze moving averages. They are as follows:
a) Single moving average and price - A single moving average is used to generate buy and sell
signals. When the price line moves above the moving average, a buy signal is generated.
Conversely, when the price line moves below the moving average, a sell signal is generated.

b) Double crossover method - In this case two moving averages are used. One is a shorter moving
average and the other a longer moving average. When the shorter moving average crosses above
the longer moving average, a buy signal is generated. Conversely, when the shorter moving average
crosses below the longer moving average, a sell signal is generated.

Relative Strength Index (RSI) - Relative strength generally means a ratio line comparing two
different entities. A ratio of a stock or industry group to the Sensex is one way of gauging relative
strength of different stocks or industry groups against one objective benchmark. Relative strength
index solves the problem of erratic movement and the need for constant upper and lower boundary.

The formula used for calculating RSI is

RSI=100-100/1+RS
RS=Average of x days’ up close/ Average of x days’ down close

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Analyzing Relative Strength Index - RSI is plotted on a vertical scale of 0 to 100. Movements above
70 are considered overbought while an oversold condition would be move under 30. Because of
shifting that takes place in bull and bear market, the 80 level usually becomes overbought level in
bull market and the 20 level the oversold level in bear market.

2) Larry William’s % R - Larry William’s % R measures the latest close in relation to its price
range over a given number of days. Today’s close is subtracted from the price high of the range for
a given number of days and that difference is divided by the total range for the same period. In
technical analysis this is a momentum indicator measuring overbought and oversold levels. It is
used to determine market entry and exit points.

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Analyzing William’s % R - The William’s % R produces values from 0 to -100. A reading over 80
usually indicates a stock is oversold, while reading below 20 suggests a stock is overbought.

3) Moving Average Convergence Divergence (MACD) - MACD is comprised of two sets of

line. One is called the faster line and the other the slower line. The faster line is the difference
between two exponential moving averages (usually 12 and 26). It is also called the MACD line.
The slower line is usually a 9 day exponential moving average of the MACD line. It is also called the
signal line. The buy and sell signals are based on the crossovers between the two lines. Hence it is
very similar to the double crossover method of moving averages.

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Analyzing MACD - When the MACD line (faster line) crosses above the signal line (slower line), a
buy signal is generated. Conversely, when the MACD line crosses below the signal line, a sell signal
is generated.
Another way of interpretation using MACD is by comparing it with the zero line to indicate
overbought or oversold conditions. An overbought condition is when the lines are well above the
zero line and hence indicating a sell signal. An oversold condition is when the lines are well below
the zero line and hence indicating a buy signal.

5) Fibonacci tools - Fibonacci tools utilize special ratios that naturally occur in nature to help
predict points of support or resistance. Fibonacci numbers are 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, etc.
The sequence occurs by adding the previous two numbers (i.e. 1+1=2, 2+3=5) The main ratio used is
.618, this is found by dividing one Fibonacci number into the next in sequence Fibonacci number
(55/89=0.618). The logic most often used by Fibonacci based traders is that since Fibonacci
numbers occur in nature and the stock, futures, and currency markets are creations of nature -
humans. Therefore, the Fibonacci sequence should apply to the financial markets.

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Chart 2.9: Illustration of Fibonacci retracement

Fibonacci retracements - Arguably the most heavily used Fibonacci tool is the Fibonacci
Retracement. To calculate the Fibonacci Retracement levels, a significant low to a significant high
should be found. From there, prices should retrace the initial difference (low to high or high to low)
by a ratio of the Fibonacci sequence, generally the 23.6%, 38.2%, 50%, 61.8%, or the 76.4%
retracement.

Technical Analysis Software - The technical analysis software used is Metastock, which is created
by Equis International, a Thomson Reuters company. It is the most widely used technical analysis
software. The major competitors of Reuters are Bloomberg and Dow Jones Newswires.

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Trading Strategy
n finance, a trading strategy is a fixed plan that is designed to achieve a profitable return by
going long or short in markets. The main reasons that a properly researched trading strategy
helps are its verifiability, quantifiability, consistency, and objectivity.
For every trading strategy one needs to define assets to trade, entry/exit points and money
management rules. Bad money management can make a potentially profitable strategy
unprofitable.[1]
Trading strategies are based on fundamental or technical analysis, or both. They are usually
verified by backtesting, where the process should follow the scientific method, and by forward
testing (a.k.a. 'paper trading') where they are tested in a simulated trading environment. [2]

Types of trading strategies

The term trading strategy can in brief be used by any fixed plan of trading a financial instrument,
but the general use of the term is within computer assisted trading, where a trading strategy is
implemented as computer program for automated trading. Technical strategies can be broadly
divided into the mean-reversion and momentum groups. [3]

• Long/short equity. A long short strategy consists of selecting a universe of equities and
ranking them according to a combined alpha factor. Given the rankings we long the top
percentile and short the bottom percentile of securities once every rebalancing period.
• Pairs trade. A pairs trading strategy consists of identifying similar pairs of stocks and taking a
linear combination of their price so that the result is a stationary time-series. We can then
compute z-scores for the stationary signal and trade on the spread assuming mean
reversion: short the top asset and long the bottom asset.
• Swing trading strategy; Swing traders buy or sell as that price volatility sets in and trades are
usually held for more than a day.
• Scalping (trading); Scalping is a method to making dozens or hundreds of trades per day, to
get a small profit from each trade by exploiting the bid/ask spread.
• Day Trading; The Day trading is done by professional traders; the day trading is the method
of buying or selling within the same day. Positions are closed out within the same day they
are taken, and no position is held overnight.
• Trading the news; The news is an essential skill for astute portfolio management, and long
term performance is the technique of making a profit by trading financial instruments (stock,
currency...) just in time and in accordance to the occurrence of events.
• Trading Signals; Trading signal is simply a method to buy signals from signals provider, is a
very effective strategy to determine the best time to buy or sell a stock or currency pair.
Aggregate analysts forecasts are often used in momentum trading strategies.[4]
• Social trading; using other peoples trading behaviour and activity to drive a trading strategy.
All these trading strategies are speculative. In the moral context speculative activities are
considered negatively and to be avoided by each individual.[5][6]who conversely should maintain a
long term horizon avoiding any types of short term speculation.

Development
The trading strategy is developed by the following methods:

• Automated trading; by programming or by visual development.

• Trading Plan Creation; by creating a detailed and defined set of rules that guide the trader
into and through the trading process with entry and exit techniques clearly outlined and risk,
reward parameters established from the outset.

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The development and application of a trading strategy preferably follows eight steps:[7] (1)
Formulation, (2) Specification in computer-testable form, (3) Preliminary testing, (4) Optimization,
(5) Evaluation of performance and robustness,[8] (6) Trading of the strategy, (7) Monitoring of
trading performance, (8) Refinement and evolution.

Performance measurement
Usually the performance of a trading strategy is measured on the risk-adjusted basis. Probably
the best-known risk-adjusted performance measure is the Sharpe ratio. However, in practice one
usually compares the expected return against the volatility of returns or the maximum drawdown.
Normally, higher expected return implies higher volatility and drawdown. The choice of the risk-
reward trade-off strongly depends on trader's risk preferences. Often the performance is
measured against a benchmark, the most common one is an Exchange-traded fund on a stock
index. In the long term a strategy that acts according to Kelly criterion beats any other strategy.
However, Kelly's approach was heavily criticized by Paul Samuelson.[9]

Executing strategies
A trading strategy can be executed by a trader (Discretionary Trading) or automated (Automated
Trading). Discretionary Trading requires a great deal of skill and discipline. It is tempting for the
trader to deviate from the strategy, which usually reduces its performance.
An automated trading strategy wraps trading formulas into automated order and execution
systems. Advanced computer modeling techniques, combined with electronic access to world
market data and information, enable traders using a trading strategy to have a unique market
vantage point. A trading strategy can automate all or part of your investment portfolio. Computer
trading models can be adjusted for either conservative or aggressive trading styles.

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Conclusion

A study has been made which shows the relationship between different economic variables and
the market variables and the interrelationship between them. Thus it has been observed that
there is not a single factor that affects the movement in the stock market but a number of
variables like GDP, P/E, etc. influence a market to a great extent. Any investor before making an
investment should analyze the general economic conditions prevailing in the economy and should
make a suitable framework for investment decisions. In the Maslow’s hierarchy we learnt that
before a company goes for overseas expansion it tries to study in which state of Maslow’s
hierarchy the desired country(India) is in. This makes the prediction of the various variables
accurate to some extent.

Along with the fundamental analysis mentioned above an educated investor would always
emphasize the importance of technical analysis as a tool to maximize profits and minimize risk. It is a
common view of experts that fundamental or technical analysis by itself are strong indicators to use
before investing, however, an educated investor should always use technical and fundamental
analysis in tandem before making an investment. This would give the investor a holistic view and
hence a more informed view of the investment

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