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B. Assumptions of Technical analysis 3. Support and Resistance A. Introduction B. Round Numbers and Support and Resistance C. Role Reversal D. The Importance of Support and Resistance 4. Importance of Trend A. Types of trends B. Trend Lengths 5. Types of Charts A. Line Chart B. Bar Chart C. Candlestick Charts D. Point and Figure Charts 6. Chart Patterns 7. Moving Averages 8. Indicators and Oscillators
9. Derivatives
10. The Scenario In India A. Need for Derivatives in India B. Factors Driving The Growth Of Derivates
11. Derivative Products A. Introduction B. Economic Function Of Derivative Market 12. Derivatives Terminologies 13. Options A. Introduction
B. Options Terminologies C. Options Trading Strategies
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Technical Analysis
Introduction:
It is a method of evaluating securities by analysing statistics and data such as historical prices and trading volumes. Technical analysts do not attempt to measure a security's intrinsic value but instead use charts, graphs, and other analytic tools to identify patterns that they believe will help predict future activity.
Technical charting analysis is a way of gathering and processing price and volume information of a particular security by applying mathematical equations and then plotting the resulting data onto graphs in order to predict future price movements. Unlike the fundamental analysis, where the economic, geo political factors or the financial health of a company is under scrutiny, technical analysis is only concerned with the price and trading volume of a security. In essence, technical analysis focuses on the effect of the previous price movements while fundamental analysis studies the causes that could affect the market. Charting analysis involves the manipulation of data relating to price and trading volume that occur with respect to time. The resulting information are then used to generate visual displays that can help the investor uncover price patterns and trends. These patterns are more commonly known as indicators and depending on the additional variables used in the mathematical formulation; the indicators can be further classified as either leading or lagging indicators. Typical leading indicators are the Williams%R, the stochastic, momentum, and the Relative Strength Index (RSI). Typical lagging indicators are the Moving Average Convergence/Divergence (MACD), the simple and exponential moving averages, and the Chaiken Oscillator. Beyond the indicators, technical analysis also consists of the utilization of number theories such as the Fibonacci sequence calculations, the Gann numbers and the Elliot wave theory. These number theories are used for the most part to help forecast resistance and support levels of a security's price.
2. Prices move in trends: Technical analysis is used to identify patterns of market behaviour that have long been recognized as significant. For many given patterns there is a high probability that they will produce the expected results. Also there are recognized patterns that repeat themselves on a consistent basis.
3. History repeats itself: Chart patterns have been recognized and categorized for over 100 years and the manner in which many patterns are repeated leads to the conclusion that human psychology changes little with time.
4. Self-fulfilling prophecy: Enough people seeing the same pattern will take actions that force the prediction to occur. While this is positive if you are on the right side of the trade, it presents a major weakness when everyone attempts to exit at the same time.
5. Momentum reverses: When a trade becomes very crowded with everyone assuming the same position, unexpected surprises can drive prices. If the exit becomes crowded, what first looked promising quickly becomes a nightmare.
Resistance: Resistance is the price level at which selling is thought to be strong enough to prevent the price from rising further. The logic dictates that as the price advances towards resistance, sellers become more inclined to sell and buyers become less inclined to buy. By the time the price reaches the resistance level, it is believed that supply will overcome demand and prevent the price from rising above resistance.
Figure 1
As you can see in Figure 1, support is the price level through which a stock or market seldom falls (illustrated by the blue arrows). Resistance, on the other hand, is the price level that a stock or market seldom surpasses (illustrated by the red arrows)
Why does it happen? These support and resistance levels are seen as important in terms of market psychology and supply and demand. Support and resistance levels are the levels at which a lot of traders are willing to buy the stock (in the case of a support) or sell it (in the case of resistance). When these trendiness are broken, the supply and demand and the psychology behind the stock's movements is thought to have shifted, in which case new levels of support and resistance will likely be established.
One type of universal support and resistance that tends to be seen across a large number of securities is round numbers. Round numbers like 10, 20, 35, 50, 100 and 1,000 tend be important in support and resistance levels because they often represent the major psychological turning points at which many traders will make buy or sell decisions. Buyers will often purchase large amounts of stock once the price starts to fall toward a major round number such as $50, which makes it more difficult for shares to fall below the level. On the other hand, sellers start to sell off a stock as it moves toward a round number peak, making it difficult to move past this upper level as well. It is the increased buying and selling pressure at these levels that makes them important points of support and resistance and, in many cases, major psychological points as well.
Role Reversal:
Once a resistance or support level is broken, its role is reversed. If the price falls below a support level, that level will become resistance. If the price rises above a resistance level, it will often become support. As the price moves past a level of support or resistance, it is thought that supply and demand has shifted, causing the breached level to reverse its role. For a true reversal to occur, however, it is important that the price make a strong move through either the support or resistance.
Figure 2
For example, as you can see in Figure 2, the dotted line is shown as a level of resistance that has prevented the price from heading higher on two previous occasions (Points 1 and 2). However, once the resistance is broken, it becomes a level of support (shown by Points 3 and 4) by propping up the price and preventing it from heading lower again. Many traders who begin using technical analysis find this concept hard to believe and don't realize that this phenomenon occurs rather frequently, even with some of the most wellknown companies. For example, as you can see in Figure 3, this phenomenon is evident on the Wal-Mart Stores Inc. (WMT) chart between 2003 and 2006. Notice how the role of the $51 level changes from a strong level of support to a level of resistance.
In almost every case, a stock will have both a level of support and a level of resistance and will trade in this range as it bounces between these levels. This is most often seen when a stock is trading in a generally sideways manner as the price moves through successive peaks and troughs, testing resistance and support.
Figure 3
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Support and resistance levels both test and confirm trends and need to be monitored by anyone who uses technical analysis. As long as the price of the share remains between these levels of support and resistance, the trend is likely to continue. It is important to note, however, that a break beyond a level of support or resistance does not always have to be a reversal. For example, if a price moved above the resistance levels of an upward trending channel, the trend has accelerated, not reversed. This means that the price appreciation is expected to be faster than it was in the channel.
Being aware of these important support and resistance points should affect the way that you trade a stock. Traders should avoid placing orders at these major points, as the area around them is usually marked by a lot of volatility. If you feel confident about making a trade near a support or resistance level, it is important that you follow this simple rule: do not place orders directly at the support or resistance level. This is because in many cases, the price never actually reaches the whole number, but flirts with it instead. So if you're bullish on a stock that is moving toward an important support level, do not place the trade at the support level. Instead, place it above the support level, but within a few points. On the other hand, if you are placing stops or short selling, set up your trade price at or below the level of support.
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Importance of Trend
One of the most important concepts in technical analysis is that of trend. The meaning in finance isn't all that different from the general definition of the term - a trend is really nothing more than the general direction in which a security or market is headed. Take a look at the chart below:
Figure 1
It isn't hard to see that the trend in Figure 1 is up. However, it's not always this easy to see a trend
Types of trends:
1. Uptrends: An uptrend is classified as a series of higher highs and higher lows, while a downtrend is one of lower lows and lower highs. Figure 3 is an example of an uptrend. Point 2 in the chart is the first high, which is determined after the price falls from this point. Point 3 is the low that is established as the price falls from the high. For this to remain an uptrend each successive low must not fall below the previous lowest point or the trend is deemed a reversal.
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Figure 3
2. Downtrends: It describes the price movement of a financial asset when the overall direction is downward. A formal downtrend occurs when each successive peak and trough is lower than the ones found earlier in the trend.
Notice how each successive peak and trough is lower than the previous one. For example, the low at Point 3 is lower than the low at Point 1. The downtrend will be deemed broken once the price closes above the high at Point 4. Downtrend is the opposite of uptrend 3. Sideways/Horizontal Trends:
As the names imply, when each successive peak and trough is higher, it's referred to as an upward trend. If the peaks and troughs are getting lower, it's a downtrend. When there is little movement up or down in the peaks and troughs, it's a sideways or horizontal trend. If you want to get really technical, you might even say that a sideways trend is actually not a trend
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on its own, but a lack of a well-defined trend in either direction. In any case, the market can really only trend in these three ways: up, down or nowhere.
Trend Lengths:
Along with these three trend directions, there are three trend classifications. A trend of any direction can be classified as a long-term trend, intermediate trend or a short-term trend. In terms of the stock market, a major trend is generally categorized as one lasting longer than a year. An intermediate trend is considered to last between one and three months and a nearterm trend is anything less than a month. A long-term trend is composed of several intermediate trends, which often move against the direction of the major trend. If the major trend is upward and there is a downward correction in price movement followed by a continuation of the uptrend, the correction is considered to be an intermediate trend. The short-term trends are components of both major and intermediate trends. Take a look a Figure 4 to get a sense of how these three trend lengths might look
Figure 4
When analysing trends, it is important that the chart is constructed to best reflect the type of trend being analysed. To help identify long-term trends, weekly charts or daily charts spanning a five-year period are used by chartists to get a better idea of the long-term trend. Daily data charts are best used when analysing both intermediate and short-term trends. It is also important to remember that the longer the trend, the more important it is; for example, a one-month trend is not as significant as a five-year trend.
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Types of Charts
There are four main types of charts that are used by investors and traders depending on the information that they are seeking and their individual skill levels. The chart types are: the line chart, the bar chart, the candlestick chart and the point and figure chart. In the following sections, we will focus on the S&P 500 Index during the period of January 2006 through May 2006. Notice how the data used to create the charts is the same, but the way the data is plotted and shown in the charts is different.
1. Line Chart
The most basic of the four charts is the line chart because it represents only the closing prices over a set period of time. The line is formed by connecting the closing prices over the time frame. Line charts do not provide visual information of the trading range for the individual points such as the high, low and opening prices. However, the closing price is often considered to be the most important price in stock data compared to the high and low for the day and this is why it is the only value used in line charts.
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2. Bar Charts
The bar chart expands on the line chart by adding several more key pieces of information to each data point. The chart is made up of a series of vertical lines that represent each data point. This vertical line represents the high and low for the trading period, along with the closing price. The close and open are represented on the vertical line by a horizontal dash. The opening price on a bar chart is illustrated by the dash that is located on the left side of the vertical bar. Conversely, the close is represented by the dash on the right. Generally, if the left dash (open) is lower than the right dash (close) then the bar will be shaded black, representing an up period for the stock, which means it has gained value. A bar that is colored red signals that the stock has gone down in value over that period. When this is the case, the dash on the right (close) is lower than the dash on the left (open).
3. Candlestick Charts
The candlestick chart is similar to a bar chart, but it differs in the way that it is visually constructed. Similar to the bar chart, the candlestick also has a thin vertical line showing the period's trading range. The difference comes in the formation of a wide bar on the vertical line, which illustrates the difference between the open and close. And, like bar charts,
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candlesticks also rely heavily on the use of colours to explain what has happened during the trading period.
4. Point and Figure Charts The point and figure chart is not well known or used by the average investor but it has had a long history of use dating back to the first technical traders. This type of chart reflects price movements and is not as concerned about time and volume in the formulation of the points. The point and figure chart removes the noise, or insignificant price movements, in the stock, which can distort traders' views of the price trends. These types of charts also try to neutralize the skewing effect that time has on chart analysis.
When first looking at a point and figure chart, you will notice a series of Xs and Os. The Xs represent upward price trends and the Os represent downward price trends. There are also numbers and letters in the chart; these represent months, and give investors an idea of the date. Each box on the chart represents the price scale, which adjusts depending on the price of the stock: the higher the stock's price the more each box represents. On most charts where the price is between $20 and $100, a box represents $1, or 1 point for the stock. The other critical point of a point and figure chart is the reversal criteria.
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This is usually set at three but it can also be set according to the chartist's discretion. The reversal criteria set how much the price has to move away from the high or low in the price trend to create a new trend or, in other words, how much the price has to move in order for a column of Xs to become a column of Os, or vice versa. When the price trend has moved from one trend to another, it shifts to the right, signalling a trend change.
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Chart Patterns
A chart pattern is a distinct formation on a stock chart that creates a trading signal, or a sign of future price movements. Chartists use these patterns to identify current trends and trend reversals and to trigger buy and sell signals. Basically there are two types of chart patterns Reversal and Continuation
Reversal: It is a change in the direction of a price trend. On a price chart, reversals undergo a recognizable change in the price structure. An uptrend, which is a series of higher highs and higher lows, reverses into a downtrend by changing to a series of lower highs and lower lows. A downtrend, which is a series of lower highs and lower lows, reverses into an uptrend by changing to a series of higher highs and higher lows. It also referred to as a "trend reversal", "rally" or "correction".
Continuation: A technical analysis pattern that suggests a trend is exhibiting a temporary diversion in behaviour, and will eventually continue on its existing trend. The symmetrical triangle charts displayed below are both exhibiting a continuation pattern. Notice how the chart extends above (below) its existing pattern.
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This is one of the most popular and reliable chart patterns in technical analysis. Head and shoulders is a reversal chart pattern that when formed, signals that the security is likely to move against the previous trend. As you can see in Figure 1, there are two versions of the head and shoulders chart pattern. Head and shoulders top (shown on the left) is a chart pattern that is formed at the high of an upward movement and signals that the upward trend is about to end. Head and shoulders bottom, also known as inverse head and shoulders (shown on the right) is the lesser known of the two, but is used to signal a reversal in a downtrend.
Figure 1: Head and shoulders top is shown on the left. Head and shoulders bottom, or inverse head and shoulders, is on the right. Both of these head and shoulders patterns are similar in that there are four main parts: two shoulders, a head and a neckline. Also, each individual head and shoulder is comprised of a
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high and a low. For example, in the head and shoulders top image shown on the left side in Figure 1, the left shoulder is made up of a high followed by a low. In this pattern, the neckline is a level of support or resistance. Remember that an upward trend is a period of successive rising highs and rising lows. The head and shoulders chart pattern, therefore, illustrates a weakening in a trend by showing the deterioration in the successive movements of the highs and lows.
Cup and Handle A cup and handle chart is a bullish continuation pattern in which the upward trend has paused but will continue in an upward direction once the pattern is confirmed.
Figure 2
As you can see in Figure 2, this price pattern forms what looks like a cup, which is preceded by an upward trend. The handle follows the cup formation and is formed by a generally downward/sideways movement in the security's price. Once the price movement pushes above the resistance lines formed in the handle, the upward trend can continue. There is a wide ranging time frame for this type of pattern, with the span ranging from several months to more than a year.
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This chart pattern is another well-known pattern that signals a trend reversal - it is considered to be one of the most reliable and is commonly used. These patterns are formed after a sustained trend and signal to chartists that the trend is about to reverse. The pattern is created when a price movement tests support or resistance levels twice and is unable to break through. This pattern is often used to signal intermediate and long-term trend reversals.
Figure 3: A double top pattern is shown on the left, while a double bottom pattern is shown on the right. In the case of the double top pattern in Figure 3, the price movement has twice tried to move above a certain price level. After two unsuccessful attempts at pushing the price higher, the trend reverses and the price heads lower. In the case of a double bottom (shown on the right), the price movement has tried to go lower twice, but has found support each time. After the second bounce off of the support, the security enters a new trend and heads upward.
Triangles:
Triangles are some of the most well-known chart patterns used in technical analysis. The three types of triangles, which vary in construct and implication, are the symmetrical triangle, ascending and descending triangle. These chart patterns are considered to last anywhere from a couple of weeks to several months.
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Figure 4
The symmetrical triangle in Figure 4 is a pattern in which two trendline converge toward each other. This pattern is neutral in that a breakout to the upside or downside is a confirmation of a trend in that direction. In an ascending triangle, the upper trendline is flat, while the bottom trendline is upward sloping. This is generally thought of as a bullish pattern in which chartists look for an upside breakout. In a descending triangle, the lower trendline is flat and the upper trendline is descending. This is generally seen as a bearish pattern where chartists look for a downside breakout.
Gaps:
A gap in a chart is an empty space between a trading period and the following trading period. This occurs when there is a large difference in prices between two sequential trading periods. For example, if the trading range in one period is between $25 and $30 and the next trading period opens at $40, there will be a large gap on the chart between these two periods. Gap price movements can be found on bar charts and candlestick charts but will not be found on
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point and figure or basic line charts. Gaps generally show that something of significance has happened in the security, such as a better-than-expected earnings announcement. There are three main types of gaps, Breakaway, Runaway (measuring) and Exhaustion. A breakaway gap forms at the start of a trend, a runaway gap forms during the middle of a trend and an exhaustion gap forms near the end of a trend.
Runaway gap on a price chart that occurs during strong bull or bear movements characterized by an abrupt change in price and appearing over a range of prices. They are best described as gaps caused by a sudden increase/decrease in interest for a stock.
The image shows a gap in the middle of a large upward movement. Exhaustion gap is the one that occurs after the rapid rise in a stock's price begins to tail off. An exhaustion gap usually reflects falling demand for a particular stock
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The image shows a gap at the end of a large upward movement, signalling a reversal
Triple tops and Triple bottoms Triple tops and triple bottoms are another type of reversal chart pattern in chart analysis. These are not as prevalent in charts as head and shoulders and double tops and bottoms, but they act in a similar fashion. These two chart patterns are formed when the price movement tests a level of support or resistance three times and is unable to break through; this signals a reversal of the prior trend.
Figure 7
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Confusion can form with triple tops and bottoms during the formation of the pattern because they can look similar to other chart patterns. After the first two support/resistance tests are formed in the price movement, the pattern will look like a double top or bottom, which could lead a chartist to enter a reversal position too soon.
Rounding Bottom:
A rounding bottom, also referred to as a saucer bottom, is a long-term reversal pattern that signals a shift from a downward trend to an upward trend. This pattern is traditionally thought to last anywhere from several months to several years.
Figure 8
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Moving Averages
An indicator frequently used in technical analysis showing the average value of a security's price over a set period. Moving averages are generally used to measure momentum and define areas of possible support and resistance.
There are a number of different types of moving averages that vary in the way they are calculated, but how each average is interpreted remains the same. The calculations only differ in regards to the weighting that they place on the price data, shifting from equal weighting of each price point to more weight being placed on recent data. The three most common types of moving averages are simple, linear and exponential.
This is the most common method used to calculate the moving average of prices. It simply takes the sum of all of the past closing prices over the time period and divides the result by the number of prices used in the calculation. For example, in a 10-day moving average, the last 10 closing prices are added together and then divided by 10. As you can see in Figure 1, a trader is able to make the average less responsive to changing prices by increasing the number of periods used in the calculation. Increasing the number of time periods in the calculation is one of the best ways to gauge the strength of the long-term trend and the likelihood that it will reverse.
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Many individuals argue that the usefulness of this type of average is limited because each point in the data series has the same impact on the result regardless of where it occurs in the sequence. The critics argue that the most recent data is more important and, therefore, it should also have a higher weighting. This type of criticism has been one of the main factors leading to the invention of other forms of moving averages.
Figure 1
This moving average indicator is the least common out of the three and is used to address the problem of the equal weighting. The linear weighted moving average is calculated by taking the sum of all the closing prices over a certain time period and multiplying them by the position of the data point and then dividing by the sum of the number of periods. For example, in a five-day linear weighted average, today's closing price is multiplied by five, yesterday's by four and so on until the first day in the period range is reached. These numbers are then added together and divided by the sum of the multipliers.
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This moving average calculation uses a smoothing factor to place a higher weight on recent data points and is regarded as much more efficient than the linear weighted average. Having an understanding of the calculation is not generally required for most traders because most charting packages do the calculation for you. The most important thing to remember about the exponential moving average is that it is more responsive to new information relative to the simple moving average. This responsiveness is one of the key factors of why this is the moving average of choice among many technical traders. As you can see in Figure 2, a 15period EMA rises and falls faster than a 15-period SMA.
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Oscillator: It is a technical analysis tool that is banded between two extreme values and built with the results from a trend indicator for discovering short-term overbought or oversold conditions. As the value of the oscillator approaches the upper extreme value the asset is deemed to be overbought, and as it approaches the lower extreme it is deemed to be oversold.
Average Directional Index: The average directional index (ADX) is a trend indicator that is used to measure the strength of a current trend. The indicator is seldom used to identify the direction of the current trend, but can identify the momentum behind trends. The ADX is a combination of two price movement measures: the positive directional indicator (+DI) and the negative directional indicator (-DI). The ADX measures the strength of a trend but not the direction. The +DI measures the strength of the upward trend while the -DI measures the strength of the downward trend. These two measures are also plotted along with the ADX line. Measured on a scale between zero and 100, readings below 20 signal a weak trend while readings above 40 signal a strong trend.
Accumulation/Distribution Line: The accumulation/distribution line is one of the more popular volume indicators that measures money flows in a security. This indicator attempts to measure the ratio of buying to selling by comparing the price movement of a period to the volume of that period.
Calculated: Acc/Dist = ((Close - Low) - (High - Close)) / (High - Low) * Period's Volume
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This is a non-bounded indicator that simply keeps a running sum over the period of the security. Traders look for trends in this indicator to gain insight on the amount of purchasing compared to selling of a security. If a security has an accumulation/distribution line that is trending upward, it is a sign that there is more buying than selling
Moving Average Convergence: The moving average convergence divergence (MACD) is one of the most well-known and used indicators in technical analysis. This indicator is comprised of two exponential moving averages, which help to measure momentum in the security. The MACD is simply the difference between these two moving averages plotted against a centerline. The centerline is the point at which the two moving averages are equal. Along with the MACD and the centerline, an exponential moving average of the MACD itself is plotted on the chart. The idea behind this momentum indicator is to measure short-term momentum compared to longer term momentum to help signal the current direction of momentum.
When the MACD is positive, it signals that the shorter term moving average is above the longer term moving average and suggests upward momentum. The opposite holds true when the MACD is negative - this signals that the shorter term is below the longer and suggest downward momentum. When the MACD line crosses over the centerline, it signals a crossing in the moving averages. The most common moving average values used in the calculation are the 26-day and 12-day exponential moving averages. The signal line is commonly created by using a nine-day exponential moving average of the MACD values. These values can be adjusted to meet the needs of the technician and the security. For more volatile securities, shorter term averages are used while less volatile securities should have longer averages. As you can see in Figure 2, one of the most common buy signals is generated when the MACD crosses above the signal line (blue dotted line), while sell signals often occur when the MACD crosses below the signal.
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Figure 2
The relative strength index (RSI) is another one of the most used and well-known momentum indicators in technical analysis. RSI helps to signal overbought and oversold conditions in a security. The indicator is plotted in a range between zero and 100. A reading above 70 is used to suggest that a security is overbought, while a reading below 30 is used to suggest that it is oversold. This indicator helps traders to identify whether a securitys price has been unreasonably pushed to current levels and whether a reversal may be on the way.
Figure 3
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Stochastic Oscillator:
The stochastic oscillator is one of the most recognized momentum indicators used in technical analysis. The idea behind this indicator is that in an uptrend, the price should be closing near the highs of the trading range, signaling upward momentum in the security. In downtrends, the price should be closing near the lows of the trading range, signaling downward momentum. The stochastic oscillator is plotted within a range of zero and 100 and signals overbought conditions above 80 and oversold conditions below 20. The stochastic oscillator contains two lines. The first line is the %K, which is essentially the raw measure used to formulate the idea of momentum behind the oscillator. The second line is the %D, which is simply a moving average of the %K. The %D line is considered to be the more important of the two lines as it is seen to produce better signals. The stochastic oscillator generally uses the past 14 trading periods in its calculation but can be adjusted to meet the needs of the user.
Figure 4
It is a technical indicator that measures the percentage change between the most recent price and the price "n" periods in the past. It is calculated by using the following formula: (Closing Price Today - Closing Price "n" Periods Ago) / Closing Price "n" Periods Ago ROC is classed as a price momentum indicator or a velocity indicator because it measures the rate of change or the strength of momentum of change.
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Fibonacci Retracement: A term used in technical analysis that refers to areas of support (price stops going lower) or resistance (price stops going higher). The Fibonacci retracement is the potential retracement of a financial asset's original move in price. Fibonacci retracements use horizontal lines to indicate areas of support or resistance at the key Fibonacci levels before it continues in the original direction. These levels are created by drawing a trendline between two extreme points and then dividing the vertical distance by the key Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8% and 100%.
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Derivatives
Introduction:
The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very high degree of volatility. Though the use of derivative products, it is possible to partially or fully transfer price risks by locking-in asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors.
Definition: Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the underlying. In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R)A) defines derivatives to include1. A security derived from a dept instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security. 2. A contract which derives its value from the prices, or index of prices, of underlying securities. Derivatives are securities under the SC(R)A and hence the trading of derivatives is governed by the regulatory framework under the SC(R)A.
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Milestones in the development of Indian derivative market Year November 18, 1996 Developments L.C. Gupta Committee set up to draft a policy framework for introducing derivatives May 11, 1998 May 25, 2000 June 12, 2000 June 4, 2001 July 2, 2001 November 9, 2001 August 29, 2008 August 31, 2009 L.C. Gupta committee submits its report on the policy framework. SEBI allows exchanges to trade in index futures Trading on Nifty futures commences on the NSE Trading for Nifty options commences o n the NSE Trading on Stock options commences on the NSE Trading on Stock futures commences on the NSE Currency derivatives trading commences on the NSE Interest rate derivatives trading commences on the NSE
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Derivative Products
Introduction:
Derivative contracts have several variants. The most common variants are forwards, futures, options and swaps. We take a brief look at various derivatives contracts that have come to be used.
Forward contract: It is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a forward contract. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into.
Futures: A future contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contract are special types of forward contracts in the sense that the former are standardized exchange-traded contracts. Options: Options are of two types calls and puts. 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 lives of options traded on options exchanges having a maximum maturity of nine months. Longer-dated 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 upto three years.
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Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average of a basket of assets. Equity index options are a form of basket options.
Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are: Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency. Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction. Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaptions is an option on a forward swap. Rather than have calls and puts, the Swaptions market has receiver swaptions and payer swaptions. A receiver swaptions is an option to receive fixed and pay floating. A payer swaptions is an option to pay fixed and receive floating.
markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kinds of mixed markets. 5. An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefit of which are immense.
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Derivatives Terminologies
Delta: The ratio comparing the change in the price of the underlying asset to the corresponding change in the price of a derivative. Sometimes referred to as the "hedge ratio". For example, with respect to call options, a delta of 0.7 means that for every $1 the underlying stock increases, the call option will increase by $0.70. Put option deltas, on the other hand, will be negative, because as the underlying security increases, the value of the option will decrease. So a put option with a delta of -0.7 will decrease by $0.70 for every $1 the underlying increases in price. As an in-the-money call option nears expiration, it will approach a delta of 1.00, and as an in-the-money put option nears expiration, it will approach a delta of -1.00. The Delta of a call is always positive and the Delta of a put is always negative.
Gamma: Gamma is the rate of change of the option's Delta with respect to the price of the underlying asset. In other words, it is the second derivative of the option price with respect to price of the underlying asset.
Theta: Theta of a portfolio of options is the rate of change of the value of the portfolio with respect to the passage of time with all else remaining the same. Theta is also referred to as the time decay of the portfolio. Theta is the change in the portfolio value when one day passes with all else remaining the same. We can either measure Theta "per calendar day" or "per trading day". To obtain the Theta per calendar day, the formula for Theta must be divided by 365; to obtain Theta per trading day, it must be divided by 250.
Vega: The Vega of a portfolio of derivatives is the rate of change in the value of the portfolio with respect to volatility of the underlying asset. If Vega is high in absolute terms, the portfolio's value is very sensitive to small changes in volatility. If Vega is low in absolute terms, volatility changes have relatively little impact on the value of the portfolio.
Rho: The Rho of a portfolio of options is the rate of change of the value of the portfolio with respect to the interest rate. It measures the sensitivity of the value of a portfolio to interest rates.
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Historical Volatility HV: The realized volatility of a financial instrument over a given time period. Generally, this measure is calculated by determining the average deviation from the average price of a financial instrument in the given time period. Standard deviation is the most common but not the only way to calculate historical volatility. Also known as "statistical volatility". Implied Volatility IV: The estimated volatility of a security's price. In general, implied volatility increases when the market is bearish and decreases when the market is bullish. This is due to the common belief that bearish markets are more risky than bullish markets. Implied volatility is sometimes referred to as "vols."
Basis: The variation between the spot price of a deliverable commodity and the relative price of the futures contract for the same actual that has the shortest duration until maturity. A security's basis is the purchase price after commissions or other expenses. Also known as "cost basis" or "tax basis". In the context of IRAs, basis is the after-tax balance in the IRA, which originates from non-deductible IRA contributions and rollover of after-tax amounts. Earnings on these amounts are tax-deferred, similar to earnings on deductible contributions and rollover of pre-tax amounts.
Initial Margin: Initial margin is taken by the stock exchanges from traders in order to cover the largest potential loss which can happen in one day. Both buyer and seller have to deposit the initial margins. The initial margin is deposited before the day opens and also before the traders takes the position in the market. Based on the volatility of underlying the initial margin can be between 5 to 20 percent.
Mark-to-market margin: All losses of the trader must be met by the trader by depositing further collateral known as mark to market margin in to the stock exchange, and any profit is credited to the account of trader at the end of trading day.
Additional margin: In case of sudden higher than expected volatility, additional margin may be called for by the stock exchange. This is generally imposed by the stock exchanges when the markets have become too volatile as was the case in year 2008 when Lehman brother collapse happened.
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Maintenance margin: Some exchanges work on the system of maintenance margin, which is set at a level slightly less than initial margin. The margin is required to be replenished to the level of initial margin, only if the margin level drops below the maintenance margin limit. For example If Initial Margin is fixed at 100 and Maintenance margin is at 85, then the trader is allowed to trade only until the maintenance margin is above 85. If it drops below 85 to 65, then a margin of 35 is to be paid so that initial margin again becomes 100.
Open Interest: The open interest is the total number of open contracts outstanding in a particular option series and this figure is tracked by the options exchanges. Every opening transaction increases the open interest by 1 while every closing transaction decreases the open interest by 1. This value is useful for determining the liquidity for a particular options series. A large open interest indicates a more liquid market and making large trades will be less of a problem.
Put-Call Ratio: The Put-Call Ratio is the number of put options traded divided by the number of call options traded in a given period. While typically the trading volume is used to compute the Put-Call Ratio, it is sometimes calculated using open interest volume or total dollar value instead. Weekly or monthly figures can also be calculated and moving averages are often used to smooth out the short term daily figures.
Spot price (ST): Spot price of an underlying asset is the price that is quoted for immediate delivery of the asset. For example, at the NSE, the spot price of Reliance Ltd. at any given time is the price at which Reliance Ltd. shares are being traded at that time in the Cash Market Segment of the NSE. Spot price is also referred to as cash price sometimes.
Forward price or futures price (F): Forward price or futures price is the price that is agreed upon at the date of the contract for the delivery of an asset at a specific future date. These prices are dependent on the spot price, the prevailing interest rate and the expiry date of the contract.
Strike price (K): The price at which the buyer of an option can buy the stock (in the case of a call option) or sell the stock (in the case of a put option) on or before the expiry date of option contracts is called strike price. It is the price at which the stock will be bought or sold
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when the option is exercised. Strike price is used in the case of options only; it is not used for futures or forwards.
Expiration date (T): In the case of Futures, Forwards and Index Options, Expiration Date is the only date on which settlement takes place. In case of stock options, on the other hand, Expiration date (or simply expiry), is the last date on which the option can be exercised. It is also called the final settlement date.
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Options
Introduction:
An option is a contract written by a seller that conveys to the buyer the right, but not the obligation to buy in the case of a call option or to sell in the case of a put option a particular asset, at a particular price say at Strike price in future. In return for granting the option, the seller collects the premium from the buyer. Exchange traded options form an important class of options which have standardized contract features and trade on public exchanges, facilitating trading among large number of investors. They provide settlement guarantee by the Clearing Corporation thereby reducing counterparty risk. Options can be used for hedging, taking a view on the future direction of the market, for arbitrage or for implementing strategies which can help in generating income for investors under various market conditions. Options are fundamentally different from forward and futures contracts. An option gives the holder of the option the right to do something. The holder does not have to exercise this right. In contrast, in a forward or futures contract, the two parties have committed themselves to doing something. Whereas it costs nothing (except margin requirements) to enter into a futures contract, the purchase of an option requires an upfront payment.
Options Terminologies:
Index options: These options have the index as the underlying. In India, they have a European style settlement. Eg. Nifty options, Mini Nifty options etc.
Stock options: Stock options are options on individual stocks. A stock option contract gives the holder the right to buy or sell the underlying shares at the specified price. They have an American style settlement.
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 his option on the seller/writer.
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Writer / seller of an option: The writer / seller 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 exercises on him.
Call option: A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price.
Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price.
Option price/premium: Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium.
Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity
Strike price: The price specified in the options contract is known as the strike price or the exercise price.
American options: American options are options that can be exercised at any time upto the expiration date.
European options: European options are options that can be exercised only on the expiration date itself.
In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cash-flow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level 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.
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At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cash-flow if it were exercised immediately. An option on the index is at-themoney when the current index equals the strike price (i.e. spot price = strike price).
Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cash-flow if it were exercised immediately. A call option on the index is out-of-the-money when the current index stands at a level which is less 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.
Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an option's time value, all else equal. At expiration, an option should have no time value.
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For aggressive investors who are very bullish about the prospects for a stock / index, buying Calls can be an excellent way to capture the upside potential with limited downside risk. Buying a call is the most basic of all options strategies. It constitutes the first options trade for someone already familiar with buying / selling stocks and would now want to trade options. Buying a call is an easy strategy to understand. When you buy it means you are bullish. Buying a Call means you are very bullish and expect the underlying stock / index to rise in future.
Risk: Limited to the Premium. (Maximum loss if market expires at or below the option strike price).
Reward: Unlimited
Example:
Mr. XYZ is bullish on Nifty on 24th June, when the Nifty is at 4191.10. He buys a call option with a strike price of Rs. 4600 at a premium of Rs. 36.35, expiring on 31st July. If the Nifty goes above 4636.35, Mr. XYZ will make a net profit (after deducting the premium) on exercising the option. In case the Nifty stays at or falls below 4600, he can forego the option (it will expire worthless) with a maximum loss of the premium.
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Buy call option Strike Price (Rs) Premium (Rs.) Break Even Point (Rs.) (Strike Price + Premium) 4600 36.65 4636.35
On expiry Nifty closes at 4100.00 4300.00 4500.00 4636.35 4700.00 4900.00 5100.00 5300.00
Net Payoff from Call Option (Rs.) -36.35 -36.35 -36.35 0 63.65 263.65 463.65 663.65
Analysis:
This strategy limits the downside risk to the extent of premium paid by Mr. XYZ (Rs. 36.35). But the potential return is unlimited in case of rise in Nifty. A long call Option is the simplest way to benefit if you believe that the market will make an upward Move and is the most common choice among first time investors in Options. As the stock Price/index raises the long Call moves into profit more and more quickly.
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When you buy a Call you are hoping that the underlying stock / index would rise. When you expect the underlying stock / index to fall you do the opposite. When an investor is very bearish about a stock / index and expects the prices to fall, he can sell Call options. This position offers limited profit potential and the possibility of large losses on big advances in underlying prices. Although easy to execute it is a risky strategy since the seller of the Call is exposed to unlimited risk.
A Call option means an Option to buy. Buying a Call option means an investor expects the underlying price of a stock / index to rise in future. Selling a Call option is just the opposite of buying a Call option. Here the seller of the option feels the underlying price of a stock / index is set to fall in the future.
When to use: Investor is very aggressive and he is very bearish about the stock / index.
Risk: Unlimited
Example:
Mr. XYZ is bearish about Nifty and expects it to fall. He sells a Call option with a strike price of Rs. 2600 at a premium of Rs. 154, when the current Nifty is at 2694. If the Nifty stays at 2600 or below, the Call option will not be exercised by the buyer of the Call and Mr. XYZ can retain the entire premium of Rs. 154.
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Strategy:
Sell Call Option Current Nifty index 2694 2600 154 Point (Rs.) (Strike Price 2754
+Premium)*
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Analysis:
This strategy is used when an investor is very aggressive and has a strong expectation of a price fall (and certainly not a price rise). This is a risky strategy since as the stock price / index rises, the short call loses money more and more quickly and losses can be significant if the stock price / index falls below the strike price. Since the investor does not own the underlying stock that he is shorting this strategy is also called Short Naked Call.
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In this strategy, we purchase a stock since we feel bullish about it. But what if the price of the stock went down. You wish you had some insurance against the price fall. So buy a Put on the stock. This gives you the right to sell the stock at a certain price which is the strike price. The strike price can be the price at which you bought the stock (ATM strike price) or slightly below (OTM strike price). In case the price of the stock rises you get the full benefit of the price rise. In case the price of the stock falls, exercise the Put Option (remember Put is a right to sell). You have capped your loss in this manner because the Put option stops your further losses. It is a strategy with a limited loss and (after subtracting the Put premium) unlimited profit (from the stock price rise). But the strategy is not Buy Call Option (Strategy 1). Here you have taken an exposure to an underlying stock with the aim of holding it and reaping the benefits of price rise, dividends, bonus rights etc. and at the same time insuring against an adverse price movement.
When to use: When ownership is desired of stock yet investor is concerned about near-term downside risk. The outlook is conservatively bullish.
Risk: Losses limited to Stock price + Put Premium Put Strike price
Reward: Profit potential is unlimited. Break-even Point: Put Strike Price + Put Premium+ Stock Price Put Strike Price
Example:
Mr. XYZ is bullish about ABC Ltd stock. He buys ABC Ltd. at current market price of Rs. 4000 on 4th July. To protect against fall in the price of ABC Ltd. (his risk), he buys an ABC Ltd. Put option with a strike price Rs.3900 (OTM) at a premium of Rs. 143.80 expiring on31st July.
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Buy Stock + Buy Put Option Current Market Price of ABC Ltd. (Rs.) 4000
Strike Price (Rs.) Buy Put (Mr. XYZ pays) Break Even Point (Rs.) (Put Strike Price + Put Premium + Stock Price Put Strike Price)* Premium (Rs.)
3900 143.80
4143.80
Example:
ABC Ltd. is trading at Rs. 4000 on 4th July. Buy 100 shares of the Stock at Rs. 4000 Buy 100 July Put Options with a Strike Price of Rs. 3900 at a premium of Rs. 143.80 per put.
Net Debit (payout) Stock Bought + Premium Paid = Rs. 4000 + Rs. 143.80 = Rs. 4,14,380/Maximum Loss Stock Price + Put Premium Put Strike = Rs. 4000 + Rs. 143.80 Rs. 3900 = Rs. 24,380/-
Maximum Gain Unlimited (as the stock rises) Breakeven Put Strike + Put Premium + Stock Price Put Strike = Rs. 3900 + Rs. 143.80 + Rs. 4000 Rs. 3900= Rs. 4143.80/54
The payoff schedule ABC Ltd. closes at (Rs.) on expiry 3400.00 3600.00 3800.00 4000.00 4143.80 4200.00 4400.00 4600.00 4800.00 Payoff from the Stock (Rs.) -600.00 -400.00 -200.00 0 143.80 200.00 400.00 600.00 800.00 Net Payoff from the Net Payoff Put Option (Rs.) (Rs.) -243.80 -243.80 -243.80 -143.80 0 56.20 256.20 456.20 656.20
Analysis:
This is a low risk strategy. This is a strategy which limits the loss in case of fall in market but the potential profit remains unlimited when the stock price rises. A good strategy when you buy a stock for medium or long term, with the aim of protecting any downside risk.
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Buying a Put is the opposite of buying a Call. When you buy a Call you are bullish about the stock / index. When an investor is bearish, he can buy a Put option. A Put Option gives the buyer of the Put a right to sell the stock (to the Put seller) at a pre-specified price and thereby limit his risk.
Example:
Mr. XYZ is bearish on Nifty on 24th June, when the Nifty is at 2694. He buys a Put option with a strike price Rs. 2600 at a premium of Rs. 52, expiring on 31st July. If the Nifty goes below 2548, Mr. XYZ will make a profit on exercising the option. In case the Nifty rises above 2600, he can forego the option (it will expire worthless) with a maximum loss of the premium.
Strategy :
Strike Price (Rs.) Premium (Rs.) Break Even Point (Rs.) (Strike Price - Premium)
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The payoff schedule On expiry Nifty closes at Net Payoff from Put Option (Rs.) 2300 2400 2500 2548 2600 2700 2800 2900 248 148 48 0 -52 -52 -52 -52
Analysis:
A bearish investor can profit from declining stock price by buying Puts. He limits his risk to the amount of premium paid but his profit potential remains unlimited. This is one of the widely used strategies when an investor is bearish.
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Selling a Put is opposite of buying a Put. An investor buys Put when he is bearish on a stock. An investor Sells Put when he is Bullish about the stock expects the stock price to rise or stay sideways at the minimum. When you sell a Put, you earn a Premium (from the buyer of the Put). You have sold someone the right to sell you the stock at the strike price. If the stock price increases beyond the strike price, the short put position will make a profit for the seller by the amount of the premium, since the buyer will not exercise the Put option and the Put seller can retain the Premium (which is his maximum profit). But, if the stock price decreases below the strike price, by more than the amount of the premium, the Put seller will lose money. The potential loss being unlimited (until the stock price fall to zero).
When to Use: Investor is very Bullish on the stock / index. The main idea is to make a short term income. Risk: Put Strike Price Put Premium.
Reward: Limited to the amount of Premium received. Breakeven: Put Strike Price Premium
Example:
Mr. XYZ is bullish on Nifty when it is at 4191.10. He sells a Put option with a strike price of Rs. 4100 at a premium of Rs. 170.50 expiring on 31st July. If the Nifty index stays above 4100, he will gain the amount of premium as the Put buyer wont exercise his option. In case the Nifty falls below 4100, Put buyer will exercise the option and the Mr. XYZ will start losing money. If the Nifty falls below 3929.50, which is the breakeven point, Mr. XYZ will lose the premium and more depending on the extent of the fall in Nifty.
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Strategy :
Sell Put Option Current Nifty index 4191.10 4100 170.5 3929.5
Strike Price (Rs.) Premium (Rs.) Break Even Point (Rs.) (Strike Price - Premium)*
The payoff schedule On expiry Nifty Closes at Net Payoff from the Put Option (Rs.) 3400.00 3500.00 3700.00 3900.00 3929.50 4100.00 4300.00 4500.00 -529.50 -429.50 -229.50 -29.50 0 170.50 170.50 170.50
Analysis:
Selling Puts can lead to regular income in a rising or range bound markets. But it should be done carefully since the potential losses can be significant in case the price of the stock/ index falls. This strategy can be considered as an income generating strategy.
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You own shares in a company which you feel may rise but not much in the near term (or at best stay sideways). You would still like to earn an income from the shares. The covered call is a strategy in which an investor Sells a Call option on a stock he owns (netting him a premium). The Call Option which is sold in usually an OTM Call. The Call would not get exercised unless the stock price increases above the strike price. Till then the investor in the stock (Call seller) can retain the Premium with him. This becomes his income from the stock. This strategy is usually adopted by a stock owner who is Neutral to moderately Bullish about the stock. An investor buys a stock or owns a stock which he feels is good for medium to long term but is neutral or bearish for the near term. At the same time, the investor does not mind exiting the stock at a certain price (target price). The investor can sell a Call Option at the strike price at which he would be fine exiting the stock (OTM strike). By selling the Call Option the investor earns a Premium. Now the position of the investor is that of a Call Seller who owns the underlying stock. If the stock price stays at or below the strike price, the Call Buyer (refer to Strategy 1) will not exercise the Call. The Premium is retained by the investor. In case the stock price goes above the strike price, the Call buyer who has the right to buy the stock at the strike price will exercise the Call option. The Call seller (the investor) who has to sell the stock to the Call buyer, will sell the stock at the strike price. This was the price which the Call seller (the investor) was anyway interested in exiting the stock and now exits at that price. So besides the strike price which was the target price for selling the stock, the Call seller (investor) also earns the Premium which becomes an additional gain for him. This strategy is called as a Covered Call strategy because the Call sold is backed by a stock owned by the Call Seller (investor). The income increases as the stock rises, but gets capped after the stock reaches the strike price. Let us see an example to understand the Covered Call strategy.
When to use: This is often employed when an investor has a short-term neutral to moderately view on the stock he holds. He takes a short position on the call option to generate income from the option premium. Since the stock is purchased simultaneously with writing (selling) the call the strategy is commonly referred to as buy-write.
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Risk: If the stock price falls to zero, the investor loses the entire value of the stock but retains the premium, since the call will not be exercised against him. So maximum risk Stock price paid Call premium. Upside capped at the strike price plus the premium received. So if the Stock rises beyond the strike price beyond the strike price the investor (call seller) gives up all the gains on the stock Reward: Limited to (Call Strike Price Stock Price paid) + Premium received
Example:
Mr A bought XYZ Ltd for Rs 3850 and simultaneously sells a call option at a strike price of Rs 4000.Which means Mr. A does not think that the price of XYZ Ltd. will rise above Rs 4000,Mr A does not mind getting exercised at that price and exiting the stock at Rs 4000(TARGET SELL PRICE =3.90% RETURN ON THE STOCK PURCHASE PRICE ). Mr A receives a premium of Rs 80 for selling the call. Thus net outflow to Mr A is (Rs 3850Rs 80) = Rs 3770. He reduces the cost of buying the stock by this strategy. If the stock price stays at or below Rs 4000, the call option will not get exercised and Mr A can retain the Rs 80 premium, which is an extra income. If the stock price goes above Rs 4000, the call option will get exercised by the call buyer. The entire position will work like this
Buy stock +Sell Call Option Market Price (Rs) Strike Price (Rs.) Premium (Rs.) 3850 4000 80
Break Even Point (Rs.) (Stock 3770 Price paid Premium Received)
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Example:
1. The price of XYZ Ltd. stays at or below Rs. 4000. The Call buyer will not exercise the Call Option. Mr. A will keep the premium of Rs. 80. This is an income for him. So if the stock has moved from Rs. 3850 (purchase price) to Rs. 3950, Mr. A makes Rs. 180/- [Rs. 3950 Rs. 3850 + Rs. 80 (Premium)] = An additional Rs. 80, because of the Call sold. 2. Suppose the price of XYZ Ltd. moves to Rs. 4100, then the Call Buyer will exercise the Call Option and Mr. A will have to pay him Rs. 100 (loss on exercise of the Call Option). What would Mr. A do and what will be his pay off?
Rs. 4100
b) Pay Rs. 100 to the Call Options buyer: - Rs. 100 c) Pay off (a b) received: (This was Mr. As target price)
Rs. 4000
Rs. 80
Rs. 4080
Rs. 3850
g) Net profit:
Rs. 4080 Rs. 3850 = Rs. 230 (Rs. 4080 Rs. 3850) X 100 Rs. 3850 = 5.97% (which is more than the target return of 3.90%).
h) Return (%):
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The Pay off Schedule XYZ Ltd. price closes at (Rs.) 3600 3700 3740 3770 3800 3900 4000 4100 4200 4300 Net Payoff (Rs.) -170 -70 -30 0 30 130 230 230 230 230
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This is a strategy wherein an investor has gone short on a stock and buys a call to hedge. This is an opposite of Put Hedge (Strategy 3). An investor shorts a stock and buys an ATM or slightly OTM Call. The net effect of this is that the investor creates a pay-off like a Long Put, but instead of having a net debit (paying premium) for a Long Put, he creates a net credit (receives money on shorting the stock). In case the stock price falls the investor gains in the downward fall in the price. However, in case there is an unexpected rise in the price of the stock the loss is limited. The pay-off from the Long Call will increase thereby compensating for the loss in value of the short stock position. This strategy hedges the upside in the stock position while retaining downside profit potential.
When to Use: If the investor is of the view that the markets will go down (bearish) but wants to protect against any unexpected rise in the price of the stock. Risk: Limited. Maximum Risk is Call Strike Price Stock Price + Premium Reward: Maximum is Stock Price Call Premium Breakeven: Stock Price Call Premium
Example: Suppose ABC Ltd. is trading at Rs. 4457 in June. An investor Mr. A buys a Rs 4500 call for Rs. 100 while shorting the stock at Rs. 4457. The net credit to the investor is Rs. 4357 (Rs. 4457 Rs. 100). Strategy : Sells Stock (Mr. A receives) Buys Call Mr. A pays Short Stock + Buy Call Option Current Market Price (Rs.) Strike Price (Rs.) Premium (Rs.) Break Even Point (Rs.) (Stock Price Call Premi.) 4457 4500 100 4357
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The payoff schedule ABC Ltd. closes at (Rs.) 4100 4150 4200 4300 4350 4357 4400 4457 4600 4700 4800 4900 5000 Payoff from the stock (Rs.) 357 307 257 157 107 100 57 0 -143 -243 -343 -443 -543 Net Payoff from the Call Option (Rs.) -100 -100 -100 -100 -100 -100 -100 -100 0 100 200 300 400 257 207 157 57 7 0 -43 -100 -143 -143 -143 -143 -143 Net Payoff (Rs.)
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A Straddle is a volatility strategy and is used when the stock price / index is expected to show large movements. This strategy involves buying a call as well as put on the same stock / index for the same maturity and strike price, to take advantage of a movement in either direction, a soaring or plummeting value of the stock / index. If the price of the stock/ index increases, the call is exercised while the put expires worthless and if the price of the stock / index decreases, the put is exercised, the call expires worthless. Either way if the stock / index shows volatility to cover the cost of the trade, profits are to be made. With Straddles, the investor is direction neutral. All that he is looking out for is the stock / index to break out exponentially in either direction.
When to Use: The investor thinks that the underlying stock / index will experience significant volatility in the near term.
Reward: Unlimited
Breakeven: Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid
Example:
Suppose Nifty is at 4450 on 27th April. An investor, Mr. A enters a long straddle by buying a May Rs 4500 Nifty Put for Rs. 85 and a May Rs. 4500 Nifty Call for Rs. 122. The net debit taken to enter the trade is Rs 207, which is also his maximum possible loss.
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Buy Put + Buy Call Current Value Strike Price (Rs.) Total Premium (Call + Put) (Rs.) Break Even Point (Rs.) (Rs.) 4450 4500 207 4707(U) 4293(L)
The payoff schedul On expiry Nifty closes at Net Payoff from Net Payoff from Net Payoff (Rs.)
Put purchased (Rs.) Call (Rs.) 615 515 415 315 215 181 122 115 15 -85 -85 -122 -122 -122 -122 -122 -122 -122 -122 -122 -122 -22
purchased
3800 3900 4000 4100 4200 4234 4293 4300 4400 4500 4600
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A Short Straddle is the opposite of Long Straddle. It is a strategy to be adopted when the investor feels the market will not show much movement. He sells a Call and a Put on the same stock / index for the same maturity and strike price. It creates a net income for the investor. If the stock / index does not move much in either direction, the investor retains the Premium as neither the Call nor the Put will be exercised. However, in case the stock / index moves in either direction, up or down significantly, the investors losses can be significant. So this is a risky strategy and should be carefully adopted and only when the expected volatility in the market is limited. If the stock / index value stays close to the strike price on expiry of the contracts, maximum gain, which is the Premium received is made.
When to Use: The investor thinks that the underlying stock / index will experience very little volatility in the near term.
Risk: Unlimited
Breakeven: Upper Breakeven Point = Strike Price of Short Call + Net Premium Received Lower Breakeven Point = Strike Price of Short Put - Net Premium Received
Example:
Suppose Nifty is at 4450 on 27th April. An investor, Mr. A, enters into a short straddle by selling a May Rs 4500 Nifty Put for Rs. 85 and a May Rs. 4500 Nifty Call for Rs. 122. The net credit received is Rs. 207, which is also his maximum possible profit.
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Sell Put + Sell Call Current Value Strike Price (Rs.) Total Premium (Call + Put) (Rs.) Break Even Point (Rs.)* 4707(U) 4450 4500 207
The payoff schedule On expiry Nifty closes at On expiry Nifty closes at Net Call Sold (Rs.) 3800 3900 4000 4100 4200 4234 4293 4300 4400 -615 -515 -415 -315 -215 -181 -122 -115 -15 122 122 122 122 122 122 122 122 122 -493 -393 -293 -193 -93 -59 0 7 107 Payoff from Net Payoff (Rs.)
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85 85 85 85 85 85 85 85
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A Strangle is a slight modification to the Straddle to make it cheaper to execute. This strategy involves the simultaneous buying of a slightly out-of-the-money (OTM) put and a slightly out-of-the-money (OTM) call of the same underlying stock / index and expiration date. Here again the investor is directional neutral but is looking for an increased volatility in the stock / index and the prices moving significantly in either direction. Since OTM options are purchased for both Calls and Puts it makes the cost of executing a Strangle cheaper as compared to a Straddle, where generally ATM strikes are purchased. Since the initial cost of a Strangle is cheaper than a Straddle, the returns could potentially be higher. However, for a Strangle to make money, it would require greater movement on the upside or downside for the stock / index than it would for a Straddle. As with a Straddle, the strategy has a limited downside (i.e. the Call and the Put premium) and unlimited upside potential.
When to Use: The investor thinks that the underlying stock / index will experience very high levels of volatility in the near term.
Reward: Unlimited
Breakeven: Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid
Example:
Suppose Nifty is at 4500 in May. An investor, Mr. A, executes a Long Strangle by buying a Rs. 4300 Nifty Put for a premium of Rs. 23 and a Rs 4700 Nifty Call for Rs 43. The net debit taken to enter the trade is Rs. 66, which is also his maxi mum possible loss.
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Strategy : Buy OTM Put + Buy OTM Call Nifty index Buy Call Option Mr. A pays Current Value Strike Price (Rs.) Premium (Rs.) Break Even Point (Rs.) Buy Put Option Mr. A pays Strike Price (Rs.) Premium (Rs.) Break Even Point (Rs.) 4500 4700 43 4766 4300 23 4234
The payoff schedule On expiry Nifty closes at Net Put purchased (Rs.) 3800 3900 4000 4100 4200 4234 4300 477 377 277 177 77 43 -23 Payoff from Net Call purchased (Rs.) -43 -43 -43 -43 -43 -43 -43 434 334 234 134 34 0 -66 Payoff from Net Payoff (Rs.)
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4400 4500 4600 4700 4766 4800 4900 5000 5100 5200 5300
-23 -23 -23 -23 -23 -23 -23 -23 -23 -23 -23
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A Short Strangle is a slight modification to the Short Straddle. It tries to improve the profitability of the trade for the Seller of the options by widening the breakeven points so that there is a much greater movement required in the underlying stock / index, for the Call and Put option to be worth exercising. This strategy involves the simultaneous selling of a slightly out-of-the-money (OTM) put and a slightly out-of-the-money (OTM) call of the same underlying stock and expiration date. This typically means that since OTM call and put are sold, the net credit received by the seller is less as compared to a Short Straddle, but the break even points are also widened. The underlying stock has to move significantly for the Call and the Put to be worth exercising. If the underlying stock does not show much of a movement, the seller of the Strangle gets to keep the Premium.
When to Use: This options trading strategy is taken when the options investor thinks that the underlying stock will experience little volatility in the near term.
Risk: Unlimited
Breakeven: Upper Breakeven Point = Strike Price of Short Call + Net Premium Received Lower Breakeven Point = Strike Price of Short Put - Net Premium Received
Example:
Suppose Nifty is at 4500 in May. An investor, Mr. A, executes a Short Strangle by selling a Rs. 4300 Nifty Put for a premium of Rs. 23 and a Rs. 4700 Nifty Call for Rs 43. The net credit is Rs. 66, which is also his maximum possible gain.
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Strategy : Sell OTM Put + Sell OTM Call Nifty index Sell Call Option Mr. A receives Current Value Strike Price (Rs.) Premium (Rs.) Break Even Point (Rs.) Sell Put Option Mr. A receives Strike Price (Rs.) Premium (Rs.) Break Even Point (Rs.) 4500 4700 43 4766 4300 23 4234
The payoff schedule On expiry Nifty closes at 3800 3900 4000 4100 4200 4234 4300 4400 Net Payoff from Put sold (Rs.) -477 -377 -277 -177 -77 -43 23 23 Net Payoff from Net Payoff (Rs.) -434 -334 -234 -134 -34 0 66 66
43 43 43 43 43 43 43 43
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4500 4600 4700 4766 4800 4900 5000 5100 5200 5300
23 23 23 23 23 23 23 23 23 23
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Conclusions
Technical analysis is a method of evaluating securities by analysing the statistics generated by market activity. It is based on three assumptions: 1) The market discounts everything, 2) Price moves in trends and 3) History tends to repeat itself.
Technicians believe that all the information they need about a stock can be found in its charts.
One of the most important concepts in technical analysis is that of a trend. There are three types of trends: uptrends, downtrends and sideways/horizontal trends.
A trendline is a simple charting technique that adds a line to a chart to represent the trend in the market or a stock.
A channel, or channel lines, is the addition of two parallel trendlines that act as strong areas of support and resistance.
Support is the price level through which a stock or market seldom falls. Resistance is the price level that a stock or market seldom surpasses. Volume is the number of shares or contracts that trade over a given period of time, usually a day. The higher the volume, the more active the security.
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The time scale refers to the range of dates at the bottom of the chart, which can vary from decades to seconds. The most frequently used time scales are intraday, daily, weekly, monthly, quarterly and annually.
There are four main types of charts used by investors and traders : Line charts, bar charts, candlestick charts and point and figure charts.
A chart pattern is a distinct formation on a stock chart that creates a trading signal, or a sign of future price movements. There are two types: Reversal and continuation.
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Limitation
The methods used to analyse securities and make investment decisions fall into two very broad categories:
Fundamental analysis involves analysing the characteristics of a company in order to estimate its value. Technical analysis takes a completely different approach; it doesn't care one bit about the "value" of a company or a commodity. Technicians are only interested in the price movements in the market. Despite all the fancy and exotic tools it employs, technical analysis really just studies supply and demand in a market in an attempt to determine what direction, or trend, will continue in the future.
1. Human error in understanding the pattern. 2. It is for short term as compared to fundamental analysis which is for long term. 3. Pattern will not always follow the history, which will in turn increase the risk.
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Bibliography
1. www.bseindia.com 2. www.moneycontrol.com 3. http://www.icharts.in/charts.html 4. http://www.investopedia.com/university/technical/#axzz1QjKKlbwH 5. http://en.wikipedia.org/wiki/Technical_analysis 6. http://www.stocktradingtogo.com/terms/technical-analysis/ 7. www.theoptionsguide.com 8. http://www.nseindia.com/index_nse.htm 9. http://en.wikipedia.org/wiki/Derivative_(finance) 10. http://finance.indiamart.com/markets/commodity/derivatives.html 11. http://www.sebi.gov.in/faq/derivativesfaq.html
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