MUTUAL FUND Introduction The Mutual Fund Industry

The genesis of the mutual fund industry in India can be traced back to 1964 with the setting up of the Unit Trust of India (UTI) by the Government of India. Since then UTI has grown to be a dominant player in the industry. UTI is governed by a special legislation, the Unit Trust of India Act, 1963. The industry was opened up for wider participation in 1987 when public sector banks and insurance companies were permitted to set up mutual funds. Since then, 6 public sector banks have set up mutual funds. Also the two Insurance companies LIC and GIC have established mutual funds. Securities Exchange Board of India (SEBI) formulated the Mutual Fund (Regulation) 1993, which for the first time established a comprehensive regulatory framework for the mutual fund industry. Since then several mutual funds have been set up by the private and joint sectors.

Growth of Mutual Funds

The Indian Mutual fund industry has passed through three phases.The first phase was between 1964 and 1987 when Unit Trust of India was the only player.By the end of 1988,UTI had total asset of Rs 6,700 crores. The second phase was between 1987 and 1993 during which period 8 funds were established (6 by banks and one each by LIC and GIC).This resulted in the total assets under management to grow to Rs 61,028 crores at the end of 1994 and the number of schemes were 167. The third phase began with the entry of private and foreign sectors in the Mutual fund industry in 1993. Several private sectors Mutual Funds were launched in 1993 and 1994. The share of the private players has risen rapidly since then. Currently there are 34 Mutual Fund organisations in India. Kothari Pioneer Mutual fund was the first fund to be established by the private sector in association with a foreign fund. This signaled a growth phase in the industry and at the end of financial year 2000, 32 funds were functioning with Rs. 1,13,005 crores as total assets under management. As on August end 2000, there were 33 funds with 391 schemes and assets under management with Rs. 1,02,849 crores. The Securities and Exchange Board of India (SEBI) came out with comprehensive regulation in 1993 which defined the structure of Mutual Fund and Asset Management Companies for the first time.

What is a Mutual Fund

Like most developed and developing countries the mutual fund cult has been catching on in India. There are various reasons for this. Mutual funds make it easy and less costly for investors to satisfy their need for capital growth, income and/or income preservation. And in addition to this a mutual fund brings the benefits of diversification and money management to the individual investor, providing an opportunity for financial success that was once available only to a select few. Understanding Mutual funds is easy as it's such a simple concept: a mutual fund is a company

that pools the money of many investors -- its shareholders -- to invest in a variety of different securities. Investments may be in stocks, bonds, money market securities or some combination of these. Those securities are professionally managed on behalf of the shareholders, and each investor holds a pro rata share of the portfolio -- entitled to any profits when the securities are sold, but subject to any losses in value as well. For the individual investor, mutual funds provide the benefit of having someone else manage your investments and diversify your money over many different securities that may not be available or affordable to you otherwise. Today, minimum investment requirements on many funds are low enough that even the smallest investor can get started in mutual funds. A mutual fund, by its very nature, is diversified -- its assets are invested in many different securities. Beyond that, there are many different types of mutual funds with different objectives and levels of growth potential, furthering your chances to diversify.

Why invest in Mutual Funds.

Investing in mutual has various benefits which makes it an ideal investment avenue. Following are some of the primary benefits. Professional investment management One of the primary benefits of mutual funds is that an investor has access to professional management. A good investment manager is certainly worth the fees you will pay. Good mutual fund managers with an excellent research team can do a better job of monitoring the companies they have chosen to invest in than you can, unless you have time to spend on researching the companies you select for your portfolio. That is because Mutual funds hire full-time, high-level investment professionals. Funds can afford to do so as they manage large pools of money. The managers have real-time access to crucial market information and are able to execute trades on the largest and most cost-effective scale. When you buy a mutual fund, the primary asset you are buying is the manager, who will be controlling which assets are chosen to meet the funds' stated investment objectives. Diversification A crucial element in investing is asset allocation. It plays a very big part in the success of any portfolio. However, small investors do not have enough money to properly allocate their assets. By pooling your funds with others, you can quickly benefit from greater diversification. Mutual funds invest in a broad range of securities. This limits investment risk by reducing the effect of a possible decline in the value of any one security. Mutual fund unit-holders can benefit from

diversification techniques usually available only to investors wealthy enough to buy significant positions in a wide variety of securities. Low Cost A mutual fund let's you participate in a diversified portfolio for as little as Rs.5,000, and sometimes less. And with a no-load fund, you pay little or no sales charges to own them. Convenience and Flexibility Investing in mutual funds has its own convenience. While you own just one security rather than many, you still enjoy the benefits of a diversified portfolio and a wide range of services. Fund managers decide what securities to trade, collect the interest payments and see that your dividends on portfolio securities are received and your rights exercised. It also uses the services of a high quality custodian and registrar. Another big advantage is that you can move your funds easily from one fund to another within a mutual fund family. This allows you to easily rebalance your portfolio to respond to significant fund management or economic changes. Liquidity In open-ended schemes, you can get your money back promptly at net asset value related prices from the mutual fund itself. Transparency Regulations for mutual funds have made the industry very transparent. You can track the investments that have been made on you behalf and the specific investments made by the mutual fund scheme to see where your money is going. In addition to this, you get regular information on the value of your investment. Variety There is no shortage of variety when investing in mutual funds. You can find a mutual fund that matches just about any investing strategy you select. There are funds that focus on blue-chip stocks, technology stocks, bonds or a mix of stocks and bonds. The greatest challenge can be sorting through the variety and picking the best for you.

Types of Mutual Funds

Getting a handle on what's under the hood helps you become a better investor and put together a more successful portfolio. To do this one must know the different types of funds that cater to investor needs, whatever the age, financial position, risk tolerance and return expectations. The mutual fund schemes can be classified according to both their investment objective (like income, growth, tax saving) as well as the number of units (if these are unlimited then the fund is an openended one while if there are limited units then the fund is close-ended). This section provides descriptions of the characteristics -- such as investment objective and potential for volatility of your investment -- of various categories of funds. These descriptions are organized by the type of securities purchased by each fund: equities, fixed-income, money market instruments, or some combination of these. Open-ended schemes

Open-ended schemes do not have a fixed maturity period. Investors can buy or sell units at NAVrelated prices from and to the mutual fund on any business day. These schemes have unlimited capitalization, open-ended schemes do not have a fixed maturity, there is no cap on the amount you can buy from the fund and the unit capital can keep growing. These funds are not generally listed on any exchange. Open-ended schemes are preferred for their liquidity. Such funds can issue and redeem units any time during the life of a scheme. Hence, unit capital of open-ended funds can fluctuate on a daily basis. The advantages of open-ended funds over close-ended are as follows: Any time exit option, The issuing company directly takes the responsibility of providing an entry and an exit. This provides ready liquidity to the investors and avoids reliance on transfer deeds, signature verifications and bad deliveries. Any time entry option, An open-ended fund allows one to enter the fund at any time and even to invest at regular intervals. Close ended schemes Close-ended schemes have fixed maturity periods. Investors can buy into these funds during the period when these funds are open in the initial issue. After that such schemes can not issue new units except in case of bonus or rights issue. However, after the initial issue, you can buy or sell units of the scheme on the stock exchanges where they are listed. The market price of the units could vary from the NAV of the scheme due to demand and supply factors, investors expectations and other market factors Classification according to investment objectives Mutual funds can be further classified based on their specific investment objective such as growth of capital, safety of principal, current income or tax-exempt income. In general mutual funds fall into three general categories: 1] Equity Funds are those that invest in shares or equity of companies. 2] Fixed-Income Funds invest in government or corporate securities that offer fixed rates of return are 3] While funds that invest in a combination of both stocks and bonds are called Balanced Funds. Growth Funds Growth funds primarily look for growth of capital with secondary emphasis on dividend. Such funds invest in shares with a potential for growth and capital appreciation. They invest in wellestablished companies where the company itself and the industry in which it operates are thought to have good long-term growth potential, and hence growth funds provide low current income. Growth funds generally incur higher risks than income funds in an effort to secure more pronounced growth. Some growth funds concentrate on one or more industry sectors and also invest in a broad range of industries. Growth funds are suitable for investors who can afford to assume the risk of potential loss in value of their investment in the hope of achieving substantial and rapid gains. They are not suitable for investors who must conserve their principal or who must maximize current income.

Growth and Income Funds Growth and income funds seek long-term growth of capital as well as current income. The investment strategies used to reach these goals vary among funds. Some invest in a dual portfolio consisting of growth stocks and income stocks, or a combination of growth stocks, stocks paying high dividends, preferred stocks, convertible securities or fixed-income securities such as corporate bonds and money market instruments. Others may invest in growth stocks and earn current income by selling covered call options on their portfolio stocks. Growth and income funds have low to moderate stability of principal and moderate potential for current income and growth. They are suitable for investors who can assume some risk to achieve growth of capital but who also want to maintain a moderate level of current income. Fixed-Income Funds Fixed income funds primarily look to provide current income consistent with the preservation of capital. These funds invest in corporate bonds or government-backed mortgage securities that have a fixed rate of return. Within the fixed-income category, funds vary greatly in their stability of principal and in their dividend yields. High-yield funds, which seek to maximize yield by investing in lower-rated bonds of longer maturities, entail less stability of principal than fixed-income funds that invest in higher-rated but lower-yielding securities. Some fixed-income funds seek to minimize risk by investing exclusively in securities whose timely payment of interest and principal is backed by the full faith and credit of the Indian Government. Fixed-income funds are suitable for investors who want to maximize current income and who can assume a degree of capital risk in order to do so. Balanced The Balanced fund aims to provide both growth and income. These funds invest in both shares and fixed income securities in the proportion indicated in their offer documents. Ideal for investors who are looking for a combination of income and moderate growth. Money Market Funds/Liquid Funds For the cautious investor, these funds provide a very high stability of principal while seeking a moderate to high current income. They invest in highly liquid, virtually risk-free, short-term debt securities of agencies of the Indian Government, banks and corporations and Treasury Bills. Because of their short-term investments, money market mutual funds are able to keep a virtually constant unit price; only the yield fluctuates. Therefore, they are an attractive alternative to bank accounts. With yields that are generally competitive with - and usually higher than -- yields on bank savings account, they offer several advantages. Money can be withdrawn any time without penalty. Although not insured, money market funds invest only in highly liquid, short-term, top-rated money market instruments. Money market funds are suitable for investors who want high stability of principal and current income with immediate liquidity. Specialty/Sector Funds These funds invest in securities of a specific industry or sector of the economy such as health care, technology, leisure, utilities or precious metals. The funds enable investors to diversify

holdings among many companies within an industry, a more conservative approach than investing directly in one particular company. Sector funds offer the opportunity for sharp capital gains in cases where the fund's industry is "in favor" but also entail the risk of capital losses when the industry is out of favor. While sector funds restrict holdings to a particular industry, other specialty funds such as index funds give investors a broadly diversified portfolio and attempt to mirror the performance of various market averages. Index funds generally buy shares in all the companies composing the BSE Sensex or NSE Nifty or other broad stock market indices. They are not suitable for investors who must conserve their principal or maximize current income.

Risk vs Reward
Having understood the basics of mutual funds the next step is to build a successful investment portfolio. Before you can begin to build a portfolio, one should understand some other elements of mutual fund investing and how they can affect the potential value of your investments over the years. The first thing that has to be kept in mind is that when you invest in mutual funds, there is no guarantee that you will end up with more money when you withdraw your investment than what you started out with. That is the potential of loss is always there. The loss of value in your investment is what is considered risk in investing. Even so, the opportunity for investment growth that is possible through investments in mutual funds far exceeds that concern for most investors. Heres why. At the cornerstone of investing is the basic principal that the greater the risk you take, the greater the potential reward. Or stated in another way, you get what you pay for and you get paid a higher return only when you're willing to accept more volatility. Risk then, refers to the volatility -- the up and down activity in the markets and individual issues that occurs constantly over time. This volatility can be caused by a number of factors -- interest rate changes, inflation or general economic conditions. It is this variability, uncertainty and potential for loss, that causes investors to worry. We all fear the possibility that a stock we invest in will fall substantially. But it is this very volatility that is the exact reason that you can expect to earn a higher long-term return from these investments than from a savings account. Different types of mutual funds have different levels of volatility or potential price change, and those with the greater chance of losing value are also the funds that can produce the greater returns for you over time. So risk has two sides: it causes the value of your investments to fluctuate, but it is precisely the reason you can expect to earn higher returns. You might find it helpful to remember that all financial investments will fluctuate. There are very few perfectly safe havens and those simply don't pay enough to beat inflation over the long run.

Types of risks
All investments involve some form of risk. Consider these common types of risk and evaluate them against potential rewards when you select an investment. Market Risk At times the prices or yields of all the securities in a particular market rise or fall due to broad outside influences. When this happens, the stock prices of both an outstanding, highly profitable company and a fledgling corporation may be affected. This change in price is due to "market risk". Also known as systematic risk. Inflation Risk Sometimes referred to as "loss of purchasing power." Whenever inflation rises forward faster than the earnings on your investment, you run the risk that you'll actually be able to buy less, not more. Inflation risk also occurs when prices rise faster than your returns. Credit Risk In short, how stable is the company or entity to which you lend your money when you invest? How certain are you that it will be able to pay the interest you are promised, or repay your principal when the investment matures? Interest Rate Risk Changing interest rates affect both equities and bonds in many ways. Investors are reminded that "predicting" which way rates will go is rarely successful. A diversified portfolio can help in offseting these changes. Exchange risk A number of companies generate revenues in foreign currencies and may have investments or expenses also denominated in foreign currencies. Changes in exchange rates may, therefore, have a positive or negative impact on companies which in turn would have an effect on the investment of the fund.

Investment Risks The sectoral fund schemes, investments will be predominantly in equities of select companies in the particular sectors. Accordingly, the NAV of the schemes are linked to the equity performance of such companies and may be more volatile than a more diversified portfolio of equities. Changes in the Government Policy Changes in Government policy especially in regard to the tax benefits may impact the business prospects of the companies leading to an impact on the investments made by the fund Effect of loss of key professionals and inability to adapt business to the rapid technological change. An industries' key asset is often the personnel who run the business i.e. intellectual properties of the key employees of the respective companies. Given the ever-changing complexion of few industries and the high obsolescence levels, availability of qualified, trained and motivated personnel is very critical for the success of industries in few sectors. It is, therefore, necessary to attract key personnel and also to retain them to meet the changing environment and challenges the sector offers. Failure or inability to attract/retain such qualified key personnel may impact the prospects of the companies in the particular sector in which the fund invests.

Choosing a fund
Mutual fund is the best investment tool for the retail investor as it offers the twin benefits of good returns and safety as compared with other avenues such as bank deposits or stock investing. Having looked at the various types of mutual funds, one has to now go about selecting a fund suiting your requirements. Choose the wrong fund and you would have been better off keeping money in a bank fixed deposit.Keep in mind the points listed below and you could at least marginalise your investment risk. Past performance While past performance is not an indicator of the future it does throw some light on the investment philosophies of the fund, how it has performed in the past and the kind of returns it is offering to the investor over a period of time. Also check out the two-year and one-year returns for consistency. How did these funds perform in the bull and bear markets of the immediate past? Tracking the performance in the bear market is particularly important because the true test of a portfolio is often revealed in how little it falls in a bad market. Know your fund manager The success of a fund to a great extent depends on the fund manager. The same fund managers manage most successful funds. Ask before investing, has the fund manager or strategy changed recently? For instance, the portfolio manager who generated the funds successful performance may no longer be managing the fund. Does it suit your risk profile? Certain sector-specific schemes come with a high-risk high-return tag. Such plans are suspect to crashes in case the industry loses the marketmens fancy. If the investor is totally risk averse he can opt for pure debt schemes with little or no risk. Most prefer the balanced schemes which

invest in the equity and debt markets. Growth and pure equity plans give greater returns than pure debt plans but their risk is higher. Read the prospectus The prospectus says a lot about the fund. A reading of the funds prospectus is a must to learn about its investment strategy and the risk that it will expose you to. Funds with higher rates of return may take risks that are beyond your comfort level and are inconsistent with your financial goals. But remember that all funds carry some level of risk. Just because a fund invests in government or corporate bonds does not mean it does not have significant risk. Thinking about your long-term investment strategies and tolerance for risk can help you decide what type of fund is best suited for you. How will the fund affect the diversification of your portfolio? When choosing a mutual fund, you should consider how your interest in that fund affects the overall diversification of your investment portfolio. Maintaining a diversified and balanced portfolio is key to maintaining an acceptable level of risk. What it costs you? A fund with high costs must perform better than a low-cost fund to generate the same returns for you. Even small differences in fees can translate into large differences in returns over time. Finally, dont pick a fund simply because it has shown a spurt in value in the current rally. Ferret out information of a fund for atleast three years. The one thing to remember while investing in equity funds is that it makes no sense to get in and out of a fund with each turn of the market. Like stocks, the right equity mutual fund will pay off big -- if you have the patience. Similarly, it makes little sense to hold on to a fund that lags behind the total market year after year.

Tax aspects of Mutual Funds

Tax Implications of Dividend Income Equity Schemes Equity Schemes are schemes, which have less than 50 per cent investments in Equity shares of domestic companies. As far as Equity Schemes are concerned no Distribution Tax is payable on dividend. In the hands of the investors, dividend is tax-free. Other Schemes For schemes other than equity, in the hands of the investors, dividend is tax-free. However, Distribution Tax on dividend @ 12.81 per cent to be paid by Mutual Funds. Tax Implications of Capital Gains The difference between the sale consideration (selling price) and the cost of acquisition (purchase price) of the asset is called capital gain. If the investor sells his units and earns capital gains he is liable to pay capital gains tax.

Capital gains are of two types: Short Term and Long Term Capital Gains. Short Term Capital Gains The holding period of the Mutual Fund units is less than or equal to 12 months from the date of allotment of units then short term capital gains is applicable. On Short Term capital gains no Indexation benefit is applicable. Tax and TDS Rate (excluding surcharge) Resident Indians and Domestic Companies The Gain will be added to the total income of the Investor and taxed at the marginal rate of tax. No TDS. NRIs: 30 per cent TDS from the gain. Long Term Capital Gains The holding period of Mutual Fund units is more than 12 months from the date of allotment of units. On Long Term capital gains Indexation benefit is applicable. Tax and TDS Rate (excluding surcharge) Resident Indians and Domestic Companies The Gain will be taxed A) at 20 per cent with indexation benefit or B) B) at 10 per cent without indexation benefit, whichever is lower. No TDS. NRIs: 20 per cent TDS from the Gain

Surcharge Resident Indians : If the Gain exceeds Rs 8.5 lakhs, surcharge is payable by investors @ 10 per cent. Domestic Companies: Payable by the investor @ 2.5 per cent. NRIs: If the Gain from the Fund exceeds Rs 8.5 lakhs, surcharge is deducted at source @ 2.5 per cent. Indexation

Indexation means that the purchase price is marked up by an inflation index resulting in lower capital gains and hence lower tax. Inflation index for the year of transfer Inflation index = ---------------------------------------------------Inflation index for the year of acquisition

Risk Tolerance Questionnaire

1 Current vs. Future Which of the following statements best reflects the manner you wish to invest to achieve your goals? My investments should be absolutely safe and I just cannot run the risk of losing even a single rupee of principal.

My investments should generate regular income that I can spend. My investments should generate some current income and also grow in value over time. I want to create wealth and not current income.

2 Volatility Depending on the kinds of investments you select, the value of your assets can remain quite stable (increasing slowly but steadily) or may rise and fall in response to market events. With respect to your goals, how much volatility are you willing to accept?

Slight. Some. Considerable.

3 Desire for Returns Investments in which the principal is 100% safe sometimes earn less than the inflation rate. This means that while no money is lost, there is a loss in purchasing power. (To illustrate: If a Rs1000 was locked in a vault 100 years ago and taken out today, it would still be worth Rs 1000 but would buy a great deal less today than when it was put in.) With respect to your goals, which of the following is most true? My money should be 100% safe, even if it means my returns do not keep pace with inflation.

It is important that the value of my investments keep pace with inflation. It is important that my investments grow faster than inflation.

4 Extent of Tolerable Loss The value of my portfolio may fluctuate over time. However, the maximum loss in any one-year period that I would be prepared to accept is approximately:

0% -5% -10% -20% -30%

5 Allocation Strategy Consider the following two investments, ABC Limited and XYZ Limited. ABC Limited provides an average annual return of 10% with minimal risk of loss of principal. XYZ Limited provides an average annual return of 20% but carries a potential loss of principal of 30% or more in any year. If I could choose to invest between this two companies to meet my goals, I would invest my money in:

100% in ABC Ltd. and 20% in XYZ Ltd. 80% in ABC Limited and 20% in XYZ Limited. 50% in ABC Limited and 50% in XYZ Limited. 20% in ABC Limited and 80% in XYZ Limited. 0% in ABC Limited and 100% in XYZ Limited.

6 Fluctuation In case of fluctuations in the value of my investments I would

Immediately sell any investment that loses money on a daily or weekly basis

If my investment loses 5% within three months, I will redeem my investment and not invest further If after a year there is a decline in the value of my funds, I will pull out my investment from mutual funds If my investment has declined in value after a year, I will exchange the mutual fund for another mutual fund 7 Risk-Return Matrix I am willing to accept these best and worst case scenarios. For an initial investment of Rs10,000 for five years.

Rs 82,000/Rs 2,000 Rs 45,000/Rs 4,000 Rs 27,000/Rs 7,000 Rs 13,000/Rs 9,950 Rs 10,050/Rs 10,000

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Futures

Introduction
o o o o o Overview Why have Derivatives? Forward Contracts? What is an Index? What are Index Futures? Hedging Speculation Arbitrage The cost of carry model Pricing in case of dividend yield Speculation Hedging Margins Settlement How to read a Futures Tables? Selecting the Right Index Glossary

Forward Contracts, Indices, Index Futures

Application of Index Futures

o o o

Pricing of Index Futures

o o o o o o o o o

Trading Strategies Margins & Settlement Miscellaneous

Futures Overview
Derivatives have made the international and financial headlines in the past for mostly with their association with spectacular losses or institutional collapses. But market players have traded derivatives successfully for centuries and the daily international turnover in derivatives trading runs into billions of dollars. Are derivative instruments that can only be traded by experienced, specialist traders? Although it is true that complicated mathematical models are used for pricing some derivatives, the basic concepts and principles underpinning derivatives and their trading are quite easy to grasp and understand. Indeed, derivatives are used increasingly by market players ranging from governments, corporate treasurers, dealers and brokers and individual investors. Indian scenario While forward contracts and exchange traded in futures has grown by leaps and bound, Indian stock markets have been largely slow to these global changes. However, in the last few years, there has been substantial improvement in the functioning of the securities market. Requirements

of adequate capitalization for market intermediaries, margining and establishment of clearing corporations have reduced market and credit risks. However, there were inadequate advanced risk management tools. And after the ICE (Information, Communication, Entertainment) meltdown the market regulator felt that in order to deepen and strengthen the cash market trading of derivatives like futures and options was imperative.

Why have derivatives?

Derivatives have become very important in the field finance. They are very important financial instruments for risk management as they allow risks to be separated and traded. Derivatives are used to shift risk and act as a form of insurance. This shift of risk means that each party involved in the contract should be able to identify all the risks involved before the contract is agreed. It is also important to remember that derivatives are derived from an underlying asset. This means that risks in trading derivatives may change depending on what happens to the underlying asset. A derivative is a product whose value is derived from the value of an underlying asset, index or reference rate. The underlying asset can be equity, forex, commodity or any other asset. For example, if the settlement price of a derivative is based on the stock price of a stock for e.g. Infosys, which frequently changes on a daily basis, then the derivative risks are also changing on a daily basis. This means that derivative risks and positions must be monitored constantly. The purpose of this Learning Centre is to introduce the basic concepts and principles of derivatives. We will try and understand What are derivatives? Why have derivatives at all? How are derivatives traded and used?

In subsequent lessons we will try and understand how exactly will an underlying asset effect the movement of a derivative instrument and how is it traded and how one can profit from these instruments.

What are forward contracts?

Derivatives as a term conjures up visions of complex numeric calculations, speculative dealings and comes across as an instrument which is the prerogative of a few smart finance professionals. In reality it is not so. In fact, a derivative transaction helps cover risk, which would arise on the trading of securities on which the derivative is based and a small investor, can benefit immensely. A derivative security can be defined as a security whose value depends on the values of other underlying variables. Very often, the variables underlying the derivative securities are the prices of traded securities. Let us take an example of a simple derivative contract:

Ram buys a futures contract. He will make a profit of Rs 1000 if the price of Infosys rises by Rs 1000. If the price is unchanged Ram will receive nothing. If the stock price of Infosys falls by Rs 800 he will lose Rs 800.

As we can see, the above contract depends upon the price of the Infosys scrip, which is the underlying security. Similarly, futures trading has already started in Sensex futures and Nifty futures. The underlying security in this case is the BSE Sensex and NSE Nifty. Derivatives and futures are basically of 3 types: Forwards and Futures Options Swaps

Forward contract A forward contract is the simplest mode of a derivative transaction. It is an agreement to buy or sell an asset (of a specified quantity) at a certain future time for a certain price. No cash is exchanged when the contract is entered into. Illustration 1: Shyam wants to buy a TV, which costs Rs 10,000 but he has no cash to buy it outright. He can only buy it 3 months hence. He, however, fears that prices of televisions will rise 3 months from now. So in order to protect himself from the rise in prices Shyam enters into a contract with the TV dealer that 3 months from now he will buy the TV for Rs 10,000. What Shyam is doing is that he is locking the current price of a TV for a forward contract. The forward contract is settled at maturity. The dealer will deliver the asset to Shyam at the end of three months and Shyam in turn will pay cash equivalent to the TV price on delivery. Illustration 2: Ram is an importer who has to make a payment for his consignment in six months time. In order to meet his payment obligation he has to buy dollars six months from today. However, he is not sure what the Re/$ rate will be then. In order to be sure of his expenditure he will enter into a contract with a bank to buy dollars six months from now at a decided rate. As he is entering into a contract on a future date it is a forward contract and the underlying security is the foreign currency. The difference between a share and derivative is that shares/securities is an asset while derivative instrument is a contract.

What is an Index?
To understand the use and functioning of the index derivatives markets, it is necessary to understand the underlying index. A stock index represents the change in value of a set of stocks, which constitute the index. A market index is very important for the market players as it acts as a barometer for market behavior and as an underlying in derivative instruments such as index futures. The Sensex and Nifty In India the most popular indices have been the BSE Sensex and S&P CNX Nifty. The BSE Sensex has 30 stocks comprising the index which are selected based on market capitalization, industry representation, trading frequency etc. It represents 30 large well-established and financially sound companies. The Sensex represents a broad spectrum of companies in a variety of industries. It represents 14 major industry groups. Then there is a BSE national index and BSE 200. However, trading in index futures has only commenced on the BSE Sensex. While the BSE Sensex was the first stock market index in the country, Nifty was launched by the National Stock Exchange in April 1996 taking the base of November 3, 1995. The Nifty index

consists of shares of 50 companies with each having a market capitalization of more than Rs 500 crore. Futures and stock indices For understanding of stock index futures a thorough knowledge of the composition of indexes is essential. Choosing the right index is important in choosing the right contract for speculation or hedging. Since for speculation, the volatility of the index is important whereas for hedging the choice of index depends upon the relationship between the stocks being hedged and the characteristics of the index. Choosing and understanding the right index is important as the movement of stock index futures is quite similar to that of the underlying stock index. Volatility of the futures indexes is generally greater than spot stock indexes. Everytime an investor takes a long or short position on a stock, he also has an hidden exposure to the Nifty or Sensex. As most often stock values fall in tune with the entire market sentiment and rise when the market as a whole is rising. Retail investors will find the index derivatives useful due to the high correlation of the index with their portfolio/stock and low cost associated with using index futures for hedging.

Understanding index futures

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. Index futures are all futures contracts where the underlying is the stock index (Nifty or Sensex) and helps a trader to take a view on the market as a whole. Index futures permits speculation and if a trader anticipates a major rally in the market he can simply buy a futures contract and hope for a price rise on the futures contract when the rally occurs. We shall learn in subsequent lessons how one can leverage ones position by taking position in the futures market. In India we have index futures contracts based on S&P CNX Nifty and the BSE Sensex and near 3 months duration contracts are available at all times. Each contract expires on the last Thursday of the expiry month and simultaneously a new contract is introduced for trading after expiry of a contract. Example: Futures contracts in Nifty in July 2001
Contract month July 2001 August 2001 September 2001 Expiry/settlement July 26 August 30 September 27

On July 27
Contract month August 2001 Expiry/settlement August 30

September 2001 October 2001

September 27 October 25

The permitted lot size is 200 or multiples thereof for the Nifty. That is you buy one Nifty contract the total deal value will be 200*1100 (Nifty value)= Rs 2,20,000. In the case of BSE Sensex the market lot is 50. That is you buy one Sensex futures the total value will be 50*4000 (Sensex value)= Rs 2,00,000. The index futures symbols are represented as follows:
BSE BSXJUN2001 (June contract) BSXJUL2001 (July contract) BSXAUG2001 (Aug contract) NSE FUTDXNIFTY28-JUN2001 FUTDXNIFTY28-JUL2001 FUTDXNIFTY28-AUG2001

In subsequent lessons we will learn about the pricing of index futures.

Hedging
We have seen how one can take a view on the market with the help of index futures. The other benefit of trading in index futures is to hedge your portfolio against the risk of trading. In order to understand how one can protect his portfolio from value erosion let us take an example. Illustration: Ram enters into a contract with Shyam that six months from now he will sell to Shyam 10 dresses for Rs 4000. The cost of manufacturing for Ram is only Rs 1000 and he will make a profit of Rs 3000 if the sale is completed.
Cost (Rs) 1000 Selling price 4000 Profit 3000

However, Ram fears that Shyam may not honour his contract six months from now. So he inserts a new clause in the contract that if Shyam fails to honour the contract he will have to pay a penalty of Rs 1000. And if Shyam honours the contract Ram will offer a discount of Rs 1000 as incentive.
Shyam defaults 1000 (Initial Investment) 1000 (penalty from Shyam) - (No gain/loss) Shyam honours 3000 (Initial profit) (-1000) discount given to Shyam 2000 (Net gain)

As we see above if Shyam defaults Ram will get a penalty of Rs 1000 but he will recover his initial investment. If Shyam honours the contract, Ram will still make a profit of Rs 2000. Thus, Ram has hedged his risk against default and protected his initial investment. The above example explains the concept of hedging. Let us try understanding how one can use hedging in a real life scenario.

Stocks carry two types of risk company specific and market risk. While company risk can be minimized by diversifying your portfolio market risk cannot be diversified but has to be hedged. So how does one measure the market risk? Market risk can be known from Beta. Beta measures the relationship between movement of the index to the movement of the stock. The beta measures the percentage impact on the stock prices for 1% change in the index. Therefore, for a portfolio whose value goes down by 11% when the index goes down by 10%, the beta would be 1.1. When the index increases by 10%, the value of the portfolio increases 11%. The idea is to make beta of your portfolio zero to nullify your losses. Hedging involves protecting an existing asset position from future adverse price movements. In order to hedge a position, a market player needs to take an equal and opposite position in the futures market to the one held in the cash market. Every portfolio has a hidden exposure to the index, which is denoted by the beta. Assuming you have a portfolio of Rs 1 million, which has a beta of 1.2, you can factor a complete hedge by selling Rs 1.2 mn of S&P CNX Nifty futures. Steps:

1. Determine the beta of the portfolio. If the beta of any stock is not known, it is safe to
assume that it is 1.

2. Short sell the index in such a quantum that the gain on a unit decrease in the index would
offset the losses on the rest of his portfolio. This is achieved by multiplying the relative volatility of the portfolio by the market value of his holdings. Therefore in the above scenario we have to shortsell 1.2 * 1 million = 1.2 million worth of Nifty. Now let us study the impact on the overall gain/loss that accrues:
Index up 10% Index down 10% Gain/(Loss) in Portfolio Rs 120,000 Gain/(Loss) in Futures (Rs 120,000) Net Effect Nil (Rs 120,000) Rs 120,000 Nil

As we see, that portfolio is completely insulated from any losses arising out of a fall in market sentiment. But as a cost, one has to forego any gains that arise out of improvement in the overall sentiment. Then why does one invest in equities if all the gains will be offset by losses in futures market. The idea is that everyone expects his portfolio to outperform the market. Irrespective of whether the market goes up or not, his portfolio value would increase. The same methodology can be applied to a single stock by deriving the beta of the scrip and taking a reverse position in the futures market. Thus, we have seen how one can use hedging in the futures market to offset losses in the cash market.

Speculation
Speculators are those who do not have any position on which they enter in futures and options market. They only have a particular view on the market, stock, commodity etc. In short, speculators put their money at risk in the hope of profiting from an anticipated price change. They consider various factors such as demand supply, market positions, open interests, economic fundamentals and other data to take their positions. Illustration: Ram is a trader but has no time to track and analyze stocks. However, he fancies his chances in predicting the market trend. So instead of buying different stocks he buys Sensex Futures.

On May 1, 2001, he buys 100 Sensex futures @ 3600 on expectations that the index will rise in future. On June 1, 2001, the Sensex rises to 4000 and at that time he sells an equal number of contracts to close out his position. Selling Price : 4000*100 = Rs 4,00,000

Less: Purchase Cost: 3600*100 = Rs 3,60,000 Net gain Rs 40,000

Ram has made a profit of Rs 40,000 by taking a call on the future value of the Sensex. However, if the Sensex had fallen he would have made a loss. Similarly, if would have been bearish he could have sold Sensex futures and made a profit from a falling profit. In index futures players can have a long-term view of the market up to atleast 3 months.

Arbitrage
An arbitrageur is basically risk averse. He enters into those contracts were he can earn riskless profits. When markets are imperfect, buying in one market and simultaneously selling in other market gives riskless profit. Arbitrageurs are always in the look out for such imperfections. In the futures market one can take advantages of arbitrage opportunities by buying from lower priced market and selling at the higher priced market. In index futures arbitrage is possible between the spot market and the futures market (NSE has provided a special software for buying all 50 Nifty stocks in the spot market. Take the case of the NSE Nifty. Assume that Nifty is at 1200 and 3 months Nifty futures is at 1300. The futures price of Nifty futures can be worked out by taking the interest cost of 3 months into account. If there is a difference then arbitrage opportunity exists.

Let us take the example of single stock to understand the concept better. If Wipro is quoted at Rs 1000 per share and the 3 months futures of Wipro is Rs 1070 then one can purchase ITC at Rs 1000 in spot by borrowing @ 12% annum for 3 months and sell Wipro futures for 3 months at Rs 1070. Sale = 1070 Cost= 1000+30 = 1030 Arbitrage profit = 40 These kind of imperfections continue to exist in the markets but one has to be alert to the opportunities as they tend to get exhausted very fast.

Pricing of Index Futures

The index futures are the most popular futures contracts as they can be used in a variety of ways by various participants in the market.

How many times have you felt of making risk-less profits by arbitraging between the underlying and futures markets. If so, you need to know the cost-of-carry model to understand the dynamics of pricing that constitute the estimation of fair value of futures. The cost of carry model The cost-of-carry model where the price of the contract is defined as: F=S+C where: F Futures price S Spot price C Holding costs or carry costs If F < S+C or F > S+C, arbitrage opportunities would exist i.e. whenever the futures price moves away from the fair value, there would be chances for arbitrage. If Wipro is quoted at Rs 1000 per share and the 3 months futures of Wipro is Rs 1070 then one can purchase Wipro at Rs 1000 in spot by borrowing @ 12% annum for 3 months and sell Wipro futures for 3 months at Rs 1070. Here F=1000+30=1030 and is less than prevailing futures price and hence there are chances of arbitrage. Sale = 1070

Cost= 1000+30 = 1030 Arbitrage profit 40

However, one has to remember that the components of holding cost vary with contracts on different assets.

Futures pricing in case of dividend yield

We have seen how we have to consider the cost of finance to arrive at the futures index value. However, the cost of finance has to be adjusted for benefits of dividends and interest income. In the case of equity futures, the holding cost is the cost of financing minus the dividend returns. Example: Suppose a stock portfolio has a value of Rs 100 and has an annual dividend yield of 3% which is earned throughout the year and finance rate=10% the fair value of the stock index portfolio after one year will be F= Rs 100 + Rs 100 * (0.10 0.03) Futures price = Rs 107

If the actual futures price of one-year contract is Rs 109. An arbitrageur can buy the stock at Rs 100, borrowing the fund at the rate of 10% and simultaneously sell futures at Rs 109. At the end of the year, the arbitrageur would collect Rs 3 for dividends, deliver the stock portfolio at Rs 109 and repay the loan of Rs 100 and interest of Rs 10. The net profit would be Rs 109 + Rs 3 - Rs 100 - Rs 10 = Rs 2. Thus, we can arrive at the fair value in the case of dividend yield.

Trading strategies
Speculation We have seen earlier that trading in index futures helps in taking a view of the market, hedging, speculation and arbitrage. In this module we will see one can trade in index futures and use forward contracts in each of these instances. Taking a view of the market Have you ever felt that the market would go down on a particular day and feared that your portfolio value would erode? There are two options available Option 1: Sell liquid stocks such as Reliance Option 2: Sell the entire index portfolio The problem in both the above cases is that it would be very cumbersome and costly to sell all the stocks in the index. And in the process one could be vulnerable to company specific risk. So what is the option? The best thing to do is to sell index futures. Illustration: Scenario 1: On July 13, 2001, X feels that the market will rise so he buys 200 Nifties with an expiry date of July 26 at an index price of 1442 costing Rs 2,88,400 (200*1442). On July 21 the Nifty futures have risen to 1520 so he squares off his position at 1520. X makes a profit of Rs 15,600 (200*78) Scenario 2: On July 20, 2001, X feels that the market will fall so he sells 200 Nifties with an expiry date of July 26 at an index price of 1523 costing Rs 3,04,600 (200*1523). On July 21 the Nifty futures falls to 1456 so he squares off his position at 1456. X makes a profit of Rs 13,400 (200*67).

In the above cases X has profited from speculation i.e. he has wagered in the hope of profiting from an anticipated price change.

Hedging
Stock index futures contracts offer investors, portfolio managers, mutual funds etc several ways to control risk. The total risk is measured by the variance or standard deviation of its return distribution. A common measure of a stock market risk is the stocks Beta. The Beta of stocks are available on the www.nseindia.com. While hedging the cash position one needs to determine the number of futures contracts to be entered to reduce the risk to the minimum. Have you ever felt that a stock was intrinsically undervalued? That the profits and the quality of the company made it worth a lot more as compared with what the market thinks? Have you ever been a stockpicker and carefully purchased a stock based on a sense that it was worth more than the market price? A person who feels like this takes a long position on the cash market. When doing this, he faces two kinds of risks: 1. His understanding can be wrong, and the company is really not worth more than the market price or 2. The entire market moves against him and generates losses even though the underlying idea was correct. Everyone has to remember that every buy position on a stock is simultaneously a buy position on Nifty. A long position is not a focused play on the valuation of a stock. It carries a long Nifty position along with it, as incidental baggage i.e. a part long position of Nifty. Let us see how one can hedge positions using index futures: X holds HLL worth Rs 9 lakh at Rs 290 per share on July 01, 2001. Assuming that the beta of HLL is 1.13. How much Nifty futures does X have to sell if the index futures is ruling at 1527? To hedge he needs to sell 9 lakh * 1.13 = Rs 1017000 lakh on the index futures i.e. 666 Nifty futures. On July 19, 2001, the Nifty futures is at 1437 and HLL is at 275. X closes both positions earning Rs 13,389, i.e. his position on HLL drops by Rs 46,551 and his short position on Nifty gains Rs 59,940 (666*90). Therefore, the net gain is 59940-46551 = Rs 13,389. Let us take another example when one has a portfolio of stocks: Suppose you have a portfolio of Rs 10 crore. The beta of the portfolio is 1.19. The portfolio is to be hedged by using Nifty futures contracts. To find out the number of contracts in futures market to neutralise risk

If the index is at 1200 * 200 (market lot) = Rs 2,40,000 The number of contracts to be sold is:

a. 1.19*10 crore = 496 contracts

2,40,000 If you sell more than 496 contracts you are overhedged and sell less than 496 contracts you are underhedged. Thus, we have seen how one can hedge their portfolio against market risk.

Margins
The margining system is based on the JR Verma Committee recommendations. The actual margining happens on a daily basis while online position monitoring is done on an intra-day basis. Daily margining is of two types: 1. Initial margins 2. Mark-to-market profit/loss The computation of initial margin on the futures market is done using the concept of Value-atRisk (VaR). The initial margin amount is large enough to cover a one-day loss that can be encountered on 99% of the days. VaR methodology seeks to measure the amount of value that a portfolio may stand to lose within a certain horizon time period (one day for the clearing corporation) due to potential changes in the underlying asset market price. Initial margin amount computed using VaR is collected up-front. The daily settlement process called "mark-to-market" provides for collection of losses that have already occurred (historic losses) whereas initial margin seeks to safeguard against potential losses on outstanding positions. The mark-to-market settlement is done in cash. Let us take a hypothetical trading activity of a client of a NSE futures division to demonstrate the margins payments that would occur. A client purchases 200 units of FUTIDX NIFTY 29JUN2001 at Rs 1500. The initial margin payable as calculated by VaR is 15%.

Total long position = Rs 3,00,000 (200*1500) Initial margin (15%) = Rs 45,000 Assuming that the contract will close on Day + 3 the mark-to-market position will look as follows: Position on Day 1
Close Price 1400*200 =2,80,000 Payment to be made Loss Margin released 20,000 (3,00,000-2,80,000) 3,000 (45,000-42,000) Net cash outflow 17,000 (20,000-3000) (17,000)

New position on Day 2 Value of new position = 1,400*200= 2,80,000 Margin = 42,000
Close Price 1510*200 =3,02,000 Gain Addn Margin 22,000 (3,02,000-2,80,000) 3,300 (45,300-42,000) Net cash inflow 18,700 (22,000-3300)

Payment to be recd

18,700

Position on Day 3 Value of new position = 1510*200 = Rs 3,02,000 Margin = Rs 3,300

Close Price 1600*200 =3,20,000 Payment to be recd Gain 18,000 (3,20,000-3,02,000) Net cash inflow 18,000 + 45,300* = 63,300 63,300

Margin account* Initial margin = Rs 45,000 Margin released (Day 1) = (-) Rs 3,000 Position on Day 2 Rs 42,000 Addn margin = (+) Rs 3,300 Total margin in a/c Rs 45,300* Net gain/loss Day 1 (loss) = (Rs 17,000) Day 2 Gain = Rs 18,700 Day 3 Gain = Rs 18,000 Total Gain = Rs 19,700 The client has made a profit of Rs 19,700 at the end of Day 3 and the total cash inflow at the close of trade is Rs 63,300.

Settlements
All trades in the futures market are cash settled on a T+1 basis and all positions (buy/sell) which are not closed out will be marked-to-market. The closing price of the index futures will be the daily settlement price and the position will be carried to the next day at the settlement price. The most common way of liquidating an open position is to execute an offsetting futures transaction by which the initial transaction is squared up. The initial buyer liquidates his long position by selling identical futures contract. In index futures the other way of settlement is cash settled at the final settlement. At the end of the contract period the difference between the contract value and closing index value is paid.

How to read the futures data sheet?

Understanding and deciphering the prices of futures trade is the first challenge for anyone planning to venture in futures trading. Economic dailies and exchange websites www.nseindia.com and www.bseindia.com are some of the sources where one can look for the daily quotes. Your website has a daily market commentary, which carries end of day derivatives summary alongwith the quotes. The first step is start tracking the end of day prices. Closing prices, Trading Volumes and Open Interest are the three primary data we carry with Index option quotes. The most important parameter are the actual prices, the high, low, open, close, last traded prices and the intra-day prices and to track them one has to have access to real time prices. The following table shows how futures data will be generally displayed in the business papers daily.
Series First Trade BSXJUN2000 4755 High 4820 Low Volume (No of Value contracts) (Rs in lakh) 4740 4783.1 146 348.70 Close No of trades Open interest (No of contracts) 104 51

BSXJUL2000 4900 BSXAUG2000 4800 Total

4900 4870

4800 4830.8 12 4800 4835 2 160

28.98 4.84 38252

10 2 116

2 1 54

Source: BSE The first column explains the series that is being traded. For e.g. BSXJUN2000 stands for the June Sensex futures contract. The column on volume indicates that (in case of June series) 146 contracts have been traded in 104 trades. One contract is equivalent to 50 times the price of the futures, which are traded. For e.g. In case of the June series above, the first trade at 4755 represents one contract valued at 4755 x 50 i.e. Rs. 2,37,750/-.

Open interest indicates the total gross outstanding open positions in the market for that particular series. For e.g. Open interest in the June series is 51 contracts. The most useful measure of market activity is Open interest, which is also published by exchanges and used for technical analysis. Open interest indicates the liquidity of a market and is the total number of contracts, which are still outstanding in a futures market for a specified futures contract. A futures contract is formed when a buyer and a seller take opposite positions in a transaction. This means that the buyer goes long and the seller goes short. Open interest is calculated by looking at either the total number of outstanding long or short positions not both. Open interest is therefore a measure of contracts that have not been matched and closed out. The number of open long contracts must equal exactly the number of open short contracts.
Action Resulting open interest New buyer (long) and new seller (short) Trade to form Rise a new contract. Existing buyer sells and existing seller buys The old Fall contract is closed. New buyer buys from existing buyer. The Existing buyer closes his position by selling to new buyer. No change there is no increase in long contracts being held

Existing seller buys from new seller. The Existing seller No change there is no increase in short contracts closes his position by buying from new seller. being held

Open interest is also used in conjunction with other technical analysis chart patterns and indicators to gauge market signals. The following chart may help with these signals.
Price Open interest Strong Warning signal Weak Warning signal Market

The warning sign indicates that the Open interest is not supporting the price direction.

Selecting the right index

In selecting the index and contract month one should consider the following points.

Expiration date: If the investor has a month or twos view about the market then he should choose that index futures which has a similar time left for expiry. Liquidity: The index and the contract month, which is the most liquid must be used. This will save cost because of the low bid-ask spread. This also saves hedging costs. Stock should be correlated to the index: The stock to be hedged should have a correlation with the index selected. Potential mispricing: One should sell index futures contract which is overpriced. In such an event one can not only hedge but also earn some profit in selling high. In a nutshell, one should hedge by using the most popular and fairly priced index and delivery month should not be very far since liquidity and predictability of very few contracts are low.

Glossary
Backwardation: A market where future prices of distant contract months are lower than the near months. Basis: The difference between the Index and the respective contract is the basis i.e. cash netted for the Futures price. A negative basis means Futures are at a premium to cash and vice versa. It is the strengthening and weakening of basis that is tracked by market players i.e. whether the basis is widening or narrowing. A widening of basis is indicative of increasing longs and narrowing means increasing short positions. Basis Point: It is equal to one hundredth of a percentage point Contango market: This is a market where futures prices are higher for distant contracts than for nearby delivery months. Cost of carry: is an indicator of the demand-supply forces in the Futures market. It basically means the annualized interest cost players decide to pay (receive) for buying (selling) a respective contract. A higher carry cost is indicative of buying pressure and vice versa. Carry Cost is a widely used parameter not only because it is more interpretable being an annualized figure, as compared to basis (Cash netted for Futures) but also because it works well with the trio of Price, Volume and Open Interest in highlighting the market trend. Delivery month: Is the month in which delivery of futures contracts need to be made. Delivery price: The price fixed by the clearinghouse at which deliveries on futures contracts are invoiced. Also known as the expiry price or the settlement price. Derivative: A financial instrument designed to replicate an underlying security for the purpose of transferring risk. Fair value: Theoretical value of a futures contract derived from a mathematical model of valuation. Hedge Ratio: The Hedge Ratio is defined as the number of Futures contracts required to buy or sell so as to provide the maximum offset of risk. This depends on the

Value of a Futures contract; Value of the portfolio to be Hedged; and Sensitivity of the movement of the portfolio price to that of the Index (Called Beta).

The Hedge Ratio is closely linked to the correlation between the asset (portfolio of shares) to be hedged and underlying (index) from which Future is derived. Initial margin: The money a customer needs to pay as deposit to establish a position in the futures market. The basic aim of Initial margin is to cover the largest potential loss in one day. Mark-to-market: The daily revaluation of open positions to reflect profits and losses based on closing market prices at the end of the trading day. Forward contract: In a forward contract, two parties agree to do a trade at some future date, at a stated price and quantity. No money changes hands at the time the deal is signed. Futures contract: A futures contract is similar to a forward contract in terms of its working. The difference is that contracts are standardized and trading is centralized. Futures markets are highly liquid and there is no counterparty risk due to the presence of a clearinghouse, which becomes the counterparty to both sides of each transaction and guarantees the trade. Far contract: The future that is furthest from its delivery month i. e. has the longest maturity. Speculation: Trading on anticipated price changes, where the trader does not hold another position which will offset any such price movements. Spread ratio: The number of futures contracts bought, divided by the number of futures contracts sold. VaR: Value at Risk. A risk management methodology, which attempts to measure the maximum loss possible on a particular position, with a specified level of certainty or confidence. Strike Price: The price at which an option holder may buy or sell the underlying asset, which is specified in an option contract.

Options

Options
o o What are Options? Type of Options Call options Put options Styles Important Terms Factors Greeks Delta Gamma Theta Vega Rho Other Models Bull Market Strategies Bear Market Strategies Volatile Market Strategies Stable Market Strategies Key Regulations How to read the options table? Advantages of options trading Barings Episode Glossary Take a Quiz

Concepts
o o o o

Pricing of Options

o o o o o o o o o o o

Trading Strategies

Miscellaneous

Options
Stock markets by their very nature are fickle. While fortunes can be made in a jiffy more often than not the scenario is the reverse. Investing in stocks has two sides to it a) Unlimited profit potential from any upside (remember Infosys, HFCL etc) or b) a downside which could make you a pauper. Derivative products are structured precisely for this reason -- to curtail the risk exposure of an investor. Index futures and stock options are instruments that enable you to hedge your portfolio or open positions in the market. Option contracts allow you to run your profits while restricting your downside risk. Apart from risk containment, options can be used for speculation and investors can create a wide range of potential profit scenarios. We have seen in the Derivatives School how index futures can be used to protect oneself from volatility or market risk. Here we will try and understand some basic concepts of options. What are options?

Some people remain puzzled by options. The truth is that most people have been using options for some time, because options are built into everything from mortgages to insurance. An option is a contract, which gives the buyer the right, but not the obligation to buy or sell shares of the underlying security at a specific price on or before a specific date. Option, as the word suggests, is a choice given to the investor to either honour the contract; or if he chooses not to walk away from the contract. To begin, there are two kinds of options: Call Options and Put Options. A Call Option is an option to buy a stock at a specific price on or before a certain date. In this way, Call options are like security deposits. If, for example, you wanted to rent a certain property, and left a security deposit for it, the money would be used to insure that you could, in fact, rent that property at the price agreed upon when you returned. If you never returned, you would give up your security deposit, but you would have no other liability. Call options usually increase in value as the value of the underlying instrument rises. When you buy a Call option, the price you pay for it, called the option premium, secures your right to buy that certain stock at a specified price called the strike price. If you decide not to use the option to buy the stock, and you are not obligated to, your only cost is the option premium. Put Options are options to sell a stock at a specific price on or before a certain date. In this way, Put options are like insurance policies If you buy a new car, and then buy auto insurance on the car, you pay a premium and are, hence, protected if the asset is damaged in an accident. If this happens, you can use your policy to regain the insured value of the car. In this way, the put option gains in value as the value of the underlying instrument decreases. If all goes well and the insurance is not needed, the insurance company keeps your premium in return for taking on the risk. With a Put Option, you can "insure" a stock by fixing a selling price. If something happens which causes the stock price to fall, and thus, "damages" your asset, you can exercise your option and sell it at its "insured" price level. If the price of your stock goes up, and there is no "damage," then you do not need to use the insurance, and, once again, your only cost is the premium. This is the primary function of listed options, to allow investors ways to manage risk. Technically, an option is a contract between two parties. The buyer receives a privilege for which he pays a premium. The seller accepts an obligation for which he receives a fee. We will dwelve further into the mechanics of call/put options in subsequent lessons.

Call option
An option is a contract between two parties giving the taker (buyer) the right, but not the obligation, to buy or sell a parcel of shares at a predetermined price possibly on, or before a predetermined date. To acquire this right the taker pays a premium to the writer (seller) of the contract. There are two types of options: Call Options

Put Options

Call options Call options give the taker the right, but not the obligation, to buy the underlying shares at a predetermined price, on or before a predetermined date. Illustration 1: Raj purchases 1 Satyam Computer (SATCOM) AUG 150 Call --Premium 8 This contract allows Raj to buy 100 shares of SATCOM at Rs 150 per share at any time between the current date and the end of next August. For this privilege, Raj pays a fee of Rs 800 (Rs eight a share for 100 shares). The buyer of a call has purchased the right to buy and for that he pays a premium. Now let us see how one can profit from buying an option. Sam purchases a December call option at Rs 40 for a premium of Rs 15. That is he has purchased the right to buy that share for Rs 40 in December. If the stock rises above Rs 55 (40+15) he will break even and he will start making a profit. Suppose the stock does not rise and instead falls he will choose not to exercise the option and forego the premium of Rs 15 and thus limiting his loss to Rs 15.

Let us take another example of a call option on the Nifty to understand the concept better. Nifty is at 1310. The following are Nifty options traded at following quotes.
Option contract Dec Nifty 1325 1345 Strike price Rs 6,000 Rs 2,000 Call premium

Jan Nifty

1325 1345

Rs 4,500 Rs 5000

A trader is of the view that the index will go up to 1400 in Jan 2002 but does not want to take the risk of prices going down. Therefore, he buys 10 options of Jan contracts at 1345. He pays a premium for buying calls (the right to buy the contract) for 500*10= Rs 5,000/-. In Jan 2002 the Nifty index goes up to 1365. He sells the options or exercises the option and takes the difference in spot index price which is (1365-1345) * 200 (market lot) = 4000 per contract. Total profit = 40,000/- (4,000*10). He had paid Rs 5,000/- premium for buying the call option. So he earns by buying call option is Rs 35,000/- (40,000-5000). If the index falls below 1345 the trader will not exercise his right and will opt to forego his premium of Rs 5,000. So, in the event the index falls further his loss is limited to the premium he paid upfront, but the profit potential is unlimited. Call Options-Long & Short Positions When you expect prices to rise, then you take a long position by buying calls. You are bullish. When you expect prices to fall, then you take a short position by selling calls. You are bearish.

Put Options

A Put Option gives the holder of the right to sell a specific number of shares of an agreed security at a fixed price for a period of time. eg: Sam purchases 1 INFTEC (Infosys Technologies) AUG 3500 Put --Premium 200 This contract allows Sam to sell 100 shares INFTEC at Rs 3500 per share at any time between the current date and the end of August. To have this privilege, Sam pays a premium of Rs 20,000 (Rs 200 a share for 100 shares). The buyer of a put has purchased a right to sell. The owner of a put option has the right to sell. Illustration 2: Raj is of the view that the a stock is overpriced and will fall in future, but he does not want to take the risk in the event of price rising so purchases a put option at Rs 7 0 on X. By purchasing the put option Raj has the right to sell the stock at Rs 70 but he has to pay a fee of Rs 15 (premium). So he will breakeven only after the stock falls below Rs 55 (70-15) and will start making profit if the stock falls below Rs 55.

Illustration 3: An investor on Dec 15 is of the view that Wipro is overpriced and will fall in future but does not want to take the risk in the event the prices rise. So he purchases a Put option on Wipro. Quotes are as under: Spot Rs 1040 Jan Put at 1050 Rs 10 Jan Put at 1070 Rs 30 He purchases 1000 Wipro Put at strike price 1070 at Put price of Rs 30/-. He pays Rs 30,000/- as Put premium. His position in following price position is discussed below.

1. Jan Spot price of Wipro = 1020 2. Jan Spot price of Wipro = 1080
In the first situation the investor is having the right to sell 1000 Wipro shares at Rs 1,070/- the price of which is Rs 1020/-. By exercising the option he earns Rs (1070-1020) = Rs 50 per Put, which totals Rs 50,000/-. His net income is Rs (50000-30000) = Rs 20,000. In the second price situation, the price is more in the spot market, so the investor will not sell at a lower price by exercising the Put. He will have to allow the Put option to expire unexercised. He looses the premium paid Rs 30,000.

Put Options-Long & Short Positions When you expect prices to fall, then you take a long position by buying Puts. You are bearish. When you expect prices to rise, then you take a short position by selling Puts. You are bullish.
CALL OPTIONS If you expect a fall in price(Bearish) If you expect a rise in price (Bullish) Short Long Long Short CALL OPTION WRITER (Seller) PUT OPTIONS

SUMMARY:
CALL OPTION BUYER

Pays premium Right to exercise and buy the shares Profits from rising prices Limited losses, Potentially unlimited gain

Receives premium Obligation to sell shares if exercised Profits from falling prices or remaining neutral Potentially unlimited losses, limited gain

PUT OPTION BUYER

PUT OPTION WRITER (Seller)

Pays premium Right to exercise and sell shares Profits from falling prices Limited losses, Potentially unlimited gain

Receives premium Obligation to buy shares if exercised Profits from rising prices or remaining neutral Potentially unlimited losses, limited gain

Option styles
Settlement of options is based on the expiry date. However, there are three basic styles of options you will encounter which affect settlement. The styles have geographical names, which have nothing to do with the location where a contract is agreed! The styles are: European: These options give the holder the right, but not the obligation, to buy or sell the underlying instrument only on the expiry date. This means that the option cannot be exercised early. Settlement is based on a particular strike price at expiration. Currently, in India only index options are European in nature. eg: Sam purchases 1 NIFTY AUG 1110 Call --Premium 20. The exchange will settle the contract on the last Thursday of August. Since there are no shares for the underlying, the contract is cash settled. American: These options give the holder the right, but not the obligation, to buy or sell the underlying instrument on or before the expiry date. This means that the option can be exercised early. Settlement is based on a particular strike price at expiration. Options in stocks that have been recently launched in the Indian market are "American Options". eg: Sam purchases 1 ACC SEP 145 Call --Premium 12 Here Sam can close the contract any time from the current date till the expiration date, which is the last Thursday of September.

American style options tend to be more expensive than European style because they offer greater flexibility to the buyer. Option Class & Series Generally, for each underlying, there are a number of options available: For this reason, we have the terms "class" and "series". An option "class" refers to all options of the same type (call or put) and style (American or European) that also have the same underlying. eg: All Nifty call options are referred to as one class. An option series refers to all options that are identical: they are the same type, have the same underlying, the same expiration date and the same exercise price.
Calls . Wipro 1300 1400 1500 45 35 20 60 45 42 75 65 48 15 25 30 20 28 40 28 35 55 JUL AUG SEP JUL Puts AUG SEP

eg: Wipro JUL 1300 refers to one series and trades take place at different premiums All calls are of the same option type. Similarly, all puts are of the same option type. Options of the same type that are also in the same class are said to be of the same class. Options of the same class and with the same exercise price and the same expiration date are said to be of the same series

Concepts
Important Terms
(Strike price, In-the-money, Out-of-the-Money, At-the-Money, Covered call and Covered Put) Strike price: The Strike Price denotes the price at which the buyer of the option has a right to purchase or sell the underlying. Five different strike prices will be available at any point of time. The strike price interval will be of 20. If the index is currently at 1,410, the strike prices available will be 1,370, 1,390, 1,410, 1,430, 1,450. The strike price is also called Exercise Price. This price is fixed by the exchange for the entire duration of the option depending on the movement of the underlying stock or index in the cash market. In-the-money: A Call Option is said to be "In-the-Money" if the strike price is less than the market price of the underlying stock. A Put Option is In-The-Money when the strike price is greater than the market price. eg: Raj purchases 1 SATCOM AUG 190 Call --Premium 10

In the above example, the option is "in-the-money", till the market price of SATCOM is ruling above the strike price of Rs 190, which is the price at which Raj would like to buy 100 shares anytime before the end of August. Similary, if Raj had purchased a Put at the same strike price, the option would have been "in-themoney", if the market price of SATCOM was lower than Rs 190 per share. Out-of-the-Money: A Call Option is said to be "Out-of-the-Money" if the strike price is greater than the market price of the stock. A Put option is Out-Of-Money if the strike price is less than the market price. eg: Sam purchases 1 INFTEC AUG 3500 Call --Premium 150 In the above example, the option is "out-of- the- money", if the market price of INFTEC is ruling below the strike price of Rs 3500, which is the price at which SAM would like to buy 100 shares anytime before the end of August. Similary, if Sam had purchased a Put at the same strike price, the option would have been "outof-the-money", if the market price of INFTEC was above Rs 3500 per share. At-the-Money: The option with strike price equal to that of the market price of the stock is considered as being "At-the-Money" or Near-the-Money. eg: Raj purchases 1 ACC AUG 150 Call or Put--Premium 10 In the above case, if the market price of ACC is ruling at Rs 150, which is equal to the strike price, then the option is said to be "at-the-money". If the index is currently at 1,410, the strike prices available will be 1,370, 1,390, 1,410, 1,430, 1,450. The strike prices for a call option that are greater than the underlying (Nifty or Sensex) are said to be out-of-the-money in this case 1430 and 1450 considering that the underlying is at 1410. Similarly in-the-money strike prices will be 1,370 and 1,390, which are lower than the underlying of 1,410. At these prices one can take either a positive or negative view on the markets i.e. both call and put options will be available. Therefore, for a single series 10 options (5 calls and 5 puts) will be available and considering that there are three series a total number of 30 options will be available to take positions in. Covered Call Option Covered option helps the writer to minimize his loss. In a covered call option, the writer of the call option takes a corresponding long position in the stock in the cash market; this will cover his loss in his option position if there is a sharp increase in price of the stock. Further, he is able to bring down his average cost of acquisition in the cash market (which will be the cost of acquisition less the option premium collected). eg: Raj believes that HLL has hit rock bottom at the level of Rs.182 and it will move in a narrow range. He can take a long position in HLL shares and at the same time write a call option with a strike price of 185 and collect a premium of Rs.5 per share. This will bring down the effective cost of HLL shares to 177 (182-5). If the price stays below 185 till expiry, the call option will not be exercised and the writer will keep the Rs.5 he collected as premium. If the price goes above 185 and the Option is exercised, the writer can deliver the shares acquired in the cash market.

Covered Put Option Similarly, a writer of a Put Option can create a covered position by selling the underlying security (if it is already owned). The effective selling price will increase by the premium amount (if the option is not exercised at maturity). Here again, the investor is not in a position to take advantage of any sharp increase in the price of the asset as the underlying asset has already been sold. If there is a sharp decline in the price of the underlying asset, the option will be exercised and the investor will be left only with the premium amount. The loss in the option exercised will be equal to the gain in the short position of the asset.

Pricing of options
Options are used as risk management tools and the valuation or pricing of the instruments is a careful balance of market factors. There are four major factors affecting the Option premium: Price of Underlying Time to Expiry Exercise Price Time to Maturity Volatility of the Underlying

And two less important factors: Short-Term Interest Rates Dividends

Review of Options Pricing Factors The Intrinsic Value of an Option The intrinsic value of an option is defined as the amount by which an option is in-the-money, or the immediate exercise value of the option when the underlying position is marked-to-market. For a call option: Intrinsic Value = Spot Price - Strike Price For a put option: Intrinsic Value = Strike Price - Spot Price The intrinsic value of an option must be positive or zero. It cannot be negative. For a call option, the strike price must be less than the price of the underlying asset for the call to have an intrinsic value greater than 0. For a put option, the strike price must be greater than the underlying asset price for it to have intrinsic value. Price of underlying The premium is affected by the price movements in the underlying instrument. For Call options the right to buy the underlying at a fixed strike price as the underlying price rises so does its premium. As the underlying price falls so does the cost of the option premium. For Put options the right to sell the underlying at a fixed strike price as the underlying price rises, the premium falls; as the underlying price falls the premium cost rises. The following chart summarises the above for Calls and Puts.
Option Call Put Underlying price Premium cost

The Time Value of an Option

Generally, the longer the time remaining until an options expiration, the higher its premium will be. This is because the longer an options lifetime, greater is the possibility that the underlying share price might move so as to make the option in-the-money. All other factors affecting an options price remaining the same, the time value portion of an options premium will decrease (or decay) with the passage of time. Note: This time decay increases rapidly in the last several weeks of an options life. When an option expires in-the-money, it is generally worth only its intrinsic value.
Option Call Put Time to expiry Premium cost

Volatility Volatility is the tendency of the underlying securitys market price to fluctuate either up o r down. It reflects a price changes magnitude; it does not imply a bias toward price movement in one direction or the other. Thus, it is a major factor in determining an options premium. The higher the volatility of the underlying stock, the higher the premium because there is a greater possibility that the option will move in-the-money. Generally, as the volatility of an under-lying stock increases, the premiums of both calls and puts overlying that stock increase, and vice versa. Higher volatility=Higher premium Lower volatility = Lower premium
Option Call Put Volatility Premium cost

Interest rates In general interest rates have the least influence on options and equate approximately to the cost of carry of a futures contract. If the size of the options contract is very large, then this factor may take on some importance. All other factors being equal as interest rates rise, premium costs fall and vice versa. The relationship can be thought of as an opportunity cost. In order to buy an option, the buyer must either borrow funds or use funds on deposit. Either way the buyer incurs an interest rate cost. If interest rates are rising, then the opportunity cost of buying options increases and to compensate the buyer premium costs fall. Why should the buyer be compensated? Because the option writer receiving the premium can place the funds on deposit and receive more interest than was previously anticipated. The situation is reversed when interest rates fall premiums rise. This time it is the writer who needs to be compensated.
Option Call Interest rates Premium cost

Put

How do we measure the impact of change in each of these pricing determinants on option premium we shall learn in the next module.

Greeks
The options premium is determined by the three factors mentioned earlier intrinsic value, time value and volatility. But there are more sophisticated tools used to measure the potential variations of options premiums. They are as follows:

Delta Gamma Vega Rho

Delta Delta is the measure of an options sensitivity to changes in the price of the underlying asset. Therefore, its is the degree to which an option price will move given a change in the underlying stock or index price, all else being equal. Change in option premium Delta = -------------------------------Change in underlying price For example, an option with a delta of 0.5 will move Rs 5 for every change of Rs 10 in the underlying stock or index. Illustration: A trader is considering buying a Call option on a futures contract, which has a price of Rs 19. The premium for the Call option with a strike price of Rs 19 is 0.80. The delta for this option is +0.5. This means that if the price of the underlying futures contract rises to Rs 20 a rise of Re 1 then the premium will increase by 0.5 x 1.00 = 0.50. The new option premium will be 0.80 + 0.50 = Rs 1.30. Far out-of-the-money calls will have a delta very close to zero, as the change in underlying price is not likely to make them valuable or cheap. An at-the-money call would have a delta of 0.5 and a deeply in-the-money call would have a delta close to 1. While Call deltas are positive, Put deltas are negative, reflecting the fact that the put option price and the underlying stock price are inversely related. This is because if you buy a put your view is bearish and expect the stock price to go down. However, if the stock price moves up it is contrary to your view therefore, the value of the option decreases. The put delta equals the call delta minus 1. It may be noted that if delta of your position is positive, you desire the underlying asset to rise in price. On the contrary, if delta is negative, you want the underlying assets price to fall. Uses: The knowledge of delta is of vital importance for option traders because this parameter is heavily used in margining and risk management strategies. The delta is often called the hedge ratio. e.g. if you have a portfolio of n shares of a stock then n divided by the delta gives you the number of calls you would need to be short (i.e. need to write) to create a riskless hedge i.e. a portfolio which would be worth the same whether the stock price rose by a very small amount or fell by a very small amount. In such a "delta neutral" portfolio any gain in the value of the shares held due to a rise in the share price would be exactly offset by a loss on the value of the calls written, and vice versa. Note that as the delta changes with the stock price and time to expiration the number of shares would need to be continually adjusted to maintain the hedge. How quickly the delta changes with the stock price is given by gamma, which we shall learn subsequently.

Gamma
This is the rate at which the delta value of an option increases or decreases as a result of a move in the price of the underlying instrument. Change in an option delta Gamma =------------------------------------Change in underlying price For example, if a Call option has a delta of 0.50 and a gamma of 0.05, then a rise of 1 in the underlying means the delta will move to 0.55 for a price rise and 0.45 for a price fall. Gamma is rather like the rate of change in the speed of a car its acceleration in moving from a standstill, up to its cruising speed, and braking back to a standstill. Gamma is greatest for an ATM (at-the-

money) option (cruising) and falls to zero as an option moves deeply ITM (in-the-money ) and OTM (out-of-the-money) (standstill). If you are hedging a portfolio using the delta-hedge technique described under "Delta", then you will want to keep gamma as small as possible as the smaller it is the less often you will have to adjust the hedge to maintain a delta neutral position. If gamma is too large a small change in stock price could wreck your hedge. Adjusting gamma, however, can be tricky and is generally done using options -- unlike delta, it can't be done by buying or selling the underlying asset as the gamma of the underlying asset is, by definition, always zero so more or less of it won't affect the gamma of the total portfolio.

Theta
It is a measure of an options sensitivity to time decay. Theta is the change in option price given a one-day decrease in time to expiration. It is a measure of time decay (or time shrunk). Theta is generally used to gain an idea of how time decay is affecting your portfolio. Change in an option premium Theta = -------------------------------------Change in time to expiry Theta is usually negative for an option as with a decrease in time, the option value decreases. This is due to the fact that the uncertainty element in the price decreases. Assume an option has a premium of 3 and a theta of 0.06. After one day it will decline to 2.94, the second day to 2.88 and so on. Naturally other factors, such as changes in value of the underlying stock will alter the premium. Theta is only concerned with the time value. Unfortunately, we cannot predict with accuracy the changes in stock markets value, but we can measure exactly the time remaining until expiration.

Vega
This is a measure of the sensitivity of an option price to changes in market volatility. It is the change of an option premium for a given change typically 1% in the underlying volatility. Change in an option premium Vega = ----------------------------------------Change in volatility If for example, XYZ stock has a volatility factor of 30% and the current premium is 3, a vega of .08 would indicate that the premium would increase to 3.08 if the volatility factor increased by 1% to 31%. As the stock becomes more volatile the changes in premium will increase in the same proportion. Vega measures the sensitivity of the premium to these changes in volatility. What practical use is the vega to a trader? If a trader maintains a delta neutral position, then it is possible to trade options purely in terms of volatility the trader is not exposed to changes in underlying prices.

Rho

The change in option price given a one percentage point change in the risk-free interest rate. Rho measures the change in an options price per unit increase typically 1% in the cost of funding the underlying. Change in an option premium Rho = --------------------------------------------------Change in cost of funding underlying Example: Assume the value of Rho is 14.10. If the risk free interest rates go up by 1% the price of the option will move by Rs 0.14109. To put this in another way: if the risk-free interest rate changes by a small amount, then the option value should change by 14.10 times that amount. For example, if the risk-free interest rate increased by 0.01 (from 10% to 11%), the option value would change by 14.10*0.01 = 0.14. For a put option the relationship is inverse. If the interest rate goes up the option value decreases and therefore, Rho for a put option is negative. In general Rho tends to be small except for long-dated options.

Options Pricing Models

There are various option pricing models which traders use to arrive at the right value of the option. Some of the most popular models have been enumerated below. The Binomial Pricing Model The binomial model is an options pricing model which was developed by William Sharpe in 1978. Today, one finds a large variety of pricing models which differ according to their hypotheses or the underlying instruments upon which they are based (stock options, currency options, options on interest rates). The Black & Scholes Model The Black & Scholes model was published in 1973 by Fisher Black and Myron Scholes. It is one of the most popular options pricing models. It is noted for its relative simplicity and its fast mode of calculation: unlike the binomial model, it does not rely on calculation by iteration. The intention of this section is to introduce you to the basic premises upon which this pricing model rests. A complete coverage of this topic is material for an advanced course The Black-Scholes model is used to calculate a theoretical call price (ignoring dividends paid during the life of the option) using the five key determinants of an option's price: stock price, strike price, volatility, time to expiration, and short-term (risk free) interest rate. The original formula for calculating the theoretical option price (OP) is as follows: Where:

The variables are: S = stock price X = strike price t = time remaining until expiration, expressed as a percent of a year r = current continuously compounded risk-free interest rate v = annual volatility of stock price (the standard deviation of the short-term returns over one year). ln = natural logarithm N(x) = standard normal cumulative distribution function e = the exponential function

Lognormal distribution: The model is based on a lognormal distribution of stock prices, as opposed to a normal, or bell-shaped, distribution. The lognormal distribution allows for a stock price distribution of between zero and infinity (ie no negative prices) and has an upward bias (representing the fact that a stock price can only drop 100 per cent but can rise by more than 100 per cent). Risk-neutral valuation: The expected rate of return of the stock (ie the expected rate of growth of the underlying asset which equals the risk free rate plus a risk premium) is not one of the variables in the Black-Scholes model (or any other model for option valuation). The important implication is that the price of an option is completely independent of the expected growth of the underlying asset. Thus, while any two investors may strongly disagree on the rate of return they expect on a stock they will, given agreement to the assumptions of volatility and the risk free rate, always agree on the fair price of the option on that underlying asset. The key concept underlying the valuation of all derivatives -- the fact that price of an option is independent of the risk preferences of investors -- is called risk-neutral valuation. It means that all derivatives can be valued by assuming that the return from their underlying assets is the risk free rate. Limitation: Dividends are ignored in the basic Black-Scholes formula, but there are a number of widely used adaptations to the original formula, which I use in my models, which enable it to handle both discrete and continuous dividends accurately. However, despite these adaptations the Black-Scholes model has one major limitation: it cannot be used to accurately price options with an American-style exercise as it only calculates the option price at one point in time -- at expiration. It does not consider the steps along the way where there could be the possibility of early exercise of an American option. As all exchange traded equity options have American-style exercise (ie they can be exercised at any time as opposed to European options which can only be exercised at expiration) this is a significant limitation. The exception to this is an American call on a non-dividend paying asset. In this case the call is always worth the same as its European equivalent as there is never any advantage in exercising early. Advantage: The main advantage of the Black-Scholes model is speed -- it lets you calculate a very large number of option prices in a very short time. Since, high accuracy is not critical for American option pricing (eg when animating a chart to show the effects of time decay) using Black-Scholes is a good option. But, the option of using the binomial model is also advisable for the relatively few pricing and profitability numbers where accuracy may be important and speed is irrelevant. You can experiment with the Black-Scholes model using on-line options pricing calculator. The Binomial Model The binomial model breaks down the time to expiration into potentially a very large number of time intervals, or steps. A tree of stock prices is initially produced working forward from the present to expiration. At each step it is assumed that the stock price will move up or down by an amount calculated using volatility and time to expiration. This produces a binomial distribution, or recombining tree, of underlying stock prices. The tree represents all the possible paths that the stock price could take during the life of the option. At the end of the tree -- ie at expiration of the option -- all the terminal option prices for each of the final possible stock prices are known as they simply equal their intrinsic values. Next the option prices at each step of the tree are calculated working back from expiration to the present. The option prices at each step are used to derive the option prices at the next step of the tree using risk neutral valuation based on the probabilities of the stock prices moving up or down, the risk free rate and the time interval of each step. Any adjustments to stock prices (at an exdividend date) or option prices (as a result of early exercise of American options) are worked into the calculations at the required point in time. At the top of the tree you are left with one option price. Advantage: The big advantage the binomial model has over the Black-Scholes model is that it can be used to accurately price American options. This is because, with the binomial model it's possible to check at every point in an option's life (ie at every step of the binomial tree) for the

possibility of early exercise (eg where, due to eg a dividend, or a put being deeply in the money the option price at that point is less than the its intrinsic value). Where an early exercise point is found it is assumed that the option holder would elect to exercise and the option price can be adjusted to equal the intrinsic value at that point. This then flows into the calculations higher up the tree and so on. Limitation: As mentioned before the main disadvantage of the binomial model is its relatively slow speed. It's great for half a dozen calculations at a time but even with today's fastest PCs it's not a practical solution for the calculation of thousands of prices in a few seconds which is what's required for the production of the animated charts in my strategy evaluation model

Bull Market Strategies

Calls in a Bullish Strategy

Puts in a Bullish Strategy

Bullish Call Spread Strategies

Bullish Put Spread Strategies

Calls in a Bullish Strategy An investor with a bullish market outlook should buy call options. If you expect the market price of the underlying asset to rise, then you would rather have the right to purchase at a specified price and sell later at a higher price than have the obligation to deliver later at a higher price.

The investor's profit potential buying a call option is unlimited. The investor's profit is the the market price less the exercise price less the premium. The greater the increase in price of the underlying, the greater the investor's profit. The investor's potential loss is limited. Even if the market takes a drastic decline in price levels, the holder of a call is under no obligation to exercise the option. He may let the option expire worthless. The investor breaks even when the market price equals the exercise price plus the premium. An increase in volatility will increase the value of your call and increase your return. Because of the increased likelihood that the option will become in- the-money, an increase in the underlying volatility (before expiration), will increase the value of a long options position. As an option holder, your return will also increase.

A simple example will illustrate the above: Suppose there is a call option with a strike price of Rs 2000 and the option premium is Rs 100. The option will be exercised only if the value of the underlying is greater than Rs 2000 (the strike price). If the buyer exercises the call at Rs 2200 then his gain will be Rs 200. However, this would not be his actual gain for that he will have to deduct the Rs 200 (premium) he has paid. The profit can be derived as follows Profit = Market price - Exercise price - Premium Profit = Market price Strike price Premium. 2200 2000 100 = Rs 100

Puts in a Bullish Strategy An investor with a bullish market outlook can also go short on a Put option. Basically, an investor anticipating a bull market could write Put options. If the market price increases and puts become out-of-the-money, investors with long put positions will let their options expire worthless. By writing Puts, profit potential is limited. A Put writer profits when the price of the underlying asset increases and the option expires worthless. The maximum profit is limited to the premium received. However, the potential loss is unlimited. Because a short put position holder has an obligation to purchase if exercised. He will be exposed to potentially large losses if the market moves against his position and declines. The break-even point occurs when the market price equals the exercise price: minus the premium. At any price less than the exercise price minus the premium, the investor loses money on the transaction. At higher prices, his option is profitable. An increase in volatility will increase the value of your put and decrease your return. As an option writer, the higher price you will be forced to pay in order to buy back the option at a later date , lower is the return.

Bullish Call Spread Strategies A vertical call spread is the simultaneous purchase and sale of identical call options but with different exercise prices. To "buy a call spread" is to purchase a call with a lower exercise price and to write a call with a higher exercise price. The trader pays a net premium for the position. To "sell a call spread" is the opposite, here the trader buys a call with a higher exercise price and writes a call with a lower exercise price, receiving a net premium for the position. An investor with a bullish market outlook should buy a call spread. The "Bull Call Spread" allows the investor to participate to a limited extent in a bull market, while at the same time limiting risk exposure.

To put on a bull spread, the trader needs to buy the lower strike call and sell the higher strike call. The combination of these two options will result in a bought spread. The cost of Putting on this position will be the difference between the premium paid for the low strike call and the premium received for the high strike call. The investor's profit potential is limited. When both calls are in-the-money, both will be exercised and the maximum profit will be realised. The investor delivers on his short call and receives a higher price than he is paid for receiving delivery on his long call.

The investors's potential loss is limited. At the most, the investor can lose is the net premium. He pays a higher premium for the lower exercise price call than he receives for writing the higher exercise price call. The investor breaks even when the market price equals the lower exercise price plus the net premium. At the most, an investor can lose is the net premium paid. To recover the premium, the market price must be as great as the lower exercise price plus the net premium. An example of a Bullish call spread: Let's assume that the cash price of a scrip is Rs 100 and you buy a November call option with a strike price of Rs 90 and pay a premium of Rs 14. At the same time you sell another November call option on a scrip with a strike price of Rs 110 and receive a premium of Rs 4. Here you are buying a lower strike price option and selling a higher strike price option. This would result in a net outflow of Rs 10 at the time of establishing the spread. Now let us look at the fundamental reason for this position. Since this is a bullish strategy, the first position established in the spread is the long lower strike price call option with unlimited profit potential. At the same time to reduce the cost of puchase of the long position a short position at a higher call strike price is established. While this not only reduces the outflow in terms of premium but his profit potential as well as risk is limited. Based on the above figures the maximum profit, maximum loss and breakeven point of this spread would be as follows: Maximum profit = Higher strike price - Lower strike price - Net premium paid = 110 - 90 - 10 = 10 Maximum Loss = Lower strike premium - Higher strike premium = 14 - 4 = 10 Breakeven Price = Lower strike price + Net premium paid = 90 + 10 = 100

Bullish Put Spread Strategies A vertical Put spread is the simultaneous purchase and sale of identical Put options but with different exercise prices. To "buy a put spread" is to purchase a Put with a higher exercise price and to write a Put with a lower exercise price. The trader pays a net premium for the position. To "sell a put spread" is the opposite: the trader buys a Put with a lower exercise price and writes a put with a higher exercise price, receiving a net premium for the position. An investor with a bullish market outlook should sell a Put spread. The "vertical bull put spread" allows the investor to participate to a limited extent in a bull market, while at the same time limiting risk exposure.

To put on a bull spread, a trader sells the higher strike put and buys the lower strike put. The bull spread can be created by buying the lower strike and selling the higher strike of either calls or put. The difference between the premiums paid and received makes up one leg of the spread. The investor's profit potential is limited. When the market price reaches or exceeds the higher exercise price, both options will be out-of-the-money and will expire worthless. The trader will realize his maximum profit, the net premium

The investor's potential loss is also limited. If the market falls, the options will be in-the-money. The puts will offset one another, but at different exercise prices. The investor breaks-even when the market price equals the lower exercise price less the net premium. The investor achieves maximum profit i.e the premium received, when the market price moves up beyond the higher exercise price (both puts are then worthless). An example of a bullish put spread.

Lets us assume that the cash price of the scrip is Rs 100. You now buy a November put option on a scrip with a strike price of Rs 90 at a premium of Rs 5 and sell a put option with a strike price of Rs 110 at a premium of Rs 15. The first position is a short put at a higher strike price. This has resulted in some inflow in terms of premium. But here the trader is worried about risk and so caps his risk by buying another put option at the lower strike price. As such, a part of the premium received goes off and the ultimate position has limited risk and limited profit potential. Based on the above figures the maximum profit, maximum loss and breakeven point of this spread would be as follows: Maximum profit = Net option premium income or net credit = 15 - 5 = 10 Maximum loss = Higher strike price - Lower strike price - Net premium received = 110 - 90 - 10 = 10 Breakeven Price = Higher Strike price - Net premium income = 110 - 10 = 100

Bear Market Strategies

Puts in a Bearish Strategy

Calls in a Bearish Strategy

Bearish Put Spread Strategies

Bearish Call Spread Strategies

Puts in a Bearish Strategy When you purchase a put you are long and want the market to fall. A put option is a bearish position. It will increase in value if the market falls. An investor with a bearish market outlook shall buy put options. By purchasing put options, the trader has the right to choose whether to sell the underlying asset at the exercise price. In a falling market, this choice is preferable to being obligated to buy the underlying at a price higher.

An investor's profit potential is practically unlimited. The higher the fall in price of the underlying asset, higher the profits. The investor's potential loss is limited. If the price of the underlying asset rises instead of falling as the investor has anticipated, he may let the option expire worthless. At the most, he may lose the premium for the option. The trader's breakeven point is the exercise price minus the premium. To profit, the market price must be below the exercise price. Since the trader has paid a premium he must recover the premium he paid for the option. An increase in volatility will increase the value of your put and increase your return. An increase in volatility will make it more likely that the price of the underlying instrument will move. This increases the value of the option. Calls in a Bearish Strategy Another option for a bearish investor is to go short on a call with the intent to purchase it back in the future. By selling a call, you have a net short position and needs to be bought back before expiration and cancel out your position. For this an investor needs to write a call option. If the market price falls, long call holders will let their out-of-the-money options expire worthless, because they could purchase the underlying asset at the lower market price.

The investor's profit potential is limited because the trader's maximum profit is limited to the premium received for writing the option. Here the loss potential is unlimited because a short call position holder has an obligation to sell if exercised, he will be exposed to potentially large losses if the market rises against his position. The investor breaks even when the market price equals the exercise price: plus the premium. At any price greater than the exercise price plus the premium, the trader is losing money. When the market price equals the exercise price plus the premium, the trader breaks even. An increase in volatility will increase the value of your call and decrease your return. When the option writer has to buy back the option in order to cancel out his position, he will be forced to pay a higher price due to the increased value of the calls. Bearish Put Spread Strategies A vertical put spread is the simultaneous purchase and sale of identical put options but with different exercise prices. To "buy a put spread" is to purchase a put with a higher exercise price and to write a put with a lower exercise price. The trader pays a net premium for the position.

To "sell a put spread" is the opposite. The trader buys a put with a lower exercise price and writes a put with a higher exercise price, receiving a net premium for the position. To put on a bear put spread you buy the higher strike put and sell the lower strike put. You sell the lower strike and buy the higher strike of either calls or puts to set up a bear spread. An investor with a bearish market outlook should: buy a put spread. The "Bear Put Spread" allows the investor to participate to a limited extent in a bear market, while at the same time limiting risk exposure.

The investor's profit potential is limited. When the market price falls to or below the lower exercise price, both options will be in-the-money and the trader will realize his maximum profit when he recovers the net premium paid for the options. The investor's potential loss is limited. The trader has offsetting positions at different exercise prices. If the market rises rather than falls, the options will be out-of-the-money and expire worthless. Since the trader has paid a net premium The investor breaks even when the market price equals the higher exercise price less the net premium. For the strategy to be profitable, the market price must fall. When the market price falls to the high exercise price less the net premium, the trader breaks even. When the market falls beyond this point, the trader profits. An example of a bearish put spread. Lets assume that the cash price of the scrip is Rs 100. You buy a November put option on a scrip with a strike price of Rs 110 at a premium of Rs 15 and sell a put option with a strike price of Rs 90 at a premium of Rs 5. In this bearish position the put is taken as long on a higher strike price put with the outgo of some premium. This position has huge profit potential on downside. If the trader may recover a part of the premium paid by him by writing a lower strike price put option. The resulting position is a mildly bearish position with limited risk and limited profit profile. Though the trader has reduced the cost of taking a bearish position, he has also capped the profit portential as well. The maximum profit, maximum loss and breakeven point of this spread would be as follows: Maximum profit = Higher strike price option - Lower strike price option - Net premium paid = 110 - 90 - 10 = 10 Maximum loss = Net premium paid = 15 - 5 = 10 Breakeven Price = Higher strike price - Net premium paid = 110 - 10 = 100

Bearish Call Spread Strategies A vertical call spread is the simultaneous purchase and sale of identical call options but with different exercise prices. To "buy a call spread" is to purchase a call with a lower exercise price and to write a call with a higher exercise price. The trader pays a net premium for the position. To "sell a call spread" is the opposite: the trader buys a call with a higher exercise price and writes a call with a lower exercise price, receiving a net premium for the position. To put on a bear call spread you sell the lower strike call and buy the higher strike call. An investor sells the lower strike and buys the higher strike of either calls or puts to put on a bear spread. An investor with a bearish market outlook should: sell a call spread. The "Bear Call Spread" allows the investor to participate to a limited extent in a bear market, while at the same time limiting risk exposure.

The investor's profit potential is limited. When the market price falls to the lower exercise price, both out-of-the-money options will expire worthless. The maximum profit that the trader can realize is the net premium: The premium he receives for the call at the higher exercise price. Here the investor's potential loss is limited. If the market rises, the options will offset one another. At any price greater than the high exercise price, the maximum loss will equal high exercise price minus low exercise price minus net premium. The investor breaks even when the market price equals the lower exercise price plus the net premium. The strategy becomes profitable as the market price declines. Since the trader is receiving a net premium, the market price does not have to fall as low as the lower exercise price to breakeven.

An example of a bearish call spread.

Let us assume that the cash price of the scrip is Rs 100. You now buy a November call option on a scrip with a strike price of Rs 110 at a premium of Rs 5 and sell a call option with a strike price of Rs 90 at a premium of Rs 15. In this spread you have to buy a higher strike price call option and sell a lower strike price option. As the low strike price option is more expensive than the higher strike price option, it is a net credit startegy. The final position is left with limited risk and limited profit. The maximum profit, maximum loss and breakeven point of this spread would be as follows: Maximum profit = Net premium received = 15 - 5 = 10 Maximum loss = Higher strike price option - Lower strike price option - Net premium received = 110 - 90 - 10 = 10 Breakeven Price = Lower strike price + Net premium paid = 90 + 10 = 100

Volatile Market Strategies

Straddles in a Volatile Market Outlook Volatile market trading strategies are appropriate when the trader believes the market will move but does not have an opinion on the direction of movement of the market. As long as there is significant movement upwards or downwards, these strategies offer profit opportunities. A trader need not be bullish or bearish. He must simply be of the opinion that the market is volatile. A straddle is the simultaneous purchase (or sale) of two identical options, one a call and the other a put. To "buy a straddle" is to purchase a call and a put with the same exercise price and expiration date. To "sell a straddle" is the opposite: the trader sells a call and a put with the same exercise price and expiration date.

A trader, viewing a market as volatile, should buy option straddles. A "straddle purchase" allows the trader to profit from either a bull market or from a bear market.

Here the investor's profit potential is unlimited. If the market is volatile, the trader can profit from an up- or downward movement by exercising the appropriate option while letting the other option expire worthless. (Bull market, exercise the call; bear market, the put.) While the investor's potential loss is limited. If the price of the underlying asset remains stable instead of either rising or falling as the trader anticipated, the most he will lose is the premium he paid for the options. In this case the trader has long two positions and thus, two breakeven points. One is for the call, which is exercise price plus the premiums paid, and the other for the put, which is exercise price minus the premiums paid. Strangles in a Volatile Market Outlook A strangle is similar to a straddle, except that the call and the put have different exercise prices. Usually, both the call and the put are out-of-the-money. To "buy a strangle" is to purchase a call and a put with the same expiration date, but different exercise prices. To "sell a strangle" is to write a call and a put with the same expiration date, but different exercise prices. A trader, viewing a market as volatile, should buy strangles. A "strangle purchase" allows the trader to profit from either a bull or bear market. Because the options are typically out-of-themoney, the market must move to a greater degree than a straddle purchase to be profitable. The trader's profit potential is unlimited. If the market is volatile, the trader can profit from an upor downward movement by exercising the appropriate option, and letting the other expire worthless. (In a bull market, exercise the call; in a bear market, the put). The investor's potential loss is limited. Should the price of the underlying remain stable, the most the trader would lose is the premium he paid for the options. Here the loss potential is also very minimal because, the more the options are out-of-the-money, the lesser the premiums. Here the trader has two long positions and thus, two breakeven points. One for the call, which breakevens when the market price equal the high exercise price plus the premium paid, and for the put, when the market price equals the low exercise price minus the premium paid. Pic:Opt35 The Short Butterfly Call Spread Like the volatility positions we have looked at so far, the Short Butterfly position will realize a profit if the market makes a substantial move. It also uses a combination of puts and calls to achieve its profit/loss profile - but combines them in such a manner that the maximum profit is limited. You are short the September 40-45-50 butterfly with the underlying at 45. You: you are neutral but want the market to move in either direction. The position is a neutral one - consisting of two short options balanced out with two long ones. Which of these positions is a short butterfly spread? The graph on the left. The profit loss profile of a short butterfly spread looks like two short options coming together at the center Calls.

The spread shown above was constructed by using 1 short call at a low exercise price, two long calls at a medium exercise price and 1 short call at a high exercise price. Your potential gains or losses are: limited on both the upside and the downside. Say you had build a short 40-45-50 butterfly. The position would yield a profit only if the market moves below 40 or above 50. The maximum loss is also limited. The Call Ratio Backspread

The call ratio backspread is similar in contruction to the short butterfly call spread you looked at in the previous section. The only difference is that you omit one of the components (or legs) used to build the short butterfly when constructing a call ratio backspread. When putting on a call ratio backspread, you are neutral but want the market to move in either direction. The call ratio backspread will lose money if the market sits. The market outlook one would have in putting on this position would be for a volatile market, with greater probability that the market will rally. To put on a call ratio backspread, you sell one of the lower strike and buy two or more of the higher strike. By selling an expensive lower strike option and buying two less expensive high strike options, you receive an initial credit for this position. The maximum loss is then equal to the high strike price minus the low strike price minus the initial net premium received. Your potential gains are limited on the downside and unlimited on the upside. The profit on the downside is limited to the initial net premium received when setting up the spread. The upside profit is unlimited. An increase in implied volatility will make your spread more profitable. Increased volatility increases a long option position's value. The greater number of long options will cause this spread to become more profitable when volatility increases. The Put Ratio Backspread In combination positions (e.g. bull spreads, butterflys, ratio spreads), one can use calls or puts to achieve similar, if not identical, profit profiles. Like its call counterpart, the put ratio backspread combines options to create a spread which has limited loss potential and a mixed profit potential. It is created by combining long and short puts in a ratio of 2:1 or 3:1. In a 3:1 spread, you would buy three puts at a low exercise price and write one put at a high exercise price. While you may, of course, extend this position out to six long and two short or nine long and three short, it is important that you respect the (in this case) 3:1 ratio in order to maintain the put ratio backspread profit/loss profile. When you put on a put ratio backspread: are neutral but want the market to move in either direction. Your market expectations here would be for a volatile market with a greater probability that the market will fall than rally. How would the profit/loss profile of a put ratio backspread differ from a call ratio backspread? Unlimited profit would be realized on the downside. The two long puts offset the short put and result in practically unlimited profit on the bearish side of the market. The cost of the long puts is offset by the premium received for the (more expensive) short put, resulting in a net premium received. To put on a put ratio backspread, you: buy two or more of the lower strike and sell one of the higher strike. You sell the more expensive put and buy two or more of the cheaper put. One usually receives an initial net premium for putting on this spread. The Maximum loss is equal to: High strike price Low strike price - Initial net premium received. For eg if the ratio backspread is 45 days before expiration. Considering only the bearish side of the market, an increase in volatility increases profit/loss and the passage of time decreases profit/loss. The low breakeven point indicated on the graph is equal to the lower of the two exercise prices... minus the call premiums paid, minus the net premiums received. The higher of this position's two breakeven points is simply the high exercise price minus the net premium.

Stable Market Strategies

Straddles in a Stable Market Outlook

Volatile market trading strategies are appropriate when the trader believes the market will move but does not have an opinion on the direction of movement of the market. As long as there is significant movement upwards or downwards, these strategies offer profit opportunities. A trader need not be bullish or bearish. He must simply be of the opinion that the market is volatile. This market outlook is also referred to as "neutral volatility." A straddle is the simultaneous purchase (or sale) of two identical options, one a call and the other a put. To "buy a straddle" is to purchase a call and a put with the same exercise price and expiration date. To "sell a straddle" is the opposite: the trader sells a call and a put with the same exercise price and expiration date.

A trader, viewing a market as stable, should: write option straddles. A "straddle sale" allows the trader to profit from writing calls and puts in a stable market environment.

The investor's profit potential is limited. If the market remains stable, traders long out-of-themoney calls or puts will let their options expire worthless. Writers of these options will not have be called to deliver and will profit from the sum of the premiums received. The investor's potential loss is unlimited. Should the price of the underlying rise or fall, the writer of a call or put would have to deliver, exposing himself to unlimited loss if he has to deliver on the call and practically unlimited loss if on the put. The breakeven points occur when the market price at expiration equals the exercise price plus the premium and minus the premium. The trader is short two positions and thus, two breakeven points; One for the call (common exercise price plus the premiums paid), and one for the put (common exercise price minus the premiums paid). Strangles in a Stable Market Outlook A strangle is similar to a straddle, except that the call and the put have different exercise prices. Usually, both the call and the put are out-of-the-money. To "buy a strangle" is to purchase a call and a put with the same expiration date, but different exercise prices. Usually the call strike price is higher than the put strike price. To "sell a strangle" is to write a call and a put with the same expiration date, but different exercise prices.

A trader, viewing a market as stable, should: write strangles. A "strangle sale" allows the trader to profit from a stable market. The investor's profit potential is: unlimited. If the market remains stable, investors having out-of-the-money long put or long call positions will let their options expire worthless. The investor's potential loss is: unlimited. If the price of the underlying interest rises or falls instead of remaining stable as the trader anticipated, he will have to deliver on the call or the put. The breakeven points occur when market price at expiration equals...the high exercise price plus the premium and the low exercise price minus the premium. The trader is short two positions and thus, two breakeven points. One for the call (high exercise price plus the premiums paid), and one for the put (low exercise price minus the premiums paid).

Why would a trader choose to sell a strangle rather than a straddle? The risk is lower with a strangle. Although the seller gives up a substantial amount of potential profit by selling a strangle rather than a straddle, he also holds less risk. Notice that the strangle requires more of a price move in both directions before it begins to lose money. Long Butterfly Call Spread Strategy The long butterfly call spread is a combination of a bull spread and a bear spread, utilizing calls and three different exercise prices. A long butterfly call spread involves: Buying a call with a low exercise price, Writing two calls with a mid-range exercise price, Buying a call with a high exercise price.

To put on the September 40-45-50 long butterfly, you: buy the 40 and 50 strike and sell two 45 strikes. This spread is put on by purchasing one each of the outside strikes and selling two of the inside strike. To put on a short butterfly, you do just the opposite. The investor's profit potential is limited. Maximum profit is attained when the market price of the underlying interest equals the mid-range exercise price (if the exercise prices are symmetrical).

The investor's potential loss is: limited. The maximum loss is limited to the net premium paid and is realized when the market price of the underlying asset is higher than the high exercise price or lower than the low exercise price. The breakeven points occur when the market price at expiration equals ... the high exercise price minus the premium and the low exercise price plus the premium. The strategy is profitable when the market price is between the low exercise price plus the net premium and the high exercise price minus the net premium.

Key Regulations
In India we have two premier exchanges The National Stock Exchange of India (NSE) and The Bombay Stock Exchange (BSE) which offer options trading on stock indices as well as individual securities. Options on stock indices are European in kind and settled only on the last of expiration of the underlying. NSE offers index options trading on the NSE Fifty index called the Nifty. While BSE offers index options on the countrys widely used index Sensex, which consists of 30 stocks. Options on individual securities are American. The number of stock options contracts to be traded on the exchanges will be based on the list of securities as specified by Securities and Exchange Board of India (SEBI). Additions/deletions in the list of securities eligible on which options contracts shall be made available shall be notified from time to time. Underlying: Underlying for the options on individual securities contracts shall be the underlying security available for trading in the capital market segment of the exchange. Security descriptor: The security descriptor for the options on individual securities shall be: Market type - N Instrument type - OPTSTK Underlying - Underlying security Expiry date - Date of contract expiry Option type - CA/PA Exercise style - American Premium Settlement method: Premium Settled; CA - Call American PA - Put American.

Trading cycle: The contract cycle and availability of strike prices for options contracts on individual securities shall be as follows: Options on individual securities contracts will have a maximum of three-month trading cycle. New contracts will be introduced on the trading day following the expiry of the near month contract. On expiry of the near month contract, new contract shall be introduced at new strike prices for both call and put options, on the trading day following the expiry of the near month contract. (See Index futures learning centre for further reading)

Strike price intervals: The exchange shall provide a minimum of five strike prices for every option type (i.e call & put) during the trading month. There shall be two contracts in-the-money (ITM), two contracts out-of-the-money (OTM) and one contract at-the-money (ATM). The strike price interval for options on individual securities is given in the accompanying table. New contracts with new strike prices for existing expiration date will be introduced for trading on the next working day based on the previous day's underlying close values and as and when required. In order to fix on the at-the-money strike price for options on individual securities contracts the closing underlying value shall be rounded off to the nearest multiplier of the strike price interval. The in-the-money strike price and the out-of-the-money strike price shall be based on the at-the-money strike price interval. Expiry day: Options contracts on individual securities as well as index options shall expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts shall expire on the previous trading day. Order type: Regular lot order, stop loss order, immediate or cancel, good till day, good till cancelled, good till date and spread order. Good till cancelled (GTC) orders shall be cancelled at the end of the period of 7 calendar days from the date of entering an order. Permitted lot size: The value of the option contracts on individual securities shall not be less than Rs 2 lakh at the time of its introduction. The permitted lot size for the options contracts on individual securities shall be in multiples of 100 and fractions if any, shall be rounded off to the next higher multiple of 100. Price steps: The price steps in respect of all options contracts admitted to dealings on the exchange shall be Re 0.05. Quantity freeze: Orders which may come to the exchange as a quantity freeze shall be the lesser of the following: 1 per cent of the marketwide position limit stipulated of options on individual securities as given in (h) below or Notional value of the contract of around Rs 5 crore. In respect of such orders, which have come under quantity freeze, the member shall be required to confirm to the exchange that there is no inadvertent error in the order entry and that the order is genuine. On such confirmation, the exchange at its discretion may approve such order subject to availability of turnover/exposure limits, etc. Base price: Base price of the options contracts on introduction of new contracts shall be the theoretical value of the options contract arrived at based on Black-Scholes model of calculation of options premiums. The base price of the contracts on subsequent trading days will be the daily close price of the options contracts. However in such of those contracts where orders could not be placed because of application of price ranges, the bases prices may be modified at the discretion of the exchange and intimated to the members. Price ranges: There will be no day minimum/maximum price ranges applicable for the options contract. The operating ranges and day minimum/maximum ranges for options contract shall be kept at 99 per cent of the base price. In view of this the members will not be able to place orders at prices which are beyond 99 per cent of the base price. The base prices for option contracts may be modified, at the discretion of the exchange, based on the request received from trading members as mentioned above. Exposure limits: Gross open positions of a member at any point of time shall not exceed the exposure limit as detailed hereunder: Index Options: Exposure Limit shall be 33.33 times the liquid networth. Option contracts on individual Securities: Exposure Limit shall be 20 times the liquid networth.

Memberwise position limit: When the open position of a Clearing Member, Trading Member or Custodial Participant exceeds 15 per cent of the total open interest of the market or Rs 100 crore, whichever is higher, in all the option contracts on the same underlying, at any time, including during trading hours.

For option contracts on individual securities, open interest shall be equivalent to the open positions multiplied by the notional value. Notional Value shall be the previous day's closing price of the underlying security or such other price as may be specified from time to time. Market wide position limits: Market wide position limits for option contracts on individual securities shall be lower of: *20 times the average number of shares traded daily, during the previous calendar month, in the relevant underlying security in the underlying segment of the relevant exchange or, 10 per cent of the number of shares held by non-promoters in the relevant underlying security i.e. 10 per cent of the free float in terms of the number of shares of a company. The relevant authority shall specify the market wide position limits once every month, on the expiration day of the near month contract, which shall be applicable till the expiry of the subsequent month contract. Exercise settlement: Exercise type shall be American and final settlement in respect of options on individual securities contracts shall be cash settled for an initial period of 6 months and as per the provisions of National Securities Clearing Corporation Ltd (NSCCL) as may be stipulated from time to time.

Reading Stock Option Tables

In India, option tables published in business newspapers and is fairly similar to the regular stock tables. The following is the format of the options table published in Indian business news papers:
NIFTY OPTIONS Contracts Exp.Date RELIANCE RELIANCE RELIANCE RELIANCE RELIANCE RELIANCE RELIANCE RELIANCE RELIANCE RELIANCE RELIANCE RELIANCE RELIANCE RELIANCE 7/26/01 7/26/01 7/26/01 7/26/01 7/26/01 7/26/01 7/26/01 7/26/01 8/30/01 8/30/01 8/30/01 7/26/01 7/26/01 7/26/01 Str.Price Opt.Type Open High Low Trd.Qty 3 29 1 35 8 10 22 4 31 15 10 38 2 59 3 39 1 40 9 14 24 7 35 15 10 38 2 60 2 29 1 35 6 10 16 2 31 15 10 38 2 53 4200 1200 1200 1200 11400 13800 11400 29400 1200 600 600 600 1200 1800 No.of.Cont. 7 2 2 2 19 23 19 49 2 1 1 1 2 3 Trd.Value 1512000 432000 456000 456000 3876000 4692000 3648000 9408000 432000 204000 192000 180000 360000 504000

360 CA 360 PA 380 CA 380 PA 340 CA 340 PA 320 CA 320 PA 360 PA 340 CA 320 PA 300 CA 300 PA 280 CA

The first column shows the contract that is being traded i.e Reliance. The second coloumn displays the date on which the contract will expire i.e. the expiry date is the
last Thursday of the month. Call options-American are depicted as 'CA' and Put options-American as 'PA'. The Open, High, Low, Close columns display the traded premium rates.

Advantages of option trading

Risk management: Put options allow investors holding shares to hedge against a possible fall in their value. This can be considered similar to taking out insurance against a fall in the share price. Time to decide: By taking a call option the purchase price for the shares is locked in. This gives the call option holder until the Expiry Day to decide whether or not to exercise the option and buy the shares. Likewise the taker of a put option has time to decide whether or not to sell the shares. Speculation: The ease of trading in and out of an option position makes it possible to trade options with no intention of ever exercising them. If an investor expects the market to rise, they may decide to buy call options. If expecting a fall, they may decide to buy put options. Either way the holder can sell the option prior to expiry to take a profit or limit a loss. Trading options has a lower cost than shares, as there is no stamp duty payable unless and until options are exercised. Leverage: Leverage provides the potential to make a higher return from a smaller initial outlay than investing directly. However, leverage usually involves more risks than a direct investment in the underlying shares. Trading in options can allow investors to benefit from a change in the price of the share without having to pay the full price of the share. We can see below how one can leverage ones position by just paying the premium.
Option Premium Bought on Oct 15 Sold on Dec 15 Profit ROI (Not annualised) Rs 380 Rs 670 Rs 290 76.3% Rs 4000 Rs 4500 Rs 500 12.5% Stock

Income generation: Shareholders can earn extra income over and above dividends by writing call options against their shares. By writing an option they receive the option premium upfront. While they get to keep the option premium, there is a possibility that they could be exercised against and have to deliver their shares to the taker at the exercise price. Strategies: By combining different options, investors can create a wide range of potential profit scenarios. To find out more about options strategies read the module on trading strategies.

Barings episodeLearnings from the market

With the introduction of index options, the derivatives market is all set to shift to a multi-product environment from a single-product market. Options like futures are leveraged products used by participants to manage the risk in the underlying market. Many people perceive options to be very risky. Debacles like the Barings episode are responsible for this misconception. At this juncture, when options are being introduced in the Indian capital market, it would be prudent to understand what happened in the Barings case to prevent similar incidents from occurring here. The episode The man behind the widely-reported debacle, Nicholas Leeson, had an established track record of being a savvy operator in the derivatives market and was the darling of the top management at the Barings headquarters in London.

As head of derivatives trading, Leeson was responsible for both the trading and clearing functions of Barings Futures Singapore (BFS), a subsidiary of London-based Barings Plc. Leeson engaged himself in proprietary trading on the Japanese stock exchange index Nikkei 225. He operated simultaneously on the Singapore Exchange Derivatives Trading Ltd., (SGX DT) (erstwhile Singapore International Monetary Exchange, SIMEX), Singapore and Osaka Securities Exchange (OSE), Japan in Nikkei 225 futures and options. A major part of Leeson's trading strategy involved the sale of options on the Nikkei 225 index futures contracts. He sold a large number of option straddles (a strategy that involves simultaneous sale of both call and put options) on Nikkei 225 index futures. Without going into the intricacies, it may be understood that straddle results in a loss, if the market moves in either direction (up or down) drastically. His strategy amounted to a bet that the Japanese stock market would neither fall nor rise substantially. But events took an unexpected and dramatic turn. The news of a killer earthquake in Kobe sent the Japanese stock markets tumbling. The futures on the Nikkei 225 started declining and Leeson's straddle position started incurring losses. Desperate to make some profit from his straddles, he started supporting the index by building up extraordinarily huge long positions in Nikkei 225 futures on both exchanges - SGX DT and OSE. However, the Barings management was made to understand that Leeson was trying to arbitrage between the SGX-DT and OSE with the Nikkei 225 index futures. When OSE authorities warned Leeson about his huge long positions on the exchange in Nikkei 225 futures, the trader claimed that he had built up exactly the opposite positions in the Nikkei 225 on SGX - DT. He wanted to suggest that if his positions in the Nikkei 225 at the OSE suffered losses, they would be made up by the profits by his position in the SGX - DT. A similar impression was given to SGX - DT authorities, when they inquired about Leeson's positions. While Leeson misled both exchanges with wrong information, neither exchanges bothered to cross-check the trader's positions on the other exchanges because they were competing for the same business. Both exchanges were more concerned about protecting their financial integrity and in doing so, allowed the continuation of the exceptionally-large positions of Leeson after securing adequate margins. We all know the consequences. A single operator couldn't take the market in the desired direction and the market crashed drastically. Consequently, Barings registered losses on Leeson's futures and straddle positions. But, we must note that the flames of the Leeson disaster did not singe the financial integrity of either market. This was because the markets were protected with proper margins. The lessons A single operator can't move the market: Leeson was trying to drive up prices by buying index futures on the Nikkei 225 but could not succeed as the market was gripped by pessimism emanating from the devastating Kobe earthquake.

The point is that, a single operator cannot change the direction of the market and it is always prudent to live with the market movement strategically. In this instance, a better strategy for Leeson would have been the dynamic management of his portfolio. For example, with the falling value of the index, his put leg of the straddle started incurring losses (call was to expire worthless), and he had the choice to square his put options off at the predetermined level (cut-off loss strategy). But Leeson, instead of squaring off his short put option position, chose to support the index price by buying futures on the Nikkei 225 and failed. Traders should have clearly defined and well-communicated position limits: Position limits mean the limits set by top management for each trader in the trading organisation. These limits are defined in various forms with regard to product, market or trader's total market exposure etc. Any laxity on this front may result in unbearable consequences to the trading organisation. These limits should be clearly defined and well communicated to all traders in the organisation. Meticulous monitoring of position limits is a must: We may note that Leeson, too, had position limits set by top management, but, he exceeded all of them. This attempt at crossing limits did not come to the notice of the top brass at Barings as Leeson himself was in charge of supervising back office operations at BFS. It is understood that he had sent fictitious reports about his trading activities to the Barings' headquarters in London. Had the top management been aware of the real situation, the disaster could probably have been avoided. Therefore, scrupulous monitoring of the position limits is as important as setting them. The top management's job of monitoring the positions of each dealer in the dealing room may be facilitated by bifurcating the front and back office operations. Different people should be in charge of front and back-office operations so that any exposure by dealers, over and above the limits set, can be detected immediately. It means having proper checks and balances at various levels to ensure that everyone in the organisation has the disciplinary approach and works within set limits. In fact, trading systems should be capable enough to automatically disallow traders any increase in exposures as soon as they touch pre-determined limits. Exchanges should compete professionally: Both the competing exchanges, SGX DT and OSE, were unconcerned about checking Barings' position at the other exchange. While both the exchanges were safeguarded through margins, people must appreciate the fact that the effect of a big failure like Barings goes much beyond the financial integrity of a system. The point to be noted is that exchanges can compete, but at the same time, must co-operate and share information. It could also help in deterring efforts at price manipulation. Big institutions are as prone to risk as individuals: One broad issue from an overall market perspective is that big institutions are as prone to incurring losses in the derivatives market as is any other individual.

Therefore, irrespective of the entity, margins should be collected by the clearing corporation/ house and/ or exchange on time. Only timely collection of margins can protect the financial integrity of the market as we have seen in the Barings case. The above-mentioned points are relevant to trading organisations in derivatives market. They have to intelligently work in-house to avoid any mishaps like the Barings episode at any point in time. SEBI has done a good job in the Indian derivatives market by making margins universally applicable to all categories of participants including institutions. This provision will go a long way in creating a financially-safe derivatives market in India. Conclusion Clearly, the failure of Barings was not a 'derivatives' failure' but a failure of management. After the investigations were through in the Barings case, the Board of Banking Supervision's report also placed responsibility on poor operational controls at Barings rather than the use of derivatives. An important lesson from the entire episode is that we all need a disciplinary and self-regulatory approach. The moment we go against this fundamental rule, this leveraged market is capable of threatening our very existence Source: Bombay Stock Exchange.

Glossary
American style: Type of option contract which allows the holder to exercise at any time up to and including the Expiry Day. Annualised return: The return or profit, expressed on an annual basis, the writer of the option contract receives for buying the shares and writing that particular option. Assignment: The random allocation of an exercise obligation to a writer. This is carried out by the exchanges. At-the-money: When the price of the underlying security equals the exercise price of the option. Buy and write: The simultaneous purchase of shares and sale of an equivalent number of option contracts. Call option: An option contract that entitles the taker (buyer) to buy a fixed number of the underlying shares at a stated price on or before a fixed Expiry Day. Class of options: Option contracts of the same type either calls or puts - covering the same underlying security. Delta: The rate in change of option premium due to a change in price of the underlying securities. Derivative: An instrument which derives its value from the value of an underlying instrument (such as shares, share price indices, fixed interest securities, commodities, currencies, etc.). Warrants and options are types of derivative.

European style: Type of option contract, which allows the holder to exercise only on the Expiry Day. Exercise price: The amount of money which must be paid by the taker (in the case of a call option) or the writer (in the case of a put option) for the transfer of each of the underlying securities upon exercise of the option. Expiry day: The date on which all unexercised options in a particular series expire. Hedge: A transaction, which reduces or offsets the risk of a current holding. For example, a put option may act as a hedge for a current holding in the underlying instrument. Implied volatility: A measure of volatility assigned to a series by the current market price. In-the-money: An option with intrinsic value. Intrinsic value: The difference between the market value of the underlying securities and the exercise price of the option. Usually it is not less than zero. It represents the advantage the taker has over the current market price if the option is exercised. Long-term option: An option with a term to expiry of two or three years from the date the series was first listed. (This is not available in currently in India) Multiplier: Is used when considering index options. The strike price and premium of an index option are usually expressed in points. Open interest: The number of outstanding contracts in a particular class or series existing in the option market. Also called the "open position". Out-of-the-money: A call option is out-of-the-money if the market price of the underlying securities is below the exercise price of the option; a put option is out-of-the-money if the market price of the underlying securities is above the exercise price of the options. Premium: The amount payable by the taker to the writer for entering the option. It is determined through the trading process and represents current market value. Put option: An option contract that entitles the taker (buyer) to sell a fixed number of underlying securities at a stated price on or before a fixed Expiry Day. Random selection: The method by which an exercise of an option is allocated to a writer in that series of option. Series of options: All contracts of the same class having the same Expiry Day and the same exercise price. Time value: The amount investors are willing to pay for the possibility that they could make a profit from their option position. It is influenced by time to expiry, dividends, interest rates, volatility and market expectations. Underlying securities: The shares or other securities subject to purchase or sale upon exercise of the option.

Volatility: A measure of the expected amount of fluctuation in the price of the particular securities. Writer: The seller of an option contract.