MODULE - VI:

Futures Options
 meaning,  Meaning and salient
features,
 Future v/s options,
 calls and put options,
 Index futures,  Types of derivatives,
 Valuation of index future.  Options price,
 Arbitrage,  Writer of options,
 Hedging,  Price changes,
 Price index futures,  Risks,
 Advantages of futures  Market structure,
index,  options v/s Badla
 Duration effect.
INTRODUCTION
 Derivatives, as the name suggests, are financial instruments that
derive their value from an underlying security or asset.

 Any security or asset that varies in value from time to time could
be used as the underlying asset.

 The underlying asset could therefore be securities, bullion,

commodities, bonds, etc.

 With variation in value comes risk – the risk that the value of an
asset that you wish to buy may rise when you hoped that it will
remain steady or still better fall; or the value of an asset that you
wish to sell may fall when you hoped that it will remain steady or
at best rise.

 Derivatives essentially enable the transfer of this risk from one

individual who is risk averse to another who welcomes the risk in
the hope of making returns.
How to benefit from Derivatives
 You are bullish on a stock say Satyam, which is currently
quoting at Rs 280 per share. You believe that in one month
it will touch Rs 330. 
If you buy Satyam.
 It touches Rs 330 as you predicted – you made a profit of
Rs 50 on an investment of Rs 280 i.e. a Return of 18% in
one month.
 Can it get any better ?
 What should you do ? Yes……
 Buy Satyam Futures instead.
 Effect: On buying Satyam Futures, you get the same
position as Satyam in the cash market, but you pay a
margin and not the entire amount. For example, if the
margin is 20%, you would pay only Rs 56. If Satyam goes
upto Rs 330, you will still earn Rs 50 as profit. Now that
translates into a fabulous return of 89% in one month.
 This is the advantage of ‘leverage’ which Stock Futures
provide. By investing a small margin (ranging from 10 to
25%), you can get into the same positions as you would be
able to in the cash market. The returns therefore get
accordingly multiplied.

 What are the risks?

 The risks are that losses will be get leveraged or multiplied

in the same manner as profits do. For example, if Satyam
drops from Rs 280 to Rs 250, you would make a loss of Rs
30. The Rs 30 loss would translate to an 11% loss in the
cash market and a 54% loss in the Futures market.
Definition
 With Securities Laws (Second Amendment) Act,1999,
Derivatives has been included in the definition of
Securities. The term Derivative has been defined in
Securities Contracts (Regulations) Act, as:-

 A Derivative includes: -
 a security derived from a debt instrument, share, loan,
whether secured or unsecured, risk instrument or
contract for differences or any other form of security;
 a contract which derives its value from the prices, or
index of prices, of underlying securities;
HISTORY OF DERIVATIVES
 Derivative products in some form or the other have existed for centuries.
 As far back as 580 B.C., or there about, specific instances of “option
contracts” based on the price of olives, are known to have been written.
 The first "futures" contract is traced to the rice market in Osaka, Japan, in
approximately 1650 AD.
 These were evidently standardized contracts, which made them similar to
today's futures, although it is not known if the contracts were frequently
traded and whether there were any credit guarantees attached to them.
 The biggest step towards a formal futures market came in 1848, with the
setting up of the Chicago Board of Trade.
 This organization changed its perspective and trading patterns over the
years until, in 1919, it finally became the Chicago Mercantile Exchange, as
we now know it. Other exchanges have come up around the US and across
the world since then.
In India…
 Interestingly, from time to time, governments and regulators have
developed discomfort with futures/options/derivatives trading.
 As a result, these have been banned in part or totally numerous
times in Europe, Japan and United States ever since the 1800s,
though these laws have eventually been repealed.
 In India too, futures trading in various commodities was
widespread until it was unceremoniously banned in the 1960s.
 Then, in 2000, trading in derivative products took on a whole new
face when trading in equity-based derivatives was allowed on the
Indian stock exchanges.
 This step proved to be a shot in the arm for the capital market and
volumes soared within three years.
 The success of the capital market reforms motivated the
government and the Forward Market Commission in India to kick
off similar reforms in the commodities market as well.
 As a result, in April 2003 the ban on trading in commodity futures
was finally lifted.
Present scenario..
 Today, both equity and commodity derivatives are thriving
in India.

 Not only do they give investors a chance to hedge against

price movements in the underlying, they bring stability to
the cash markets as well, due to the arbitrage
opportunities (an opportunity to make a quick return using
the price differentials of the underlying in two different
markets) that are available between the cash and the
derivatives markets.

 Since the introduction of futures and options in the Indian

equity markets, the turnover in this segment has increased
manifold.
Structure of Derivative Markets in
India
 Derivative trading in India takes place either on a
separate and independent Derivative Exchange or on
a separate segment of an existing Stock Exchange.

 Derivative Exchange/Segment function as a Self-

Regulatory Organization (SRO) and SEBI acts as the
oversight regulator.

 The clearing & settlement of all trades on the

Derivative Exchange/Segment would have to be
through a Clearing Corporation/House, which is
independent in governance and membership from the
Derivative Exchange/Segment.
Futures And Options
Indian perspective
FUTURES CONTRACTS
 Futures contracts are derivative contracts wherein you agree to buy or
sell a specified quantity of the underlying asset on a specified particular
date in the future, at the price agreed upon at the time of entering into
contract.

 In Indian equity futures market, this price is the spot price (i.e. the
price of the underlying asset in the cash market) prevailing on the date
of the expiry of the contract.

 Futures are standardized contracts in terms of quantity, quality,

delivery time, delivery place and date of delivery.

 Further, futures are legally binding and both parties are bound to
uphold the agreement.

 As a result of these additional features, futures are easily tradable on

exchanges and therefore offer better liquidity than forwards Contracts.
FORWARD CONTRACTS
 Forwards are derivative contracts wherein you agree to sell or buy the
underlying asset at an agreed price, on a predetermined date in the
future.
 The quantity and quality specifications of the underlying and the place
of delivery are mutually decided while entering into the agreement.
 Essentially, the agreement takes place on a one-to-one level, between
you and the buyer/seller (as the case may be) and hence, is more or
less tailor-made to meet the specific needs of both the parties
involved.
 The duration of the contract, the quality and quantity of the
underlying, etc. are decided upon after mutual negotiation.
 In India, forward contracts are used in the foreign exchange markets
to reduce currency risks and in the commodities market to reduce the
price risk.
Equity Derivatives in India - An
Overview
 Derivatives Markets
Derivatives markets broadly can be classified into
two categories, those that are traded on the
exchange and the those traded one to one or
‘over the counter’. They are hence known as
 Exchange Traded Derivatives
 OTC Derivatives (Over The Counter)

At present the average daily turnover of 23 commodity

exchanges put together crosses Rs 8,000-9,000 crore.
 NCDEX
 MCX..
Equity Derivatives Exchanges in
India
 In the equity markets both the National
Stock Exchange of India Ltd. (NSE) and
The Stock Exchange, Mumbai (BSE) have
applied to SEBI for setting up their
derivatives segments.
 The exchanges are expected to start
trading in Stock Index futures by mid-May
2000.
BSE's and NSE’s
 Both the exchanges have set-up an in-house
segment instead of setting up a separate
exchange for derivatives.

 BSE’s Derivatives Segment, will start with Sensex

futures as it’s first product.

 NSE’s Futures & Options Segment will be

launched with Nifty futures as the first product.
 Product Specifications BSE-30 Sensex Futures
 Contract Size - Rs. 50 times the Index
 Tick Size - 0.1 points or Rs. 5
 Expiry day - last Thursday of the month
 Settlement basis - cash settled
 Contract cycle - 3 months
 Active contracts - 3 nearest months
 Product Specifications S&P CNX Nifty Futures
 Contract Size - Rs. 200 times the Index
 Tick Size - 0.05 points or Rs. 10
 Expiry day - last Thursday of the month
 Settlement basis - cash settled
 Contract cycle - 3 months
 Active contracts - 3 nearest months
Illustration
 Company GTEL India Limited, which is in the business of
importing fine Fabric, requires US $ 50,000 to pay for a
consignment that is due 3 months from now. Suppose one
US $ 1 is currently worth Rs 40.

 The company expects the price of the US $ to strengthen

against the Rupee three months hence. This means that it
fears that it may even have to pay Rs 42.00 per US $ by
then.

 It could request its bank to make an agreement with a

foreign exchange dealer wherein GETL India Limited will
pay Rs 41.00 per US $ three months later. This would
constitute a forward agreement.
Types of Futures
 The Indian markets offer trading opportunities in both

 Stock Futures
 Index futures.

 A stock future is one, where the underlying asset is shares

of companies that are traded on the bourses.

 An index future is one, where the underlying asset is units

of the index.
Pricing of a futures contract
 Assuming that the underlying asset
is shares of a company, the price per
share of a futures contract should be
the spot price, i.e., the price of the
underlying stock on the day that you
purchase the futures contract, plus
the ‘cost of carry’.
 The ‘cost of carry’ comprises of all
costs that you would have had to
bear if you had purchased the
underlying in the cash market and
kept it until the maturity date of the
futures contract, less any dividends
received, if any, during this period.
 The costs that you would have to bear in
the case of stocks typically consist of
interest/financing charges, etc.
 Therefore, in reality, there is always a
difference between the futures price per
share and the spot price per share in the
cash market. This difference is called the
‘basis’ and could be positive, negative or
zero.
‘Contango’\ ‘Backwardation’
 If the basis is positive (which is the more
common situation), it means that the futures
price per share of the underlying asset is higher
than the spot price per share in the cash market.
This situation is termed as a ‘contango’ market.

 Sometimes the basis could turn negative, i.e., the

futures price per share is lower than the spot
price per share in the cash market. This situation
is termed as a ‘backwardation’.
 On the day of expiry of the futures
contract, the basis necessarily becomes
zero since futures contracts in India are
settled at the spot price of the underlying
asset as it prevails on the expiry date.
xpiry
ommodity
Date
an-2008
UM (ALUMINIUM)
Execute
FUTURES PRICE OF ALUMINIUM
 
  AT NCDEX

Prev Close Open High Low Close Volum Open Traded Value(Rs. In Delivery
Date
Price Price Price Price Price e Interest Lakhs) Centre

31-DEC-
93.80 0.00 0.00 0.00 93.80 0 0 0.00 Mumbai
2007

01-JAN-
93.80 0.00 0.00 0.00 93.80 0 0 0.00 Mumbai
2008

02-JAN-
93.30 0.00 0.00 0.00 93.30 0 0 0.00 Mumbai
2008

03-JAN-
93.70 0.00 0.00 0.00 93.70 0 0 0.00 Mumbai
2008

04-JAN-
93.90 0.00 0.00 0.00 93.90 0 0 0.00 Mumbai
2008

05-JAN-
96.20 0.00 0.00 0.00 96.20 0 0 0.00 Mumbai
2008

07-JAN-
96.80 0.00 0.00 0.00 96.80 0 0 0.00 Mumbai
2008

08-JAN-
96.80 0.00 0.00 0.00 96.80 0 0 0.00 Mumbai
2008

09-JAN-
95.00 0.00 0.00 0.00 95.00 0 0 0.00 Mumbai
2008

10-JAN-
96.40 0.00 0.00 0.00 96.40 0 0 0.00 Mumbai
2008

11-JAN-
96.70 0.00 0.00 0.00 96.70 0 0 0.00 Mumbai
2008

12-JAN-
95.40 0.00 0.00 0.00 95.40 0 0 0.00 Mumbai
2008
What is a stock index?
 Stock Index represents change in the value of a
set of stocks, which constitute the index, over a
base year.

 Any Index is an average of its constituents.

 For example, the BSE Sensex is a weighted

average of prices of 30 select stocks and S&P
CNX Nifty of 50 select stocks, where the weight is
the market capitalization of individual stocks.
Index Futures Products
SR. NO. PRODUCT CODE

1 BSE 30 SENSEX FUTURES SENFUT

2 BSE SENSEX MINI FUTURES MSXFUT

3 BSE TECK FUTURES TECKFUT

4 BSE BANKEX FUTURES BNKXFUT

5 BSE OIL & GAS FUTURES ONGXFUT

6 BSE PSU FUTURES PSUFUT

7 BSE METAL FUTURES METLFUT

8 BSE FMCG FUTURES FMCGFUT

TRADING SYSTEM
 The Derivatives Trading at BSE takes place through a fully
automated screen based trading platform called as DTSS
(Derivatives Trading and Settlement System).

 The DTSS is designed to allow trading on a real time basis.

 In addition to generating trades by matching opposite

orders, the DTSS also generates various reports for the
member participants.
Order Matching Rules
 Order Matching will take place after order
acceptance wherein the system searches for an
opposite matching order. If a match is found, a
trade will be generated.

 The order against which the trade has been

generated will be removed from the system.

 In case the order is not exhausted further

matching orders will be searched for and trades
generated till the order gets exhausted or no
more match-able orders are found.
 If the order is not entirely exhausted, the
system will retain the order in the pending
order book.

 Matching of the orders will be in the

priority of price and timestamp.

 A unique trade-id will be generated for

each trade and the entire information of
the trade is sent to the members involved.
SESSION TIMINGS
SESSION NAME FROM TO

Login Session 8:30 9:55

Trading Session 9:55 15:30
Position Transfer Session 15:30 15:50
Closing Session 15:50 16:10
Option Exercise Session 16:10 16:40
Margin Session 16:40 16:55
Query Session 16:55 17:40
Option contract
 An option is a contract, which gives the buyer
(holder) the right, but not the obligation, to buy
or sell specified quantity of the underlying assets,
at a specific (strike) price on or before a specified
time (expiration date).

 The underlying may be commodities like wheat/

rice/ cotton/ gold/ oil or financial instruments like
equity stocks/ stock index/ bonds etc.
Definition
 Under Securities Contracts (Regulations)
Act,1956 options on securities has been
 defined as "option in securities" means a
contract for the purchase or sale of a right to
buy or sell, or a right to buy and sell, securities
in future, and includes a teji, a mandi, a teji
mandi, a galli, a put, a call or a put and call in
securities;
Example:
 An investor buys One European call option on
Infosys at the strike price of Rs. 3500 at a
premium of Rs. 100. If the market price of
Infosys on the day of expiry is more than Rs.
3500, the option will be exercised.
 The investor will earn profits once the share price
crosses Rs. 3600 (Strike Price + Premium i.e.
3500+100).
 Suppose stock price is Rs. 3800, the option will
be exercised and the investor will buy 1 share of
Infosys from the seller of the option at Rs 3500
and sell it in the market at Rs 3800 making a
profit of Rs. 200 { (Spot price - Strike price) -
Premium}.
Option Premium
 This is the price paid by the
buyer to the seller to acquire the
right to buy or sell
Strike Price or Exercise Price
 The strike or exercise price of an option is
the specified/ pre-determined price of the
underlying asset at which the same can be
bought or sold if the option buyer
exercises his right to buy/ sell on or before
the expiration day.
Expiration date
 The date on which the option expires is
known as Expiration Date. On Expiration
date, either the option is exercised or it
expires worthless.
Exercise Date
 The date on which the option is actually
exercised.
Open Interest
 The total number of options
contracts outstanding in the market
at any given point of time.
Example
 `A' buys one contract of Nifty on Monday while
`B' buys two on the same day. Open interest at
the end of the day will be three.

 On Tuesday, while `A' sells his one contract to

`C', `B' buys another Nifty contract.

 The open interest at the end of the day is now

four. In other words, if both parties to the trade
initiate a new position, it increases the open
interest by one contract.
 But if the traders square off their existing
positions, open interest will decrease by the same
number of contracts.
 However, if one of the parties to the transaction
squares off his position while the other creates
one, open interest will remain unchanged.
 Open interest, thus, mirrors the flow of money
into the derivatives market, which makes it a
vital indicator of market direction. Here is how
you interpret open interest:
 The buyer / holder of the option purchases the
right from the seller/writer for a consideration
which is called the premium.

 The seller/writer of an option is obligated to settle

the option as per the terms of the contract when
the buyer/holder exercises his right.

 The underlying asset could include securities, an

index of prices of securities etc.
Types of options

An Option to buy is called

Call option

An option to sell is called Put

option.
What are Call Options?
 A call option gives the holder (buyer/ one who is
long call), the right to buy specified quantity of
the underlying asset at the strike price on or
before expiration date.

 The seller however, has the obligation to sell the

underlying asset if the buyer of the call option
decides to exercise his option to buy.
Example:
 An investor buys One European call option on
Infosys at the strike price of Rs. 3500 at a
premium of Rs. 100. If the market price of
Infosys on the day of expiry is more than Rs.
3500, the option will be exercised.
 The investor will earn profits once the share price
crosses Rs. 3600 (Strike Price + Premium i.e.
3500+100).
 Suppose stock price is Rs. 3800, the option will
be exercised and the investor will buy 1 share of
Infosys from the seller of the option at Rs 3500
and sell it in the market at Rs 3800 making a
profit of Rs. 200 { (Spot price - Strike price) -
Premium}.
 In another scenario, if at the time of
expiry stock price falls below Rs. 3500 say
suppose it touches Rs. 3000, the buyer of
the call option will choose not to exercise
his option. In this case the investor loses
the premium (Rs 100), paid which shall be
the profit earned by the seller of the call
option.
What are Put Options?
 A Put option gives the holder (buyer/ one who is
long Put), the right to sell specified quantity of the
underlying asset at the strike price on or before a
expiry date.

 The seller of the put option (one who is short Put)

however, has the obligation to buy the underlying
asset at the strike price if the buyer decides to
exercise his option to sell.
Example:
 An investor buys one European Put option on Reliance
at the strike price of Rs. 300/-, at a premium of Rs.
25/-. If the market price of Reliance, on the day of
expiry is less than Rs. 300, the option can be
exercised as it is 'in the money'.
 The investor's Break even point is Rs. 275/ (Strike
Price - premium paid) i.e., investor will earn profits if
the market falls below 275.
 Suppose stock price is Rs. 260, the buyer of the Put
option immediately buys Reliance share in the market
@ Rs. 260/- & exercises his option selling the Reliance
share at Rs 300 to the option writer thus making a net
profit of Rs. 15 {(Strike price - Spot Price) - Premium
paid}.
 In another scenario, if at the time of expiry,
market price of Reliance is Rs 320/ - , the buyer
of the Put option will choose not to exercise his
option to sell as he can sell in the market at a
higher rate.
 In this case the investor loses the premium paid
(i.e Rs 25/-), which shall be the profit earned by
the seller of the Put option. (Please see table)
American\ European option
 if an option that is exercisable on or before
the expiry date is called American option
 in the case of American options the buyer
has the right to exercise the option at
anytime on or before the expiry date.

 and one that is exercisable only on expiry

date, is called European option.
 In case of European Options the exercise
date is same as the expiration date while
in case of American Options, the options
contract may be exercised any day
between the purchase of the contract and
its expiration date (see European/
American Option)
settlement
 As in the case of futures contracts, option contracts
can be also be settled by delivery of the underlying
asset or cash.

 Option contract entails paying/receiving the

difference between the strike price/exercise price
and the price of the underlying asset either at the
time of expiry of the contract or at the time of
exercise / assignment of the option contract.
 How are options different from futures?
The significant differences in Futures and Options are as under:
Futures are agreements/contracts to buy or sell specified quantity of the underlying assets at a price agreed upon by the buyer and seller, on or before a specified time. Both the buyer
and seller are obligated to buy/sell the underlying asset.
In case of options the buyer enjoys the right and not the obligation, to buy or sell the underlying asset.
Futures Contracts have symmetric risk profile for both buyers as well as sellers, whereas options have asymmetric risk profile.
In case of Options, for a buyer (or holder of the option), the downside is limited to the premium (option price) he has paid while the profits may be unlimited.
For a seller or writer of an option, however, the downside is unlimited while profits are limited to the premium he has received from the buyer.
The futures contracts prices are affected mainly by the prices of the underlying asset. Prices of options are however, affected by prices of the underlying asset, time remaining for expiry
of the contract and volatility of the underlying asset.
It costs nothing to enter into a futures contract whereas there is a cost of entering into an options contract, termed as Premium.
Explain In the Money, At the Money and Out of the money Options.
An option is said to be 'at-the-money', when the option's strike price is equal to the underlying asset price. This is true for both puts and calls.
A call option is said to be in-the-money when the strike price of the option is less than the underlying asset price. For example, a Sensex call option with strike of 3900 is 'in-the-money',
when the spot Sensex is at 4100 as the call option has value.
The call holder has the right to buy a Sensex at 3900, no matter how much the spot market price has risen. And with the current price at 4100, a profit can be made by selling Sensex at
this higher price.
On the other hand, a call option is out-of-the-money when the strike price is greater than the underlying asset price. Using the earlier example of Sensex call option, if the Sensex falls to
3700, the call option no longer has positive exercise value. The call holder will not exercise the option to buy Sensex at 3900 when the current price is at 3700. (Please see table)
A put option is in-the-money when the strike price of the option is greater than the spot price of the underlying asset. For example, a Sensex put at strike of 4400 is in-the-money when
the Sensex is at 4100. When this is the case, the put option has value because the put holder can sell the Sensex at 4400, an amount greater than the current Sensex of 4100.
Likewise, a put option is out-of-the-money when the strike price is less than the spot price of underlying asset. In the above example, the buyer of Sensex put option won't exercise the
option when the spot is at 4800. The put no longer has positive exercise value.
Options are said to be deep in-the-money (or deep out-of-the-money) if the exercise price is at significant variance with the underlying asset price.
What are Covered and Naked Calls?
A call option position that is covered by an opposite position in the underlying instrument (for example shares, commodities etc), is called a covered call.
Writing covered calls involves writing call options when the shares that might have to be delivered (if option holder exercises his right to buy), are already owned.
E.g. A writer writes a call on Reliance and at the same time holds shares of Reliance so that if the call is exercised by the buyer, he can deliver the stock.
Covered calls are far less risky than naked calls (where there is no opposite position in the underlying), since the worst that can happen is that the investor is required to sell shares
already owned at below their market value.
When a physical delivery uncovered/ naked call is assigned an exercise, the writer will have to purchase the underlying asset to meet his call obligation and his loss will be the excess of
the purchase price over the exercise price of the call reduced by the premium received for writing the call.