Futures and options in India

Name- Asmita Ajay Sodekar

Roll no-3502

Class-TYBMS [B]
INTRODUCTION

The Indian capital market has witnessed impressive growth and qualitative changes,
especially over the last two decades. In the fifties, sixties and seventies, it was in a
dormant stage when the investors were not familiar with or inclined towards, the
corporate securities. During this time, only few companies accessed the capital market.
As a consequence trading volumes were low during these years. However gradual
dilution of the Foreign Exchange and Regulation Act (FERA) towards the close of
seventies provided a stimulus to investor interest in the capital market. Particularly since
the mid-eighties, the capital market saw an influx of millions of investors, a
multiplication of new issues, and a manifold increase in trading volumes. The process of
liberalization of the Indian economy since the early nineties has further contributed to the
changes in the capital market scenario. The entry of foreign investors in the market has
resulted in a substantial change in the scale of operations introducing trading in
derivatives including futures and options in India.

The term “futures and options” (also known as derivatives) refers to contracts which
are traded in financial markets. A future Contract requires delivery of a commodity,
bond, currency, stock or index, at a specified price, on a specified future date. The
physical delivery of underlying asset may or may not happen. Instead, it may be squared
off before its expiry date. For example, if a person is “long” on index future i.e. who
bought the contract at the beginning of the month may sell it just two days prior to its
expiry. The difference in the value of contract will be paid to him as profit (or deducted
from his account as loss) as the case may be. Similar to trading stocks, a certain
percentage of the traded value will be levied as commission (brokerage), a service tax (to
the brokerage amount) and a securities transaction tax (STT). The brokerage may vary for
different brokers. Some may charge a fixed brokerage; some may charge based on traded
value.

Futures
Futures contract prices also have the same structure like the cash market prices. ,there is
no price band for futures or options so as to avoid errors in entering orders the exchange
board may fix the price range. Prices in excess of the range will need to be reviewed by
the exchange board. In addition, if the “open interest” or the maximum number of
outstanding contracts exceeds a certain value then no fresh positions will be allowed for
the particular script.

Options
An option is a contract between buyer and seller giving the buyer the right, but not
obligation, to buy or sell an asset (a stock or index) at a specific price on or before a
specified date. In the case of a stock option, its value is based on the underlying stock.
For an index option, its value is based on the underlying index.
Objectives of Study

• TO STUDY THE SCOPE OF FUTURES AND OPTIONS IN INDIA.

• TO STUDY THE TRADING OF FUTURES ANDOPTIONS ON INDIA

BOURSES.

• TO UNDERSTAND EARLIER SYSTEMS OF “BADDA “AND ”TEJI AND

MANDI” IN OPTION TRADING.

RESEARCH METHODOLOGY

SEBI- Securities and Exchange Board of India.

NSE-National Stock Exchange.

MF-Mutual Funds.

BSE- Bombay Stock Exchange.

LIMITATIONS

• THE RESEARCH ARTICLE INCLUDES DERIVATIVE

TRADINGS OPERATED IN INDIA.NO OTHER COUNTRIES
ARE INCLUDED.

• In this case study, only futures and options market is reviewed, stock
market or share market is not included.

• Any specific time period is not undertaken, it’s overall review.

OPTIONS IN INDIA IN THE PAST

The concept of derivatives and their trading in India is not entirely new to the capital
market. However, the trading has been of the limited type and on limited scale, since it
was not enforceable by law. There were two legal hurdles:
1- The securities and contracts regulation act did not recognize index as a security thus
preventing any type of contracts with an index as an underline.
2- The Indian contract act which prohibits settling in a contract in the form of
differentials, being a wagering contract.

Before looking into the introduction of the derivatives training in the Indian market ,after
having cleared the legal barriers , we examine the nature of training which has been
prevalent in the past ,in fact, according to market sources, option trading has been in
vogue in places like ahemdabad, Mumbai, kolkata and Delhi for long. However, the
nature and extent of operations have been expectedly, rather limited since it has had no
legal sanction and is exposed to the risk associated with the illegal business. Also, there is
no question of a regulated market for such product and there is a lack of guarantee of
performance of the contracts. The limited mutual faith among the parties involved in such
contracts also has a effect that the time period of squaring the transaction is very short in
comparison to normal life span of the options in the legalized regulated markets.

The operations in the Indian market have been confined to call options known as teji, put
options known as mandi, their combination in the form of straddles known as jhota or do
ranga and bhav-bhav on stocks only. while in option trading markets in the world,
options with exercise prices are available so that the call options are accordingly labeled
as in-the- money, at-the-money or out-of-money in the Indian markets only out-of-money
call options, i.e.options with an exercise price higher than the current stock price are
traded. Hence the name teji for a value, the option premium. The buyer of the option is
called teji lagaii-wal.

Similarly, the put options traded are also those which are out-of-money options, i.e.,
options with an exercise price lower than the present stock price. The writers of such
options agree to buy a share in the event of its price falling below the exercise price, i.e.,
mandi, in consideration for a premium. The writer of an option of this type is called
mandi khaii-wal while the buyer is a mandi lagaii-wal.

Both teji and mandi usually have the expiry time at the stroke of 15 minutes before
closing the time of trading of the next business day. However sometimes they are event-
based, so that while they can originate any day but the exercise date is fixed, like the day
following the budget day or the day following the annual general meeting of the company
whose shares underlies the teji/mandi contract. The premium on teji/mandi options is
fixed customarily, usually at 25 paisa per share, and is not negotiable, although the strike
price ay be negotiated. On event based options, the premium payable is double than that
on the ordinary options.
The greater part of the derivative trading in India is in the form of jhota or fatak which
Involves the buyer, known variously as lagaii wal or lagane-wala or punter,the writer,
known by various names like khaii-wall,khane-wala or bookie,the mediator. a fatak
involves a call option available to the punter at exercise prices higher and lower than a
certain value, which is generally the closing price of a share on a given day. the size of
fatak that is to say ,the gap between the exercise prices of call and put options is generally
higher before the market trading hours and it is smaller during these hours.

To understand fatak,suppose a share closes at rs 66 on a given day. a bookie on such a

share would agree to give a punter the right to buy from bookie the share at say rs 69,or
sale to the bookie the shares at a rate of rs 63.thus, with the share price of rs66,he bookie
creates a fatak or gate for himself and his safety between the prices of rs63 and rs69, and
make himself liable only when the share price plummets below rs63 or raised beyond rs
69.the winter of a fatak obviously perceives that the market shall move the two sided risk,
the premium on a fatak is typically bauble the premium on teji mandi options.

It may be noted that most of the traders in such market are intra day of contra settlements
players and not long duration investors. they tend to move with the market and their
prime strategy is to remain with the market .accordingly most of the trades take positions
in keeping with the market prices with an allowance for positioned in keeping with an
allowance for some variations. it accounts for the fact that between 50 and 60 percent of
the traders in derivatives in the market are in the form of fatak trades while about 30-40
percentage accounted for by teji and mandi transactions.

Another derivative traded in the market is known as nazrana .in this case, the closing
price of the day is taken as the exercise price and the holder of nazrana can exercise a
call or put option depending on the price of the stock. For instance, if the closing price of
a stock is rs 66 on the given day, then the holder shall hold both options with him. Buy
the share from the bookie at a price of rs66 at the time of exercise .it will obviously pay
the option buyer to buy at rs 66 if the share price goes beyond this level and sell it to the
writer at rs66, if the share price decreases below rs66.
INTRODUCTION OF FUTURES AND OPTIONS IN INDIA.

India is one of the many emerging markets of the world where derivatives have been
introduced in the recent past. For long exchanges like stock exchange, Mumbai, and
vadodara stock exchange showed their willingness in introducing trading in futures and
options. However a concerted effort in this direction was made by the national stock
exchange in July 1995 when it considered the modalities of introducing derivatives
trading, mainly futures and options within a few months NSE developed a system of
futures and options trading aiming at modifying the carry forward system to include
futures and options in its scope. By January 1996 NSE started working on the scheme of
such trading. In March 1996 it made a presentation to SEBI on its plans to commence
trading in futures and options .the exchange proposed to start with index based futures
and index based options, which are seen as comparatively safer forms of derivatives.

While the exchanges were willing for derivatives trading .options differed widely about
the advisability of their introduction. it was largely felt that derivatives are important for
an emerging country like India essentially for the same reasons as they are for all
securities markets. They work as instruments of risk management and tools for market
development and serve to enhance market efficiency basically in areas of risk transfer
and price discovery. The derivatives allow shifting of risk from one who does not want it
to one who wants to take it and in absence of them; people have to suffer risk without
much choice. The lack of derivatives leaves much to be desired to be hedging purpose.i.e.
Transfer of risk .further international experience suggests that introduction of successful
index derivatives and options on equity are accompanied by a substantial improvement in
the market quality of the underlying equity market. The improved market efficiency
implies that the market prices of securities become more informative. Besides options are
also allow one to gauge the markets perception of volatility of the underlying security.
Knowledge about volatility and its forecast is helpful in investment and other decisions
also, as discussed earlier derivatives markets permit price discovery particularly where
the underlying product has a decentralized cash market. in fact once futures market
comes into existence a certain de-linking of the roles in cash and futures market is
witnessed. whereas the relatively non-speculative orders come to the cash market, the
futures market absorbs the effects of any news first and enables price discovery which in
turn is transmitted to the cash market through arbitrageurs further, availability of tradable
index futures enables one to take positions on indices at a low transaction cost which, in
the essence of such market, is possible only at a very high cost because positions are
required to be taken on the securities which underline such indices.

Those who were positive about the introduction of such trading in India were confident
that the investors could learn the complicities and intricacies of the derivatives fast. it was
felt that the knowledge of the market players of teji and mandi would enable them to
grasp the concept of futures and options. Some others observed that although the
concepts of badla, and futures and options are not strictly comparable, they both serve the
basic functions of trading on margins based upon the price movements of the underlying
securities and that of adding to the market liquidity. With the market operators well
versed with the badla concept, they believe that the Indian market can have all the three
instruments concurrently.

L.c.gupta committee on derivatives

The committee was setup in November 1996 in order to develop appropriate regulatory
framework for derivatives trading in India. The committee’s concern was with financial
derivatives in general and equity derivatives in particular.

The main recommendations of the committee are given below:

1-the committee strongly favored the introduction of financial derivatives trading in order
to provide the much needed facility of hedging to the general as well as institutional
investors in the most co-efficient way. it also recognized the importance of speculators in
the market to act as counter parties to hedger .thus it was recognized that in order to have
a sound market, both hedgers and speculators should be present in good numbers.

2-since there are interconnections among various types of financial derivatives ,the
committee recognized the need for equity derivatives ,interest rate derivatives and
currency derivatives .in the case of equity derivatives the committee felt the need to
introduce both futures and options contracts in accordance with the needs of market
forces. any such contracts, the committee laid, should be launched as per the market
needs and under the general oversight of SEBI .the committee held that it would be best
to make a beginning with the introduction of stock index futures .

3- the committee favored a phase introduction of equity derivatives so as to make sure

that the market first gets to understand the use of simpler variants of equity derivatives
before the more complex forms of contracts are introduced in the market. this way to
avoid all unnecessary confusion over the use of equity derivatives contracts and to
increase the acceptability of all the contracts to be used .it was considered desirable from
the regulatory angel as well.

4-the committee recommended a two level regulatory frame work. for derivatives trading
in the form of exchange level and SEBI level regulatory framework. the committee’s
main emphasis was on ensuring an effective exchange level regulation framework by
ensuring that all the exchanges providing derivatives contracts should be functioning as
self-regulatory organizations under constant supervision of SEBI.

5-the committee recommended that SEBI should take care of the overall governance and
guidance by playing the part of the overall supervisor of all the exchanges providing
trading facilities in the derivatives segment. the committee as asked for steps such as
better surveillance facilities on the regulators end, better margin emphasizing and
collection systems on the exchanges end ,better net worth requirements for the
participating brokers etc.
6-the committee provided very clear and specific entry requirements in the derivatives
segment for all brokers/dealers stating that the existing members of the stock exchanges
will not be made the members of the derivatives segment automatically. for membership
adequacy every broker/dealer needs to have a net worth of at least rs300 lac and a
minimum deposit of rs50 lac has to be maintained with the exchange at all times and it is
essential for all the brokers/dealers and their authorized sales person to pass a SEBI
recognized certification requirement.

7-in the committee also recommended removing the existing prohibition on the use of
derivatives by mutual funds, as they are one of the major providers of liquidity to the
market. But, the responsibility for proper control in this regard should be of the trustees
of the mutual funds. Thus, the committee advised that the involvement of MF’s should be
kept under minimum possible checks so as to allow them to play their part freely. This
would help in increasing the liquidity of the derivatives contracts tremendously.

8-the committee felt that the introduction of equity derivatives is going to increase the
responsibility of SEBI many folds as these derivatives contracts have the equity cash
market as their underlying which themselves are in need of constant regulation and
improvement.so, the committee has advised SEBI to take all possible care to introduce
derivatives ,which can have a competitive and healthy cash market for an underlying.

9-committee further recommended that SEBI create a derivatives cell, a derivatives

advisory committee and economic research wing .it would need to develop competence
among its personnel in order to be able to guide this new development along sound lines.
the committee has proposed a SEBI-RBI coordination mechanism in order to keep the
problems related to overlapping jurisdictions at bay.the idea here is to help in controlling
the various related financial derivatives markets.

10-the committee recommended government of India to take the required legal action in
order to enable the use of stock index derivatives by expanding the definition of
”securities” under section2(h)(iia)of the securities contract regulation act,1956,by
declaring derivatives contracts based on index prices and other derivative securities to be
securities. the committee also recommended that the notification issued by the central
government in June 1969,under section 16 of securities contract regulation act ,be
amended so as to enable trading in futures and options contract.
BEGINNING OF DERIVATIVES TRADING AND THEIRAFTER..

Pursuant to the l.c.gupta committee report the exchange-traded derivatives were

introduced in the Indian capital market in June 2000, beginning with stock index futures
contracts. both NSE and BSE started trading in NIFTY futures and SENSEX futures
contracts respectively, almost simultaneously. as expected, market interest in these
contracts was limited initially. no previous trading experience in derivatives instruments,
lack of knowledge and awareness about derivatives amongst most of the market
participants and the relatively tough rules framed by the market regulator kept most of the
market traders away from the derivatives market, resulting in very low volumes of
trading .SEBI’s thinking about introducing index futures as the first exchange-traded
derivative instrument in India was that perhaps this instrument was easier to understand
and regulate.also,index futures were viewed as useful instruments of hedging and
something that the small investors could also use to safeguard their interests
.internationally as well ,index futures are among the most popular derivative instruments.

In India ,however relatively tight regulations such a minimum trade lot size limit of
rs2lakh per contract and lack of sufficient understanding kept most of the market players
uninterested in these dynamic instruments of trading .SEBI’s intended segment of small
retail investors was not in position to participate in such expensive contracts. Another
factor that kept the initial growth of derivatives as a low key affair was the booming stock
market. the ever increasing prices of shares kept the attention of big market players
focused on the cash market only .also, the market players were used to the then prevalent
weekly settlement cycles and use of official deferral products such as ALBM and
BLESS. They were not keen to adapt to modern and dynamic instruments and systems
like derivatives and rolling settlements, of which they had no understanding.

Following a global meltdown in technology sector shares, the bull run in the Indian stock
markets that started in 1999,met its end in march 2001.as a result the Indian capital
market moved into a very depressed state. in less than a year, the face of the market
change beyond recognition as badla finally met its dead end and weekly settlements gave
way to rolling settlements. a positive result of all these developments was that derivatives
finally started growing rapidly.SEBI also started putting emphasis on introducing more
exchange traded derivative instruments.

The stock market scam that came to light in the month of march2001 was a significant
contributing factor for several significant changes such as end of badla system and the
introduction of the rolling settlements on july2 ,2001.also,the broker bank nexus which
earlier also had been responsible for unwarranted inflows of bank funds into the capital
market resurfaced .in fact, it hurt both the capital market as well as the banking system
so badly that RBI was forced to take stringent steps to restrict and channelise the bank
funds from entering the stock market
With the exit of badla and the introduction of rolling settlements initially the markets
were practically dried of funds and liquidity as speculators and arbitrageurs were finding
it difficult to sustain in the market without a proper deferral product also, the foreign
institutional investors, the financial institutions and mutual funds who were supposed to
benefit from measures such as the introduction of rolling settlements were initially not
able to do their best due to severe lack of liquidity in the market.

Many markets players accused SEBI of not regulating the markets in the mo9st efficient
manner and taking many harsh decisions, such as banning the badla and cancellation of
several brokers’ trading licenses etc, that were affecting the markets health adversely it
was felt that if things kept going the way they had been,the Indian capital market would
no longer remain as healthy. Fortunately, SEBI took the decision of introducing more
derivative instruments in the market: stock index options and options on individual stock.
such options were introduced in july2001 on a total of 31 stocks to provide more
instruments for market players and attempt to increase overall liquidity in the capital
market players owing to the rigid rules framed by the market regulators in their regard.

However, trading got fillip once SEBI introduced ,in November 2001 ,futures on the
same 31 individual stocks in which options were being traded. as stock futures possess
shades of badla,market participants welcomed their introduction with open arms. their
trading opened gates for new business opportunities. in fact, within days of their
inception, they surpasses tradind in other derivative products available. they have done
not only well in the context of Indian derivatives market but also in erms of global
trading of such contracts.
CONCLUSION

Now there are two exchanges in which derivatives trading is done, the NSE and the
stock exchange Mumbai. Even of these NSE shares the trading bulk..
Futures on individual stocks are the most traded derivative in India.
At present all options and futures contracts traded in India are settled in cash. While the
contracts involving indices can b settled in cash only, the contracts on stocks may be
settled in cash or in delivery of the underlaying.the futures and options contracts on
individual stocks, which are settled in cash as of now, are under the consideration of
SEBI for settlement through physical delivery.
Clearance has been given to mutual funds and the foreign institutional investors to trade
freely in the derivatives it is likely to provide greater and better opportunities to the
market players and a boon to further development of derivatives market in India.
Reference.

FUTURES AND OPTIONS, BY N.D.VOHRA & B.R.BAGRI

LETTERS ON DERIVATIVE TRADING.

INTERNET.