Risk Management Using Derivatives

Chapter I
Introduction
The time one talks about stock market, another word also clicks and that is risk. People have
lost their millions in this stock market. Stocks are just like gamble for those who don’t know
how to invest. The market behaves differently to different people. For speculators it can be
risky. They are the speculators who mostly lose the most. If is talk about wise people these
are always hedgers. Hedgers always keep risk involved in mind and try to minimize it using
different strategies. One can hedge risk using derivative instruments whether using future
trading or option trading.
Securities markets provide a channel for allocation of savings to those who have a productive
need for them. As a result, the savers and investors are not constrained by their individual
abilities, but by the economy’s abilities to invest and save respectively, which inevitably
enhances savings and investment in the economy.
The securities market has two interdependent and inseparable segments: the primary and the
secondary market.
Primary Market
The primary market provides the channel for sale of new securities. Primary market provides
opportunity to issuers of securities; Government as well as corporates, to raise resources to
meet their requirements of investment and/or discharge some obligation.
They may issue the securities at face value, or at a discount/premium and these securities
may take a variety of forms such as equity, debt etc. They may issue the securities in
domestic market and/or international market.
The primary market issuance is done either through public issues or private placement. A
public issue does not limit any entity in investing while in private placement, the issuance is
done to select people. In terms of the Companies Act, 1956, an issue becomes public if it
results in allotment to more than 50 persons. This means an issue resulting in allotment to less
-1-
than 50 persons is private placement. There are two major types of issuers who issue
securities. The corporate entities issue mainly debt and equity instruments (shares,
debentures, etc.), while the governments (central and state governments) issue debt securities
(dated securities, treasury bills).
The price signals, which subsume all information about the issuer and his business including
associated risk, generated in the secondary market, help the primary market in allocation of
funds.
Secondary Market
Secondary market refers to a market where securities are traded after being initially offered to
the public in the primary market and/or listed on the Stock Exchange. Majority of the trading
is done in the secondary market. Secondary market comprises of equity markets and the debt
markets.
The secondary market enables participants who hold securities to adjust their holdings in
response to changes in their assessment of risk and return. They also sell securities for cash to
meet their liquidity needs. Once the new securities are issued in the primary market they are
traded in the stock (secondary) market. The secondary market is operated through two
mediums, namely, the Over-the-Counter (OTC) market and the Exchange-Traded market.
Two exchanges, namely NSE and the Stock Exchange, Mumbai (BSE) provide trading of
securities. Today the market participants have the flexibility of choosing from a basket of
products like:
 Equities
 Bonds issued by both Government and Companies
 Futures on benchmark indices as well as stocks
 Options on benchmark indices as well as stocks
 Futures on interest rate products like Notional 91-day T-Bills, 10 year notional zero
coupon bond and 6% notional 10 year bond.
-2-
Reforms in the securities market, particularly the establishment and empowerment of SEBI,
market determined allocation of resources, screen based nation-wide trading,
dematerialisation and electronic transfer of securities, rolling settlement and ban on deferral
products, sophisticated risk management and derivatives trading, have greatly improved the
regulatory framework and efficiency of trading and settlement. Indian market is now
comparable to many developed markets in terms of a number of qualitative parameters.
Derivatives
The emergence of the market for derivative products, most notably forwards, futures and
options, can be traced back to the willingness of risk-averse economic agents to guard
themselves against uncertainties arising out of fluctuations in asset prices. By their very
nature, the financial markets are marked by a very high degree of volatility. Through the use
of derivative products, it is possible to partially or fully transfer price risks by locking-in asset
prices. As instruments of risk management, these generally do not influence the fluctuations
in the underlying asset prices. However, by locking in asset prices, derivative products
minimize the impact of fluctuations in asset prices on the profitability and cash flow situation
of risk-averse investors.
Derivative products initially emerged, as hedging devices against fluctuations in commodity

prices and commodity-linked derivatives remained the sole form of such products for almost
three hundred years. The financial derivatives came into spotlight in post-1970 period due to
growing instability in the financial markets. However, since their emergence, these products
have become very popular and by 1990s, they accounted for about two-thirds of total
transactions in derivative products. In recent years, the market for financial derivatives has
grown tremendously both in terms of variety of instruments available, their complexity and
also turnover. In the class of equity derivatives, futures and options on stock indices have
gained more popularity than on individual stocks,especially among institutional investors,
who are major users of index-linked derivatives.
Even small investors find these useful due to high correlation of the popular indices with
various portfolios and ease of use. The lower costs associated with index derivatives vis-vis
derivative products based on individual securities is another reason for their growing use.
-3-
Derivative is a product whose value is derived from the value of one or more basic variables,
called bases (underlying asset, index, or reference rate), in a contractual manner. The
underlying asset can be equity, forex, commodity or any other asset. For example, wheat
farmers may wish to sell their harvest at a future date to eliminate the risk of a change in
prices by that date. Such a transaction is an example of a derivative. The price of this
derivative is driven by the spot price of wheat which is the "underlying".
In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R)A) defines
"derivative" to include-
1. 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.
2. A contract which derives its value from the prices, or index of prices, of underlying
securities. Derivatives are securities under the SC(R)A and hence the trading of derivatives is
governed by the regulatory framework under the SC(R)A.
The word “DERIVATIVES” is derived from the word itself derived of a underlying asset. It
is a future image or copy of a underlying asset which may be shares, stocks, commodities,
stock indices, etc.
Derivatives is a financial product (shares, bonds) any act which is concerned with lending and
borrowing (bank) does not have its value borrow the value from underlying asset/ basic
variables.
Derivatives is derived from the following products:
A. Shares
B. Debentures
C. Mutual funds
D. Gold
E. Steel
F. Interest rate
G. Currencies.
-4-
Derivatives is a type of market where two parties are entered into a contract one is bullish and
other is bearish in the market having opposite views regarding the market. There cannot be
derivatives having same views about the market. In short it is like a INSURANCE market
where investors cover their risk for a particular position.
Derivatives are financial contracts of pre-determined fixed duration, whose values are derived
from the value of an underlying primary financial instrument, commodity or index, such as:
interest rates, exchange rates, commodities, and equities.
Derivatives are risk shifting instruments. Initially, they were used to reduce exposure to
changes in foreign exchange rates, interest rates, or stock indexes or commonly known as risk
hedging. Hedging is the most important aspect of derivatives and also its basic economic
purpose. There has to be counter party to hedgers and they are speculators. Speculators don’t
look at derivatives as means of reducing risk but it’s a business for them. Rather he accepts
risks from the hedgers in pursuit of profits. Thus for a sound derivatives market, both hedgers
and speculators are essential.
Derivatives trading have been a new introduction to the Indian markets. It is, in a sense
promotion and acceptance of market economy, that has really contributed towards the
growing awareness of risk and hence the gradual introduction of derivatives to hedge such
risks.
BACKGROUND
Consider a hypothetical situation in which ABC trading company has to import a raw
material for manufacturing goods. But this raw material is required only after 3 months.
However in 3 months the prices of raw material may go up or go down due to foreign
exchange fluctuations and at this point of time it cannot be predicted whether the prices
would go up or come down. Thus he is exposed to risks with fluctuations in forex rates. If he
buys the goods in advance then he will incur heavy interest and storage charges. However,
the availability of derivatives solves the problem of importer. He can buy currency
derivatives. Now any loss due to rise in raw material prices would be offset by profits on the
futures contract and vice versa. Hence the company can hedge its risk through the use of
derivatives
-5-
Chapter II
FACTORS CONTRIBUTING TO THE GROWTH OF DERIVATIVES
Over the last three decades, the derivatives market has seen a phenomenal growth. A large
variety of derivative contracts have been launched at exchanges across the world.
Factors contributing to the explosive growth of derivatives are price volatility, globalisation
of the markets, technological developments and advances in the financial theories.
A.} PRICE VOLATILITY –
A price is what one pays to acquire or use something of value. The objects having value
maybe commodities, local currency or foreign currencies. The concept of price is clear to
almost everybody when we discuss commodities. There is a price to be paid for the purchase
of food grain, oil, petrol, metal, etc. the price one pays for use of a unit of another persons
money is called interest rate. And the price one pays in one’s own currency for a unit of
another currency is called as an exchange rate.
Prices are generally determined by market forces. In a market, consumers have ‘demand’ and
producers or suppliers have ‘supply’, and the collective interaction of demand and supply in
the market determines the price. These factors are constantly interacting in the market causing
changes in the price over a short period of time. Such changes in the price are known as
‘price volatility’. This has three factors: the speed of price changes, the frequency of price
changes and the magnitude of price changes.
The changes in demand and supply influencing factors culminate in market adjustments
through price changes. These price changes expose individuals, producing firms and
governments to significant risks. The break down of the BRETTON WOODS agreement
brought and end to the stabilising role of fixed exchange rates and the gold convertibility of
the dollars. The globalisation of the markets and rapid industrialisation of many
underdeveloped countries brought a new scale and dimension to the markets. Nations that
were poor suddenly became a major source of supply of goods. The Mexican crisis in the
south east-Asian currency crisis of 1990’s has also brought the price volatility factor on the
-6-
surface. The advent of telecommunication and data processing bought information very
quickly to the markets. Information which would have taken months to impact the market
earlier can now be obtained in matter of moments.
Even equity holders are exposed to price risk of corporate share fluctuates rapidly.
These price volatility risks pushed the use of derivatives like futures and options increasingly
as these instruments can be used as hedge to protect against adverse price changes in
commodity, foreign exchange, equity shares and bonds.
B.} GLOBALISATION OF MARKETS –
Earlier, managers had to deal with domestic economic concerns; what happened in other part
of the world was mostly irrelevant. Now globalisation has increased the size of markets and
as greatly enhanced competition .it has benefited consumers who cannot obtain better quality
goods at a lower cost. It has also exposed the modern business to significant risks and, in
many cases, led to cut profit margins
In Indian context, south East Asian currencies crisis of 1997 had affected the competitiveness
of our products vis-à-vis depreciated currencies. Export of certain goods from India declined
because of this crisis. Steel industry in 1998 suffered its worst set back due to cheap import of
steel from south East Asian countries. Suddenly blue chip companies had turned in to red.
The fear of china devaluing its currency created instability in Indian exports. Thus, it is
evident that globalisation of industrial and financial activities necessitates use of derivatives
to guard against future losses. This factor alone has contributed to the growth of derivatives to
a significant extent.
C.} TECHNOLOGICAL ADVANCES –
A significant growth of derivative instruments has been driven by technological

breakthrough. Advances in this area include the development of high speed processors,
network systems and enhanced method of data entry. Closely related to advances in computer
technology are advances in telecommunications. Improvement in communications allow for
instantaneous worldwide conferencing, Data transmission by satellite. At the same time there
were significant advances in software programmes without which computer and
telecommunication advances would be meaningless. These facilitated the more rapid
movement of information and consequently its instantaneous impact on market price.
-7-
Although price sensitivity to market forces is beneficial to the economy as a whole resources
are rapidly relocated to more productive use and better rationed overtime the greater price
volatility exposes producers and consumers to greater price risk. The effect of this risk can
easily destroy a business which is otherwise well managed. Derivatives can help a firm
manage the price risk inherent in a market economy. To the extent the technological
developments increase volatility, derivatives and risk management products become that
much more important.
D.} ADVANCES IN FINANCIAL THEORIES –
Advances in financial theories gave birth to derivatives. Initially forward contracts in its
traditional form, was the only hedging tool available. Option pricing models developed by
Black and Scholes in 1973 were used to determine prices of call and put options. In late
1970’s, work of Lewis Edeington extended the early work of Johnson and started the hedging
of financial price risks with financial futures. The work of economic theorists gave rise to
new products for risk management which led to the growth of derivatives in financial
markets.
The above factors in combination of lot many factors led to growth of derivatives instruments
Chapter III
Myths and realities about derivatives

-8-
 Derivatives increase speculation and do not serve any economic purpose
 Indian Market is not ready for derivative trading
 Disasters prove that derivatives are very risky and highly leveraged instruments
 Derivatives are complex and exotic instruments that Indian investors will find
difficulty in understanding
 Is the existing capital market safer than Derivatives?
a. Derivatives increase speculation and do not serve any
economic purpose
While the fact is...

Numerous studies of derivatives activity have led to a broad consensus, both in the private
and public sectors that derivatives provide numerous and substantial benefits to the users.
Derivatives are a low-cost, effective method for users to hedge and manage their exposures to
interest rates, commodity prices, or exchange rates. The need for derivatives as hedging tool
was felt first in the commodities market. Agricultural futures and options helped farmers and
processors hedge against commodity price risk. After the fallout of Bretton wood agreement,
the financial markets in the world started undergoing radical changes. This period is marked
by remarkable innovations in the financial markets such as introduction of floating rates for
the currencies, increased trading in variety of derivatives instruments, on-line trading in the
capital markets, etc. As the complexity of instruments increased many folds, the
accompanying risk factors grew in gigantic proportions. This situation led to development
derivatives as effective risk management tools for the market participants.
Looking at the equity market, derivatives allow corporations and institutional investors to
effectively manage their portfolios of assets and liabilities through instruments like stock
index futures and options. An equity fund, for example, can reduce its exposure to the stock
market quickly and at a relatively low cost without selling off part of its equity assets by
using stock index futures or index options.
By providing investors and issuers with a wider array of tools for managing risks and raising
capital, derivatives improve the allocation of credit and the sharing of risk in the global
economy, lowering the cost of capital formation and stimulating economic growth. Now that
world markets for trade and finance have become more integrated, derivatives have
-9-
strengthened these important linkages between global markets, increasing market liquidity
and efficiency and facilitating the flow of trade and finance.
b. Indian Market is not ready for derivative trading

Often the argument put forth against derivatives trading is that the Indian capital market
is not ready for derivatives trading. Here, we look into the pre-requisites, which are
needed for the introduction of derivatives and how Indian market fares:
PRE- REQUISITES INDIAN SCENARIO

Large market India is one of the largest market-capitalised countries in Asia with a
Capitalisation market capitalisation of more than Rs.765000 crores.
The daily average traded volume in Indian capital market today is
High Liquidity in the around 7500 crores. Which means on an average every month 14%
underlying of the country’s Market capitalisation gets traded. These are clear
indicators of high liquidity in the underlying.
The first clearing corporation guaranteeing trades has become fully
functional from July 1996 in the form of National Securities
Trade guarantee Clearing Corporation (NSCCL). NSCCL is responsible for
guaranteeing all open positions on the National Stock Exchange
(NSE) for which it does the clearing.
National Securities Depositories Limited (NSDL) which started
A Strong Depository functioning in the year 1997 has revolutionalised the security
settlement in our country.
In the Institution of SEBI (Securities and Exchange Board of India)
A Good legal today the Indian capital market enjoys a strong, independent, and
guardian innovative legal guardian who is helping the market to evolve to a
healthier place for trade practices.
c. Disasters prove that derivatives are very risky and highly leveraged instruments

Disasters can take place in any system. The 1992 Security scam is a case in point. Disasters
are not necessarily due to dealing in derivatives, but derivatives make headlines. Here I have
- 10 -
tried to explain some of the important issues involved in disasters related to derivatives.
Careful observation will tell us that these disasters have occurred due to lack of internal
controls and/or outright fraud either by the employees or promoters.
Barings Collapse
1. 233 year old British bank goes bankrupt on 26th February 1995
2. Downfall attributed to a single trader, 28 year old Nicholas Leeson
3. Loss arose due to large exposure to the Japanese futures market
4. Leeson, chief trader for Barings futures in Singapore, takes huge position in index futures
of Nikkei 225
Comparison of New System with Existing System
Many people and brokers in India think that the new system of Futures & Options and
banning of Badla is disadvantageous and introduced early, but I feel that this new system is
very useful especially to retail investors. It increases the no of options investors for
investment. In fact it should have been introduced much before and NSE had approved it but
was not active because of politicization in SEBI.
Chapter IV
DERIVATIVE PRODUCTS
Derivative contracts have several variants. The most common variants are forwards, futures,
options and swaps.
- 11 -
Forwards: A forward contract is a customized contract between two entities, where
settlement takes place on a specific date in the future at today's pre-agreed price.
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. Futures contracts are special types of forward
contracts in the sense that the former are standardized exchange-traded contracts.
Options: Options are of two types - calls and puts. Calls give the buyer the right but not the
obligation to buy a given quantity of the underlying asset, at a given price on or before a
given future date. Puts give the buyer the right, but not the obligation to sell a given quantity
of the underlying asset at a given price on or before a given date.
Swaps: Swaps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios of forward
contracts. The two commonly used swaps are:
· Interest rate swaps: These entail swapping only the interest related cash flows between the
parties in the same currency.
· Currency swaps: These entail swapping both principal and interest between the parties, with
the cash flows in one direction being in a different currency than those in the opposite
direction.
Forward Contracts
A forward contract is an agreement to buy or sell an asset on a specified date for a specified
price. One of the parties to the contract assumes a long position and agrees to buy the
underlying asset on a certain specified future date for a certain specified price. The other
party assumes a short position and agrees to sell the asset on the same date for the same price.
Other contract details like delivery date, price and quantity are negotiated bilaterally by the
parties to the contract. The forward contracts are normally traded outside the exchanges.
- 12 -
The salient features of forward contracts are:
• They are bilateral contracts and hence exposed to counter-party risk.

• Each contract is custom designed, and hence is unique in terms of contract size, expiration
date and the asset type and quality.
• The contract price is generally not available in public domain.
• On the expiration date, the contract has to be settled by delivery of the asset.
• If the party wishes to reverse the contract, it has to compulsorily go to the same counter-
party, which often results in high prices being charged.
However forward contracts in certain markets have become very standardized, as in the case
of foreign exchange, thereby reducing transaction costs and increasing transactions volume.
This process of standardization reaches its limit in the organized futures market.
Forward contracts are very useful in hedging and speculation. The classic hedging application
would be that of an exporter who expects to receive payment in dollars three months later. He
is exposed to the risk of exchange rate fluctuations. By using the currency forward market to
sell dollars forward, he can lock on to a rate today and reduce his uncertainty. Similarly an
importer who is required to make a payment in dollars two months hence can reduce his
exposure to exchange rate fluctuations by buying dollars forward.
If a speculator has information or analysis, which forecasts an upturn in a price, then he can
go long on the forward market instead of the cash market. The speculator would go long on
the forward, wait for the price to rise, and then take a reversing transaction to book profits.
Speculators may well be required to deposit a margin upfront. However, this is generally a
relatively small proportion of the value of the assets underlying the forward contract. The use
of forward markets here supplies leverage to the speculator.
Introduction to Futures
Futures markets were designed to solve the problems that exists in forward markets. 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. There is a multilateral contract between the buyer and seller for a
- 13 -
underlying asset which may be financial instrument or physical commodities. But unlike
forward contracts the future contracts are standardized and exchange traded.
PURPOSE
The primary purpose of futures market is to provide an efficient and effective mechanism
for management of inherent risks, without counter-party risk.
It is a derivative instrument and a type of forward contract The future contracts are affected
mainly by the prices of the underlying asset. As it is a future contract the buyer and seller
has to pay the margin to trade in the futures market. It is essential that both the parties
compulsorily discharge their respective obligations on the settlement day only, even though
the payoffs are on a daily marking to market basis to avoid default risk. Hence, the gains or
losses are netted off on a daily basis and each morning starts with a fresh opening value. Here
both the parties face an equal amount of risk and are also required to pay upfront margins to
the exchange irrespective of whether they are buyers or sellers. Index based financial futures
are settled in cash unlike futures on individual stocks which are very rare and yet to be
launched even in the US. Most of the financial futures worldwide are index based and hence
the buyer never comes to know who the seller is, both due to the presence of the clearing
corporation of the stock exchange in between and also due to secrecy reasons.
EXAMPLE
Profit
The current market price of TATASTEEL is Rs.650/-.
There are two parties in the contract i.e. Ram and Krishna. Ram is bullish and Krishna is
50
bearish in the market. The initial margin is 10%. paid by the both parties. Here Ram has
25
purchased the one month contract of TATASTEEL futures with the price of Rs. 650/-.The lot
size of Tata Steel is 500 shares.
0
600 625 650 675
Suppose the stock rises to-25
Rs. 700/-. 700
-50 - 14 -
Loss
Unlimited profit for the buyer(Ram) = Rs.25,000 [(700-650*5oo)] and notional profit for the
buyer is 50.
Unlimited loss for the seller because the seller is bearish in the market.
Suppose the stock falls to Rs. 600/-
Profit
50
25
0
600 625 650 675
-25 700
-50
- 15 -
Loss
Unlimited profit for the seller = Rs.25,000.[(650-600*500)] and notional profit for the seller
is Rs. 50/-.
Unlimited loss for the buyer because the buyer is bullish in the market.
Finally, Futures contracts try to "bet" what the value of an index or commodity will be at
some date in the future. Futures are often used by mutual funds and large institutions to hedge
their positions when the markets are rocky. Also, Futures contracts offer a high degree of
leverage, or the ability to control a sizable amount of an asset for a cash outlay, which is
distantly small in proportion to the total value of contract.
Chapter V
Derivatives Products Traded in Derivatives Segment of BSE
The BSE created history on June 9, 2000 when it launched trading in Sensex based futures
contract for the first time. It was followed by trading in index options on June 1, 2001; in
stock options and single stock futures (31 stocks) on July 9, 2001 and November 9, 2002,
respectively. Currently, the number of stocks under single futures and options is 109 . BSE
achieved another milestone on September 13, 2004 when it launched Weekly Options, a
unique product unparalleled worldwide in the derivatives markets. It permitted trading in the
stocks of some leading companies namely; State Bank of India, Reliance Industries and
TISCO (renamed now Tata Steel).
Chhota (mini) SENSEX was launched on January 1, 2008. With a small or 'mini' market lot
of 5, it allows for comparatively lower capital outlay, lower trading costs, more precise
- 16 -
hedging and flexible trading. Currency futures were introduced on October 1, 2008 to enable
participants to hedge their currency risks through trading in the U.S. dollar-rupee future
platforms. Table 2 summarily specifies the derivative products and their date of introduction
on the BSE
Table :
Products Traded in Derivatives Segment of the BSE
Sr. No. Product Traded with underlying asset Introduction Date
1 Index Futures- Sensex June 9,2000
2 Index Options- Sensex June 1,2001
3 Stock Option July 9, 2001
4 Stock futures November9,2002
5 Weekly Option on 4 Stocks September 13,2004
6 Chhota (mini) SENSEX January 1, 2008
Futures & Options on Sectoral Indices namely BSE TECK,

7 N.A
BSE FMCG, BSE Metal, BSE Bankex and BSE Oil & Gas
8 Currency Futures on US Dollar Rupee October 1,2008
Source: Compiled from BSE website
SENSEX FUTURES
A financial derivative product enabling the investor to buy or sell underlying sensex on a
future date at a future price decided by the market forces
First financial derivative product in India.
Useful primarily for hedging the index based portfolios and also for expressing the views on
the market
SENSEX OPTIONS:
A financial derivative product enabling the investor to buy or sell call or put options (to be
exercised on a future date) on the underlying sensex at a premium decided by the market
forces
- 17 -
Useful primarily for Hedging the Sensex based portfolios and also for expressing the views
on the market.
STOCK FUTURES:
A financial derivative product enabling the investor to buy or sell underlying stock on a
future date at a price decided by the market forces
Available on individual stocks approved by SEBI
Useful primarily for Hedging, Arbitrage and for expressing the views on the market.
STOCK OPTIONS:
A financial derivative product enabling the investor to buy or sell call options(to be exercised
at a future date) on the underlying stock at a premium decided by the market forces.
Available on individual stocks approved by SEBI.
Useful primarily for Hedging, Arbitrage and for expressing the views on the market.
CONTRACT SPECIFICATIONS
SENSEX FUTURES AND STOCK FUTURES AND

PARTICULARS
OPTIONS OPTIONS
Corresponding stock in the
Underlying Asset Sensex
cash market
50 times the sensex (futures)
Stock specific E.g. market lot
Contract Multiplier of RIL is 600, Infosys is 100
100 times the sensex
& so on
(options)
3 nearest serial months
(futures)
Contract Months 1, 2 and 3 months
1, 2 and 3 months(options)
Tick size 0.1 point 0.01*
Price Quotation Sensex point Rupees per share
Trading Hours 9:00a.m. to 3:30p.m. 9:00a.m. to 3:30p.m.
Settlement value In case of sensex options the In case of stock options the
closing value of the sensex closing value of the
on the expiry day respectative in the cash
- 18 -
segment of BSE
In case of sensex options In case of stock options
Specified time (exercise Specified time (exercise
session) on the last trading session) on the last trading
day of the contract. All in the day of the contract. All in the
Exercise Notice Time
money options would deem money options would deem
to be exercised unless to be exercised unless
communicated otherwise by communicated otherwise by
the participant. the participant.
Last Thursday of the contract Last Thursday of the contract
month. If it is a holiday, the month. If it is a holiday, the
Last Trading Day
immediately preceding immediately preceding
business day business day
The difference is settled in
On the last trading day, the
cash on the expiration day on
closing value of the Sensex
the basis of the closing value
Final Settlement would be the final settlement
of the respective underlying
price of the expiring
scrip in the cash market on
futures/option contract.
the expiration day
Chapter VI
Derivatives Products Traded in Derivatives Segment of NSE
NSE started trading in index futures, based on popular S&P CNX Index, on June 12, 2000 as its first
derivatives product. Trading on index options was introduced on June 4, 2001. Futures on individual
securities started on November 9, 2001. The futures contracts are available on 233 securities
stipulated by the Securities & Exchange Board of India (SEBI). Trading in options on individual
securities commenced from July 2, 2001. The options contracts are American style and cash settled
and are available on 233 securities. Trading in interest rate futures was introduced on 24 June 2003
but it was closed subsequently due to pricing problem. The NSE achieved another landmark in
product introduction by launching Mini Index Futures & Options with a minimum contract size of Rs
1 lac. NSE crated history by launching currency futures contract on US Dollar-Rupee on August 29,
2008 in Indian Derivatives market. Table presents a description of the types of products traded at
F& O segment of NSE.
Sr No. Product Traded with underlying asset Introduction Date
- 19 -
1 Index Futures- S&P CNX Nifty June 12,2000
2 Index Options- S&P CNX Nifty June 4,2001
3 Stock futures on 233 Stocks July 2, 2001
4 Stock Option on 233 Stocks November 9,2001
5 Interest Rate Futures- T – Bills and 10 Years Bond August 29,2003
6 CNX IT Futures & Options June 13,2005
7 Bank Nifty Futures & Options June 1,2007
8 CNX Nifty Junior Futures & Options June 1,2007
9 Nifty Midcap 5 0 Futures & Options January 1, 2008
10 Mini index Futures & Options - S&P CNX Nifty index March 3,2008
11 Long Term Option contracts on S&P CNX Nifty Index August 29,2008
12 Currency Futures on US Dollar Rupee August 29,2008
13 Currency Futures on US Dollar Rupee December 10, 2008
14 S& P CNX Defty Futures & Options December 10, 2008
Source: Complied from NSE website
Chapter VII
FUTURES AND OPTIONS
An interesting question to ask at this stage is - when would one use options instead of
futures? Options are different from futures in several interesting senses. At a practical level,
the option buyer faces an interesting situation. He pays for the option in full at the time it is
purchased. After this, he only has an upside. There is no possibility of the options position
generating any further losses to him (other than the funds already paid for the option). This is
different from futures, which is free to enter into, but can generate very large losses. This
characteristic makes options attractive to many occasional market participants, who cannot
put in the time to closely monitor their futures positions. Buying put options is buying
insurance. To buy a put option on Nifty is to buy insurance which reimburses the full extent
to which Nifty drops below the strike price of the put option. This is attractive to many
people, and to mutual funds creating "guaranteed return products".
Options made their first major mark in financial history during the tulip- bulb mania in
seventeenth- century Holland. It was one of the most spectacular get rich quick binges in
- 20 -
history. The first tulip was brought into Holland by a botany professor fro m Vienna. Over a
decade, the tulip became the most popular and expensive item in Dutch gardens. The more
popular they became, the more Tulip bulb prices began rising. That was when options came
into the picture. They were initially used for hedging. By purchasing a call option on tulip
bulbs, a dealer who was committed to a sales contract could be assured of obtaining a fixed
number of bulbs for a set price. Similarly, tulip-bulb growers could assure themselves of
selling their bulbs at a set price by purchasing put options. Later, however, options were
increasingly used by speculators who found that call options were an effective vehicle for
obtaining maximum possible gains on investment. As long as tulip prices continued to
skyrocket, a call buyer would realize returns far in excess of those that could be obtained by
purchasing tulip bulbs themselves.
The writers of the put options also prospered as bulb prices spiralled since writers were able
to keep the premiums and the options were never exercised. The tulip- bulb market collapsed
in 1636 and a lot of speculators lost huge sums of money. Hardest hit were put writers who
were unable to meet their commitments to purchase Tulip bulbs.
FUTURES V/S OPTIONS
RIGHT OR OBLIGATION :
Futures are agreements/contracts to buy or sell specified quantity of the underlying assets at
a price agreed upon by the buyer & 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 & not the obligation, to buy or sell the
underlying asset.
RISK
Futures Contracts have symmetric risk profile for both the buyer as well as the seller.
While 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.
- 21 -
PRICES:
The Futures contracts prices are affected mainly by the prices of the underlying asset.While
the prices of options are however, affected by prices of the underlying asset, time remaining
for expiry of the contract & volatility of the underlying asset.
COST:
It costs nothing to enter into a futures contract whereas there is a cost of entering into an
options contract, termed as Premium.
STRIKE PRICE:
In the Futures contract the strike price moves while in the option contract the strike price
remains constant .
Liquidity:
As Futures contract are more popular as compared to options. Also the premium charged is
high in the options. So there is a limited Liquidity in the options as compared to Futures.
There is no dedicated trading and investors in the options contract.
Price behaviour:
The trading in future contract is one-dimensional as the price of future depends upon the price
of the underlying only. While trading in option is two-dimensional as the price of the option
depends upon the price and volatility of the underlying.
PAY OFF:
As options contract are less active as compared to futures which results into non linear pay
off. While futures are more active has linear pay off .
- 22 -
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. Futures contracts are special types of forward contracts in the
sense that the former are standardized exchange- traded contracts.
Single Stock Futures
Single-stock futures (SSF's) are futures contracts with the underlying asset being one
particular stock, usually in batches of 100. When purchased, no transmission of share rights
or dividends occurs. Being futures contracts they are traded on margin, thus offering leverage,
and they are not subject to the short selling limitations that stocks are. They are traded in
various financial markets, including those of the United States, United Kingdom, Spain, India
and others.
Single stock futures values are priced by the market in accordance with the standard
theoretical pricing model for forward and futures contracts.
The single stock futures market in India has been a great success story across the world. NSE
ranks first in the world in terms of number of contracts traded in single stock futures. One of
the reasons for the success could be the ease of trading and settling these contracts. To trade
securities, a customer must open a security trading account with a securities broker and a
demat account with a securities depository. Buying security involves putting up all the money
upfront. With the purchase of shares of a company, the holder becomes a part owner of the
company. The shareholder typically receives the rights and privileges associated with the
security, which may include the receipt of dividends, invitation to the annual shareholders
meeting and the power to vote.
- 23 -
Selling securities involves buying the security before selling it. Even in cases where short
selling is permitted, it is assumed that the securities broker owns the security and then "lends"
it to the trader so that he can sell it. Besides, even if permitted, short sales on security can
only be executed on an up-tick.
To trade futures, a customer must open a futures trading account with a derivatives broker.
Buying futures simply involves putting in the margin money. They enable the futures traders
to take a position in the underlying security without having to open an account with a
securities broker. With the purchase of futures on a security, the holder essentially makes a
legally binding promise or obligation to buy the underlying security at some point in the
future (the expiration date of the contract). Security futures do not represent ownership in a
corporation and the holder is therefore not regarded as a shareholder.
A futures contract represents a promise to transact at some point in the future. In this light, a
promise to sell security is just as easy to make as a promise to buy security. Selling security
futures without previously owning them simply obligates the trader to selling a certain
amount of the underlying security at some point in the future. It can be done just as easily as
buying futures, which obligates the trader to buying a certain amount of the underlying
security at some point in the future. In the following sections we shall look at some uses of
security future.
INDEX FUTURES
Index Futures are Future contracts where the underlying asset is the Index. This is of great
help when one wants to take a position on market movements. Suppose you feel that the
markets are bullish and the Sensex would cross 20,000 points. Instead of buying shares that
constitute the Index you can buy the market by taking a position on the Index future
Index futures can be used for hedging, speculating, arbitrage, cash flow management and
asset allocation. The S&P 500 futures products are the largest traded index futures product in
the world.
Index derivatives offer various advantages and hence have become very popular.
- 24 -
Institutional and large equity-holders need portfolio-hedging facility. Index-derivatives are
more suited to them and more cost-effective than derivatives based on individual stocks.
Pension funds in the US are known to use stock index futures for risk hedging purposes.
 Index derivatives offer ease of use for hedging any portfolio irrespective of its composition.
 Stock index is difficult to manipulate as compared to individual stock prices, more so in

India, and the possibility of cornering is reduced. This is partly because an individual stock
has a limited supply, which can be cornered.
 Stock index, being an average, is much less volatile than individual stock prices. This implies
much lower capital adequacy and margin requirements.
 Index derivatives are cash settled, and hence do not suffer from settlement delays and
problems related to bad delivery, forged/fake certificates.
Reasons for Hedging an Equity Portfolio with Index Futures
Hedging can be justified if the hedger feels that the stocks in the portfolio have been chosen
well. In these circumstances, the hedger might be very uncertain about the performance of the
market as a whole, but confident that the stocks in the portfolio will outperform the market. A
hedge using index futures removes the risk arising from market moves and leaves the hedger
exposed only to the performance of the portfolio relative to the market. Another reason for
hedging may be that the hedger is planning to hold a portfolio for a long period of time and
requires short term protection in an uncertain market situation. The alternative strategy of
selling the portfolio and buying it back later might involve unacceptably high transaction
costs.
- 25 -
Chapter VIII
Options
INTRODUCTION TO OPTIONS
It is a interesting tool for small retail investors. 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 physical commodities like wheat/ rice/ cotton/ gold/ oil or financial
instruments like equity stocks/ stock index/ bonds etc.
Options are of two types - calls and puts. Calls give the buyer the right but not the obligation
to buy a given quantity of the underlying asset, at a given price on or before a given future
date. Puts give the buyer the right, but not the obligation to sell a given quantity of the
underlying asset at a given price on or before a given date.
An option gives a person the right but not the obligation to buy or sell something. An option
is a contract between two parties where in the buyer receives a privilege for which he pays a
fee (premium) and the seller accepts an obligation for which he receives a fee. The premium
is the price negotiated and set when the option is bought or sold. A person who buys an
option is said to be long in the option. A person who sells (or writes) an option is said to be
short in the option.
Although options have existed for a long time, they were traded OTC, without much
knowledge of valuation. The first trading in options began in Europe and the US as early as
the seventeenth century. It was only in the early 1900s that a group of firms set up what was
known as the put and call Brokers and Dealers Association with the aim of providing a
mechanism for bringing buyers and sellers together. If someone wanted to buy an option, he
or she would contact one of the member firms. The firm would then attempt to find a seller
or writer of the option either from its own clients or those of other member firms. If no seller
could be found, the firm would undertake to write the option itself in return for a price. This
- 26 -
market however suffered from two deficiencies. First, there was no secondary market and
second, there was no mechanism to guarantee that the writer of the option would honour the
contract. In 1973, Black, Merton and Scholes invented the famed Black -Scholes formula. In
April 1973, CBOE was set up specifically for the purpose of trading options. The market for
options developed so rapidly that by early '80s, the number of shares underlying the option
contract sold each day exceeded the daily volume of shares traded on the NYSE. Since then,
there has been no looking back.
NSE introduced trading in index options on June 4, 2001. The options contracts are European
style and cash settled and are based on the popular market benchmark S&P CNX Nifty index.
(Selection criteria for indices)
Security descriptor
The security descriptor for the S&P CNX Nifty options contracts is:
Market type : N
Instrument Type : OPTIDX
Underlying : NIFTY
Expiry date : Date of contract expiry
Option Type : CE/ PE
Strike Price: Strike price for the contract
Instrument type represents the instrument i.e. Options on Index.
Underlying symbol denotes the underlying index, which is S&P CNX Nifty.
Expiry date identifies the date of expiry of the contract.
Option type identifies whether it is a call or a put option., CE - Call European, PE - Put
European.
Underlying Instrument
The underlying index is S&P CNX NIFTY.
Trading cycle:
- 27 -
S&P CNX Nifty options contracts have 3 consecutive monthly contracts, additionally 3
quarterly months of the cycle March / June / September / December and 5 following semi-
annual months of the cycle June / December would be available, so that at any point in time
there would be options contracts with at least 3 year tenure available. On expiry of the near
month contract, new contracts (monthly/quarterly/ half yearly contracts as applicable) are
introduced at new strike prices for both call and put options, on the trading day following the
expiry of the near month contract.
Expiry day:
S&P CNX Nifty options contracts expire on the last Thursday of the expiry month. If the last
Thursday is a trading holiday, the contracts expire on the previous trading day.
Contract size
The value of the option contracts on Nifty may not be less than Rs. 2 lakhs at the time of
introduction. The permitted lot size for futures contracts & options contracts shall be the same
for a given underlying or such lot size as may be stipulated by the Exchange from time to
time.
Price steps
The price step in respect of S&P CNX Nifty options contracts is Re.0.05.
Base Prices
Base price of the options contracts, on introduction of new contracts, would be the theoretical
value of the options contract arrived at based on Black-Scholes model of calculation of
options premiums.
The options price for a Call, computed as per the following Black Scholes formula:
C = S * N (d1) - X * e- rt * N (d2)
and the price for a Put is :
P = X * e- rt * N (-d2) - S * N (-d1)
where :
- 28 -
d1 = [ln (S / X) + (r + σ2 / 2) * t] / σ * sqrt(t)
d2 = [ln (S / X) + (r - σ2 / 2) * t] / σ * sqrt(t)
= d1 - σ * sqrt(t)
C = price of a call option
P = price of a put option
S = price of the underlying asset
X = Strike price of the option
r = rate of interest
t = time to expiration
σ = volatility of the underlying
N represents a standard normal distribution with mean = 0 and standard deviation = 1
ln represents the natural logarithm of a number. Natural logarithms are based on the constant
e (2.71828182845904).
Rate of interest may be the relevant Mumbai Inter-bank Offerred Rate (MIBOR) rate or such
other rate as may be specified.
The base price of the contracts on subsequent trading days, will be the daily close price of the
options contracts. The closing price shall be calculated as follows:
If the contract is traded in the last half an hour, the closing price shall be the last half an hour
weighted average price.
If the contract is not traded in the last half an hour, but traded during any time of the day, then
the closing price will be the last traded price (LTP) of the contract.
If the contract is not traded for the day, the base price of the contract for the next trading day
shall be the theoretical price of the options contract arrived at based on Black-Scholes model
- 29 -
of calculation of options premiums.
Index options:
These options have the index as the underlying.
Some options are European while others are American. Like index futures contracts, index
options contracts are also cash settled.
Stock options:
Stock options are options on individual stocks. Options currently trade on over 500 stocks in
the United States. A contract gives the holder the right to buy or sell shares at the specified
price.
Terminologies used while trading with Options
•Strike price:
The price specified in the options contract is known as the strike price or the exercise price.
•American options:
American options are options that can be exercised at any time upto the expiration date.
Most exchange-traded options are American.
•European options:
European options are options that can be exercised only on the expiration date itself.
European options are easier to analyze than American options, and properties of an American
option are frequently deduced from those of its European counterpart.
•In- the-money option:
An in-the-money (ITM) option is an option that would lead to a positive cashflow to the
holder if it were exercised immediately. A call option on the index is said to be in-the-money
when the current index stands at a level higher than the strike price (i.e. spot price > strike
price). If the index is much higher than the strike price, the call is said to be deep ITM. In the
case of a put, the put is ITM if the index is below the strike price.
- 30 -
•At- the -money option:
An at -the-money (ATM) option is an option that would lead to zero cash flow if it were
exercised immediately. An option on the index is at-the-money when the current index equals
the strike price (i.e. spot price = strike price).
•Out-of-the -money option:
An out-of-the-money (OTM) option is an option that would lead to a negative cash flow if it
were exercised immediately. A call option on the index is out -of-the-money when the
current index stands at a level which is less than the strike price (i.e. spot price < strike price).
If the index is much lower than the strike price, the call is said to be deep OTM. In the case of
a put, the put is OTM if the index is above the strike price.
•Intrinsic value of an option:
The option premium can be broken down into two components - intrinsic value and time
value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is
OTM, its intrinsic value is zero. Putting it another way, the intrinsic value of a call is Max [0,
(S K)] which means the intrinsic value of a call is the greater
T of 0 or
(S— K).
Similarly, the intrinsic value of a put is Max[0, K— S],i.e. t the greater of 0 or (K — S).
K is the strike price and S is the spot price.
•Time value of an option:
The time value of an option is the difference between its premium and its intrinsic value.
Both calls and puts have time value. An option that is OTM or ATM has only time value.
Usually, the maximum time value exists when the option is ATM. The longer the time to
expiration, the greater is an option's time value, all else equal. At expiration, an option should
have no time value.
- 31 -
FACTORS AFFECTING OPTION PREMIUM
THE PRICE OF THE UNDERLYING ASSET: (S)
Changes in the underlying asset price can increase or decrease the premium of an option.
These price changes have opposite effects on calls and puts.
For instance, as the price of the underlying asset rises, the premium of a call will increase and
the premium of a put will decrease. A decrease in the price of the underlying asset’s value
will generally have the opposite effect
THE SRIKE PRICE: (K)
The strike price determines whether or not an option has any intrinsic value. An option’s
premium generally increases as the option gets further in the money, and decreases as the
option becomes more deeply out of the money.
Time until expiration: (t)

An expiration approaches, the level of an option’s time value, for puts and calls, decreases.
Volatility:
Volatility is simply a measure of risk (uncertainty), or variability of an option’s underlying.
Higher volatility estimates reflect greater expected fluctuations (in either direction) in
underlying price levels. This expectation generally results in higher option premiums for puts
and calls alike, and is most noticeable with at- the- money options.
Interest rate: (R1)

This effect reflects the “COST OF CARRY” – the interest that might be paid for margin, in
case of an option seller or received from alternative investments in the case of an option
buyer for the premium paid.
Higher the interest rate, higher is the premium of the option as the cost of carry increases.
- 32 -
PLAYERS IN THE OPTION MARKET:
a) Developmental institutions
b) Mutual Funds
c) Domestic & Foreign Institutional Investors
d) Brokers
e) Retail Participants
VARIOUS STRATEGIES ADOPTED :
1. Long Call
2. Short Call
3. Long Put
4. Short Put
5. Long Call Spread
6. Short Put Spread
7. Short Call Spread
8 Long Put Spread
9. Long Combo
10. Short Combo
11. Long Straddle
12. Short Straddle
13. Long Strangle
14. Short Strangle
15. Long Guts
16. Short Guts
17. Long Butterfly
18. Short Butterfly
19. Long Condor
- 33 -
20. Short Condor
21. Long Iron Butterfly
22. Short Iron Butterfly
23. Long Iron Condor
24. Short Iron Condor
25. Long Call Strip
26. Short Call Strip
27. Long Put Strip
28. Short Put Strip
29. Long Calendar Spread
30. Long Diagonal Calendar Spread
31. Long Straddle Calendar Spread
32. Long Diagonal Straddle Calendar Spread
33. Long Jelly Roll
34. Long Straddle (Calendar) Strip
35. Long Box
36. Long Two by One Ratio Call Spread
37. Short Two by One Ratio Call Spread
38. Long Two by One Ratio Put Spread
39. Short Two by One Ratio Put Spread
40. Long Call Ladder
41. Short Call Ladder
42. Long Put Ladder
43. Short Put Ladder
44. Synthetic Long Underlying
45. Synthetic Short Underlying
46. Long Call Spread versus Put
47. Short Call Spread versus Put
- 34 -
48. Long Put Spread versus Call
49. Short Put Spread versus Call
50. Long Straddle versus Call
51. Short Straddle versus Call
52. Long Straddle versus Put
53. Short Straddle versus Put
54. Long Volatility Trade
55. Short Volatility Trade
56. Conversion/Reversal
57. Delta Neutral Strategies
Chapter IX
Options Strategies
- 35 -
STRATEGY 1 : LONG CALL
For aggressive investors who are very bullish about the prospects for a stock / index, buying
calls can be an excellent way to capture the upside potential with limited downside risk.
Buying a call is the most basic of all options strategies. It constitutes the first options trade for
someone already familiar with buying / selling stocks and would now want to trade options.
Buying a call is an easy strategy to understand. When you buy it means you are bullish.
Buying a Call means you are very bullish and expect the underlying stock /index to rise in
future.
Example
Mr. XYZ is bullish on Nifty on 24th Oct, when the Nifty is at 6191.10. He buys a call option
with a strike price of Rs. 6600 at a premium of Rs. 36.35, expiring on 25th Nov. If the Nifty
goes above 6636.35, Mr. XYZ will make a net profit (after deducting the premium) on
exercising the option. In case the Nifty stays at or falls below 6600, he can forego the option
(it will expire worthless) with a maximum loss of the premium.
ANALYSIS: This strategy limits the downside risk to the extent of premium paid by Mr.
XYZ (Rs. 36.35). But the potential return is unlimited in case of rise in Nifty. A long call
option is the simplest way to benefit if you believe that the market will make an upward
move and is the most common choice among first time investors in Options. As the stock
price / index rises the long Call moves into profit more and more quickly.
STRATEGY 2 : SHORT CALL
When you buy a Call you are hoping that the underlying stock / index would rise. When
- 36 -
you expect the underlying stock / index to fall you do the opposite. When an investor is
very bearish about a stock / index and expects the prices to fall, he can sell Call options.
This position offers limited profit potential and the possibility of large losses on big advances
in underlying prices. Although easy to execute it is a risky strategy since the seller of the Call
is exposed to unlimited risk.
A Call option means an Option to buy. Buying a Call option means an investor expects the
underlying price of a stock / index to rise in future. Selling a Call option is just the opposite of
buying a Call option. Here the seller of the option feels the underlying price of a stock / index
is set to fall in the future.
Example
Mr. XYZ is bearish about Nifty and expects it to fall. He sells a Call option with a strike price
of Rs. 6200 at a premium of Rs. 154, when the current Nifty is at 6294. If the Nifty stays at
6200 or below, the Call option will not be exercised by the buyer of the Call and Mr. XYZ
can retain the entire premium of Rs.154.
ANALYSIS: This strategy is used when an investor is very aggressive and has a strong
expectation of a price fall (and certainly not a price rise). This is a risky strategy since as
the stock price / index rises, the short call loses money more and more quickly and losses can
be significant if the stock price / index falls below the strike price. Since the investor does not
own the underlying stock that he is shorting this strategy is also called Short Naked Call.
STRATEGY 3 : LONG PUT
Buying a Put is the opposite of buying a Call. When you buy a Call you are bullish about the
stock / index. When an investor is bearish, he can buy a Put option. A Put Option gives the
- 37 -
buyer of the Put a right to sell the stock (to the Put seller) at a pre-specified price and thereby
limit his risk.
A long Put is a Bearish strategy. To take advantage of a falling market an investor can buy
Put options.
When to use: Investor is bearish about the stock / index.
Risk: Limited to the amount of Premium paid. (Maximum loss if stock / index expires at or
above the option strike price).
Reward: Unlimited
Break-even Point: Stock Price – Premium
Example:
Mr. XYZ is bearish on Nifty on 24th June, when the Nifty is at 5694. He buys a Put option
with a strike price Rs. 5600 at a premium of Rs. 52, expiring on 31st July. If the Nifty goes
below 5548, Mr. XYZ will make a profit on exercising the option. In case the Nifty rises
above 5600, he can forego the option (it will expire worthless) with a maximum loss of the
premium.
Strategy : Buy Put Option

Current Nifty index 5694
Put Option Strike Price (Rs.) 5600
Mr. XYZ Pays Premium (Rs.) 52
Break Even Point (Rs.) 5548
(Strike Price - Premium)
ANALYSIS: A bearish investor can profit from declining stock price by buying Puts. He
limits his risk to the amount of premium paid but his profit potential remains unlimited. This
is one of the widely used strategy when an investor is bearish.
STRATEGY 4 : SHORT PUT
Selling a Put is opposite of buying a Put. An investor buys Put when he is bearish on a stock.
An investor Sells Put when he is Bullish about the stock – expects the stock price to rise or
stay sideways at the minimum. When you sell a Put, you earn a Premium (from the buyer of
the Put). You have sold someone the right to sell you the stock at the strike price. If the stock
price increases beyond the strike price, the short put position will make a profit for the seller
- 38 -
by the amount of the premium, since the buyer will not exercise the Put option and the Put
seller can retain the Premium (which is his maximum profit). But, if the stock price decreases
below the strike price, by more than the amount of the premium, the Put seller will lose
money. The potential loss being unlimited (until the stock price fall to zero).
When to Use: Investor is very Bullish on the stock / index. The main idea is to make a short
term income.
Risk: Put Strike Price – Put Premium.
Reward: Limited to the amount of Premium received.
Breakeven: Put Strike Price – Premium
Example
Mr. XYZ is bullish on Nifty when it is at 6191.10. He sells a Put option with a strike price of
Rs. 6100 at a premium of Rs. 170.50 expiring on 28th October. If the Nifty index stays above
6100, he will gain the amount of premium as the Put buyer won’t exercise his option. In case
the Nifty falls below 6100, Put buyer will exercise the option and the Mr. XYZ will start
losing money. If the Nifty falls below 5929.50, which is the breakeven point, Mr. XYZ will
lose the premium and more depending on the extent of the fall in Nifty.
Strategy : Sell Put Option
Current Nifty index 6191.1
Put Option Strike Price (Rs.) 6100
Mr. XYZ receives Premium (Rs.) 170.5
Break Even Point (Rs.) 5929.5
(Strike Price - Premium)*
* Breakeven Point is from the point of Put Option Buyer
ANALYSIS: Selling Puts can lead to regular income in a rising or range bound markets. But
it should be done carefully since the potential losses can be significant in case the price of the
stock / index falls. This strategy can be considered as an income generating strategy.
- 39 -
STRATEGY 5 : COVERED CALL
You own shares in a company which you feel may rise but not much in the near term (or at
best stay sideways). You would still like to earn an income from the shares. The covered call
is a strategy in which an investor Sells a Call option on a stock he owns (netting him a
premium). The Call Option which is sold in usually an OTM Call. The Call would not get
exercised unless the stock price increases above the strike price. Till then the investor in the
stock (Call seller) can retain the Premium with him. This becomes his income from the stock.
This strategy is usually adopted by a stock owner who is Neutral to moderately Bullish
about the stock.
An investor buys a stock or owns a stock which he feel is good for medium to long term but
is neutral or bearish for the near term. At the same time, the investor does not mind exiting
the stock at a certain price (target price). The investor can sell a Call Option at the strike price
at which he would be fine exiting the stock (OTM strike). By selling the Call Option the
investor earns a Premium. Now the position of the investor is that of a Call Seller who owns
the underlying stock. If the stock price stays at or below the strike price, the Call Buyer will
not exercise the Call. The Premium is retained by the investor.
In case the stock price goes above the strike price, the Call buyer who has the right to buy the
stock at the strike price will exercise the Call option. The Call seller (the investor) who has to
sell the stock to the Call buyer, will sell the stock at the strike price. This was the price which
the Call seller (the investor) was anyway interested in exiting the stock and now exits at that
price. So besides the strike price which was the target price for selling the stock, the Call
seller (investor) also earns the Premium which becomes an additional gain for him. This
strategy is called as a Covered Call strategy because the Call sold is backed by a stock owned
by the Call Seller (investor). The income increases as the stock rises, but gets capped after the
stock reaches the strike price. Let us see an example to understand the Covered Call strategy.
When to Use: This is often employed when an investor has a short-term neutral to
moderately bullish view on the stock he holds. He takes a short position on the Call option
to generate income from the option premium.
Since the stock is purchased simultaneously with writing (selling) the Call, the strategy is
commonly referred to as “buy-write”.
- 40 -
Risk: If the Stock Price falls to zero, the investor loses the entire value of the Stock but
retains the premium, since the Call will not be exercised against him. So maximum risk =
Stock Price Paid –Call Premium.
Upside capped at the Strike price plus the Premium received. So if the Stock rises beyond the
Strike price the investor (Call seller) gives up all the gains on the stock.
Reward: Limited to (Call Strike Price – Stock Price paid) + Premium received
Breakeven: Stock Price paid - Premium Received
Example
Mr. A bought XYZ Ltd. for Rs 5850 and simultaneously sells a Call option at an strike price
of Rs 6000. Which means Mr. A does not think that the price of XYZ Ltd. will rise above Rs.
6000. However, incase it rises above Rs. 6000, Mr. A does not mind getting exercised at that
price and exiting the stock at Rs. 6000 (TARGET SELL PRICE = 3.90% return on the stock
purchase price). Mr. A receives a premium of Rs 80 for selling the Call. Thus net outflow to
Mr. A is (Rs. 5850 – Rs. 80) = Rs. 5770. He reduces the cost of buying the stock by this
strategy. If the stock price stays at or below Rs. 6000, the Call option will not get exercised
and Mr. A can retain the Rs. 80 premium, which is an extra income. If the stock price goes
above Rs 6000, the Call option will get exercised by the Call buyer. The entire position will
work like this :
Strategy : Buy Stock + Sell Call Option

Mr. A buys the Market Price (Rs.) 5850
stock XYZ Ltd.
Call Options Strike Price (Rs.) 6000
Mr. A receives Premium (Rs.) 80
Break Even Point 5770
(Rs.) (Stock Price
paid - Premium
Received)
STRATEGY 6 : LONG COMBO : SELL A PUT, BUY A CALL
- 41 -
A Long Combo is a Bullish strategy. If an investor is expecting the price of a stock to move
up he can do a Long Combo strategy. It involves selling an OTM (lower strike) Put and
buying an OTM (higher strike) Call. This strategy simulates the action of buying a stock (or a
futures) but at a fraction of the stock price. It is an inexpensive trade, similar in pay-off to
Long Stock, except there is a gap between the strikes (please see the payoff diagram). As the
stock price rises the strategy starts making profits. Let us try and understand Long Combo
with an example.
When to Use: Investor is Bullish on the stock.

Risk: Unlimited (Lower Strike + net debit)
Reward: Unlimited
Breakeven : Higher strike + net debit
Example:
A stock ABC Ltd. is trading at Rs. 450. Mr. XYZ is bullish on the stock. But does not want to
invest Rs. 450. He does a Long Combo. He sells a Put option with a strike price Rs. 400 at a
premium of Rs. 1.00 and buys a Call Option with a strike price of Rs. 500 at a premium of
Rs. 2. The net cost of the strategy (net debit) is Rs. 1.
Strategy : Sell a Put + Buy a Call

ABC Ltd. Current Market Price (Rs.) 450
Sells Put Strike Price (Rs.) 400
Mr. XYZ Premium (Rs.) 1.00
receives
Buys Call Strike Price (Rs.) 500
Mr. XYZ pays Premium (Rs.) 2.00
Net Debit (Rs.) 1.00
Break Even Point (Rs.) Rs. 501

(Higher Strike + Net Debit)
- 42 -
STRATEGY 7 : LONG STRADDLE
A Straddle is a volatility strategy and is used when the stock price / index is expected to
show large movements. This strategy involves buying a call as well as put on the same
stock / index for the same maturity and strike price, to take advantage of a movement in either
direction, a soaring or plummeting value of the stock / index. If the price of the stock / index
increases, the call is exercised while the put expires worthless and if the price of the stock /
index decreases, the put is exercised, the call expires worthless. Either way if the stock /
index shows volatility to cover the cost of the trade, profits are to be made. With Straddles,
the investor is direction neutral. All that he is looking out for is the stock / index to break out
exponentially in either direction.
When to Use: The investor thinks that the underlying stock / index will experience
significant volatility in the near term.
Risk: Limited to the initial premium paid.
Reward: Unlimited
Breakeven:
Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid
Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid
Example
Suppose Nifty is at 5450 on 27th April. An investor, Mr. A enters a long straddle by buying a
May Rs 5500 Nifty Put for Rs. 85 and a May Rs. 5500 Nifty Call for Rs. 122. The net debit
taken to enter the trade is Rs 207, which is also his maximum possible loss.
Strategy : Buy Stock + Sell Call Option
Nifty index Current Value 5450
Call and Put Strike Price (Rs.) 5500
Mr. A pays Total Premium 207

(Call + Put) (Rs.)
Break Even Point 5707 (U)
(Rs.)
(Rs.) 5293 (L)
- 43 -
The Payoff schedule
On expiry Net Pay off from Net payoff from call Net Payoff (Rs.)
Nifty Closes at Put Purchased (Rs.) purchased (Rs.)
5100 315 -122 193
5200 215 -122 93
5300 115 -122 -7
5400 15 -122 -107
5500 -85 -122 -207
5600 -85 -22 -107
5700 -85 78 -7
5800 -85 178 93
5900 -85 278 193
- 44 -
STRATEGY 8 : SHORT STRADDLE
A Short Straddle is the opposite of Long Straddle. It is a strategy to be adopted when the
investor feels the market will not show much movement. He sells a Call and a Put on the
same stock / index for the same maturity and strike price. It creates a net income for the
investor. If the stock / index does not move much in either direction, the investor retains the
Premium as neither the Call nor the Put will be exercised. However, incase the stock / index
moves in either direction, up or down significantly, the investor’s losses can be significant.
So this is a risky strategy and should be carefully adopted and only when the expected
volatility in the market is limited. If the stock / index value stays close to the strike price on
expiry of the contracts, maximum gain, which is the Premium received is made.
When to Use: The investor thinks that the underlying stock / index will experience very little
volatility in the near term.
Risk: Unlimited
Reward: Limited to the premium received
Breakeven:
Upper Breakeven Point = Strike Price of Short Call + Net Premium Received
Lower Breakeven Point = Strike Price of Short Put - Net Premium Received
Example
Suppose Nifty is at 5450 on 27th April. An investor, Mr. A, enters into a short straddle by
selling a May Rs 5500 Nifty Put for Rs. 85 and a May Rs. 5500 Nifty Call for Rs. 122. The
net credit received is Rs. 207, which is also his maximum possible profit.
Strategy : Sell Put + Sell Call

Call and Put Strike Price (Rs.) 5500
Mr. A receives Total Premium 207
(Call + Put) (Rs.)
Break Even Point 5707 (U)
(Rs.)*
(Rs.)* 5293 (L)
* From buyer’s point of view
- 45 -
The Payoff schedule
On expiry Net Pay off from Net payoff from Call Net Payoff (Rs.)
Nifty Closes at Put Sold (Rs.) Sold (Rs.)
5100 -315 122 -193
5200 -215 122 -93
5300 -115 122 7
5400 -15 122 107
5500 85 122 207
5600 85 22 107
5700 85 -78 7
5800 85 -178 -93
5900 85 -278 -193
- 46 -
STRATEGY 9 : LONG STRANGLE
A Strangle is a slight modification to the Straddle to make it cheaper to execute. This

strategy involves the simultaneous buying of a slightly out-of-the-money (OTM) put and a
slightly out-of-the-money (OTM) call of the same underlying stock / index and expiration
date. Here again the investor is directional neutral but is looking for an increased volatility in
the stock / index and the prices moving significantly in either direction. Since OTM options
are purchased for both Calls and Puts it makes the cost of executing a Strangle cheaper as
compared to a Straddle, where generally ATM strikes are purchased. Since the initial cost of
a Strangle is cheaper than a Straddle, the returns could potentially be higher. However, for a
Strangle to make money, it would require greater movement on the upside or downside for
the stock / index than it would for a Straddle. As with a Straddle, the strategy has a limited
downside (i.e. the Call and the Put premium) and unlimited upside potential.
When to Use: The investor thinks that the underlying stock / index will experience very high
levels of volatility in the near term.
Risk: Limited to the initial premium paid
Reward: Unlimited
Breakeven:
Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid
Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid
Example
Suppose Nifty is at 5500 in May. An investor, Mr. A, executes a Long Strangle by buying a
Rs. 5300 Nifty Put for a premium of Rs. 23 and a Rs 5700 Nifty Call for Rs 43. The net debit
taken to enter the trade is Rs. 66, which is also his maximum possible loss.
Strategy : Buy OTM Put + Buy OTM Call

- 47 -
Buy Call Option Strike Price (Rs.) 5700
Mr. A pays Premium (Rs.) 43
Break Even Point(Rs.) 5766
Buy Put Option Strike Price (Rs.) 5300
The Payoff schedule

Nifty Closes at Put Purchased (Rs.) purchased (Rs.)
5100 177 -43 134
5200 77 -43 34
5300 -23 -43 -66
5400 -23 -43 -66
5500 -23 -43 -66
5600 -23 -43 -66
5700 -23 -43 -66
5800 -23 57 34
5900 -23 157 134
- 48 -
STRATEGY 10. SHORT STRANGLE
A Short Strangle is a slight modification to the Short Straddle. It tries to improve the
profitability of the trade for the Seller of the options by widening the breakeven points so
that there is a much greater movement required in the underlying stock / index, for the Call
and Put option to be worth exercising. This strategy involves the simultaneous selling of a
slightly out-of-the-money (OTM) put and a slightly out-of-the-money (OTM) call of the same
underlying stock and expiration date. This typically means that since OTM call and put are
sold, the net credit received by the seller is less as compared to a Short Straddle, but the break
even points are also widened. The underlying stock has to move significantly for the Call and
the Put to be worth exercising. If the underlying stock does not show much of a movement,
the seller of the Strangle gets to keep the Premium.
When to Use: This options trading strategy is taken when the options investor thinks that the
underlying stock will experience little volatility in the near term.
Risk: Unlimited
Reward: Limited to the premium received
Breakeven:
Upper Breakeven Point = Strike Price of Short Call + Net Premium Received
Lower Breakeven Point = Strike Price of Short Put - Net Premium Received
Example
Suppose Nifty is at 5500 in May. An investor, Mr. A, executes a Short Strangle by selling
a Rs. 5300 Nifty Put for a premium of Rs. 23 and a Rs. 5700 Nifty Call for Rs 43. The
net credit is Rs. 66, which is also his maximum possible gain.
Strategy : Sell OTM Put + Sell OTM Call

Sell Call Option Strike Price (Rs.) 5700
Break Even Point 5766
(Rs.)
Sell Put Option Strike Price (Rs.) 5300
- 49 -
The Payoff schedule
Nifty Closes at Put Sold (Rs.) Sold (Rs.)
5100 -177 43 -134
5200 -77 43 -34
5300 23 43 66
5400 23 43 66
5500 23 43 66
5600 23 43 66
5700 23 43 66
5800 23 -57 -34
5900 23 -157 -134
6000 23 -257 -234
- 50 -
STRATEGY 11. COLLAR
A Collar is similar to Covered Call (Strategy 6) but involves another leg – buying a Put to
insure against the fall in the price of the stock. It is a Covered Call with a limited risk. So a
Collar is buying a stock, insuring against the downside by buying a Put and then financing
(partly) the Put by selling a Call.
The put generally is ATM and the call is OTM having the same expiration month and must be
equal in number of shares. This is a low risk strategy since the Put prevents downside risk.
However, do not expect unlimited rewards since the Call prevents that. It is a strategy to be
adopted when the investor is conservatively bullish. The following example should make
Collar easier to understand.
When to Use: The collar is a good strategy to use if the investor is writing covered calls to
earn premiums but wishes to protect himself from an unexpected sharp drop in the price of
the underlying security.
Risk: Limited
Reward: Limited
Breakeven: Purchase Price of Underlying – Call Premium + Put Premium
Example
Suppose an investor Mr. A buys or is holding ABC Ltd. currently trading at Rs. 5758. He
decides to establish a collar by writing a Call of strike price Rs. 6000 for Rs. 39 while
simultaneously purchasing a Rs. 5700 strike price Put for Rs. 27. Since he pays Rs. 5758
for the stock ABC Ltd., another Rs. 27 for the Put but receives Rs. 39 for selling the Call
option, his total investment is Rs.5746.
Strategy : Buy Stock + Buy Put + Sell Call
ABC Ltd. Current Market Price 5758
(Rs.)
Sell Call Option Strike Price (Rs.) 6000
Net Premium 12
Received(Rs.)
- 51 -
Example :
1) If the price of ABC Ltd. rises to Rs. 6100 after a month, then,a. Mr. A will sell the stock at
Rs. 6100 earning him a profit of Rs. 342 (Rs.6100 – Rs. 5758)
b. Mr. A will get exercised on the Call he sold and will have to pay Rs. 100.
c. The Put will expire worthless.
d. Net premium received for the Collar is Rs. 12
e. Adding (a + b + d) = Rs. 342 -100 – 12 = Rs. 254
This is the maximum return on the Collar Strategy.
However, unlike a Covered Call, the downside risk here is also limited :
2) If the price of ABC Ltd. falls to Rs. 5400 after a month, then, a. Mr. A loses Rs. 358 on the
stock ABC Ltd.
b. The Call expires worthless
c. The Put can be exercised by Mr. A and he will earn Rs. 300
d. Net premium received for the Collar is Rs. 12
e. Adding (a + b + d) = - Rs. 358 + 300 +12 = - Rs. 46
This is the maximum the investor can loose on the Collar Strategy.
The Upside in this case is much more than the downside risk.
STRATEGY 12. BULL CALL SPREAD STRATEGY: BUY CALL

OPTION, SELL CALL OPTION
- 52 -
A bull call spread is constructed by buying an in-the-money (ITM) call option, and selling
another out-of-the-money (OTM) call option. Often the call with the lower strike price will be
in-the-money while the Call with the higher strike price is out-of-the-money. Both calls must
have the same underlying security and expiration month. The net effect of the strategy is to
bring down the cost and breakeven on a Buy Call (Long Call) Strategy. This strategy is
exercised when investor is moderately bullish to bullish, because the investor will make a
profit only when the stock price / index rises. If the stock price falls to the lower (bought)
strike, the investor makes the maximum loss (cost of the trade) and if the stock price rises to
the higher (sold) strike, the investor makes the maximum profit.
When to Use: Investor is moderately bullish.

Risk: Limited to any initial premium paid in establishing the position. Maximum loss
occurs where the underlying falls to the level of the lower strike or below.
Reward: Limited to the difference between the two strikes minus net premium cost.
Maximum profit occurs where the underlying rises to the level of the higher strike or above.
Break-Even-Point (BEP): Strike Price of Purchased call + Net Debit Paid
Example:
Mr. XYZ buys a Nifty Call with a Strike price Rs. 6100 at a premium of Rs. 170.45 and he
sells a Nifty Call option with a strike price Rs. 6400 at a premium of Rs. 35.40. The net debit
here is Rs. 135.05 which is also his maximum loss.
Strategy : Buy a Call with a lower strike (ITM) +
Sell a Call with a higher strike (OTM)
Nifty index Current Value 6191.1
Buy ITM Call Strike Price (Rs.) 6100
Option
Mr. XYZ Pays Premium (Rs.) 170.45
Sell OTM Call Strike Price (Rs.) 6400
Option
Mr. XYZ Premium (Rs.) 35.4
Receives
Net Premium Paid 135.05
(Rs.)
The Bull Call Spread Strategy has brought the breakeven point down (if only the Rs. 6100
strike price Call was purchased the breakeven point would have been Rs. 6270.45), reduced
the cost of the trade (if only the Rs. 6100 strike price Call was purchased the cost of the trade
would have been Rs. 170.45), reduced the loss on the trade (if only the Rs. 6150 strike price
- 53 -
Call was purchased the loss would have been Rs. 170.45 i.e. the premium of the Call
purchased). However, the strategy also has limited gains and is therefore ideal when markets
are moderately bullish.
The Payoff schedule

On expiry Nifty Net Pay off from Net payoff from call Net Payoff (Rs.)
Closes at Call Buy (Rs.) Sold (Rs.)
5800 -170.45 35.4 -135.05
5900 -170.45 35.4 -135.05
6000 -170.45 35.4 -135.05
6100 -170.45 35.4 -135.05
6200 -70.45 35.4 -35.05
6300 29.55 35.4 64.95
6400 129.55 35.4 164.95
6500 229.55 -64.6 164.95
6600 329.55 -164.6 164.95
6700 429.55 -264.6 164.95
STRATEGY 13. BULL PUT SPREAD STRATEGY: SELL PUT OPTION,

BUY PUT OPTION
A bull put spread can be profitable when the stock / index is either range bound or rising. The
concept is to protect the downside of a Put sold by buying a lower strike Put, which acts as an
insurance for the Put sold. The lower strike Put purchased is further OTM than the higher
strike Put sold ensuring that the investor receives a net credit, because the Put purchased
- 54 -
(further OTM) is cheaper than the Put sold. This strategy is equivalent to the Bull Call Spread
but is done to earn a net credit (premium) and collect an income.
If the stock / index rises, both Puts expire worthless and the investor can retain the Premium.
If the stock / index falls, then the investor’s breakeven is the higher strike less the net credit
received. Provided the stock remains above that level, the investor makes a profit. Otherwise
he could make a loss. The maximum loss is the difference in strikes less the net credit
received. This strategy should be adopted when the stock / index trend is upward or range
bound.
When to Use: When the investor is moderately bullish.

Risk: Limited. Maximum loss occurs where the underlying falls to the level of the lower
strike or below
Reward: Limited to the net premium credit. Maximum profit occurs where underlying rises
to the level of the higher strike or above.
Breakeven: Strike Price of Short Put - Net Premium Received
Example:
Mr. XYZ sells a Nifty Put option with a strike price of Rs. 6000 at a premium of Rs. 21.45
and buys a further OTM Nifty Put option with a strike price Rs. 5800 at a premium of Rs.
3.00 when the current Nifty is at 6191.10, with both options expiring on 29th Nov.
Strategy : Sell a Put + Buy a Put

Nifty index Current Value 6191.1
Sell Put Option Strike Price (Rs.) 6000
Mr. XYZ Receives Premium (Rs.) 21.45
Mr. XYZ Pays Premium (Rs.) 3
Net Premium 18.45

Received (Rs.)
- 55 -
The strategy earns a net income for the investor as well as limits the downside risk of a Put
sold.
The Payoff schedule

On expiry Nifty Net Pay off from Put Net payoff from Put Sold Net Payoff (Rs.)
Closes at Buy (Rs.) (Rs.)
5600 197 -378.55 -181.55
5700 97 -278.55 -181.55
5800 -3 -178.55 -181.55
5900 3 -78.55 -81.55
6000 -3 21.45 18.45
6100 -3 21.45 18.45
6200 -3 21.45 18.45
6300 -3 21.45 18.45
6400 -3 21.45 18.45
6500 -3 21.45 18.45
- 56 -
STRATEGY 14: LONG CALL BUTTERFLY: SELL 2 ATM CALL
OPTIONS, BUY 1 ITM CALL OPTION AND BUY 1 OTM CALL OPTION.
A Long Call Butterfly is to be adopted when the investor is expecting very little movement in
the stock price / index. The investor is looking to gain from low volatility at a low cost. The
strategy offers a good risk / reward ratio, together with low cost. A long butterfly is similar to
a Short Straddle except your losses are limited. The strategy can be done by selling 2 ATM
Calls, buying 1 ITM Call, and buying 1 OTM Call options (there should be equidistance
between the strike prices). The result is positive incase the stock / index remains range bound.
The maximum reward in this strategy is however restricted and takes place when the stock /
index is at the middle strike at expiration. The maximum losses are also limited.
When to use: When the investor is neutral on market direction and bearish on volatility.
Risk Net debit paid.
Reward Difference between adjacent strikes minus net debit
Break Even Point:
Upper Breakeven Point = Strike Price of Higher Strike Long Call – Net Premium Paid
Lower Breakeven Point = Strike Price of Lower Strike Long Call + Net Premium Paid
Example:
Nifty is at 6200. Mr. XYZ expects very little movement in Nifty. He sells 2 ATM Nifty Call
Options with a strike price of Rs. 6200 at a premium of Rs. 97.90 each, buys 1 ITM Nifty
Call Option with a strike price of Rs. 6100 at a
premium of Rs. 141.55 and buys 1 OTM Nifty Call Option with a strike price of Rs. 6300 at a
premium of Rs. 64. The Net debit is Rs. 9.75.
- 57 -
STRATEGY : SELL 2 ATM CALL, BUY 1 ITM CALL
OPTION AND BUY 1 OTM CALL OPTION
Sell 2 ATM Call
Strike Price (Rs.) 6200
Option
Mr. XYZ
Premium (Rs.) 195.8
Receives
Buy 1 ITM Call
Option
Mr. XYZ Pays Premium (Rs.) 141.55
Buy 1 OTM Call
Option
Mr. XYZ pays Premium (Rs.) 64
Break Even Point
6290.25
(Rs.)
Break Even Point
6109.75
(Lower) (Rs.)
The Payoff schedule

On expiry Nifty Net Pay off Net payoff from Net payoff Net Payoff
Closes at from 2 ATM 1 ITM Call from 1 OTM (Rs.)
Calls Sold (Rs.) purchased (Rs.) Call
purchased(Rs.)
5700 195.8 -141.55 -64 -9.75
5800 195.8 -141.55 -64 -9.75
5900 195.8 -141.55 -64 -9.75
6000 195.8 -141.55 -64 -9.75
6100 195.8 -141.55 -64 -9.75
6200 195.8 -41.55 -64 90.25
6300 -4.2 58.45 -64 -9.75
6400 -204.2 158.45 36 -9.75
6500 -404.2 258.45 136 -9.75
6600 -604.2 358.45 236 -9.75
- 58 -
- 59 -
Chapter X
Lesser Used Products
WARRANTS:
Options generally have lives of upto one year, the majority of options traded on options
exchanges having a maximum maturity of nine months. Longer- dated options are called
warrants and are generally traded over-the-counter.
LEAPS:
The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options
having a maturity of upto three years.
Baskets:
Basket options are options on portfolios of underlying assets. The underlying asset is usually
a moving average of a basket of assets. Equity index options are a form of basket options.
Swaps:
Swaps are private agreements between two parties to exchange cash flows in the future
according to a prearranged formula. They can be regarded as portfolios of forward contracts.
Interest rate swaps:
These entail swapping only the interest related cash flows between the parties in the same
currency.
Currency swaps:
These entail swapping both principal and interest between the parties, with the cash flows in
one direction being in a different currency than those in the opposite direction.
Swaptions:
Swaptions are options to buy or sell a swap that will become operative at the expiry of the
options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the
swaptions market has receiver swaptions and payer swaptions.
Chapter XI
- 60 -
PARTICIPANTS IN THE DERIVATIVES MARKETS
There are Three broad categories of participants - hedgers, speculators, and arbitrageurs -
trade in the derivatives market. Hedgers face risk associated with the price of an asset. They
use futures or options markets to reduce or eliminate this risk. Speculators wish to bet on
future movements in the price of an asset. Futures and options contracts can give them an
extra leverage; that is, they can increase both the potential gains and potential losses in a
speculative venture. Arbitrageurs are in business to take advantage of a discrepancy between
prices in two different markets. If, for example, they see the futures price of an asset getting
out of line with the cash price, they will take offsetting positions in the two markets to lock in
a profit.
The derivative market performs a number of economic functions. First, prices in an organized
derivatives market reflect the perception of market participants about the future and lead the
prices of underlying to the perceived future level. The prices of derivatives converge with the
prices of the underlying at the expiration of derivative contract. Thus derivatives help in
discovery of future as well as current prices. Second, the derivatives market helps to transfer
risks from those who have them but may not like them to those who have appetite for them.
Third, derivatives, due to their inherent nature, are linked to the underlying cash markets.
With the introduction of derivatives, the underlying market witnesses higher trading volumes
because of participation by more players who would not otherwise participate for lack of an
arrangement to transfer risk. Fourth, speculative trades shift to a more controlled environment
of derivatives market. In the absence of an organized derivatives market, speculators trade in
the underlying cash markets.
Margining, monitoring and surveillance of the activities of various participants become

extremely difficult in these kind of mixed markets. Fifth, an important incidental benefit that
flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The
derivatives have a history of attracting many bright, creative, well-educated people with an
entrepreneurial attitude. They often energize others to create new businesses, new products
and new employment opportunities, the benefit of which are immense. Sixth, derivatives
markets help increase savings and investment in the long run. Transfer of risk enables market
- 61 -
participants to expand their volume of activity. Derivatives thus promotes economic
development to the extent the later depends on the rate of savings and investment.
HEDGERS :
Hedgers are the traders who wish to eliminate the risk of price change to which trhey are
already exposed. It is a mechanism by which the participants in the physical/ cash markets
can cover their price risk. Hedgers are those persons who don’t want to take the risk therefore
they hedge their risk while taking position in the contract. In short it is a way of reducing
risks when the investor has the underlying security.
PURPOSE:
“TO REDUCE THE VOLATILITY OF A PORTFOLIO, BY REDUCING THE RISK”
STRATEGY:
The basic hedging strategy is to take an equal and opposite position in the futures market to
the spot market. If the investor buys the scrip in the spot market but suddenly the market
drops then the investor hedge their risk by taking the short position in the Index futures
HEDGING
Many of the participants in futures markets are hedgers. Their aim is to use futures markets to
reduce a particular risk that they face. This risk might relate to the prices of oil, a foreign
exchange rate, the level of the stock market, or some other variable. A perfect hedge is one
that completely eliminates the risk. Therefore, a study of hedging using futures contracts is a
study of the ways in which hedges can be constructed so that they perform as close to perfect
as possible.
The hedger simply takes a futures position at the beginning of the life of the hedge and closes
out the position at the end of the life of the hedge.
Basic Principle
- 62 -
When a individual or company chooses to use futures markets to hedge a risk, the objective is
usually to take a position that neutralises the risk as far as possible. Considering a company
that knows it will gain Rs. 10000 for each Rupee increase in the price of a stock over the next
three months and lose Rs. 10000 for each Rupee decrease in the price during the same period.
To hedge, the company’s treasurer should take a short futures position that is designed to
offset this risk. The futures position should lead to a loss of Rs. 10000 for each Rupee
increase in the price of the commodity over the three months and a gain of Rs. 10000 for each
Rupee decrease in the price during this period. If the price of the stock goes down, the gain on
the futures position offsets the loss on the rest of the company’s business. If the price of the
commodity goes down, the gain on the futures position offsets the loss on the rest of the
company’s business. If the price of the commodity goes up, the loss on the futures position is
offset by the gain on the rest of the company’s business.
Short Hedges
A short hedge is a hedge that involves a short position in futures contracts. A short hedge is
appropriate when the hedger already owns and asset and expects to sell it at some time in the
future. A short hedge can also be used when an asset is not owned right now but will be
owned at some time in the future. For eg. A Indian exporter who knows that he will receive
dollars in three months. The exporter will realise a gain if the dollar increases in value
relative to the Indian Rupee and will sustain a loss if the dollar decreases in value relative to
the Indian Rupee. A short futures position leads to a loss if the dollar increases in value and a
gain if it decreases in value. It has the effect of offsetting the exporters risk.
Long Hedges.
Hedges that involve taking a long position in a futures contract are known as long hedges. A
long hedge is appropriate when a company knows it will have to purchase a certain asset in
the future and wants to lock in a price now.
Long hedges can also be used to partially offset an existing short position. For eg. an investor
who has shorted a certain stock. Part of the risk faced by the investor is related to the
performance of the stock market as a whole. The investor can neutralise this risk by taking a
long position in index futures contracts.
- 63 -
Basis Risk
The hedges in the above examples so far have been almost too good to be true. The hedger
was able to identify the precise date in the future when an asset would be bought or sold. The
hedger was then able to use futures contracts to remover almost all the risk arising from the
price of the asset on that date. In practice, hedging is often not quite as straightforward. Some
of the reasons are as follows :
1. The asset whose price is to be hedged may not be exactly the same as the asset
underlying the futures contract.
2. The hedger may be uncertain as to the exact date when the asset will be bought or
sold.
3. The hedge may require the futures contract to be closed out well before its expiration
date.
These problems give rise to what is termed basis risk.
The basis in a hedging situation is as follows :

Basis = Spot price of asset to be hedged – Futures price of Contract used.
If the asset to be hedged and the asset underlying the futures contract are the same, the basis
should be zero at the expiration of the futures contract. Prior to expiration, the basis may be
positive or negative. When the underlying asset is a low interest rate currency or gold or
silver, the futures price is greater than the spot price. This means that the basis is negative.
For high-interest rate currencies and many commodities, the reverse is true, and the basis is
positive.
When the spot increases by more than the futures price, the basis increases. This is referred to
as a strengthening of the basis. When the futures price increases by more than the spot price,
the basis declines. This is referred to as a weakening of the basis.
Basis risk can lead to an improvement or a worsening of a hedger’s position. Consider a

hedge. If the basis strengthens unexpectedly, the hedger’s position improves; if the basis
weakens unexpectedly, the hedger’s position worsens. For a long hedge, the reverse holds. If
the basis strengthens unexpectedly, the hedger’s position worsens; if the basis weakens
unexpectedly, the hedger’s position improves.
- 64 -
One key factor affecting basis risk is the choice of the futures contracts to be used for
hedging. This choice has two components:
1. The choice of the asset underlying the futures contract.
2. The choice of the delivery month.
If the asset being hedged exactly matches an asset underlying a futures contract, the first
choice is generally fairly easy. It is necessary to carry out a careful analysis to determine
which of the available futures contracts has futures prices that are most closely correlated
with the price of the asset being hedged.
The choice of the delivery month is likely to be influenced by several factors. We assumed
that when the expiration of the hedge corresponds to a delivery month, the contract with that
delivery month is chosen. In fact, a contract with a later delivery month is usually chosen in
these circumstances. The reason is that futures prices are in some instances quite erratic
during the delivery month. Also, a long hedger runs the risk of having to take delivery of the
physical asset if the contract is held during the delivery month. Taking delivery can be
expensive and inconvenient.
HEDGING AND DIVERSIFICATION:
Hedging is one of the principal ways to manage risk, the other being diversification.
Diversification and hedging do not have have cost in cash but have opportunity cost.
Hedging is implemented by adding a negatively and perfectly correlated asset to an existing
asset. Hedging eliminates both sides of risk: the potential profit and the potential loss.
Diversification minimizes risk for a given amount of return (or, alternatively, maximizes
return for a given amount of risk). Diversification is affected by choosing a group of assets
instead of a single asset (technically, by adding positively and imperfectly correlated assets).
ILLUSTRATION
- 65 -
Ram enters into a contract with Shyam that he sells 50 pens to Shyam for Rs.1000. The cost
of manufacturing the pen for Ram is only Rs. 400 and he will make a profit of Rs 600 if the
sale is completed.
COST SELLING PRICE PROFIT

400 1000 600
However, Ram fears that Shyam may not honour his contract. 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.400.
And if Shyam honours the contract Ram will offer a discount of Rs 100 as incentive.
Shyam defaults Shyam honors

400 (Initial Investment) 600 (Initial profit)
400 (penalty from Shyam (-100) discount given to Shyam
- (No gain/loss) 500 (Net gain)
Finally if Shyam defaults Ram will get a penalty of Rs 400 but Ram will recover his initial
investment. If Shyam honors the bill the ram will get a profit of 600 deducting the discount
of Rs.100 and net profit for ram is Rs.500. Thus Ram has hedged his risk against default and
protected his initial investment.
Now let’s see how investor hedge their risk in the market
Example:
- 66 -
Say you have bought 1000 shares of XYZ Company but in the short term you expect that the
market would go down due to some news. Then, to minimize your downside risk you could
hedge your position by buying a Put Option. This will hedge your downside risk in the
market and your loss of value in XYZ will be set off by the purchase of the Put Option.
Therefore hedging does not remove losses .The best that can be achieved using hedging is the
removal of unwanted exposure, i.e.unnessary risk. The hedging position will make less profits
than the un-hedged position, half the time. One should not enter into a hedging strategy
hoping to make excess profits for sure; all that can come out of hedging is reduce risk.
HEDGING WITH OPTIONS:

Options can be used to hedge the position of the underlying asset. Here the options buyers are
not subject to margins as in hedging through futures. Options buyers are however required to
pay premium which are sometimes so high that makes options unattractive.
ILLUSTRATION:
With a market price of ACC Rs.600 the investor buys the 50 shares of ACC.Now the
investor excepts that price will fall by 100. So he decided to buy the put Option by paying
the premium of Rs.25. Thus the investor has hedge their risk by purchasing the put Option.
Finally stock falls by 100 the loss of investor is restricted t the premium paid of Rs.2500 as
investor recovered Rs.75 a share by buying ACC put.
HEDGING STRATEGIES:
LONG SECURITY, SELL NIFTY FUTURES:
- 67 -
Under this investor takes a long position on the security and sell some amount of Nifty
Futures. This offsets the hidden Nifty exposure that is inside every long- security position.
Thus the position LONG SECURITY, SELL NIFTY is a pure play on the performance of the
security, without any extra risk from fluctuations of the market index. Finally the investor has
“HEDGED AWAY” his index exposure.
LONG SECURITY, SELL FUTURES
Here stock futures can be used as an effective risk –management tool. In this case the
investor buys the shares of the company but suddenly the rally goes down. Thus to maximize
the risk the Hedger enters into a future contract and takes a short position. However the losses
suffers in the security will be offset by the profits he makes on his short future position.
Spot Price of ACC = 390
Market action = 350
Loss = 40
Strategy = BUY SECURITY, SELL FUTURES
Two month Futures = 390
Premium = 12
Short position = 390
Future profit = 40(390-350)
As the fall in the price of the security will result in a fall in the price of Futures. Now the
Futures will trade at a price lower then the price at which the hedger entered into a short
position.
Finally the loss of Rs.40 incurred on the security hedger holds, will be made up the profits
made on his short futures position.
HAVE STOCK, BUY PUTS:
- 68 -
This is one of the simplest ways to take on hedge. Here the investor buys 100 shares of
HLL.The spot price of HLL is 232 suddenly the investor worries about the fall of price.
Therefore the solution is buy put options on HLL.
The investor buys put option with a strike of Rs.240. The premium charged is Rs.10.Here the
investor has two possible scenarios three months later.
1) IF PRICE RISES
Market action: 215
Loss : 17(232-15)
Strike price : 240
Premium : 08
Profit : 17(240-215-8)
Thus loss he suffers on the stock will be offset by the profit the investor earns on the put
option bought.
2) IF PRICE RISES:
Market share : 250
Loss : 10
Short position : 250(spot market)
Thus the investor has a limited loss (determined by the strike price investor chooses) and
an unlimited profit.
HAVE PORTFOLIO, SHORT NIFTY FUTURES:
- 69 -
Here the investor are holding the portfolio of stocks and selling nifty futures. In the case
of portfolios, most of the portfolio risk is accounted for by index fluctuations. Hence a
position LONG PORTFOLIO+ SHORT NIFTY can often become one-tenth as risky as
the LONG PORTFOLIO position.
Let us assume that an investor is holding a portfolio of following scrips as given below on 1st
May, 2009.
Company Beta Amount of Holding ( in Rs)

Infosys 1.55 400,0000.00
Bharti Airtel 2.06 200,0000.00
Tata Motors 1.95 175,0000.00
Tata Steel 1.9 125,0000.00
Total Value of Portfolio 1,000,0000.00
Trading Strategy to be followed
The investor feels that the market will go down in the next two months and wants to protect
him from any adverse movement. To achieve this the investor has to go short on 2 months
NIFTY futures i.e he has to sell June Nifty. This strategy is called Short Hedge.
Formula to calculate the number of futures for hedging purposes is
Beta adjusted Value of Portfolio / Nifty Index level
Beta of the above portfolio
=(1.55*400,0000)+(2.06*200,0000)+(1.95*175,0000)+(1.9*125,0000)/1,000,0000
=1.61075 (round to 1.61)
Applying the formula to calculate the number of futures contracts
Assume NIFTY futures to be 6150 on 1st October 2010
= (1,000,0000.00 * 1.61) / 6150
= 2600 Units
- 70 -
Since one Nifty contract is 50 units, the investor has to sell 52 Nifty contracts.
Short Hedge
Stock Market Futures Market

st
1 Oct Holds Rs 1,000,0000.00 in Sell 52 NIFTY futures
stock portfolio contract at 6150.
25th October Stock portfolio fall by 6% NIFTY futures falls by 4.5%
to Rs 940,0000.00 to 6098.25
Profit / Loss Loss: -Rs 60,0000.00 Profit: 72,4500.00
Net Profit: + Rs 15,4500.00
Warning:
Hedging does not always make money. The best that can be achieved using hedging is the
removal of unwanted exposure, i.e. unnecessary risk. The hedged position will make less
profits than the unhedged position, half the time. One should not enter into a hedging
strategy hoping to make excess profits for sure; all that can come out of hedging is reduced
risk.
SPECULATORS:
- 71 -
If hedgers are the people who wish to avoid price risk, speculators are those who are willing
to take such risk. speculators are those who do not have any position and simply play with the
others money. 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. Here if speculators view is correct he earns profit. In the event of speculator not
being covered, he will loose the position. They consider various factors such as demand
supply, market positions, open interests, economic fundamentals and other data to take their
positions.
SPECULATION IN THE FUTURES MARKET
• Speculation is all about taking position in the futures market without having the
underlying. Speculators operate in the market with motive to make money. They take:
• Naked positions - Position in any future contract.
• Spread positions - Opposite positions in two future contracts. This is a conservative

speculative strategy.
Speculators bring liquidity to the system, provide insurance to the hedgers and facilitate the
price discovery in the market.
ILLUSTRATION:
Here the Speculator believes that stock market will going to appreciate.
Current market price of PATNI COMPUTERS = 1500
Strategy: Buy February PATNI futures contract at 1500
Lot size = 100 shares
Contract value = 1,50,000 (1500*100)
Margin = 15000 (10% of 150000)
Market action = rise to 1550
Future Gain:Rs. 5000 [(1550-1500)*100]
Market action = fall to 1400
Future loss: Rs.-10000 [(1400-1500)*100]
- 72 -
Thus the Speculator has a view on the market and accept the risk in anticipating of profiting
from the view. He study the market and play the game with the stock market
TYPES:
POSITION TRADERS:
These traders have a view on the market an hold positions over a period of as days until their
target is met.
DAY TRADERS:
Day traders square off the position during the curse of the trading day and book the profits.
SCALPERS:
Scalpers in anticipation of making small profits trade a number of times throughout the day.
SPECULATING WITH OPTIONS:
A speculator has a definite outlook about future price, therefore he can buy put or call option
depending upon his perception about future price. If speculator has a bullish outlook, he will
buy calls or sell (write) put. In case of bearish perception, the speculator will buy put or write
calls. If speculator’s view is correct he earns profit. In the event of speculator not being
covered, he will loose the position. A Speculator will buy call or put if his price outlook in a
particular direction is very strong but if is either neutral or not so strong. He would prefer
writing call or put to earn premium in the event of price situations.
ILLUSTRATION:
Here if speculator excepts that RELIANCE stock price will rise from present level of Rs.1050
then he buys call by paying premium. If prices have gone up then he earns profit otherwise he
losses call premium which he pays to buy the call. if speculator sells that RELIANCE stock
will come down then he will buy put on the sale price until he can write either call or put.
Finally Speculators provide depth an liquidity to the futures market an in their absence; the
price protection sought the hedger would be very costly.
STRATEGIES:
- 73 -
BULLISH SECURITY,SELL FUTURES:
Here the Speculator has a view on the market. The Speculator is bullish in the market.
Speculator buys the shares of the company an makes the profit. At the same time the
Speculator enters into the future contract i.e. buys futures and makes profit.
Spot Price of RELIANCE = 1000
Value = 1000*100shares = 1,00,000
Market action = 1010
Profit = 1000
Initial margin = 20,000
Market action = 1010
Profit = 400(investment of Rs.20,000)
This shows that with a investment of Rs.1,00,000 for a period of 2 months the speculator
makes a profit of 1000 and got a annual return of 6% in the spot market but in the case of
futures the Speculator makes a profit of Rs.400 on the investment of Rs.20,000 and got
return of 12%.
Thus because of leverage provided security futures form an attractive option for speculator.
BULLISH STOCK, BUY CALLS OR BUY PUTS:
Under this strategy the speculator is bullish in the market. He could do any of the following:
BUY STOCK
Fortis spot price : 150

- 74 -
No of shares : 200
Price : 150*200 = 30,000
Market action : 160
Profit : 2,000
Return : 6.6% returns over 2months
BUY CALL OPTION:
Strike price : 150
Premium : 8
Lot size : 200 shares
Market action :160
Profit : (160-150-8)*200 = 400
Return : 25% returns over 2months
This shows that investor can earn more in the call option because it gives 25% returns over a
investment of 2months as compared to 6.6% returns over a investment in stocks
BEARISH SECURITY,SELL FUTURES:
In this case the stock futures is overvalued and is likely to see a fall in price. Here simple
arbitrage ensures that futures on an individual securities more correspondingly with the
underlying security as long as there is sufficient liquidity in the market for the security. If the
security price rises the future price will also rise and vice-versa.
Two month Futures on SBI = 240
Margin = 24
Market action = 220
Future profit = 20(240-220)

- 75 -
Finally on the day of expiration the spot and future price converges the investor makes a
profit because the speculator is bearish in the market and all the future stocks need to sell in
the market.
BULLISH INDEX, LONG NIFTY FUTURES:
Here the investor is bullish in the index. Using index futures, an investor can “BUY OR
SELL” the entire index trading on one single security. Once a person is LONG NIFTY using
the futures market, the investor gains if the index rises and loss if the index falls.
1st July = Index will rise
Buy nifty July contract = 5960
Lot =200
14th July nifty risen = 5967.35
Nifty July contract = 5980
Short position = 5980
Profit = 4000(200*20)
ARBITRAGEURS:
Arbitrage is the concept of simultaneous buying of securities in one market where the price is
low and selling in another market where the price is higher.
Arbitrageurs thrive on market imperfections. Arbitrageur is intelligent and knowledgeable

person and ready to take the risk He is basically risk averse. He enters into those contracts
were he can earn risk less profits. When markets are imperfect, buying in one market and
- 76 -
simultaneously selling in other market gives risk less 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.
JM Morgan introduced EQUITY DERIVATIVES FUND called as ARBITRAGE FUND

where the investor buys the shares in the cash market and sell the shares in the future market.
ARBITRAGEURS IN FUTURES MARKET
Arbitrageurs facilitate the alignment of prices among different markets through operating in
them simultaneously.
• Fair Price = Cash Price + Cost of Carry.
Example:Current market price of ONGC in BSE= 500
Current market price of ONGC in NSE= 510
Thus the Arbitrageur earns the profit of Rs.1000(10*100)
ARBITRAGE STRATEGIES:
BUY SPOT, SELL FUTURES:
In this the investor observing that futures have been overpriced, how can the investor cash in
this opportunity to earn risk less profits. Say for instance ACC = 1000 and One month ACC
futures = 1025.
This shows that futures have been overpriced and therefore as an Arbitrageur, investor can
make risk less profits entering into the following set f transactions.
• On day one, borrow funds, buy security on the spot market at 1000
• Simultansely, sell the futures on the security at1025
• Take delivery of the security purchased and hold the security for a month on the
futures expiration date, the spot and futures converge . Now unwind the position
• Say the security closes at Rs.1015. Sell the security
- 77 -
• Futures position expires with the profit f Rs.10
• The result is a risk less profit of Rs.15 on the spot position and Rs.10 on the futures
position
• Return the Borrow funds.
Finally if the cost of borrowing funds to buy the security is less than the arbitrage profit
possible, it makes sense for the investor to enter into the arbitrage. This is termed as cash –
and- carry arbitrage.
BUY FUTURES, SELL SPOT:
In this the investor observing that futures have been under priced, how can the investor cash
in this opportunity to earn risk less profits. Say for instance ACC = 1000 and One month
ACC futures = 965.
This shows that futures have been under priced and therefore as an Arbitrageur, investor can
make risk less profits entering into the following set f transactions.
• On day one, sell the security on the spot market at 1000

• Mae delivery of the security
• Simultansely, buy the futures on the security at 965
• On the futures expiration date, the spot and futures converge . Now unwind the
position
• Say the security closes at Rs.975. Sell the security
• Futures position expires with the profit f Rs.10
• The result is a risk less profit of Rs.25 the spot position and Rs.10 on the futures
position
Finally if the returns get investing in risk less instruments is less than the return from the
arbitrage it makes sense for the investor to enter into the arbitrage. This is termed as reverse
cash – and- carry arbitrage.
ARBITRAGE WITH NIFTY FUTURES:
Arbitrage is the opportunity of taking advantage of the price difference between two markets.
An arbitrager will buy at the cheaper market and sell at the costlier market. It is possible to
- 78 -
arbitraged between NIFTY in the futures market and the cash market. If the futures price is
any of the prices given below other than the equilibrium price then the strategy to be followed
is
CASE-1
Spot Price of INFOSYS = 1650
Future Price Of INFOSYS = 1675
In this case the arbitrager will buy INFOSYS in the cash market at Rs.1650 and sell in the
futures at Rs.1675 and finally earn risk free profit Of Rs.25.
CASE-2
Future Price Of ACC = 675
Spot Price of ACC = 700
In this case the arbitrager will buy ACC in the Future market at Rs.675 and sell in the Spot at
Rs.700 and finally earn risk free profit Of Rs.25.
Chapter XII
NSE-SIMEX ARBITRAGE
NSE now faces the battle of its life. SGX is a competitor with technology, branding, proven
track record of high ethical standards, and managerial capability that equals or exceeds that of
- 79 -
NSE. NSE is constrained by the speed at which India's regulators allow derivatives trading to
grow, and by the speed at which India's securities firms plunge into derivatives trading.
However, NSE has one great edge: monopolistic access to the great Indian retail market.
India's remarkable equity market liquidity is dominated by retail trading, and until capital
account convertibility comes about, this investor base cannot go to SGX. This edge will fade
away as India moves towards capital account convertibility, but it will take a while for SGX
terminals to be as prevalent in rural Andhra Pradesh as NSE terminals.
These developments open up one new market: arbitrage between Nifty at SGX and Nifty at
NSE. As mentioned above, there is one catch in this arbitrage, which is the currency. Hence,
arbitrageurs will fall into two groups:
(a) those who use the dollar-rupee forward market that prevails in Hong Kong or Singapore,
or
(b) those who are permitted to engage in forward transactions on the dollar-rupee forward
market in India under existing RBI regulations.
Chapter XIII
Conclusion
In less than three decades of their coming into vogue, derivatives markets have become the
most important markets in the world. Today, derivatives have become part and parcel of the
day-to-day life for ordinary people in major part of the world.
Until the advent of NSE, the Indian capital market had no access to the latest trading methods
and was using traditional out-dated methods of trading. There was a huge gap between the
investors’ aspirations of the markets and the available means of trading. The opening of
Indian economy has precipitated the process of integration of India’s financial markets with
the international financial markets. Introduction of risk management instruments in India has
- 80 -
gained momentum in last few years thanks to Reserve Bank of India’s efforts in allowing
forward contracts, cross currency options etc. which have developed into a very large market.
In terms of the products derivatives markets, and the variety of derivatives users, the Indian
market has equaled or exceeded many other regional markets. While the use of products is
being spearheaded mainly by retail investors, private sector institutions and large corporations,
smaller companies and state-owned institutions are gradually getting into the act. Foreign
brokers such as JP Morgan Chase are boosting their presence in India in reaction to the growth
in derivatives. The variety of derivatives instruments available for trading is also expanding.
There remain major areas of concern for Indian derivatives users. Large gaps exist in the range
of derivatives products that are traded actively. In equity derivatives, NSE figures show that
almost 90% of activity is due to stock futures or index futures, whereas trading in options is
limited to a few stocks, partly because they are settled in cash and not the underlying stocks.
Exchange-traded derivatives based on interest rates and currencies are virtually absent.
The major activities in stock futures and index futures are due to the different players in the
stock market.
What role does each person play in the derivatives market?
 Speculators provide liquidity and volume to the market.
 Hedgers provide depth.
 Arbitrageurs assist in proper price discovery and correct price abnormalities.
 Speculators are willing to take risks.
 Hedgers want to give away risks (generally to the speculators).
- 81 -
BIBLIOGRAPHY
Books:
BSE’s Certificate on Derivative Exchange (BCDE)
Derivative Market’s Dealer Module
NSE’s Certification in Financial Market
Derivatives in India
Options and Derivatives by John Hull
- 82 -
Websites:
www.bseindia.com
www.nseindia.com
www.wikipedia.com
www.cboe.com
www.investopedia.com
www.sebi.gov.in
www.euronext.com
www.derivativesindia.com
- 83 -

Risk Management Using Derivatives

Caricato da

Informazioni sul documento

Descrizione originale:

Titolo originale

Copyright

Formati disponibili

Condividi questo documento

Condividi o incorpora il documento

Opzioni di condivisione

Hai trovato utile questo documento?

Questo contenuto è inappropriato?

Copyright:

Formati disponibili

Risk Management Using Derivatives

Caricato da

Copyright:

Formati disponibili

Chapter I

Derivative products initially emerged, as hedging devices against fluctuations in commodity

Derivatives is derived from the following products:

FACTORS CONTRIBUTING TO THE GROWTH OF DERIVATIVES

A.} PRICE VOLATILITY –

B.} GLOBALISATION OF MARKETS –

C.} TECHNOLOGICAL ADVANCES –

A significant growth of derivative instruments has been driven by technological

D.} ADVANCES IN FINANCIAL THEORIES –

Myths and realities about derivatives

While the fact is...

b. Indian Market is not ready for derivative trading

While the fact is...

PRE- REQUISITES INDIAN SCENARIO

While the fact is...

Comparison of New System with Existing System

• They are bilateral contracts and hence exposed to counter-party risk.

Suppose the stock falls to Rs. 600/-

Products Traded in Derivatives Segment of the BSE

Sr. No. Product Traded with underlying asset Introduction Date

1 Index Futures- Sensex June 9,2000

2 Index Options- Sensex June 1,2001

3 Stock Option July 9, 2001

4 Stock futures November9,2002

5 Weekly Option on 4 Stocks September 13,2004

6 Chhota (mini) SENSEX January 1, 2008

Futures & Options on Sectoral Indices namely BSE TECK,

8 Currency Futures on US Dollar Rupee October 1,2008

Source: Compiled from BSE website

First financial derivative product in India.

Available on individual stocks approved by SEBI

Available on individual stocks approved by SEBI.

SENSEX FUTURES AND STOCK FUTURES AND

Derivatives Products Traded in Derivatives Segment of NSE

Sr No. Product Traded with underlying asset Introduction Date

2 Index Options- S&P CNX Nifty June 4,2001

3 Stock futures on 233 Stocks July 2, 2001

4 Stock Option on 233 Stocks November 9,2001

5 Interest Rate Futures- T – Bills and 10 Years Bond August 29,2003

6 CNX IT Futures & Options June 13,2005

7 Bank Nifty Futures & Options June 1,2007

8 CNX Nifty Junior Futures & Options June 1,2007

9 Nifty Midcap 5 0 Futures & Options January 1, 2008

12 Currency Futures on US Dollar Rupee August 29,2008

13 Currency Futures on US Dollar Rupee December 10, 2008

14 S& P CNX Defty Futures & Options December 10, 2008

Source: Complied from NSE website

FUTURES AND OPTIONS

FUTURES V/S OPTIONS

Single Stock Futures

 Stock index is difficult to manipulate as compared to individual stock prices, more so in

Reasons for Hedging an Equity Portfolio with Index Futures

Instrument Type : OPTIDX

Expiry date : Date of contract expiry

Option Type : CE/ PE

Strike Price: Strike price for the contract

Instrument type represents the instrument i.e. Options on Index.

Expiry date identifies the date of expiry of the contract.

The underlying index is S&P CNX NIFTY.

and the price for a Put is :

C = price of a call option

P = price of a put option