Dinesh Report

1.Introduction TITLE Derivatives are new concept to India market. The Indian capital market is significant in terms of the degree of development, volume of trading and its tremendous growth. With over 21 million shareholders, India has a third largest investor base the world after USA and Japan. Over 9000 companies are listed on stock exchange, whish are serviced by approximately 7500 stockbrokers. Most of the investments are not taking place in under develop as economically weak countries because of the risk of return attached with it. In any of the investment there is a risk of loss. The risk may include earth quake, cyclone, storm and or monsoon failure which are uncontrollable caused by nature. Through our study we have attempted to know the planning program, and system used by investor and individuals to manage the risk associated with future and options. This is leads to study about futures and options in derivatives market.

1.1 OBJECTIVES OF THE RESEARCH ➢ Understanding derivatives system in India. ➢ Trading method and strategies in derivative market. ➢ Rules and guidelines trading in futures and option.

SCOPE OF STUDY With globalization of the financial sector, it's time to recast the architecture of the financial market. To reduce this risk, the concept of derivatives comes into the picture. The Project is about current scenario of derivatives market and also current 1

developments of market. This project leads to complete understanding derivatives market.

In India we have different types of derivatives available like futures and

options. We are using different trading strategies used for futures and options. This project is study complete design about the futures and options. What purpose is need for derivatives market in India and practical concept behind that trading strategy used in options. Derivatives are products whose values are derived from one or more basic variables called bases. India is traditionally an agriculture country with strong government intervention Rules and guidelines followed by SEBI

LIMITATIONS  The study is conducted in Bangalore only.  Since the study covers the overview of derivatives market, it cannot be

generalized.  The depth of study has not fulfilled  Respondent’s information is not reliable.

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RESEARCH METHODOLOGY AND RESEARCH DESIGN: The methodology is the plan, structure and strategy of the investigation process

that sets out to obtain answer to the study. The methodology followed for the collecting information are using two sources of data namely ➢ Primary Data ➢ Secondary Data Primary Data

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The data collected first hand by the researcher concerned with the research problem refers to the Primary data. Personal discussion was made with Unit manager and interaction with other personnel in the organization for this purpose.

There is no formal design of

questionnaire used in this study. Secondary Data The information available at various sources made for some other purpose but facilitating the study undertaken is called as Secondary Data. The various sources that were used for the collection of secondary data are ➢ Various Text books were used to understand the concepts of portfolio management. ➢ Websites ➢ Annual reports of different companies. ➢ Newspapers such as Economic Times, Financial Express. ➢ Magazines such as Business World, Business Today, Investors Guide, Capital Market. Sample Size Sample size

: 100 respondents

Sampling procedure

: Non Probability Sampling Method

Sampling type

: Convience sampling 3

Sampling area

: Bangalore

Sampling design

: Exploratory Research Design

Research instrument

: Structured Distinguished Questionnaire

Description of the research design Achieve the objectives of the project all possible information relevant the investor profile were collected. Taking the help of the theoretical mode, the most appropriate methodology was decided.

SAMPLING PROCEDURE Sample unit Who is to be surveyed? The marketing researches must define the targeted population that will be sampled. Once this unit is determine a sampling frame must be developed so that every one in the targeted population has as equal of known chance of being sampled. Sample size How many people should be surveyed? Sampled give more reliable results than small samples. However it is necessary to sample the entire target population or even a substation portion to achieve reliable results. Sample of less than 1% of population often provide good reliability, given a credible sampling procedure. Data collection instrument The questionnaire is the most common instrument in collect primary data. A questionnaire of a set of question presented to respondents for their answers. The questionnaire very flexible in that there any number of way to ask questions.

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Questionnaire need to be carefully developed tested and debugged before they are administrated on a large scale. Once a usually spot several errors a casually prepared questionnaire. In preparing a questionnaire the professional researcher carefully chooses the questions and their form, working and sequence. A common types of errors occurs in the questions asked , that is in including question that cannot would not , or need to be answered and in omitting questions that be answered each question should be checked to determine whether it contributes in the research objectives. The question should flow in a logical order on the respondents demographics come last because they are more personal and less interesting to the respondents

Questionnaire design Close ended question Questions, which restrict the interviewee’s answer to pre-defined options, are called close-ended questions. Close-ended questions give respondents a finite set of specified responses to choose firm. Such questions are deemed appropriate when the respondent has a specific answer to give a , when the researcher has a specified answer in mind , when detailed narrative information is not needed or when there is a finite numbers of ways to answer a question. These questions are common in survey researches.

Analysis of Findings ➢ Derivative market transaction volume is four times of the Spot market's volume the allocation into derivatives is less than the investment into the Spot market 5

➢ Investors are not confident on the research report on various stocks mainly due to its variance from the actual happenings in the market. ➢ Traders mainly want to make short term gain by investing into Derivatives then for using Derivative as an instrument to reduce the market risk. ➢ The retail investors are reluctant to go by options mainly due to the low liquidity in the Option's market Meanings of derivatives Derivatives are the financial instruments, which derive their value from some other financial instruments, called the underlying. The foundation of all derivatives market is the underlying market, which could be spot market for gold, or it could be a pure number such as the level of the wholesale price index of a market price.

“A derivative is a financial instrument whose value depends on the value

of other basic underlying variables”

John c hull

According to the Securities Contract (Regulation) Act, 1956, derivatives include: ✔ A security derived from a debt instrument, share, and loan whether secured or unsecured, risk instrument or contract for differences or any other form of security. ✔ A contract, which derives its value from the prices or index of prices of underlying securities.

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Therefore, derivatives are specialized contracts to facilitate temporarily for hedging which is protection against losses resulting from unforeseen price or volatility changes. Thus, derivatives are a very important tool of risk management. Derivatives performs a number of economic functions like price discovery, risk transfer and market completion. The simplest kind of derivative market is the forward market. Here a buyer and seller write a contract for delivery at a specific future date and a specified future price. In India, a forward market exists in the form of the dollar-rupee market. But forward market suffers from two serious problems; counter party risk resulting in comparatively high rate of contract non-compliance and poor liquidity. Futures markets were invented to cope with these two difficulties of forward markets. Futures are standardized forward contracts traded on an organized stock exchange. In essence, a future contract is a derivative instrument whose value is derived from the expected price of the underlying security or asset or index at a pre-determined future date.

TYPES OF DERIVATIVES The following are the popular and important derivatives:

DERIVATIVES

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FORWARD S

FUTURE

OPTIONS

SWAPS

One form of classification of derivatives is between commodity derivatives and financial derivatives. Thus futures of option on gold sugar, jute, pepper etc are commodity derivatives While futures options or swaps on currencies, gilt-edged securities, stock and share stock market indices etc are financial derivatives. Forwards Futures Options and Swaps

Derivatives

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Forwards

Future

Commodity

Securit y

Call

Security

Put Interest rate

Commodi

i)

Swap Swap

Option

Currency

Forward contract

A forward contract is a customized contract between the buyer and the seller where settlement takes place on a specific date in future at a price agreed today. The rupeedollar exchange rate is a big forward contract market in India with banks, financial institutions, corporate and exporters being the market participants. The main features of a forward contract are:

•

Each contract is custom designed and hence unique in terms of contract size, expiration date, asset type, asset quality etc.

•

A contract has to be settled in delivery or cash on expiration date.

•

In case one of the two parties wishes to reverse a contract, he has to compulsorily go to the other party. The counter party being in a monopoly situation can command the price he wants.

•

Traded in Over the Counter (OTC) markets.

•

No down payment required.

•

Settlement is done on the date of maturity.

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(ii) FUTURES A future contract is very similar to a forward contract in all respects excepting the fact that it is completely a standardized one. Hence, it is rightly said that a futures contract is nothing but a standardized forward contract. It is legally enforceable and it is always traded on an organized exchange. A future is a contract to buy or sell an asset at a specified future date at a specified price. These contracts are traded on the stock exchanges and it can change many hands before final settlement is made.

Features of future contracts 1. Highly standardized in nature. 2. No down payment is required at the time of agreement. 3. Settlement: futures instruments are ‘marked to the market’ and the exchange records profit and loss on them on daily basis though held till maturity. 4. Hedging of price risk is most common in futures. 5. Non-linearity. 6. Non-delivery of asset: In future contracts generally parties simply exchange the difference between the future and spot prices.

The advantage of a future is that it eliminates counterparty risk. Since there is an exchange involved in between, and the exchange guarantees each trace, the buyer or seller does not get affected with the opposite party defaulting.

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FUTURES V/S FORWARDS Futures

Forwards

Futures are traded on a stock Forwards are non-tradable, negotiated exchange. Futures

instruments. are

contracts

having Forwards are contracts customized by

standard terms and conditions.

the buyer and seller.

No default risk as the exchange High risk of default by either party. provides a counter guarantee. Exit route is provided because of No exit route for these contracts. high liquidity on the stock exchange. Highly

regulated

with

strong No such systems are present in a

margining and surveillance systems.

forward market.

a) Commodity futures A commodity future is a futures contract in commodities like agriculture products, metals and minerals etc. In organized commodity future markets, contracts are standardized with standard quantities. commodity to commodity.

Of course, this standard varies from

They also fixed delivery dates in each month or a few

months in a year. In India commodity futures in agricultural products are popular.

b) Financial futures Financial futures refer to a futures contract in foreign exchange or financial instruments like Treasury bill, commercial paper, and stock market index or interest rate. It is an area where financial service companies can play a very dynamic role. Financial futures are very popular in Western countries as hedging instruments to

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protect against exchange rate/interest rate fluctuations and for ensuring future interest rates on loans. The Stock Index Futures contract is a futures contract on major stock market indices.

This type of contract is very much useful for speculators, investors and

especially portfolio managers. They can hedge against future decline or increase in prices of portfolios depending upon the situation. Generally the asset will not be delivered on the maturity of the contract. The parties simply exchange the difference between the future and spot prices on the date of maturity. But, these kinds of financial futures are relatively new in India. may be larger than the initial margin deposit. For example, assume it’s now January. The July crude oil futures price is presently quoted at $15 a barrel and over the coming month you expect the price to increase. You decide to deposit the required initial margin of $2,000 and buy one July crude oil futures contract. Further assume that by April the July crude oil futures price has risen to $16 a barrel and you decide to take your profit by selling. Since each contract is for 1,000 barrels, your $1 a barrel profit would be $1,000 less transaction costs.

Price per barrel

Value of 1,000 barrel contract

January Buy 1 July crude oil $15.00

$15,000

futures contract April

Sell 1 July crude oil $16.00 futures contract

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$16,000

Gain

$1.00

$1,000

* For simplicity, examples do not take into account commissions and other transaction costs. These costs are important. You should be sure you understand them. Suppose, instead, that rather than rising to $16 a barrel, the July crude oil price by April has declined to $14 and that, to avoid the possibility of further loss, you elect to sell the contract at that price. On the 1,000 barrel contract your loss would come to $1,000 plus transaction costs.

Price per barrel

Value of 1,000 barrel contract

January Buy 1 July crude oil $15.00

$15,000

futures contract April

Sell 1 July crude oil $14.00

$14,000

futures contract Loss

$1.00

$1,000

Note that if at any time the loss on the open position had reduced funds in your margin account to below the maintenance margin level, you would have received a margin call for whatever sum was needed to restore your account to the amount of the initial margin requirement. (iii) OPTIONS In the volatile environment, risk of heavy fluctuations in the prices of assets is very heavy. Option is yet another tool to manage such risks. Options are one better 13

than futures. In option, as the name indicates, gives one party the option to take or make delivery. But this option is given to only one party in the transaction while the other party has an obligation to take or make delivery. The asset can be a stock, bond, index, currency or a commodity. But since the other party has an obligation and a risk associated with making good the obligation, he receives a payment for that.

This payment is called as

premium. The party that had the option or the right to buy/sell enjoys low risk. The cost or this low risk is the premium amount that is paid to the other party. The buyer of the right is called the option holder. The seller of the right (and buyer of the obligation) is called the option writer. The cost of this transaction is the premium. In an options contract, the seller is usually referred to as a “writer” since he is said to write the contract. It is similar to the seller who is said to be in ‘Short position’ in a forward contract. However, in a put option, the writer is in a different position. He is obliged to buy shares. In an option contract, the buyer has to pay a certain amount at the time of writing the contract for enjoying the right to buy or sell.

American Option Vs European Option In an option contract, if the option can be exercised at any time between the writing of the contract and its expiration, it is called as an American option. On other hand, if it can be exercised only the time of maturity, it is termed as European option.

Types of options Options may fall under any one of the following main categories: Call Option Put Option 14

1) CALL OPTION A call option is one which gives the option holder the right to buy a underlying asset (commodities, foreign exchange, stocks, shares etc.) at a predetermined price called ‘exercise price’ or strike price on or before a specified date in future. In such a case, the writer of a call option is under an obligation to sell the asset at the specified price, in case the buyer exercises his option to buy. Thus, the obligation to sell arises only when the option is exercised. 2) PUT OPTION A put option is one, which gives the option holder the right to sell an underlying asset at a predetermined price on or before a specified date in future. It means that the writer of a put option is under an obligation to buy the asset at the exercise price provided the option holder exercises his option to sell.

a. Option Premium In an option contract, the option writer agrees to buy or sell an underlying asset at a future date for an agreed price from/to the option buyer/seller at his option. This contract, like any other contract must be supported by consideration. The consideration for this contract is a sum of money called ‘premium’. The premium is nothing but the price, which is required to be paid for the purchase of ‘right to buy or sell’. The premium, one pays is the maximum amount to which he is exposed in the market, since, in any case he can not lose more than that amount. Thus, his risk is limited to that extent only. However, his gain potential is unlimited. In the case of a double option, this premium money is also double.

b. Options Market Options market refers to the market where option contracts are brought and sold. Once an option contract is written, it can be bought or sold on the options market. The first

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option market namely the Chicago Board of Options Exchange was set up in 1973. Thereafter, several options markets have been established.

Features of Option Market 1. Highly Flexible. 2. Down Payment. 3. Settlement. 4. Non-Linearity. 5. No Obligation to Buy or Sell. For example :An investor buys one European Call option on one share of Reliance Petroleum at a premium of Rs. 2 per share on 31 July . The strike price is Rs.60 and the contract matures on 30 September . The payoffs for the investor on the basis of fluctuating spot prices at any time are shown by the payoff table (Table 1). It may be clear form the graph that even in the worst case scenario, the investor would only lose a maximum of Rs.2 per share which he/she had paid for the premium. The upside to it has an unlimited profits opportunity. On the other hand the seller of the call option has a payoff chart completely reverse of the call options buyer. The maximum loss that he can have is unlimited though a profit of Rs.2 per share would be made on the premium payment by the buyer.

S 57 58 59 60 61

Payoff from Call Buying/Long (Rs.) Xt C Payoff Net Profit 60 2 0 -2 60 2 0 -2 60 2 0 -2 60 2 0 -2 60 2 1 -1 16

62 63 64 65 66

60 60 60 60 60

2 2 2 2 2

2 3 4 5 6

0 1 2 3 4

A European call option gives the following payoff to the investor: max (S - Xt, 0). The seller gets a payoff of: -max (S - Xt,0) or min (Xt - S, 0). Notes: S - Stock Price Xt - Exercise Price at time 't' C - European Call Option Premium iv) SWAPS Swap is yet another exciting trading instrument. Infact, it is a combination of forward by two counterparties. It is arranged to reap the benefits arising from the fluctuations in the market – either currency market or interest rate market or any other market for that matter.

Features of Swaps 1. Basically a forward. 2. Double coincidence of wants. 3. Necessity of an intermediary. 4. Settlement. 5. Long term agreement. Kinds of Swap A swap can be arranged for the exchange of currencies, interest rates etc. A swap in which two currencies are exchanged are exchanged is called cross-currency swap. A swap in which a fixed rate of interest is exchanged for a floating rate is called 17

interest rate swap. This interest rate swap can also be arranged in multi-currencies. A swap in which on stream of floating interest rate is exchanged for another stream of floating interest is called ‘Basis swap’. Thus, swap can be arranged according to the requirements of the parties concerned and may innovative swap instruments can be evolved like this. Advantages 1. Borrowing at Lower Cost. 2. Access to New Financial Markets. 3. Hedging of Risk. 4. Tool to correct Asset-Liability Mismatch. 5. Additional Income.

Distinction between futures and options Futures

Options

•

Exchange traded, with novation

•

Exchange defines the product

•

Prize is zero, strike price moves

Strike price is fixed, price moves.

•

Price is zero

Price is always positive

•

Linear payoff

Non linear payoff.

•

Both long and short at risk

Only short at risk.

Same as futures. Same as futures

The Nifty index fund industry will find it very useful to make a bundle of a Nifty index fund and a nifty put option to create a new kind of a Nifty index fund, which gives the investor protection against extreme drop in Nifty. Selling put options is selling insurance,

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so any one who feels like earning revenues by selling insurance can set himself up to do so on the index options market. More generally, options offer "nonlinear payoffs" whereas futures only have "linear payoffs". By combining futures and options, a wide variety of innovative and useful pay off structures can be created

DERIVATIVES MARKET IN INDIA Liberalization period: In India financial markets, there were only a few financial products and the stringent regulatory products and the stringent regulation environment also eluded any possibility of development of a derivatives market in country. All Indian corporate were mainly relying on term lending institution for meeting their project financing or any other financing requirements and on commercial banks for meeting working capital finance requirement. Commercial banks are on their assets and liabilities. The only derivative product they were aware of is the foreign exchange forward contract. But this scenario changed in the post liberalization period. Conservative Indian business practitioners began to take a different view of various aspects of their operations to remain competitive. Financial risks were given adequate attention and “treasury function” has assumed a significance role in all major corporate since then. Initially, banks were allowed to pass on gains arising out of cancellation of forward’s contracts to the customers and customers were permitted to cancel and rebook the forward contracts. This remarkable change was followed by the introduction of cross currency forward contacts. But the major milestone in developing forex derivatives market in India was the introduction of cross currency options. The RBI’s objective of introducing cross currency options was to provide a complicated hedging strategy for the corporate in their risk management activities.

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First traded in Mumbai in 1875: The concept of “derivatives” is of course not new to the Indian market. Though derivatives in the financial markets have nothing to talk about home, in the commodity markets they have a long history of over hundred years. In 1875, the first commodity futures exchange was set up in Mumbai under the guidance of Bombay Cotton Traders Association. A clearinghouse for clearing and settlement of these traders was set up in 1918. Over a period of twenty years during 1900-1920, other futures markets were set up in various places. Futures market in raw jute in Kolkata (1912), wheat futures market in Hapur (1913), and bullion futures market in Mumbai (1920). When it comes to financial markets, derivatives in equities claim a long existence. The official history of Bombay Stock Exchange (then known as Native Share and Stock Brokers Association) reveals that the concept of options existed since 1898 as is reflected from a quote given by one of the MPs-“India being the original home of options, a native broker would give a few points to the brokers of the other nations in the manipulation of puts and calls” Approved by government of India However, such an early expertise gained by Indian traders in derivatives trading has come to an end with the Government of India’s ban on forward contract during the 1960’s on the ground of their intrinsic undesirability. But ironically, the same were reintroduced by the government in the 1980’s as essential instruments for eliminating wide fluctuations in prices and more so because of the World Bank – UNCTAD report, which strongly urged the Indian government to start futures trading in major cash crops, especially in view of India’s entry to WTO. With the world embracing the derivative trading on large scale, the Indian market obviously cannot remain aloof, especially after liberalization has been set in motion. Now we are in the threshold of introducing trading in derivatives, beginning with 20

the stock index futures to be well set for the introduction of derivative trading. With L.C. Gupta committee having recently submitted its report on the subject, SEBI is engaged in the process of assessing the feasibility and desirability of introducing such trading. The NSE and BSE are two exchanges on which financial derivatives are traded. The combined notional value of the daily volumes on both the bourses stand at around RS. 400 cr. In developed markets trading in the derivatives segment are thrice as large as in the cash markets. In India, the figure is hardly 20% of cash markets. Quite clearly our derivative markets have a long way to go. Traded at NSE & BSE According to the Executive Director of Association of NSE Member of India (Amni), Vinod Jain, “ Volumes in derivatives segment are stagnating due to lack of growth in the number of markets participants. Besides these products are still to catch up with the masses who are keeping away from this segment due to lack of understanding of the products and high contract price” Like our stock markets, the Indian derivatives markets are also becoming heavily dependent on few instruments. For instance, futures in three blue chip companies such as Satyam Computers, Reliance Industries and Infosys Technologies, have accounted for as 42% of the total turnover in the derivatives segment of the National Stock Exchange in June 2002. Stock futures of Satyam Computers, Infosys Technologies and HPCL accounted for 37% of the total turnover in May 2002, 35% in April 2002 and 34% in March 2002 . These highly speculative stock futures instruments accounted for about 69% of the total turnover. This may lead to price manipulations. Meanwhile, options contracts are witnessing a decline in trading interest. The turnover in individual stock options plunged to Rs. 4,642cr. In June compared with Rs. 5,133cr. In May similarly, the turnover index options also declined from Rs. 463cr. in May to Rs. 389cr. in June.

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Division of Derivatives markets a) COMMODITIES DERIVATIVES MARKETS In order to give more thrust on agricultural sector, the National Agricultural Policy, 2000 has envisaged and domestic market reforms and dismantling of all controls and regulations in agricultural commodity markets. It has also proposed to extend the coverage of futures markets to minimize the wide fluctuations in commodity market prices and for hedging the risk from price fluctuations. As a result of these recommendations, there are presently, 15 exchanges carrying out futures trading in as many as 30 commodity items. Out to these, two exchanges viz. IPSTA, Cochin and the Bombay Commodity Exchange (BCE) Ltd.; have been upgraded to international exchanged to deal international contracts in peeper and castor oil respectively. Moreover, permission has been given to two more exchange viz. the First Commodities Exchange of India Ltd., Kochi (for copra/coconut, its oil and oilcake), and Keshave Commodity Exchange Ltd., Delhi (for potato), where futures trading started very recently. The government has also permitted four exchange viz., EICA, Mumbai. The Central Gujarat Cotton Dealers Association, Vadodara; The South India cotton Association Coimbatore; and the Ahmedabad Cotton Merchants Association, Ahmedabad, for conducting forward (non-transferable specific delivery) contracts in cotton. Lately as part of further liberalization of trade in agriculture and dismantling of ECA, 1955 futures trade in sugar has been permitted and three new exchanges viz., ECommodities Limited, Mumbai; NCS InfoTech Ltd., Hyderabad; and E-Sugar India.com, Mumbai have been given approval for conducting sugar futures (Ministry of Food and Consumer Affairs, 1999). In the recent past, the GOI has set up a committee to explore and appraise matters important to the establishment and financing of the proposed national 22

commodity exchange for the nationwide trading of commodity futures contracts. The usage of warehouse receipts as a means for delivery of commodities under the contracts is also being explored. The warehouse receipts system has been operationalised in COFEI (coffee futures exchange of India) with effect from 1998. The Government of India is on the move to establish a system of warehouse receipts in other commodity stock exchanges at various places of the country. Besides these domestic developments, during 1998, Reserve Bank of India permitted the Indian Corporate Sector to access the exchanges subject to certain conditions with a view to enable domestic metal manufacturers to compete with global players. The de-regulation of oil-imports being on the cards, government should create the right atmosphere for oil sector to participate in the international oil-derivatives Markets. Despite these developments, there are still many impediments that hold back the farming community from entering the futures market and reap full benefits. b) Currency Derivatives Foreign exchange derivatives market is one of the oldest derivatives markets in India. Presently, India has got a well-established dollar-rupee forward market with contrast traded for one month, two months and three months expiration. Currency derivatives markets have begun to evolve with the allowing of banks to pass on the gains upon cancellation of a forward to the customer and permitting customer to cancel and rebook forward contracts. Introduction of cross currency options can be considered as another major step towards developing forex derivatives markets in India. Today, Indian corporate are permitted to purchase cross currency options to hedge exposures arising out of trade. Authorized dealers who offer these products have to necessarily cover their exposure in international markets i.e., they shall not carry the risk in their own books. Cross currency

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options are essentially meant for buying or selling any foreign currency in terms of US dollar. They are therefore, useful only to those traders who invoice their exports and imports in currencies other than US dollar or for corporate who borrow in currencies other than US dollar. As against this, majority of Indian trade is invoiced in the US dollars. Thus, they have almost no relevance in the Indian context. Indian banks are allowed to use the foreign currency interest rate swaps, forward rate agreements/interest rate options/swaps, and forward rate agreements/ interest rate option/swap/option/caps/floors to hedge interest rate and currency mismatch in their balance sheets. Resident and the non-resident clients are also permitted to use the above products as hedges for liabilities on their balance sheets. Here it is worth remembering that globally, foreign exchange traders are becoming as common as stock traders. But in India, forex dealers still play second fiddle to stock traders and merely meet the needs of the exporters deposits. This may be due to their risk averting behavior and perhaps lack of proper research. Such being the position of the forex market, it is too premature to expect that once, foreign currency-Indian rupee options are introduced, the market will pick up momentum. This is all the more essential in a market where exchange rates though stated to be market determined, are often found influenced by RBI’s intervention in the exchange market. As a result, exchange rate movements hardly obey the principle of interest rate differentials. The incongruence in the domestic money rates as derived from the USD/INR forwards yield curve supports this assertion. For example, the one-year domestic term money is around 6-6.25% whereas that of the one-year implied forward rate is around 5.40%. In such a scenario, it is difficult for a currency trader to take a firm view on the exchange rate movement.

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c) Stock market derivatives Today trading on the “spot market” for equity in India has always been a futures market with weekly/fortnightly settlements. These markets features the risks and difficulties of futures market, But without the gains in price discovery and hedging services that come with separation the spot market from the futures market. India’s primary market is acquainted with two types of derivatives… •

Convertible bonds

•

Warrants

As these warrants are listed and traded, it could be said that options market of a limited sort already exist in our market. Besides, a wide range of interesting derivatives markets exists in the informal sector. Contracts such as “bhav-bhav” “teji-mandi” etc. are traded in these markets. These informal markets enjoy a very limited participation and have their presence outside the conventional institutions of India’s financial system. The first step towards introduction of derivatives trading in India in its current format was the promulgation of the securities laws (Amendment) Ordinance, 1995 that withdrew the prohibition on options in securities. The real push to derivatives market in India was however given by the SEBI. The security market watchdog, in November 1996 by setting up a committee under the chairmanship of Dr L C Gupta to develop “appropriate regulatory framework for derivatives trading in India.” In 2000, SEBI permitted NSE and BSE to commence trading in index futures contracts based on S&P CNX Nifty and BSE 30 (sensex) index. This was followed by approval for trading in options based on these two indexes and options on individual securities. Futures contracts on Individual stocks were launched on November 9,2001. Trading and settlement is done in accordance with the rules of the respective exchanges. But the trading volumes were initially quite modest. This could be due to ----25

 Initially, few members have been permitted by SEBI to trade on derivatives;  FII’S, MFS have been allowed to have a very limited participation;  Mandatory requirements for brokerage firms to have “SEBI approvedcertification-test-passed” brokers for undertaking derivatives trading’ and  Lack of clarity on taxation and accounting aspects under derivatives trading. The current trading behavior in the derivatives segments reveals that single stock futures continues to account for sizeable proportion. A recent press report indicates that futures in Indian exchanges have reached global volumes. One possible reason for such skewed behavior of the traders could be that futures closely resemble the erstwhile badla system. Such distortions are not however in the interest of the market. SEBI has permitted trading in options and futures on individual stocks, but not on all

the listed stocks. It was very selective, stocks that are said to be highly volatile

with a low market capitalization are not allowed for option trading. This act of SEBI is strongly resented by a section of the market. Their argument is that equity options are indispensable to investors who need to protect their investment from volatility. The higher the volatility of a stock the more necessary it is to list options on that stock. They are highly vocal in arguing that SEBI should design an effective monitoring, surveillance and risk management system at the level of the exchanges and clearing house to avert and manage the default risks that are likely to arise owing to high volatility in low market capital stocks instead of simply banning trading in options on them. SEBI needs to examine these arguments. It may have to take a stand to nip in the bud all kinds of manipulations by handling out severe punishments to all such erring companies. Today, mutual funds are permitted to use equity derivatives products for “hedging and portfolio rebalancing”. However, such usage is not favored by fund managers as they strongly apprehend that the dividing line between hedging and

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speculation being thin, they may always get exposed to the questioning by the regulatory authorities. d) CREDIT DERIVATIVES AND OTHERS A credit derivative is a financial transaction whose pay-off depends on whether or not a credit event occurs. A credit event can be: •

Bankruptcy

•

Default

•

Upgrade

•

Downgrade

•

Interest rate movement

•

Mortgage defaults

•

Unforeseen pay-offs

A credit derivative, like any other derivative, derives it’s value from an case is the credit. In the event of the underlying asset failing to perform as expected, credit derivatives, ensures that someone other than the principal lender absorbs the resulting financial loss. Credit derivatives market in India though could be said as non-existent holds huge potential. Some of the important factors/situation such as opening up of the insurance sector to foreign private players, relief to investors, tax benefits to corporate, proxy hedgers etc., could provide the momentum to the credit derivatives market in India, boosting yields and bringing down risk for both the corporate and banks. Secondly, Indian banking system is saddled with huge NPA’s, which it

is of

course, eagerly trying to get rid off. The mounting pressure on profitability is making banks more credit-averse. In such a situation, if markets can offer “credit-insurance” in the form of derivatives, everyone would jump for it.

DERIVATIVES: Development in India 27

The derivatives markets has existed for centuries as a result of the need for both users and producers of natural resources to hedge against price fluctuations in the underlying commodities. Although trading in agricultural and other commodities has been the driving force behind the development of derivatives exchanges, the demand for products based on financial instruments—such as bond, currencies, stocks and stock indices—have now far outstripped that for the commodities contracts. India has been trading derivatives contracts in silver, gold, spices, coffee, cotton and oil etc for decades in the gray market. Trading derivatives contracts in organized market was legal before Morarji Desai’s government banned forward contracts. Derivatives on stocks were traded in the form of Teji and Mandi in unorganized markets. Recently futures contract in various commodities were allowed to trade on exchanges. For example, now cotton and oil futures trade in Mumbai, soybean futures trade in Bhopal, pepper futures in Kochi, coffee futures in Bangalore etc. I

n June 2000, National Stock Exchange and Bombay Stock Exchange started

trading in futures on Sensex and Nifty. Options trading on Sensex and Nifty commenced in June 2001. Very soon thereafter trading began on options and futures in 31 prominent stocks in the month of July and November respectively. Currently there are 41 stocks trading on NSE Derivative and the list keeps growing. How many stocks are trading in Futures & Option? What is the minimum quantity we need to trade? The minimum quantity trade in is one market lot. The market lot is different for different stocks/index. Time to time list will keep changing. CNXIT 100

ICICI Bank 1400

Oriental Bank 1200

Nifty 200

Infosys 200

PNB 1200

28

ACC 1500

IOC 600

Polaris 1400

Andhra Bank 4600

MTNL 1600

Ranbaxy 400

Bajaj Auto 400

ONGC 300

Wipro 600

Bank of Baroda 1400

Nalco 1150

REL 550

Bank of India 3800

Tisco 1350

Union Bank 4200

BEL 550

M&M 625

TCS 250

Bank of India 3800

Maruti 400

Tata Tea 550

Grasim Ind 350

BEL 550

ITC 300

BHEL 600

IPCL 1100

RIL 600

BPCL 550

Hero Honda 400

i-flex 300

Canada Bank 1600

HDFC Bank 800

HPCL 650

29

Cipla 1000

HDFC 600

HLL 2000

Dr. Reddy’s 200

Gujarat Ambuja 1100

Hindalco 300

GAIL 1500

HCL Tech 1300

Tata Power 800

Evolution of derivatives Development Prior to 1995 In the last few years there have been substantial improvements in the functioning of the securities market.

Requirements of adequate capitalization, margining and

establishment of clearing corporations have reduced market and credit risks. System improvements have been effected through introduction of screen based trading system and electronic transfer and maintenance of ownership records of securities. However, there are inadequate advanced risk management tools. In order to provide such tools and to deepen and strengthen cash market, a need was felt for trading of derivatives like futures and options. But it was not possible in view of prohibitions in the SCRA. Its preamble stated that the Act is to prevent undesirable transactions in securities by prohibiting options and by providing for certain others matters connected therewith. Section 20 of the Act explicitly prohibited all options in securities. The Act empowered central Government to prohibit by notification any type of transaction in any security. In exercise of this power, Government by its notification in 1969 prohibited all forward trading in securities. As the need for derivatives was felt, it was thought that if these prohibitions were withdrawn, trading in derivatives could commence. The securities laws (amendment) ordinance, 30

1995, promulgated on 25th January 1995, lifted the ban by repealing section 20 of the SCRA and amending its preamble. From 1996 to 1997 The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24 member committee under the Chairmanship of Dr. L.C.Gupta on 18th November 1996 to develop appropriate regulatory framework for derivatives trading in India.

The Committee submitted its

report on March 17, 1998. Market went ahead with preparation. It was soon realized that there was no law under which the regulations could be framed for derivatives.

It was felt that if

derivatives could be treated as securities under the SC(R) Act, trading in derivatives would be possible within the framework of that Act. According to section 2(h) of the SC(R) Act, securities includes shares, scrips, stocks bonds, debentures, debentures stock, or other marketable securities of a like nature in or of any incorporated company or other body corporate, government securities, such other instruments as may be declared by the Central Government to be securities, and rights and interest in securities. SEBI felt that the definition of “Securities” under SC(R)A could be expanded by declaring derivative contracts based on index of prices of securities and other derivative contracts as securities. It was thought that Government could declare derivatives to be securities under its delegated powers.

Government, however did not declare

derivatives as securities, probably because its power was circumscribed by the words such other. Only those instruments, which resemble the ones listed in the Act could be declared.

EVENTS THAT MADE THE LAUNCH OF DERIVATIVES IN INDIA 31

•

November 1996, SEBI set up a committee under the chairmanship of Dr. L C

Gupta, the well known economist and former SEBI Board Member. •

The Committee submitted its report on the March 17 1998. It advocated the

introduction of derivatives in Indian market in a phased manner, starting with the ‘ Index Futures’. •

SEBI accepted the report on May 11, 1998 and June 16, 1998, it issued a

circulation allowing exchanges to submit their proposals for introduction of Derivative trading. •

Government issued notification delineating the areas of responsibility between

RBI and Market Regulator SEBI. •

On June 2000, derivative trading started in NSE and BSE.

Market players of Derivatives market: Hedgers: The objective of these kind of traders is to reduce the risk. They are not in the derivatives market to make profits. They are in it to safeguard their existing positions. Apart from equity markets, hedging is common in the foreign exchange markets where fluctuations in the exchange rate have to be taken care of in the foreign currency transactions or could be in the commodities market where spiraling oil prices have to be tamed using the security in derivative instruments. Speculators: They are traders with a view and objective of making profits. They are willing to take risks and they bet upon whether the markets would go up or come down. Arbitrageurs: Riskless Profit Making is the prime goal of Arbitrageurs. Buying in one

32

market and selling in another, buying two products in the same market are common. They could be making money even without putting there own money in and such opportunities often come up in the market but last for very short timeframes. This is because as soon as the situation arises arbitrageurs take advantage and demandsupply forces drive the markets back to normal.

Derivatives Trading in Financial Markets Derivatives were not traded in the financial markets of the world up to the period about three decades back, though Stock Exchanges trading in securities in the cash market came to be in vogue more than a century ago. In India the first Stock Exchange, BSE was established in 1875. But BSE commenced trading in derivatives only from 2001. Even in the international financial/securities market the advent of derivatives as trading products was a concurrent-effect with the process of globalization and integration of the national economies of the developed countries beginning from the Seventies of the last Century. As volumes traded increased and as competition turned intense, trade & business became more complex in the new environment. The new opportunities were matched by fresh challenges and unpredictable volatility of the trading environment. Corporate for the first time sensed the formidable risks inherent in business transactions and the unpredictability of the markets to which they are exposed. Facing multiple risks the business organizations, were induced to search for new remedies, i.e. risk containment devices/instruments. Derivatives came to be the natural remedy in this context. To quote an international professional authority: "As capital markets become increasingly integrated, shocks transmit easily from one market to another. The proliferation of new instruments with complex features has led to enhanced investment opportunities. One such instrument which has become darling of corporate, banks, institutions alike is 'Derivatives'. To have a touch of the tree top's view, Derivatives transaction is defined as a bilateral contract whose value is derived, from the value of an underlying asset, or reference rate, or index. Derivative 33

transactions have evolved in the past twenty years to cover a broad range of products which include instruments like 'forwards', 'futures', 'options', 'swaps' covering a broad spectrum of underlying assets including exchange rates, interest rates, commodities, and equities."

Though recent in origin derivatives instruments issued over the years have grown by leaps and bounds and the total amount issued globally is estimated to approach $80 trillion by the advent of the new millennium. Derivative positions have grown at a compounding rate of 20% since 1990. In India though derivatives were introduced very recently in 2001, the trading turnover has already surpassed that of the equity segment. In NSE alone as per a report on its website the total turnover of the derivatives segment for the month of May 2003 stood at Rs. 53424 crores. During the month of May 2003, the percentage of derivatives segment as a percentage of the cash segment was 97.68%. However in the earlier two months the turnover of Derivatives was higher than that of the cash segment.

Trading process of derivatives ➢ Detailed knowledge about derivatives market

➢ Open a Demat Account with minimum balance ➢ Starting process of Trading with help of demat account. ➢ Create market watch and watching that particulars of derivatives market. ➢ Buy commodities like oil and currency. ➢ Select particulars buying & selling contract for derivatives market. ➢ Minimum amount entering in to derivatives Rs.40000. ➢ Incur Initial expense of transaction. ➢ Buyers usually enter into lot size. ➢ Decides whether states price at spot or futures prices ➢ Waiting for increase price for contract 34

➢ Laterally square off transaction both futures & options. Different types of derivatives products ➢ Commodity ➢ Oil ➢ Currency ➢ Agricultural commodities ➢ Ornaments like gold. ➢ Cattle TRADING METHOD Listed securities are traded on the floor of the recognized stock exchange where its members trade. An investor is not permitted to enter the floor of the exchange and he has to trust the broker to: 1.

Negotiate the best price for the trade.

2.

Settle the account, i.e. payment for securities sold due date.

3.

Take delivery of securities purchased.

Trading in a stock exchange is conducted in two ways: 1.

Ready delivery contracts.

2.

Forward delivery contracts.

Ready delivery contracts or cash trading on cash transaction. These fulfill the following criterion: ➢

All listed securities can be traded.

➢

Settlement within seven days. 35

Carryover facilities not permitted.

➢

Depository account: A depository account is similar to the bank accounts. It gives a summary of an investor’s holding of securities in the companies traded in the Indian Stock Exchanges and records transaction details of securities bought and sold during the period. This information of securities holding is maintained in the electric form. The securities in the depository account do not have any numbers to distinguish them and are identified by the total number of securities held for each company by the depository on the investors account. INTRODUCTION TO ONLINE TRADING There is a world of difference in the way people trade these days. Gone are the days when traders and brokers jostled, screaming their lungs out in a crowded bullring to make various deals. With the advent of Internet trading there has come about a drastic change in trading. It is now rather quite on the stock market front. After online banking, online trading is probably the biggest revolution unleashed by technological innovation. For the first time in a century and a half, trading power has shifted from stockbrokers to individual investors. This revolution has advanced significantly in the US and is being felt in Europe, Japan, Australia, China and South Korea. Online trading has become quite popular in the last couple of years because of the convenience and ease of use. Online trading has basically replaced a phone call with the Internet. Instead of interacting with the brokers over the phone, consumers are now clicking the mouse. Online trading has given customers access to account information, stock quotes, elaborate market research and interacting.

36

Online trading is the perfect combination of the medium of the net catering to a real life concept. Given that trading is all about having access to multiple information sources, from the company’s performance to the industrial and economic scenarios as well as possessing the analytical tools to process this information, the net is the perfect solution to investor needs. Online trading is all about bringing together under one site all the relevant factors to enable an informed investment at cheaper rates. Through online trading, the securities industry has, for the first time paved the way for implementation of direct order placement, directly onto the broking firms trading system via the Internet. Due to this price setting power for trading execution has shifted from the brokers and traditional stock exchanges to the Electronic Communication Networks (ECN). ADVANTAGES Internet trading has a variety of advantages, and below, a few of them are listed. They are: 1.

Easy access to information and research: Internet brokerage houses offer easily

accessible company information, investment advice, counseling on how to profitably invest and better manage an investors’ portfolio and verity the various portfolio and verify the various tips got from various sources. 2.

Markets on the desktop: Investors do not have to go take the trouble of going to

the stock exchange or to his brokers’ office, the investor has got all he requires on his desktop. 3.

Portfolio management: Investors can track their portfolio performance, that is, it is

faring in the market. If the portfolio is not performing well investors can get advice on restructuring it. 4.

Best prices: Online trading has resulted in a phenomenal reduction in the

transaction cost for the investor as online trading ensures a matching of buying and

37

selling orders within an ENC without the intervention of market markets or traditional stock exchanges. 5.

Liquidity: The liquidity option available for investors has been considerably

stretched as the online trading offers 24 hours trading facilities. 6.

Audit trial: Online trading has imparted greater transparency which is subject to

scrutiny, by providing an audit trial for an investor right at his desk, which earlier, used to stop at his brokers trading terminal. The integrated electronic chain, starting with the order-placement-clearing and settlement function and ending with the credit and settlement function and ending with the credit to the depositary an account of the investor is largely a transparent process. 7.

Benefit of saving: Individual investors can save a lot more through online trading

as the cost per trade while trading online is less. 8.

Variety: Individual invests in a variety of products, unlike earlier when investors

bought bonds, mutual funds and stocks for long-term basis and sat on term. Now individuals can invest in stocks, stick options, mutual funds, individual, government, corporate, municipal bonds, various types of IRA account mortgages and even insurance. DISADVANTAGES A few of the possible disadvantages of online trading can be noted as follows: 1.

Speedy net connection: One the most important requirements for any investor

while trading online is the need for fast internet connection as time is of essence while trading. This has not yet been well established in India. 2.

Guidance: Individuals are restricted to first hand guidance; the individual is the

one to make the own decision, online trading doesn’t help investors while decision making as a broker can. 3.

Crashes: If the network crashes, there will be problems and delays due to large

influx of traffic and rapid online trading criteria. 38

4.

Communication links: There is need more effective communication links over the

internet and the ability of the server to deal with the volume of visitors. Profit is ascertained Payoff For Derivatives Contracts A payoff is the likely profit/loss that would accrue to a market participant with change in the price of the underlying asset. This is generally depicted in the form of payoff diagrams which show the price of the underlying asset on the X–axis and the profits/losses on the Y–axis. Payoff For A Buyer Of Nifty Futures The figure shows the profits/losses for a long futures position. The investor bought futures when the index was at 1220. If the index goes up, his futures position starts making profit. If the index falls, his futures position starts showing losses.

Payoff For A Buyer Of Nifty Futures

39

Futures contracts have linear payoffs. In simple words, it means that the losses as well as profits for the buyer and the seller of a futures contract are unlimited. These linear payoffs are fascinating as they can be combined with options and the underlying to generate various complex payoffs.

Payoff For A Seller Of Nifty Futures The figure shows the profits/losses for a short futures position. The investor sold futures when the index was at 1220. If the index goes down, his futures position starts making profit. If the index rises, his futures position starts showing losses. Payoff For A Seller Of Nifty Future

The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited downside.

40

Payoff For Buyer Of Call Option

Payoff Profile For Buyer Of Call Options – Long Call

A call

option gives the buyer the right to buy the underlying asset at the strike price specified in the option. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. If upon expiration, the spot price exceeds the strike price, he makes a profit. Higher the spot price, more is the profit he makes. If the spot price of the underlying is less than the strike price, he lets his option expire un-exercised. His loss in this case is the premium he paid for buying the option. The figure shows the profits/losses for the buyer of a three-month Nifty 1250 call option. As can be seen, as the spot Nifty rises, the call option is in-the-money. If upon expiration, Nifty closes above the strike of 1250, the buyer would exercise his option and profit to the extent of the difference between the Nifty-close and the strike price. The profits possible on this option are potentially unlimited. However if Nifty falls below the strike of 1250, he lets the option expire. His losses are limited to the extent of the premium he paid for buying the option i.e. Rs.86.6 /Payoff Profile For Writer Of Call Options - Short Call For selling the option, the writer of the option charges a premium. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. 41

Whatever is the buyer’s profit is the seller’s loss. If upon expiration, the spot price exceeds the strike price, the buyer will exercise the option on the writer. Hence as the spot price increases the writer of the option starts making losses. Higher the spot price, more is the loss he makes. If upon expiration the spot price of the underlying is less than the strike price, the buyer lets his option expire unexercised and the writer gets to keep the premium.

Payoff For Writer Of Call Option

The figure shows the profits/losses for the seller of a three-month Nifty 1250 call option. As the spot Nifty rises, the call option is in-the-money and the writer starts making losses . If upon expiration, Nifty closes above the strike of 1250, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the Nifty-close and the strike price. The loss that can be incurred by the writer of the option is potentially unlimited, whereas the maximum profit is limited to the extent of the up-front option premium of Rs.86.60 charged by him. Payoff Profile For Buyer Of Put Options: Long Put A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. If upon expiration, the spot price is below the strike

42

price, he makes a profit. Lower the spot price, more is the profit he makes. If the spot price of the underlying is higher than the strike price, he lets his option expire unexercised. His loss in this case is the premium he paid for buying the option. The below figure shows the profits/losses for the buyer of a three-month Nifty 1250 put option. As can be seen, as the spot Nifty falls, the put option is in-the-money. If upon expiration, Nifty closes below the strike of 1250, the buyer would exercise his option and profit to the extent of the difference between the strike price and Nifty-close. The profits possible on this option can be as high as the strike price. However if Nifty rises above the strike of 1250, he lets the option expire. His losses are limited to the extent of the premium he paid for buying the option i.e. Rs.61.70/-

Payoff For Buyer Of Put Option

Payoff Profile For Writer Of Put Options - Short Put A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. For selling the option, the writer of the option charges a premium. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. Whatever is the buyer’s profit is the seller’s loss. If upon expiration, 43

the spot price happens to be below the strike price, the buyer will exercise the option on the writer. If upon expiration the spot price of the underlying is more than the strike price, the buyer lets his option expire un-exercised and the writer gets to keep the premium. The below figure shows the profits/losses for the seller of a three-month Nifty 1250 put option. As the spot Nifty falls, the put option is in-the-money and the writer starts making losses. If upon expiration, Nifty closes below the strike of 1250, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the strike price and Nifty-close.

Payoff For Writer Of Put Option

The loss that can be incurred by the writer of the option is a maximum extent of the strike price( Since the worst that can happen is that the asset price can fall to zero) 44

whereas the maximum profit is limited to the extent of the up-front option premium of Rs.61.70 charged by him. TRADING STRATEGIES Single Option and Stock These strategies involve using an option along with a position in a stock. Strategy 1: A Covered Call: A long position in stock and short position in a call option. Illustration : An investor enters into writing a call option on one share of Rel. Petrol. At a strike price of Rs.60 and a premium of Rs.6 per share. The maturity date is two months form now and along with this option he/she buys a share of Rel.Petrol. in the spot market at Rs. 58 per share. By this the investor covers the position that he got in on the call option contract and if the investor has to fulfill his/her obligation on the call option then can fulfill it using the Rel.Petrol. share on which he/she entered into a long contract. The payoff table below shows the Net Profit the investor would make on such a deal. Writing a Covered Call Option S

Xt

C

Profit from Net Profit from Share

Profit

Total

writing call

from

Profit

Call Writing

bought

stock 50

60

6

0

6

58

-8

-2

52

60

6

0

6

58

-6

0

54

60

6

0

6

58

-4

2

56

60

6

0

6

58

-2

4

58

60

6

0

6

58

0

6

45

60

60

6

0

6

58

2

8

62

60

6

-2

4

58

4

8

64

60

6

-4

2

58

6

8

66

60

6

-6

0

58

8

8

68

60

6

-8

-2

58

10

8

70

60

6

-10

-4

58

12

8

Strategy 2: Reverse of Covered Call: This strategy is the reverse of writing a covered call. It is applied by taking a long position or buying a call option and selling the stocks. Illustration : An investor enters into buying a call option on one share of Rel. Petrol. At a strike price of Rs.60 and a premium of Rs.6 per share. The maturity date is two months from now 46

and along with this option he/she sells a share of Rel.Petrol. in the spot market at Rs. 58 per share. The payoff chart describes the payoff of buying the call option at the various spot rates and the profit from selling the share at Rs.58 per share at various spot prices. The net profit is shown by the thick line.

47

Strategy 3: Protective Put Strategy: This strategy involves a long position in a stock and long position in a put. It is a protective strategy reducing the downside heavily and much lower than the premium paid to buy the put option. The upside is unlimited and arises after the price rises high above the strike price. Illustration 5: An investor enters into buying a put option on one share of Rel. Petrol. At a strike price of Rs.60 and a premium of Rs.6 per share. The maturity date is two months from now and alongwith this option he/she buys a share of Rel.Petrol. in the spot market at Rs. 58 per share.

48

Protective Put Strategy S

Xt

p

Profit from

Net Profit

Spot Price

buying put

from Buying of Buying

option

put option

Profit from Total stock

Profit

the stock

50

60

-6

10

4

58

-8

-4

52

60

-6

8

2

58

-6

-4

54

60

-6

6

0

58

-4

-4

56

60

-6

4

-2

58

-2

-4

58

60

-6

2

-4

58

0

-4

60

60

-6

0

-6

58

2

-4

62

60

-6

0

-6

58

4

-2

64

60

-6

0

-6

58

6

0

66

60

-6

0

-6

58

8

2

68

60

-6

0

-6

58

10

4

70

60

-6

0

-6

58

12

6

49

Strategy 4: Reverse of Protective Put This strategy is just the reverse of the above and looks at the case of taking short positions on the tock as well as on the put option. Illustration 6: An investor enters into selling a put option on one share of Rel. Petrol. At a strike price of Rs.60 and a premium of Rs.6 per share. The maturity date is two months from now and alongwith this option he/she sells a share of Rel.Petrol. in the spot market at Rs. 58 per share. Reverse of Protective Put Strategy S

50

Xt

60

p

6

Profit from

Net Profit

Spot Price of Profit

writing a put

from Put

Selling the

from

option

Writing

stock

stock

-10

-4 50

58

Total Profit

8

4

52

60

6

-8

-2

58

6

4

54

60

6

-6

0

58

4

4

56

60

6

-4

2

58

2

4

58

60

6

-2

4

58

0

4

60

60

6

0

6

58

-2

4

62

60

6

0

6

58

-4

2

64

60

6

0

6

58

-6

0

66

60

6

0

6

58

-8

-2

68

60

6

0

6

58

-10

-4

70

60

6

0

6

58

-12

-6

51

All the four cases describe a single option with a position in a stock. Some of these cases look similar to each other and these can be explained by Put-Call Parity. Put Call Parity P + S = c + Xe-r(T-t) + D ---------------------- (1) Or S - c = Xe-r(T-t) + D - p ---------------------- (2) The second equation shows that a long position in a stock and a short position in a call is equivalent to the short put position and cash equivalent to Xe-r(T-t) + D. The first equation shows a long position in a stock combined with long put position is equivalent to a long call position plus cash equivalent to Xe-r(T-t) + D. SPREADS The above involved positions in a single option and squaring them off in the spot market. The spreads are a little different. They involve using two or more options of the same type in the transaction. Strategy 1: Bull Spread: The investor expects prices to increase in the future. This makes him purchase a call option at X1 and sell a call option on the same stock at X2, where X1<X2. Using an illustration it would be clear how this is put to use.

Illustration An investor purchases a call option on the BSE Sensex at premium of Rs.450 for a strike price at 4300. The investor squares this off with a sell call option at Rs. 400 for a strike price at 4500. The contracts mature on the same date. The payoff chart below

52

describes the net profit that one earns on the buy call option, sell call option and both contracts together. Payoff From a Bull Spread S

X1

X2

c1

c2

Profit from Net profit Profit form Net

Total

X1

Profit

from X1

X2

Profit from X2

4200 4300

4500

-450

400

0

-450

0

400

-50

4250 4300

4500

-450

400

0

-450

0

400

-50

4300 4300

4500

-450

400

0

-450

0

400

-50

4350 4300

4500

-450

400

50

-400

0

400

0

4400 4300

4500

-450

400

100

-350

0

400

50

4450 4300

4500

-450

400

150

-300

0

400

100

4500 4300

4500

-450

400

200

-250

0

400

150

4550 4300

4500

-450

400

250

-200

-50

350

150

4600 4300

4500

-450

400

300

-150

-100

300

150

4650 4300

4500

-450

400

350

-100

-150

250

150

4700 4300

4500

-450

400

400

-50

-200

200

150

4750 4300

4500

-450

400

450

0

-250

150

150

53

The premium on call with X1 would be more than the premium on call with X2. This is because as the strike price rises the call option becomes unfavourable for the buyer. The payoffs could be generalised as follows. Spot Rate

Profit on

Profit on

Total

long call

short call

Payoff

Net Profit

Which option(s) Exercised

S >= X2

S - X1

X2 - S

X2 - X1

X2 - X1 - c1 +

Both

c2 X1 < S <= X2

S - X1

0

S - X1

S - X1 - c1 +c2

Option 1

S >= X1

0

0

0

c2 - c1

None

The features of the Bull Spread: 54

•

This requires an initial investment.

•

This reduces both the upside as well as the downside potential.

The spread could be in the money, on the money and out of money. Another side of the Bull Spread is that on the Put Side. Buy at a low strike price and sell the same stock put at a higher strike price. This contract would involve an initial cash inflows unlike the Bull Spread based on the Call Options. The premium on the low strike put option would be lower than the premium on the higher strike put option as more the strike price more is favourability to buy the put option on the part of the buyer. Illustration An investor purchases a put option on the BSE Sensex at premium of Rs.50 for a strike price at 4300. The investor squares this off with a sell put option at Rs. 100 for a strike price at 4500. The contracts mature on the same date. The payoff chart below describes the net profit that one earns on the buy put option, sell put option and both contracts together. Payoff From a Bull Spread (Put Options) S

X1

X2

p1

p2

profit from Net profit Profit X1

from X1

Net

Total

from X2 Profit

Profit

from X2 4200 4300

4500

-50

100

100

50

-300

-200

-150

4250 4300

4500

-50

100

50

0

-250

-150

-150

4300 4300

4500

-50

100

0

-50

-200

-100

-150

4350 4300

4500

-50

100

0

-50

-150

-50

-100

4400 4300

4500

-50

100

0

-50

-100

0

-50

55

4450 4300

4500

-50

100

0

-50

-50

50

0

4500 4300

4500

-50

100

0

-50

0

100

50

4550 4300

4500

-50

100

0

-50

0

100

50

4600 4300

4500

-50

100

0

-50

0

100

50

4650 4300

4500

-50

100

0

-50

0

100

50

4700 4300

4500

-50

100

0

-50

0

100

50

4750 4300

4500

-50

100

0

-50

0

100

50

Spot Rate

Profit on

Profit on

long put

short put

Total Payoff

Net Profit

Which option(s) Exercised

S >= X2

0

0

0

p2 - p1

None

X1 < S <= X2

0

S - X2

S - X2

S - X2 - p1 + p2

Option 2

S <= X1

X1 - S

S - X2

X1 - X2

X2 - X1 - p1 + p2 Both

56

1.3 Empirical analysis TABLE NO.1 TABLE SHOWING DIFFERENT TYPE OF INVESTORS investment s

Frequen cy

Long term investor

47

Short term investor

24

Daily trader

29

Graph No.1 57

GRAPH SHOWING DIFFERENT TYPE OF INVESTORS Type of Investors

Analysis : The above table shows the different type of investors long term short term and day trade. As per the graph are 47%long term, 24% are short term and 29% are day trader.

Interpretation : Out of the 100 investors surveyed 47 investors are long term investors which makes a percent of 47%. Here investors who have an investment of three months or more than three months are called long term investors. Investors with an investment period in between one to three months are called short term investors. About 29 percent of the investors are day traders who buy and sell on the same date.

TABLE NO.2 TABLE SHOWING THE PERCENTAGE OF INVESTMENT IN DERIVATIVES Frequency Less than 20 %

37

20%-40%

28

40%-60%

19 58

Above 60%

16

GRAPH NO.2 GRAPH SHOWING THE PERCENTAGE OF INVESTMENT IN DERIVATIVES

Analysis : The above table shows the percentage of investment in derivatives. As per the table 37% investors invest in less than 20% derivatives.

Interpretation : Around 37 percent of the investors invest less than twenty percent of their investment into derivatives. And around 28 percent allocate 20% to 40% into derivatives.

TABLE NO.3 TABLE SHOWING THE INFORMATION USED FOR TRADE IN DERIVATIVES Frequency Technical information

10

Market information

25 59

Individual analysis

45

All the above

20

GRAPH NO.3 GRAPH SHOWING THE INFORMATION USED FOR TRADE IN DERIVATIVES

Analysis : The above table shows that different information used for derivatives trading such as technical information, market information and individual analysis. As per the graph 45% investor go by their by their individual analysis.

Interpretation : On the question about the information used in order to trade in derivatives it was found that around 45% of the investors go by their individual analysis before investing.

TABLE NO.4 TABLE SHOWING THE INSTRUMENTS TRADED IN DERIVATIVES Frequency 60

futures

69

options

31

GRAPH NO.4 GRAPH SHOWING THE INSTRUMENTS TRADED IN DERIVATIVES

Analysis : The above table shows the investors trading future and option.

As per graph

investors in futures are more compared to the investors in option.

Interpretation : 69% of the investors have traded in Futures segment and around 31 percent of the traders traded in options. So investors are favoring futures than options.

TABLE NO.5 TABLE SHOWING THE MOST INSTRUMENTS

Frequency 61

Stock index futures Futures on individual stocks Stock index options Options on individual stocks

40 35 11 14

GRAPH NO.5 GRAPH SHOWING THE MOST FAVORED DERIVATIVES IN INSTRUMENT

Analysis : The above table shows the instruments traded in derivatives. out of 100 respondents 69 invest in futures and 31 invest in option.

Interpretation : When asked about the most favored derivative instruments, forty percent of the investors favored index futures and 35% of the investor went for futures on individual stocks. So it is obvious that options are still not favored by investors.

TABLE NO.6 TABLE SHOWING THE DIFFERENT CONTRACTS ENTERED Frequency index futures index options stock futures stock options

24 14 43 19 62

GRAPH NO.6 GRAPH SHOWING THE DIFFERENT CONTRACTS ENTERED

Analysis : The above table shows that 24 respondents invest in index futures , 43invest in stock future and 19 in stock options.

Interpretation : Around 43 percent of the respondents have entered into stock futures contract.

TABLE NO.7 TABLE SHOWING THE BEST DERIVATIVES Frequency Hedging

35

Speculation

65

GRAPH NO.7 GRAPH SHOWING THE BEST DERIVATIVES Hedging vs. Speculations 63

Analysis: The above table shows the best for derivatives out of 100 respondents 65 investors prefer hedging and 35 investors prefer speculation.

Interpretation: More than 65% traders feel that Derivative is best for speculation than for hedging. Out of 100 investors 35 were favoring derivative as a speculative instrument. Traders mainly want to make short term gain by investing into Derivatives then for using Derivative as an instrument to reduce the market risk.

TABLE NO.8

TABLE SHOWING STRATEGY USED FOR HEDGING Frequency Long & Short Futures Short stock & Long Futures Long & Shot Call Short Stock & Long Call Long Stock & Long Put Short Stock & Short Put Long Index futures & Short stock Short Index Futures & Long Stock

35 14 11 15 7 7 6 5

GRAPH NO.8 GRAPH SHOWING STRATEGY USED FOR HEDGING 64

Analysis: The above table shows 35 respondents prefer long and short futures hedging, 14 prefer short and long futures, 11long and short call, 15short stock and long call, 7 long stock and long put, 7 in short stock and short put, 6 in long index future and short stock, 5 in short index future and long stock.

Interpretation: Among the strategies used for hedging Short Stock & Long Call have used as the most used strategy.

TABLE NO.9 TABLE SHOWING THE STRATEGIES USED FOR HEDGING IN A BULLISH MARKET

Frequency long futures

34

long call

23

long index futures

18

long index call

25

65

GRAPH NO.9 GRAPH SHOWIN THE STRATEGOES USED FOR HEDGING IN A BULLISH MARKET

Analysis : The above table shows 34& respondents prefer long index future, 23% prefer long index call, 18% prefer long call, 25% prefer long future.

Interpretation : Among the strategies used for hedging in a bullish market, Long Index Futures is being preferred by majority of the respondent

TABLE NO.10 TABLE SHOWING STRATEGIES USED IN A BEARISH MARKET Frequency short futures

36

short index futures

19

short call

29

short index call

16

Graph No.10

66

GRAPH SHOWING STRATEGIES USED IN A BEARISH MARKET

Analysis : The above table shows

36%respondents prefer short futures in bearish

market, 19% prefers short calls, 29% prefers short index future and 16% prefer short index call.

Interpretation : In a bearish market, the most preferred strategy is Index Future short call and its percentage is 29%.

TABLE NO.11 TABLE SOWING EXPECTED RISH REWARD RATIO Frequency 1:0.2

32

1:0.4

23

1:0.6

22

1:0.8

10

1:1

13 67

Graph No.11 GRAPH SHOWING EXPECTED RISK-REWARD RATIO

ANALYSIS: The above table shows that out of total respondent 27 respondents expect 1:0.4 risk reward ratio, 21 expect 1:0.6, 8 expect 1:0.8, and the remaining 14 respondent expects 1:1 ratio.

Interpretation : Around 38 percent of the investors are looking out for an annual return of 40 percent from their investments. And 20 percent of the respondents have a high expectation of 100 percent return.

TABLE NO.12 TABLE SHOWING GROWTH RATE IN OPTIONS IN INDIA Frequency Grow very fast Grow Moderately Not Much Growth Can't Say anything

15 19 11 25

Graph No.12 GRAPH SHOWING GROWTH RATE IN OPTIONS IN INDIA 68

Analysis : The above table shows the growth rate in options in India. Fast growth frequency is 21%, moderate growth frequency is 27% , no much growth is 16% , no idea frequency is 36%.

Interpretation. More than 36 percent of the investors are still don't have any idea about the future growth of the Option market in India, And 27% respondents feel that the option market would grow moderately. And 21 percent expect the market to grow very fast.

TABLE NO.13 TABLE SHOWING INTERESTED CONTRACT MATURITY PERIOD FOR INDEX FUTURES & OPTIONS Frequency Current

45

Next month

35

Forward month

20

Graph No.13 GRAPH SHOWING INTERESTED CONTRACT MATURITY PERIOD FOR INDEX FUTURES & OPTIONS

69

Analysis: The above table shows the interested contract maturity period for index futures and options for current month is 45, next month 35 and forward month 20.

Interpretation: More than 35 percent of the respondents are favoring Next Month contract and its percentage is 43%.

TABLE NO.14 TABLE SHOWING INTERESTED CONTRACT MATURITY PERIOD FOR FUTURES AND OPTIONS ON INDIVIDUAL STOCKS

Frequency Current

45

Next month

31

forward month

24

Graph No.14 70

GRAPH SHOWING INTERESTED CONTRACT MATURITY PERIOD FOR FUTURES AND OPTIONS ON INDIVIDUAL STOCKS

Analysis: The above table shows the frequency of future and option on individual stock for current month is 45, for next month is 31 and for forward month is 24.

Interpretation: F&O On individual stocks are mainly favored on the current month contract, And the for month contract is least liked by the investors.

TABLE NO.16 TABLE SHOWING THE AGE GROUP Frequency below 25

41

26-40

29

41-60

19

61 & above

11

Graph No.16 GRAPH SHOWING THE AGE GROUP 71

Analysis:

The above table shows that out of the total respondents 42 are below 25 years of age, 29 are between 26 and 40, and remaining 29 are above 60 years.

Interpretation: Most of the respondents are of age group below 25 years and the percentage is 41

TABLE NO.17 TABLE SHOWING OCCUPATION OF INVESTORS Frequency Business

28

Salaried

45

Professional

21

Others

6

Graph No.17 SHOWING OCCUPATION OF INVESTORS

Analysis:

72

The above table shows that out of total respondents 28 are engaged in business, 21 are professionals and remaining 45 are salaried.

Interpretation: Most of the respondents are professionals and their percentage is 55.7.

TABLE NO.18 TABLE SHOWING MONTHLY INCOME OF INVESTORS Frequency less than 10000

14

10000 - 30000

33

300000-50000

28

Above 50000

25

Graph No.18 GRAPH SHOWING MONTHLY INCOME OF INVESTORS

Analysis: The table shows the monthly income of investors out of total respondents 9 earn less than 10000, 23 earn 10000 - 30000, 18 earns 30000 - 50000, 20 earns above 50000.

Interpretation:

73

Most of respondents have the income between 10000 - 30000 and its percentage is 39.

1.5 FINDINGS

1. Around 41 percent of the investors invest less than twenty percent of their investment in derivatives. And around 37 percent allocate 20% to 40% into derivatives. So even normally the derivative market transaction volume is four times of the Spot market's volume the allocation into derivatives is less than the investment into the Spot market. 2. It was found that around 73 %of the investors go by their individual analysis before investing..and only 37% of the investors take into consideration technical analysis before making a decision. 57% of the investors take market information such as news from the broker, friends, market experts etc. Investors are not confident on the research report on various stocks mainly due to its variance from the actual happenings in the market. Investors generally feel

that only the research reports on sectors and macro economic 74

research provide some valid in formation upon which the analysis on different stocks can start. 3. When asked about the most favoured derivative instruments, fifty percent of the investors favoured index futures and 42% of the investor went for futures on individual stocks. So it is obvious that options are still not favored by investors. The retail investors are reluctant to go by options mainly due to the low liquidity in the Option's market. 4. More than fifty Percent traders feel that Derivative is best for speculation than for hedging. Out of 70 investors 46 were favouring derivative as a speculative instrument. Traders mainly want to make short term gain by investing into Derivatives then for using Derivative as an instrument to reduce the market risk. 5.

One major finding is that the investors do not know much about the various derivative strategies. They just come and invest in derivatives based on some analysis. Though there are many strategies which helps to reduce the market risk many are not aware of it. Only 60 percent have used this Long Stock & Short Futures Strategy in an undervalued spot market. And only 35 percent went for Short stock & long futures strategy. And around 22.9 percent of the total respondents have used long stock & short call strategy So traders are not interested in all of these strategies either due to less knowledge or because they are much interested in speculation than hedging. 70 percent of the respondents have applied the Short stock & Long call strategy.48.6 percent went through Long stock & Long put strategy. Only 17 percent of the investors have used this Long index Futures and Short stock.

6. Around 33 percent of the respondents have applied this short Index Futures and long stock. 7. The various strategies used by investors is that around 98 %of the'- respondents went Long in Futures with a speculative motive Tn a bullish market. Around 75 percent of the respondents have used Long call as speculative strategy. And Only 64 percent of the of investors went for long In Call.

75

8. So percent of the respondents Short Futures as the market seemed to be bearish. 67 percent went for short call in a bearish market. 9. Around 38 percent of the investors are looking out for an annual return of 40 percent from their investments. And 20 percent of the respondents have a high expectation of 100 percent return. So the investors are rich in their expectations. 10.More

than 35 percent of the investors are still don't have any idea about the future growth

of the Option market in India. And 19 percent respondents feel that the Option market would grow moderately. And 21 percent expect the market to grow very fast. But anyway the Option market is not efficient in India as other developed market have. India Option segment is mainly lagging behind liquidity problem as there is less number of participants. 11. More than 40 percent of the respondents are favouring Next month contract In index Futures and options and far month contract is least liked by the respondents. Only 17 percent of the investors are favouring Far month contract In index F&O segment. 12. .Future & Option on individual stocks are mainly favoured on the current month contract. And the far month contract is least liked by the investors. 13.On

the question about the growth of the market indices one year down the line around 78

percent of the respondents expect the market to on a range of 30 – 50 percent. And 21 percent of the traders expect the market to grow by more than 50 percent. So even if the market crashed from the highest-level 12k many feel that the market would grow than fifty percent.

1.6 SUGGESTIONS 1. This study reveals that among investors the knowledge about the various Derivative strategies is limited, thereby not making an exact investment strategy which matches with the financial goals of the investors. 76

2. This study also focused on the effectiveness of hedging. In the recent market crash those who have hedges their position had made only a limited loss or no losses give importance to the effectiveness of hedging. 3. The usage of option market should be adequate with respect to the market conditions in order to protect the position from the market risk arising from market volatility. 4. More of retail participation would bring more liquidity into the system and make Option market very aggressive.

1.7 CONCLUSION

77

Though trading in derivative instruments is riskier it is catching the attention of traders very rapidly due to its specialty such as margin payment system, short term nature etc. There are many important functions done by these derivative instruments in the financial system of a country. Numerous studies have led to a broad consensus, both in the private and public sectors, that derivatives provide substantial benefits to the users. Derivatives are a low-cost, effective method for users to hedge and manage their exposures to interest 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 strengthened these important linkages among global markets, increasing market liquidity and efficiency, and facilitating the flow of trade and finance. So now within a short span of time derivative instruments have become essential parts of investment even for medium term investors.

78

2. APPENDICES Respected Sir, My name is DINESH KUMAR.R currently pursuing MBA at Magnus School of Business. I am doing a research on “DERIVATIVE MARKET IN INDIA” I solicit your kind assistance by this questionnaire to conduct this research. The findings of the survey will be used strictly for academic purpose only. Personal Details Name

:_______________________________________________

E-Mail :

_______________________________________________

Age Group:

Below 25

Occupation:

Business

26-40 salaried

41-60

61 & Above

Professional

Others__________

Monthly Income: [ ] Less than 10000

[ ] 10000-300000

[ ] 30000 – 500000

[ ] Above 500000

1. Are you a __________________ [ ] Long term investor

[ ] Short Term Investor

[ ] Daily trader 2. What percent of your total investment you allocate into Derivatives? [ ] Less than 20% [ ] 40% - 60%

[ ] 20% - 40% [ ] Above 60%

3. You trade in Derivatives by using______________________ [ ] Technical Information

[ ] Market Information

[ ] Individual Analysis

[ ] All the Above.

4. What are the instruments you trade in Derivatives? [ ] Futures

[ ] Options

5. Which of the following do you favor most? [ ] Stock index future

[ ] Stock index options 79

[ ] Futures on individual stocks

[ ] Options on individual stocks

6. The contracts you entered into are _________________ [ ] Index futures

[ ] Index options

[ ] Stock future

[ ] Stock options

7. In you opinion Derivative is best for [ ] Hedging

[ ] Speculation

8. If Hedging, what are the strategies you make use of to get maximum benefit of market ______________ [ ] Long stock & short futures

[ ] Short stock & long futures

[ ] Long stock 7 short call

[ ] Short stock & long Call

[ ] Long stock & Long put

[ ] Short Stock & Short Put

[ ] Long index futures & short Stock

[ ] Short index futures and Long stock

9.If speculation, What are the strategies you make use of to get maximum return from a bullish market.____________ [ ] Long futures

[ ] Long Call

[ ] Long Index futures

[ ] Long index Call

10.What are the strategies you make use of in a bearish market [ ] Short futures

[ ] Short Call

[ ] Short index futures

[ ] Short index Call

11. What kind of Risk-Reward you expect from your trading [ ] 1:0.2

[ ] 1:0.4

[ ] 1:0.6

[ ] 1:0.8

[ ] 1:1 12.Do you expect that the trading in Options in India will [ ] Grow very fast

[ ] Grow moderately

[ ] Not grow much

[ ] Can’t say anything

13.What contact period would interest you for trading in ------------? 80

[ ] Current

[ ] Next Month

[ ] Forward month

14.Futures and option on individual stocks_________________ [ ] Current

[ ] Next month

[ ] Forward month

3. REFERENCES

WEB: •

www.lem.com

•

www.cbot.com

•

www.bseindia.com

•

www.moneycontrol.com

•

www.amfiindia.com

•

www.indiamutual.com

•

www.derivativesindia.com

BOOKS: •

AMFI COURSE BOOK

81

4. GLOSSARY Here are some of the related terms and terminology used in Options and Futures Trading. Bid - The highest offered price at a specified time. Black-Scholes Model – A theoretical method of pricing using strike price, market price, interest rates, expiration date and other factors. Butterfly Spread – A trading strategy consisting of the purchase of two identical options, together with the sale of one option with a higher strike price, and one option with an lower strike price. (All options are of the same type, have the same underlying asset and the same expiration date.) Calendar Spread – A trading strategy consisting of one long and one short option of the same type with the same exercise price, but which expire in different months. Call – An options contract conferring the right to buy an underlying asset, such as 100 shares of stock, at a pre-set price, by a specified date. Condor – A trading strategy consisting of the sale (or purchase) of two options with consecutive exercise prices, together with the sale (or purchase) of one option with a lower exercise price and one option with a higher exercise price.

82

Covered Call – A trading strategy which consists of holding a long position in an asset and selling call options on that same asset. Delta - A ratio comparing the change in the price of an option to that of a change in the underlying asset. Exercise Price – See Strike Price Hedge – A technique of reducing risk by taking positions which tend to move in opposite directions. Historic Volatility – (See Volatility) Calculated by using the standard deviation of underlying asset price changes from close to close trading for the prior 21 days. Holder – The buyer of an option. (See Writer) In-the-Money - A (call/put) option is in-the-money if the strike price is (less/more) than the market price of the underlying security. Intrinsic Value - The difference between the underlying asset's price and the strike price. (For both puts and calls, if the difference is negative, the value is given as zero.) Last Trading Day - This is the final day when trading may occur in a given futures or options contract month. Futures contracts outstanding at the end of the last trading day must be settled by delivery of the underlying commodity or securities or by agreement for monetary settlement. Naked Option - An option written (sold) without a position in the underlying asset. Option – A contract to buy (call) or sell (put) an underlying asset at a pre-set price by ('American style') or on ('European style') a specified date. Open Interest - The total number of options contracts not closed or delivered on a given day. Out-of-the-Money - An option whose exercise price has no intrinsic value. Premium - The price an option buyer pays to an option seller. 83

Put - An option contract granting the right to sell an asset at a pre-set price within a specified time. Straddle - A trading strategy consisting of a long (short) call and a long (short) put, in which both options have the same strike price and expiration date. Strangle - A trading strategy consisting of a long (short) call and a long (short) put in which both options have the same expiration date, but different strike prices. Strike Price - The price at which an underlying asset must be bought (call) or sold (put), if an option is exercised. Time Value - The amount by which the current market price of a option exceeds its intrinsic value. Volatility - A measurement of degree of change in price over a specified period of time. Writer - The seller of either a call or put option

84