Workbook for

NISM-Series-VIII:
Equity Derivatives
Certification Examination

National Institute of Securities Markets

www.nism.ac.in

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This workbook has been developed to assist candidates in preparing for the National Foreword
Institute of Securities Markets (NISM) NISM-Series-VIII: Equity Derivatives
NISM is a leading provider of high end professional education, certifications, training
Certification Examination (NISM-Series-VIII: ED Examination).
and research in financial markets. NISM engages in capacity building among
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Workbook Version: January 2020 NISM Certification programs aim to enhance the quality and standards of professionals
employed in various segments of the financial services sector. NISM’s School for
Certification of Intermediaries (SCI) develops and conducts certification examinations
and Continuing Professional Education (CPE) programs that aim to ensure that
Published by: professionals meet the defined minimum common knowledge benchmark for various
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NISM supports candidates by providing lucid and focused workbooks that assist them in
Website: www.nism.ac.in understanding the subject and preparing for NISM Examinations. The book covers basics
of the equity derivatives, trading strategies using equity futures and equity options,
clearing, settlement and risk management as well as the regulatory environment in
which the equity derivatives markets operate in India. It will be immensely useful to all
those who want to have a better understanding of various derivatives products available
in Indian equity derivatives markets.

S.K. Mohanty
All rights reserved. Reproduction of this publication in any form without prior permission Director
of the publishers is strictly prohibited.

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Disclaimer About NISM Certifications
The contents of this publication do not necessarily constitute or imply its endorsement, The School for Certification of Intermediaries (SCI) at NISM is engaged in developing and
recommendation, or favoring by the National Institute of Securities Markets (NISM) or administering Certification Examinations and CPE Programs for professionals employed
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The statements/explanations/concepts are of general nature and may not have taken
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into account the particular objective/ move/ aim/ need/ circumstances of individual
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Therefore, before acting on or following the steps suggested on any theme or before of required functional knowledge through Certification Examinations and Continuing
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The publication contains information, statements, opinions, statistics and materials that Certification creates quality market professionals and catalyzes greater investor
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have made best efforts to avoid any errors. However, publishers of this material offer no students and job aspirants in the securities markets.
guarantees and warranties of any kind to the readers/users of the information About the NISM-Series-VIII: Equity Derivatives Certification Examination
contained in this publication.
The examination seeks to create a common minimum knowledge benchmark for
Since the work and research is still going on in all these knowledge streams, NISM and associated persons functioning as approved users and sales personnel of the trading
SEBI do not warrant the totality and absolute accuracy, adequacy or completeness of member of an equity derivatives exchange or equity derivative segment of a recognized
this information and material and expressly disclaim any liability for errors or omissions stock exchange.
in this information and material herein. NISM and SEBI do not accept any legal liability
The examination aims to enable a better understanding of various derivatives products
whatsoever based on any information contained herein.
available in equity derivatives markets, regulations and risks associated with the
While the NISM Certification examination will be largely based on material in this products and the exchange mechanisms of clearing and settlement. The examination
workbook, NISM does not guarantee that all questions in the examination will be from also covers knowledge competencies related to the understanding of the financial
material covered herein. structure in India and the importance of the different rules and regulations governing
the Indian securities market, especially those related to the equity derivatives segment.
Acknowledgement Examination Objectives
This workbook has been jointly developed by the Certification Team of National Institute On successful completion of the examination the candidate should:
of Securities Markets and Mr. Manish Bansal and Mr. Ashutosh Wakhare of Value Ideas  Know the basics of the Indian equity derivatives market.
Investment Services Pvt. Ltd.  Understand the various trading strategies that can be built using futures and
options on both stocks and stock indices.
NISM gratefully acknowledges the contribution of the Examination Committee for NISM-
 Understand the clearing, settlement and risk management as well as the
Series-VIII: Equity Derivatives Certification Examination consisting of representatives of
operational mechanism related to equity derivatives markets.
the equity derivatives exchanges and industry experts.
 Know the regulatory environment in which the equity derivatives markets
operate in India.

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Assessment Structure Table of Contents
The NISM-Series-VIII: Equity Derivatives Certification Examination (NISM-Series-I: ED
Examination) will be of 100 marks consisting of 100 questions of 1 mark each, and Chapter 1: Basics of Derivatives...................................................................................9
1.1 Basics of Derivatives ..................................................................................................... 9
should be completed in 2 hours. There will be negative marking of 25% of the marks
1.2 Derivatives Market – History & Evolution .................................................................... 9
assigned to each question. The passing score for the examination is 60%.
1.3 Indian Derivatives Market ........................................................................................... 10
How to register and take the examination 1.4 Market Participants .................................................................................................... 11
1.5 Types of Derivatives Market ....................................................................................... 12
To find out more and register for the examination please visit www.nism.ac.in 1.6 Significance of Derivatives .......................................................................................... 13
1.7 Various risks faced by the participants in derivatives ................................................ 13

Chapter 2: Understanding Index ................................................................................ 14

2.1 Introduction to Index .................................................................................................. 14
2.2 Significance of Index ................................................................................................... 14
2.3 Types of Stock Market Indices .................................................................................... 14
2.4 Attributes of an Index ................................................................................................. 17
2.5 Index management ..................................................................................................... 18
2.6 Major Indices in India.................................................................................................. 19
2.7 Application of Indices.................................................................................................. 19

Chapter 3: Introduction to Forwards and Futures ...................................................... 20

3.1 Introduction to forward and futures Contracts .......................................................... 20
3.2 Pay off Charts for Futures contract............................................................................. 28
3.3 Futures pricing ............................................................................................................ 30
3.4 Commodity, Equity & Index Futures ........................................................................... 35
3.5 Uses of futures ............................................................................................................ 35

Chapter 4: Introduction to Options............................................................................ 46

4.1 Basics of options ......................................................................................................... 46
4.2 Pay off Charts for Options ........................................................................................... 49
4.3 Basics of Option Pricing and Option Greeks ............................................................... 57
4.4 Uses of Options ........................................................................................................... 60

Chapter 5: Option Trading Strategies ......................................................................... 67

5.1 Option Spreads............................................................................................................ 67
5.2 Straddle ....................................................................................................................... 74
5.3 Strangle ....................................................................................................................... 78
5.4 Covered Call ................................................................................................................ 81
5.5 Protective Put ............................................................................................................. 84
5.6 Collar ........................................................................................................................... 85
5.7 Butterfly Spread .......................................................................................................... 87

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Chapter 6: Introduction to Trading Systems ............................................................... 90 Chapter 1: Basics of Derivatives
6.1 Trading System............................................................................................................ 90
6.2 Selection criteria of Stocks for trading ....................................................................... 95 LEARNING OBJECTIVES:
6.3 Selection criteria of Index for trading ......................................................................... 97 After studying this chapter, you should know about:
6.4 Adjustments for Corporate Actions ............................................................................ 97  Meaning of derivatives and types of derivatives products
6.5 Position Limit ............................................................................................................ 100  History of derivatives market
6.6 Using Daily Newspapers to Track Futures and Options ............................................ 101  Significance of derivative markets
 Risks in derivatives trading
Chapter 7: Introduction to Clearing and Settlement System ..................................... 103
7.1 Clearing Members ..................................................................................................... 103 1.1 Basics of Derivatives
7.2 Clearing Mechanism ................................................................................................. 104 Derivative is a contract or a product whose value is derived from value of some other
7.3 Settlement Mechanism ............................................................................................. 105 asset known as underlying. Derivatives are based on wide range of underlying assets.
7.4 Risk Management ..................................................................................................... 109 These include:
7.5 Margining and mark to market under SPAN............................................................. 110  Metals such as Gold, Silver, Aluminium, Copper, Zinc, Nickel, Tin, Lead etc.
 Energy resources such as Oil (crude oil, products, cracks), Coal, Electricity,
Chapter 8: Legal and Regulatory Environment ......................................................... 115 Natural Gas, etc.
8.1 Securities Contracts (Regulation) Act, 1956 ............................................................. 115  Agri commodities such as wheat, Sugar, Coffee, Cotton, Pulses etc, and
8.2 Securities and Exchange Board of India Act, 1992 ................................................... 116  Financial assets such as Shares, Bonds and Foreign Exchange.
8.3 Regulation in Trading ................................................................................................ 117
8.4 Regulations in Clearing & Settlement and Risk Management .................................. 119
1.2 Derivatives Market – History & Evolution
8.5 Major recommendations of Dr. L.C.Gupta Committee ............................................ 121
8.6 Major recommendations of Prof. J.R.Verma Committee ......................................... 123 History of Derivatives may be mapped back to the several centuries. Some of the
specific milestones in evolution of Derivatives Market Worldwide are given below:
Chapter 9: Accounting and Taxation ........................................................................ 124 12th Century- In European trade fairs, sellers signed contracts promising future delivery
9.1 Accounting ................................................................................................................ 124 of the items they sold.
9.2 Taxation of derivative transaction in securities ........................................................ 131
13th Century- There are many examples of contracts entered into by English Cistercian
Monasteries, who frequently sold their wool up to 20 years in advance, to foreign
Chapter 10: Sales Practices and Investors Protection Services .................................. 134
merchants.
10.1 Understanding risk profile of the client .................................................................. 136
10.2 Investors Grievance Mechanism............................................................................. 142 1634-1637 - Tulip Mania in Holland: Fortunes were lost in after a speculative boom in
tulip futures burst.
Appendix A: Sample Questions.….............................................................................150 Late 17th Century- In Japan at Dojima, near Osaka, a futures market in rice was
developed to protect rice producers from bad weather or warfare.
In 1848, The Chicago Board of Trade (CBOT) facilitated trading of forward contracts on
various commodities.
In 1865, the CBOT went a step further and listed the first ‘exchange traded” derivative
contract in the US. These contracts were called ‘futures contracts”.
In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, was reorganised to allow
futures trading. Later its name was changed to Chicago Mercantile Exchange (CME).
In 1972, Chicago Mercantile Exchange introduced International Monetary Market
(IMM), which allowed trading in currency futures.

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In 1973, Chicago Board Options Exchange (CBOE) became the first marketplace for 2000. Later, trading in Index options commenced in June 2001 and trading in options on
trading listed options. individual stocks commenced in July 2001. Futures contracts on individual stocks started
In 1975, CBOT introduced Treasury bill futures contract. It was the first successful pure in November 2001. Metropolitan Stock Exchange of India Limited (MSEI) started trading
interest rate futures. in derivative products in February 2013.

In 1977, CBOT introduced T-bond futures contract. Products in Derivatives Market

Forwards
In 1982, CME introduced Eurodollar futures contract.
It is a contractual agreement between two parties to buy/sell an underlying asset at a
In 1982, Kansas City Board of Trade launched the first stock index futures. certain future date for a particular price that is pre-decided on the date of contract.
In 1983, Chicago Board Options Exchange (CBOE) introduced option on stock indexes Both the contracting parties are committed and are obliged to honour the transaction
with the S&P 100® (OEX) and S&P 500® (SPXSM) Indexes. irrespective of price of the underlying asset at the time of delivery. Since forwards are
negotiated between two parties, the terms and conditions of contracts are customized.
Factors influencing the growth of derivative market globally
These are Over-the-counter (OTC) contracts.
Over the last four decades, derivatives market has seen a phenomenal growth. Many
derivative contracts were launched at exchanges across the world. Some of the factors Futures
driving the growth of financial derivatives are: A futures contract is similar to a forward, except that the deal is made through an
organized and regulated exchange rather than being negotiated directly between two
 Increased fluctuations in underlying asset prices in financial markets. parties. Indeed, we may say futures are exchange traded forward contracts.
 Integration of financial markets globally.
 Use of latest technology in communications has helped in reduction of Options
transaction costs. An Option is a contract that gives the right, but not an obligation, to buy or sell the
 Enhanced understanding of market participants on sophisticated risk underlying on or before a stated date and at a stated price. While buyer of option pays
management tools to manage risk. the premium and buys the right, writer/seller of option receives the premium with
 Frequent innovations in derivatives market and newer applications of products. obligation to sell/ buy the underlying asset, if the buyer exercises his right.
Swaps
1.3 Indian Derivatives Market A swap is an agreement made between two parties to exchange cash flows in the future
As the initial step towards introduction of derivatives trading in India, SEBI set up a 24– according to a prearranged formula. Swaps are, broadly speaking, series of forward
member committee under the Chairmanship of Dr. L. C. Gupta on November 18, 1996 to contracts. Swaps help market participants manage risk associated with volatile interest
develop appropriate regulatory framework for derivatives trading in India. The rates, currency exchange rates and commodity prices.
committee submitted its report on March 17, 1998 recommending that derivatives
should be declared as ‘securities’ so that regulatory framework applicable to trading of 1.4 Market Participants
‘securities’ could also govern trading of derivatives. Subsequently, SEBI set up a group in There are broadly three types of participants in the derivatives market - hedgers, traders
June 1998 under the Chairmanship of Prof. J.R.Verma, to recommend measures for risk (also called speculators) and arbitrageurs. An individual may play different roles in
containment in derivatives market in India. The committee submitted its report in different market circumstances.
October 1998. It worked out the operational details of margining system, methodology
Hedgers
for charging initial margins, membership details and net-worth criterion, deposit
They face risk associated with the prices of underlying assets and use derivatives to
requirements and real time monitoring of positions requirements.
reduce their risk. Corporations, investing institutions and banks all use derivative
In 1999, The Securities Contract Regulation Act (SCRA) was amended to include products to hedge or reduce their exposures to market variables such as interest rates,
“derivatives” within the domain of ‘securities’ and regulatory framework was developed share values, bond prices, currency exchange rates and commodity prices.
for governing derivatives trading. In March 2000, government repealed a three-decade-
Speculators/Traders
old notification, which prohibited forward trading in securities.
They try to predict the future movements in prices of underlying assets and based on
The exchange traded derivatives started in India in June 2000 with SEBI permitting BSE the view, take positions in derivative contracts. Derivatives are preferred over
and NSE to introduce equity derivative segment. To begin with, SEBI approved trading in underlying asset for trading purpose, as they offer leverage, are less expensive (cost of
index futures contracts based on Nifty and Sensex, which commenced trading in June

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transaction is generally lower than that of the underlying) and are faster to execute in anonymous auction platform. A clearing corporation, guarantees contract performance
size (high volumes market). (settlement of transactions).
Arbitrageurs
Arbitrage is a deal that produces profit by exploiting a price difference in a product in 1.6 Significance of Derivatives
two different markets. Arbitrage originates when a trader purchases an asset cheaply in Like other segments of Financial Market, Derivatives Market serves following specific
one location and simultaneously arranges to sell it at a higher price in another location. functions:
Such opportunities are unlikely to persist for very long, since arbitrageurs would rush in  Derivatives market helps in improving price discovery based on actual valuations
to these transactions, thus closing the price gap at different locations. and expectations.
 Derivatives market helps in transfer of various risks from those who are exposed
1.5 Types of Derivatives Market to risk but have low risk appetite to participants with high risk appetite. For
In the modern world, there is a huge variety of derivative products available. They are example, hedgers want to give away the risk where as traders are willing to take
either traded on organised exchanges (called exchange traded derivatives) or agreed risk.
directly between the contracting counterparties over the telephone or through  Derivatives market helps shift of speculative trades from unorganized market to
electronic media (called Over-the-counter (OTC) derivatives). Few complex products are organized market. Risk management mechanism and surveillance of activities of
constructed on simple building blocks like forwards, futures, options and swaps to cater various participants in organized space provide stability to the financial system.
to the specific requirements of customers.
Over-the-counter market is not a physical marketplace but a collection of broker-dealers 1.7 Various risks faced by the participants in derivatives
scattered across the country. Main idea of the market is more a way of doing business Market Participants must understand that derivatives, being leveraged instruments,
than a place. Buying and selling of contracts is matched through negotiated bidding have risks like counterparty risk (default by counterparty), price risk (loss on position
process over a network of telephone or electronic media that link thousands of because of price move), liquidity risk (inability to exit from a position), legal or
intermediaries. OTC derivative markets have witnessed a substantial growth over the regulatory risk (enforceability of contracts), operational risk (fraud, inadequate
past few years, very much contributed by the recent developments in information documentation, improper execution, etc.) and may not be an appropriate avenue for
technology. The OTC derivative markets have banks, financial institutions and someone of limited resources, trading experience and low risk tolerance. A market
sophisticated market participants like hedge funds, corporations and high net-worth participant should therefore carefully consider whether such trading is suitable for
individuals. OTC derivative market is less regulated market because these transactions him/her based on these parameters. Market participants, who trade in derivatives are
occur in private among qualified counterparties, who are supposed to be capable advised to carefully read the Model Risk Disclosure Document, given by the broker to his
enough to take care of themselves. clients at the time of signing agreement.

The OTC derivatives markets – transactions among the dealing counterparties, have Model Risk Disclosure Document is issued by the members of Exchanges and contains
following features compared to exchange traded derivatives: important information on trading in Equities and F&O Segments of exchanges. All
prospective participants should read this document before trading on Capital
 Contracts are tailor made to fit in the specific requirements of dealing Market/Cash Segment or F&O segment of the Exchanges.
counterparties.
 The management of counter-party (credit) risk is decentralized and located within
individual institutions.
 There are no formal centralized limits on individual positions, leverage, or
margining.
 There are no formal rules or mechanisms for risk management to ensure market
stability and integrity, and for safeguarding the collective interest of market
participants.
 Transactions are private with little or no disclosure to the entire market.
On the contrary, exchange-traded contracts are standardized, traded on organized
exchanges with prices determined by the interaction of buyers and sellers through

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Chapter 2: Understanding Index Let us understand the concept with the help of an example: There are five stocks in an
index. Base value of the index is set to 100 on the start date which is January 1, 1995.
LEARNING OBJECTIVES: Calculate the present value of index based on following information.
After studying this chapter, you should know about:
Stock price as Number Today’s
 Meaning of Index and its significance Sr. Stock on January 1, of shares stock price
 Different types of stock market indices No. Name 1995 (in Rs.) in lakhs (in Rs.)
 Index management and maintenance 1 AZ 150 20 650
 Application of indices 2 BY 300 12 450
3 CX 450 16 600
2.1 Introduction to Index
4 DW 100 30 350
Index is a statistical indicator that measures changes in the economy in general or in
5 EU 250 8 500
particular areas. In case of financial markets, an index is a portfolio of securities that
represent a particular market or a portion of a market. Each Index has its own
calculation methodology and usually is expressed in terms of a change from a base Old Value New Value
value. The base value might be as recent as the previous day or many years in the past. Shares Old M. of Portfolio New of portfolio
Old in Cap (in Old (price * New M. New (price *
Thus, the percentage change is more important than the actual numeric value. Financial
Price Lakhs lakhs) weights weightage) price Cap weight weightage)
indices are created to measure price movement of stocks, bonds, T-bills and other type
of financial securities. More specifically, a stock index is created to provide market 150 20 3000 0.16 23.94 650 13000 0.31 198.82
participants with the information regarding average share price movement in the 300 12 3600 0.19 57.45 450 5400 0.13 57.18
market. Broad indices are expected to capture the overall behaviour of equity market
and need to represent the return obtained by typical portfolios in the country. 450 16 7200 0.38 172.34 600 9600 0.23 135.53
100 30 3000 0.16 15.96 350 10500 0.25 86.47
2.2 Significance of Index
250 8 2000 0.11 26.60 500 4000 0.09 47.06
 A stock index is an indicator of the performance of overall market or a particular
sector. 18800 1 296.28 42500 1 525.06
 It serves as a benchmark for portfolio performance - Managed portfolios, Market capitalization (Mcap) = Number of Shares * Market Price
belonging either to individuals or mutual funds; use the stock index as a measure Old value of portfolio is equated to 100. Therefore, on that scale new value of portfolio
for evaluation of their performance. would be (525.05/ 296.27)*100 = 177.22
 It is used as an underlying for financial application of derivatives – Various Thus, the present value of Index under market capitalization weighted method is
products in OTC and exchange traded markets are based on indices as underlying 177.22.
asset.
Popular indices in India Sensex and Nifty were earlier designed on market capitalization
2.3 Types of Stock Market Indices weighted method.
Indices can be designed and constructed in various ways. Depending upon their Free-Float Market Capitalization Index
methodology, they can be classified as under: In various businesses, equity holding is divided differently among various stake holders –
Market capitalization weighted index promoters, institutions, corporates, individuals etc. Market has started to segregate this
In this method of calculation, each stock is given weight according to its market on the basis of what is readily available for trading or what is not. The one available for
capitalization. So higher the market capitalization of a constituent, higher is its weight in immediate trading is categorized as free float. And, if we compute the index based on
the index. Market capitalization is the market value of a company, calculated by weights of each security based on free float market cap, it is called free float market
multiplying the total number of shares outstanding to its current market price. For capitalization index. Indeed, both Sensex and Nifty, over a period of time, have moved
example, ABC company with 5,00,00,000 shares outstanding and a share price of Rs 120 to free float basis. SX40, index of MSEI is also a free float market capitalization index.
per share will have market capitalization of 5,00,00,000 x 120 = Rs 6,00,00,00,000 i.e.
600 Crores.

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Price-Weighted Index Base level of this index would be (150+300+450+100+250)/5 = 250. We equate this to
A stock index in which each stock influences the index in proportion to its price. Stocks 100.
with a higher price will be given more weight and therefore, will have a greater Current level of this index would be (650+450+600+350+500)/5 = 510. It means current
influence over the performance of the Index. level of index on the base of 100 would be (510/250)*100 = 204.
Let us take the same example for calculation of price-weighted index. 2.4 Attributes of an Index
Stock price as Number Today’s A good market index should have following attributes:
Sr. Stock on January 1, of shares stock price  It should reflect the market behaviour
No. Name 1995 (in Rs.) in lakhs (in Rs.)  It should be computed by independent third party and be free from influence of
1 AZ 150 20 650 any market participant
2 BY 300 12 450  It should be professionally maintained
3 CX 450 16 600 Impact Cost
4 DW 100 30 350 Liquidity in the context of stock market means a market where large orders are
5 EU 250 8 500 executed without moving the prices.
Computation of the index would be as follows: Let us understand this with help of an example. The order book of a stock at a point in
time is as follows:
Stock price as Price Today’s Price Buy Sell
Stock on January 1, Price weighted stock price Price weighted Sr. No. Quantity Price (in Rs.) Price (in Rs.) Quantity Sr. No.
Name 1995 (in Rs.) weights Prices (in Rs.) weights Prices 1 1000 4.00 4.50 2000 5
AZ 150 0.12 18 650 0.254902 166 2 1000 3.90 4.55 1000 6
BY 300 0.24 72 450 0.176471 79 3 2000 3.80 4.70 500 7
CX 450 0.36 162 600 0.235294 141 4 1000 3.70 4.75 100 8
DW 100 0.08 8 350 0.137255 48
In the order book given above, there are four buy orders and four sell orders. The
EU 250 0.2 50 500 0.196078 98
difference between the best buy and the best sell orders is 0.50 - called bid-ask spread.
1250 310 2550 532
If a person places a market buy order for 100 shares, it would be matched against the
We equate 310 to 100 to find the current value, which would be (532/310)*100 =
best available sell order at Rs. 4.50. He would buy 100 shares for Rs. 4.50. Similarly, if he
171.7268
places a market sell order for 100 shares, it would be matched against the best available
Dow Jones Industrial Average and Nikkei 225 are popular price-weighted indices.
buy order at Rs. 4 i.e. the shares would be sold at Rs.4. Hence, if a person buys 100
Equal Weighted Index shares and sells them immediately, he is poorer by the bid-ask spread i.e. a loss of Rs 50.
An equally-weighted index makes no distinction between large and small companies, This spread is regarded as the transaction cost which the market charges for the
both of which are given equal weighting. The value of the index is generated by adding privilege of trading (for a transaction size of 100 shares).
the prices of each stock in the index and dividing that by the total number of stocks.
Now, suppose a person wants to buy and then sell 3000 shares. The sell order will hit
Let us take the same example for calculation of equal weighted index. the following buy orders:
Stock price as Number Today’s Sr. No. Quantity Price (in Rs.)
Sr. Stock on January 1, of shares stock price 1 1000 4.00
No. Name 1995 (in Rs.) in lakhs (in Rs.) 2 1000 3.90
1 AZ 150 20 650 3 1000 3.80
2 BY 300 12 450 While the buy order will hit the following sell orders:
3 CX 450 16 600 Quantity Price (in Rs.) Sr. No.
4 DW 100 30 350 2000 4.50 1
5 EU 250 8 500 1000 4.55 2

16 17
There is increase in the transaction cost for an order size of 3000 shares in comparison Index Maintenance and Index Revision
to the transaction cost for order for 100 shares. The “bid-ask spread” therefore conveys Maintenance and Revision of the indices is done with the help of various mathematical
transaction cost for small trade. formulae. In order to keep the index comparable across time, the index needs to take
Now, we come across the term called impact cost. We have to start by defining the ideal into account corporate actions such as stock splits, share issuance, dividends and
price as the average of the best bid and offer price. In our example it is (4+4.50)/2, i.e. restructuring events. While index maintenance issue gets triggered by a corporate
Rs. 4.25. In an infinitely liquid market, it would be possible to execute large transactions action, index revision is an unabated phenomenon to ensure that index captures the
on both buy and sell at prices that are very close to the ideal price of Rs.4.25. However, most vibrant lot of securities in the market and continues to correctly reflect the
while actually trading, you will pay more than Rs.4.25 per share while buying and will market.
receive less than Rs.4.25 per share while selling. Percentage degradation, which is 2.6 Major Indices in India
experienced vis-à-vis the ideal price, when shares are bought or sold, is called impact These are few popular indices in India:
cost. Impact cost varies with transaction size. Also, it would be different for buy side and  S&P BSE Sensex  Nifty  SX 40
sell side.  S&P BSE Midcap  Nifty Next 50
Buy Quantity Buy Price (in Rs.) Sell Price (in Rs.) Sell Quantity  S&P BSE 100  Nifty 100
1000 9.80 9.90 1000  S&P BSE 200  Nifty 200
2000 9.70 10.00 1500  S&P BSE 500  Nifty 500
3000 9.60 10.10 1000 2.7 Application of Indices
To buy 1500 shares, Ideal price = (9.8+9.9)/ 2 = Rs.9.85 Traditionally, indices were used as a measure to understand the overall direction of
Actual buy price = [(1000*9.9)+(500*10.00)]/1500 = Rs.9.93 stock market. However, few applications on index have emerged in the investment field.
Impact cost for (1500 shares) = {(9.93 - 9.85)/9.85}*100 = 0.84 % Few of the applications are explained below.
Index Funds
2.5 Index management
These types of funds invest in a specific index with an objective to generate returns
Index construction, maintenance and revision process is generally done by specialized
equivalent to the return on index. These funds invest in index stocks in the proportions
agencies. For instance, NSE indices are managed by a separate company called NSE
in which these stocks exist in the index. For instance, Sensex index fund would get
Indices Limited.
similar returns as that of Sensex index (except for a small “tracking error” which occurs
Index construction is all about choosing the index stocks and deciding on the index due to fund management related expenses). Since Sensex has 30 shares, the fund will
calculation methodology. Maintenance means adjusting the index for corporate actions also invest in these 30 companies in the proportion in which they exist in the Sensex.
like bonus issue, rights issue, stock split, consolidation, mergers etc. Revision of index Similarly, a Nifty index fund would invest in the 50 component companies of Nifty index
deals with change in the composition of index as such i.e. replacing some existing stocks in the same proportion in which they exist in the Nifty index and therefore generates
by the new ones because of change in the trading paradigm of the stocks / interest of similar returns as that of Nifty index (adjusted for a small “tracking error”).
market participants.
Index Derivatives
Index Construction
Index Derivatives are derivative contracts which have the index as the underlying asset.
A good index is a trade-off between diversification and liquidity. A well-diversified index
Index Options and Index Futures are the most popular derivative contracts worldwide.
reflects the behaviour of the overall market/ economy. While diversification helps in
Index derivatives are useful as a tool to hedge against the market risk.
reducing risk, beyond a point it may not help in the context. Going from 10 stocks to 20
stocks gives a sharp reduction in risk. Going from 50 stocks to 100 stocks gives very little Exchange Traded Funds
reduction in risk. Going beyond 100 stocks gives almost zero reduction in risk. Hence, Exchange Traded Funds (ETFs) is basket of securities that trade like individual stock, on
there is little to gain by diversifying beyond a point. an exchange. They have number of advantages over other mutual funds as they can be
Stocks in the index are chosen based on certain pre-determined qualitative and bought and sold on the exchange. Since, ETFs are traded on exchanges intraday
quantitative parameters, laid down by the Index Construction Managers. Once a stock transaction is possible. Further, ETFs can be used as basket trading in terms of the
satisfies the eligibility criterion, it is entitled for inclusion in the index. Generally, final smaller denomination and low transaction cost. The first ETF in Indian Securities Market
decision of inclusion or removal of a security from the index is taken by a specialized was the Nifty BeES, introduced by the Benchmark Mutual Fund in December 2001.
committee known as Index Committee. Prudential ICICI Mutual Fund introduced SPIcE in January 2003, which was the first ETF
on Sensex.
18 19
Chapter 3: Introduction to Forwards and Futures In the above-mentioned example, if on April 9, 2018 the gold trades at Rs. 30,500 in the
cash market, the forward contract becomes favourable to you because you can then
LEARNING OBJECTIVES: purchase gold at Rs. 30,450 under the contract and sell in cash market at Rs. 30,500 i.e.
After studying this chapter, you should know about: net profit of Rs. 50. Similarly, if the spot price is 30,390 then you incur loss of Rs. 60 (buy
 Meaning of Forward and Futures Contracts price – sell price).
 Terminology related to futures contract Major limitations of forwards
 Payoff for futures contract
 Pricing of futures contract Liquidity Risk
 Uses of futures contract and its application by speculators, hedgers and Liquidity is nothing but the ability of the market participants to buy or sell the desired
arbitrageurs quantity of an underlying asset. As forwards are tailor made contracts i.e. the terms of
the contract are according to the specific requirements of the parties, other market
3.1 Introduction to forward and futures Contracts participants may not be interested in these contracts. Forwards are not listed or traded
Forward contract is an agreement made directly between two parties to buy or sell an on exchanges, which makes it difficult for other market participants to easily access
asset on a specific date in the future, at the terms decided today. Forwards are widely these contracts or contracting parties. The tailor made contracts and their non-
used in commodities, foreign exchange, equity and interest rate markets. availability on exchanges creates illiquidity in the contracts. Therefore, it is very difficult
for parties to exit from the forward contract before the contract’s maturity.
Let us understand with the help of an example. What is the basic difference between
cash market and forwards? Assume on March 9, 2018 you wanted to purchase gold Counterparty risk
from a goldsmith. The market price for gold on March 9, 2018 was Rs. 30,425 for 10 Counterparty risk is the risk of an economic loss from the failure of counterparty to fulfil
gram and goldsmith agrees to sell you gold at market price. You paid him Rs. 30,425 for its contractual obligation. For example, A and B enter into a bilateral agreement, where
10 gram of gold and took gold. This is a cash market transaction at a price (in this case A will purchase 100 kg of rice at Rs.20 per kg from B after 6 months. Here, A is
Rs. 30,425) referred to as spot price. counterparty to B and vice versa. After 6 months, if price of rice is Rs.30 in the market
then B may forego his obligation to deliver 100 kg of rice at Rs.20 to A. Similarly, if price
Now suppose you do not want to buy gold on March 9, 2018, but only after 1 month.
of rice falls to Rs.15 then A may purchase from the market at a lower price, instead of
Goldsmith quotes you Rs. 30,450 for 10 grams of gold. You agree to the forward price
honouring the contract. Thus, a party to the contract may default on his obligation if
for 10 grams of gold and go away. Here, in this example, you have bought forward or
there is incentive to default. This risk is also called default risk or credit risk.
you are long forward, whereas the goldsmith has sold forwards or short forwards. There
is no exchange of money or gold at this point of time. After 1 month, you come back to In addition to the illiquidity and counterparty risks, there are several issues like lack of
the goldsmith pay him Rs. 30,450 and collect your gold. This is a forward, where both transparency, settlement complications as it is to be done directly between the
the parties are obliged to go through with the contract irrespective of the value of the contracting parties. Simple solution to all these issues lies in bringing these contracts to
underlying asset (in this case gold) at the point of delivery. the centralized trading platform. This is what futures contracts do.
Essential features of a forward are: Futures contract
 It is a contract between two parties (Bilateral contract). Futures markets were innovated to overcome the limitations of forwards. A futures
 All terms of the contract like price, quantity and quality of underlying, delivery contract is an agreement made through an organized exchange to buy or sell a fixed
terms like place, settlement procedure etc. are fixed on the day of entering into amount of a commodity or a financial asset on a future date at an agreed price. Simply,
the contract. futures are standardised forward contracts that are traded on an exchange. The clearing
corporation associated with the exchange guarantees settlement of these trades. A
In other words, Forwards are bilateral over-the-counter (OTC) transactions where the
trader, who buys futures contract, takes a long position and the one, who sells futures,
terms of the contract, such as price, quantity, quality, time and place are negotiated
takes a short position. The words buy and sell are figurative only because no money or
between two parties to the contract. Any alteration in the terms of the contract is
underlying asset changes hand, between buyer and seller, when the deal is signed.
possible if both parties agree to it. Corporations, traders and investing institutions
extensively use OTC transactions to meet their specific requirements. The essential idea Features of futures contract
of entering into a forward is to fix the price and thereby avoid the price risk. Thus, by In futures market, exchange decides all the contract terms of the contract other than
entering into forwards, one is assured of the price at which one can buy/sell an price. Accordingly, futures contracts have following features:
underlying asset.  Contract between two parties through Exchange

20 21
  Centralised trading platform i.e. exchange contract and buying the next contract. Both the sides of a roll over should be executed
 Price discovery through free interaction of buyers and sellers at the same time.
 Margins are payable by both the parties Tick Size: It is minimum move allowed in the price quotations. Exchanges decide the tick
 Quality decided today (standardized) sizes on traded contracts as part of contract specification. Tick size for Nifty futures is 5
 Quantity decided today (standardized) paisa. Bid price is the price buyer is willing to pay and ask price is the price seller is
Futures terminologies willing to sell.
Let us understand various terms in the futures market with the help of quotes on Nifty Contract Size and Contract Value: Futures contracts are traded in lots and to arrive at
futures from NSE: the contract value we have to multiply the price with contract multiplier or lot size or
Quotes given on the NSE website for Nifty futures as on March 7, 2018 contract size.
1. Instrument type : Future Index Basis: The difference between the spot price and the futures price is called basis. If the
2. Underlying asset : Nifty 50 futures price is greater than spot price, basis for the asset is negative. Similarly, if the
3. Expiry date : March 28, 2018 spot price is greater than futures price, basis for the asset is positive. On March 7, 2018,
4. Open price (in Rs.) : 10200.00 spot price < future price thus basis for Nifty futures is negative i.e. (10154.20 - 10171.55
5. High price (in Rs.) : 10254.00 = - Rs 17.35).
6. Low price (in Rs.) : 10155.00 Importantly, basis for one-month contract would be different from the basis for two or
7. Closing price (in Rs.) : 10171.55 three month contracts. Therefore, definition of basis is incomplete until we define the
8. No of contracts traded : 1,98,900 basis vis-a-vis a futures contract i.e. basis for one month contract, two months contract
etc. It is also important to understand that the basis difference between say one month
9. Turnover (in Rs. Lakhs) : 15,21,894.99
and two months futures contract should essentially be equal to the cost of carrying the
10. Underlying value (in Rs.) : 10154.20 underlying asset between first and second month. Indeed, this is the fundamental of
Spot Price: The price at which an asset trades in the cash market. This is the underlying linking various futures and underlying cash market prices together.
value of Nifty on March 7, 2018 which is 10154.20. During the life of the contract, the basis may become negative or positive, as there is a
Futures Price: The price of the futures contract in the futures market. The closing price movement in the futures price and spot price. Further, whatever the basis is, positive or
of Nifty in futures trading is Rs. 10171.55. Thus Rs. 10171.55 is the future price of Nifty, negative, it turns to zero at maturity of the futures contract i.e. there should not be any
on a closing basis. difference between futures price and spot price at the time of maturity/ expiry of
contract. This happens because final settlement of futures contracts on last trading day
Contract Cycle: It is a period over which a contract trades. On March 7, 2018, the
takes place at the closing price of the underlying asset.
maximum number of index futures contracts is of 3 months contract cycle- the near
month (March 2018), the next month (April 2018) and the far month (May 2018). Every It may be noted that derivatives trading based on the on global indices was also
futures contract expires on last Thursday of respective month or the day before if the launched by India derivatives exchanges. These contracts are denominated in Indian
last Thursday is a trading holiday (in this case since Thursday, March 29, 2018 is a Rupees. For example, NSE introduced derivative contracts on FTSE100, S&P 500 and
trading holiday, the March contract expires on the day before i.e., on March 28, 2018). Dowjones and BSE introduced derivative contracts on iBovespa (Brazilian index), MICEX
And, a new contract (in this example - June 2018) is introduced on the trading day (Russian index), Hang Seng (Hongkong index)& FTSE/JSE Top40 (South African index).
following the expiry day of the near month contract. The National Stock Exchange has also launched future contracts on India Volatility Index
Expiration Day: The day on which a derivative contract ceases to exist. It is last trading (VIX) enabling traders to hedge market risk arising out of volatility.
day of the contract. Generally, it is the last Thursday of the expiry month unless it is a Cost of Carry
trading holiday on that day. If the last Thursday is a trading holiday, the contracts expire Cost of Carry is the relationship between futures prices and spot prices. It measures the
on the previous trading day. For the March 2018 contract, the expiry date is given as storage cost (in commodity markets) plus the interest that is paid to finance or ‘carry’
March 28, 2018 since March 29, 2018 (Thursday) is a trading holiday. On expiry date, all the asset till delivery less the income earned on the asset during the holding period. For
the contracts are compulsorily settled. If a contract is to be continued, then it must be equity derivatives, carrying cost is the interest paid to finance the purchase less (minus)
rolled to the near future contract. For a long position, this means selling the expiring dividend earned.

22 23
For example, assume the share of ABC Ltd is trading at Rs. 100 in the cash market. A An open interest is the total number of contracts outstanding (yet to be settled) for an
person wishes to buy the share, but does not have money. In that case he would have to underlying asset. It is important to understand that number of long futures as well as
borrow Rs. 100 at the rate of, say, 6% per annum. Suppose that he holds this share for number of short futures is equal to the Open Interest. This is because total number of
one year and in that year he expects the company to give 200% dividend on its face long futures will always be equal to total number of short futures. Only one side of
value of Rs. 1 i.e. dividend of Rs. 2. Thus his net cost of carry = Interest paid – dividend contracts is considered while calculating/mentioning open interest. The level of open
received = 6 – 2 = Rs. 4. Therefore, break even futures price for him should be Rs.104. interest indicates depth in the market.
It is important to note that cost of carry will be different for different participants. Volumes traded give us an idea about the market activity with regards to specific
contract over a given period – volume over a day, over a week or month or over entire
Margin Account
life of the contract.
As exchange guarantees the settlement of all the trades, to protect itself against default
by either counterparty, it charges various margins from brokers. Brokers in turn charge Contract Specifications
margins from their customers. Brief about margins is as follows: Contract specifications include the salient features of a derivative contract like contract
maturity, contract multiplier also referred to as lot size, contract size, tick size etc. An
Initial Margin
example contract specification is given below:
The amount one needs to deposit in the margin account at the time of entering a
NSE’s Nifty Index Futures Contracts
futures contract is known as the initial margin. Let us take an example - On March 8,
Underlying index Nifty 50
2018 a person decided to enter into a futures contract. He expects the market to go up
Contract Multiplier (Lot size) 75
so he takes a long Nifty Futures position for March expiry. On March 7, 2018, Nifty
Tick size or minimum price 0.05 index point (i.e., Re 0.05 or 5 paise)
March month futures contract closes at 10171.55.
difference
The contract value = Nifty futures price * lot size= 10171.55 * 75 = Rs 7,62,866. Last trading day / Expiration day Last Thursday of the expiration month. If it
Therefore, Rs 7,62,866 is the contract value of one Nifty Future contract expiring on happens to be a holiday, the contract will expire
March 28, 2018. on the previous business day.
Contract months 3 contracts of 1, 2 and 3 month’s maturity. At the
Assuming that the broker charges 10% of the contract value as initial margin, the person expiry of the nearest month contract, a new
has to pay him Rs. 76,287 as initial margin. Both buyers and sellers of futures contract contract with 3 months maturity will start. Thus,
pay initial margin, as there is an obligation on both the parties to honour the contract. at any point of time, there will be 3 contracts
The initial margin is dependent on price movement of the underlying asset. As high available for trading.
volatility assets carry more risk, exchange would charge higher initial margin on them. Daily settlement price Settlement price of the respective futures
contract.
Marking to Market (MTM)
In futures market, while contracts have maturity of several months, profits and losses Final settlement price Settlement price of the cash index on the expiry
are settled on day-to-day basis – called mark to market (MTM) settlement. The date of the futures contract.
exchange collects these margins (MTM margins) from the loss making participants and Price band
pays to the gainers on day-to-day basis. Price Band is essentially the price range within which a contract is permitted to trade
Let us understand MTM with the help of the example. Suppose a person bought a during a day. The band is calculated with regard to previous day closing price of a
futures contract on March 8, 2018 when the Nifty futures contract was trading at specific contract. For example, previous day closing price of a contract is Rs.100 and
10171.55. He paid an initial margin of Rs. 76,287 as calculated above. At the end of that price band for the contract is 10% then the contract can trade between Rs.90 and
day, Nifty futures contract closes at 10242.95. This means that he/she benefits due to Rs.110 for next trading day. On the first trading day of the contract, the price band is
the 71.4 points gain on Nifty futures contract. Thus, his/her net gain for the day is Rs decided based on the closing price of the underlying asset in cash market. For example,
71.4 x 75 = Rs 5355. This money will be credited to his account and next day his/her today is first trading day of a futures contract for an underlying asset i.e. company A.
position will start from 10242.95 (for MTM computation purpose). The price band for the contract is decided on the previous day’s closing price of
company ‘A’ stock in cash market. Price band is clearly defined in the contract
Open Interest and Volumes Traded specifications so that all market participants are aware of the same in advance.

24 25
Sometimes, bands are allowed to be expanded at the discretion of the exchanges with if he sells a contract which he had bought before or he buys a contract which he had
specific trading halts. sold earlier.
Positions in derivatives market Limitations of Futures Contract
As a market participant, you will always deal with certain terms like long, short and open As futures are standardized contracts introduced by the exchanges, they too have
positions in the market. Let us understand the meanings of commonly used terms: certain limitations in the context of limited maturities, limited underlying set, lack of
Long position flexibility in contract design and increased administrative costs on account of MTM
settlement etc.
Outstanding/ unsettled buy position in a contract is called “Long Position”. For instance,
if Mr. X buys 5 contracts on Sensex futures then he would be long on 5 contracts on Differences between Forwards and Futures
Sensex futures. If Mr. Y buys 4 contracts on Pepper futures then he would be long on 4 Feature Forward contracts Futures contracts
contracts on pepper. Operational It is not traded on the It is an exchange-traded
Short Position mechanism exchanges. contract.
Outstanding/ unsettled sell position in a contract is called “Short Position”. For instance, Contract Terms of the contracts differ Terms of the contracts are
if Mr. X sells 5 contracts on Sensex futures then he would be short on 5 contracts on specifications from trade to trade (tailor made standardized.
Sensex futures. If Mr. Y sells 4 contracts on Pepper futures then he would be short on 4 contract) according to the need
contracts on pepper. of the participants.
Counter-party Exists, but at times gets reduced
Exists but the clearing agency
Open position
risk by a guarantor. associated with exchanges
Outstanding/ unsettled either long (buy) or short (sell) position in various derivative
becomes the counter-party to all
contracts is called “Open Position”. For instance, if Mr. X shorts say 5 contracts on
trades assuring guarantee on
Infosys futures and longs say 3 contracts on Reliance futures, he is said to be having
their settlement.
open position, which is equal to short on 5 contracts on Infosys and long on 3 contracts
Liquidation Low, as contracts are tailor High, as contracts are
of Reliance. If next day, he buys 2 Infosys contracts of same maturity, his open position
profile made catering to the needs of standardised exchange-traded
would be – short on 3 Infosys contracts and long on 3 Reliance contracts.
the parties involved. Further, contracts.
Naked and calendar spread positions contracts are not easily
Naked position in futures market simply means a long or short position in any futures accessible to other market
contract without having any position in the underlying asset. Calendar spread position is participants.
a combination of two positions in futures on the same underlying - long on one maturity
contract and short on a different maturity contract. For instance, a short position in near Price discovery Not Efficient, as markets are Efficient, centralised trading
month contract coupled with a long position in far month contract is a calendar spread scattered. platform helps all buyers and
position. Calendar spread position is computed with respect to the near month series sellers to come together and
and becomes an open position once the near month contract expires or either of the discover the price through
offsetting positions is closed. common order book.
A calendar spread is always defined with regard to the relevant months i.e. spread Quality of Quality of information may be Futures are traded nationwide.
between August contract and September contract, August contract and October information poor. Speed of information Every bit of decision related
contract and September contract and October contract etc. and its dissemination is week. information is distributed very
dissemination fast.
Opening a position
Examples Currency markets are an Commodities futures, Currency
Opening a position means either buying or selling a contract, which increases client’s
example of forwards. Today futures, Index futures and
open position (long or short).
currency futures and options Individual stock futures in India.
Closing a position have been introduced in India,
Closing a position means either buying or selling a contract, which essentially results in but yet a market for currency
reduction of client’s open position (long or short). A client is said to be closed a position forwards exists through banks.

26 27
3.2 Pay off Charts for Futures contract 60
Long Futures Payoff

Pay off Charts

Pay off on a position is the likely profit/ loss that would accrue to a market participant
40
with change in the price of the underlying asset at expiry. The pay off diagram is
graphical representation showing the price of the underlying asset on the X-axis and
profits/ losses on the Y-axis. 20

Pay off charts for futures

Profit/Loss (Rs.)
In case of futures contracts, long as well as short position has unlimited profit or loss
potential. This results into linear pay offs for futures contracts. Futures pay offs are 0
50 60 70 80 90 100 110 120 130 140 150
explained in detail below:
CMP @ Expiry
Pay off for buyer of futures: Long futures
-20
Let us say a person goes long in a futures contract at Rs.100. This means that he has
agreed to buy the underlying at Rs. 100 on expiry. Now, if on expiry, the price of the
underlying is Rs. 150, then this person will buy at Rs. 100, as per the futures contract
-40
and will immediately be able to sell the underlying in the cash market at Rs.150, thereby
making a profit of Rs. 50. Similarly, if the price of the underlying falls to Rs. 70 at expiry,
he would have to buy at Rs. 100, as per the futures contract, and if he sells the same in Long Futures Payoff
-60
the cash market, he would receive only Rs. 70, translating into a loss of Rs. 30.
This potential profit/loss at expiry when expressed graphically, is known as a pay off Short Futures pay off
chart. The X Axis has the market price of the underlying at expiry. It increases on the As one person goes long, some other person has to go short, otherwise a deal will not
Right Hand Side (RHS). We do not draw the X Axis on the Left Hand Side (LHS), as prices take place. The profits and losses for the short futures position will be exactly opposite
cannot go below zero. The Y Axis shows profit & loss. In the upward direction, we have of the long futures position. This is shown in the below table and chart:
profits and in the downward direction, we show losses in the chart. Short Futures at 100
The below table and pay off chart show long futures pay offs: Market price Short Futures
at expiry Pay off
Long Futures at 100 50 50
Market price Long Futures 60 40
at expiry Pay off 70 30
50 -50 80 20
60 -40 90 10
70 -30 100 0
80 -20 110 -10
90 -10 120 -20
100 0 130 -30
110 10 140 -40
120 20 150 -50
130 30
140 40
150 50

28 29
 60
Short Futures Payoff
 Create a synthetic forward/futures position by buying in the cash market and
carrying the asset to future date.
Price of acquiring the asset as on future date in both the cases should be same i.e. cost
40
of synthetic forward/ futures contract (spot price + cost of carrying the asset from today
to the future date) should be equivalent to the price of present forward/ futures
contract. If prices are not same then it will trigger arbitrage and will continue until prices
20 in both the markets are aligned.
The cost of creating a synthetic futures position is the fair price of futures contract. Fair
Profit/Loss (Rs.)

price of futures contract is nothing but addition of spot price of underlying asset and
0
50 60 70 80 90 100 110 120 130 140 150
cost of carrying the asset from today until delivery. Cost of carrying a financial asset
from today to the future date would entail different costs like transaction cost, custodial
CMP @ Expiry
charges, financing cost, etc whereas for commodities, it would also include costs like
-20 warehousing cost, insurance cost, etc.
Let us take an example from Bullion Market. The spot price of gold is Rs 40,000 per 10
grams. The cost of financing, storage and insurance for carrying the gold for three
-40
months is Rs. 100 per 10 grams. Now you purchase 10 grams of gold from the market at
Rs 40,000 and hold it for three months. We may now say that the value of the gold after
Short Futures Payoff
3 months would be Rs 40,100 per 10 grams.
-60
Assume the 3-month futures contract on gold is trading at Rs 40,150 per 10 grams.
As can be seen, a short futures position makes profits when prices fall. If prices fall to 60 What should one do? Apparently, one should attempt to exploit the arbitrage
at expiry, the person who has shorted at Rs.100 will buy from the market at 60 on expiry opportunity present in the gold market by buying gold in the cash market and sell 3-
and sell at 100, thereby making a profit of Rs. 40. This is shown in the above chart. month gold futures simultaneously. We borrow money to take delivery of gold in cash
market today, hold it for 3 months and deliver it in the futures market on the expiry of
3.3 Futures pricing our futures contract. Amount received on settling the futures contract could be used to
Pricing of a futures contract depends on the characteristics of underlying asset. There is repay the financer of our gold purchase. The net result will be a profit of Rs 50 without
no single way to price futures contracts because different assets have different demand taking any risk. (Please note that we have not considered any transaction costs in this
and supply patterns, different characteristics and cash flow patterns. This makes it example).
difficult to design a single methodology for calculation of pricing of futures contracts.
Because of this mispricing, as more and more people come to the cash market to buy
Market participants use different models for pricing futures. Here, our discussion is
gold and sell in futures market, spot gold price will go up and gold futures price will
limited to only two popular models of futures pricing - Cash and Carry model and
come down. This arbitrage opportunity continues until the prices between cash and
Expectancy model.
futures markets are aligned.
Cash and Carry Model for Futures Pricing
Therefore, if futures price is more than the future fair price of asset/ synthetic futures
Cash and Carry model is also known as non-arbitrage model. This model assumes that in
price, it will trigger cash and carry arbitrage, which will continue until the prices in both
an efficient market, arbitrage opportunities cannot exist. In other words, the moment
the markets are aligned.
there is an opportunity to make money in the market due to mispricing in the asset
price and its replicas, arbitrageurs will start trading to profit from these mispricing and Similarly, if futures prices is less than the future fair price of asset/ synthetic futures
thereby eliminating these opportunities. This trading continues until the prices are price, it will trigger reverse cash and carry arbitrage i.e. market participants start buying
aligned across the products/ markets for replicating assets. gold in futures markets and sell gold in cash market. Now people will borrow gold and
deliver it to honour the contract in the cash market and earn interest on the cash
Let us understand the entire concept with the help of an example. Practically, forward/
market sales proceeds. After three months, they give gold back to the lender on receipt
futures position in a stock can be created in following manners:
of the same in futures market. This reverse arbitrage will result in reduction of gold’s
 Enter into a forward/futures contract, or

30 31
spot price and increase of its futures price, until these prices are aligned to leave no = 10000 (1+0.12-0.04)^(90/365)
money on the table. = Rs. 10,191.58
[Alternatively, we could use exponential form for calculating the futures value as spot
Cost of transaction and non-arbitrage bound
Cost components of futures transaction like margins, transaction costs (commissions), price * e(r-q)T. Value in that case would have been 10000 * e((0.12-0.04)*90/365) = Rs.
taxes etc. create distortions and take markets away from equilibrium. In fact, these cost 10,199.22].
components create a non-arbitrage bound in the market i.e. if the futures price is within If index futures is trading above 10199.22, we can buy index stocks in cash market and
that bound around the future fair value/ synthetic futures value, arbitrage will not take simultaneously sell index futures to lock the gains equivalent to the difference between
place. In other words, because of the frictions in the market, for arbitrage to get futures price and future fair price (the cost of transaction, taxes, margins etc. are not
triggered, it is important for the futures price to fall beyond the non-arbitrage bound in considered while calculating the future fair value).
either direction for the arbitragers to make profit from the arbitrage opportunities.
Note: Cost of borrowing of funds and securities, return expectations on the held asset
etc. are different for the different market participants. The number of fair values of
futures can be equal to the number of market participants in the market. Perhaps the
difference among the fair values of futures contracts and non-arbitrage bound for
Fair Price different market participants is what makes the market on continuous basis.
Assumptions in cash and carry model
Non-arbitrage bound Cash and carry model of futures pricing works under certain assumptions. The important
assumptions are stated below (*):
 Underlying asset is available in abundance in cash market.
Practically, every component of carrying cost contributes towards widening this non-  Demand and supply in the underlying asset is not seasonal.
arbitrage bound. Here, we should appreciate that wider the non-arbitrage bound,  Holding and maintaining of underlying asset is easy and feasible.
farther the markets are from the equilibrium. In other words, for markets to be efficient,  Underlying asset can be sold short.
different costs of operating in the markets should be as low as possible. Lower costs  No transaction costs.
would narrow down the non-arbitrage bound, which in-turn would ensure the efficient  No taxes.
price alignment across the markets.  No margin requirements.
Extension of cash & carry model to the assets generating returns [*This is not an exhaustive list of the assumptions of the model but is the list of important assumptions]
Let us extend the concept of cash and carry model by adding the inflows during the The assumption that underlying asset is available in abundance in the cash market i.e.
holding period of underlying assets. For instance, underlying asset like securities (equity we can buy and/or sell as many units of the underlying assets as we want. This
or bonds) may have certain inflows, like dividend on equity and interest on debt assumption does not work especially when underlying asset has seasonal pattern of
instruments, during the holding period. These inflows are adjusted in the future fair demand and supply. The prices of seasonal assets (especially commodities) vary
price. Thus, modified formula of future fair price or synthetic futures price is: drastically in different demand-supply environments. When supplies arrive to the
Fair price = Spot price + Cost of carry - Inflows market place, prices are generally low whereas prices are generally high immediately
In mathematical terms, F = S (1+r-q)T before the supply of the underlying.
Where F is fair price of the futures contract, S is the Spot price of the underlying asset, q
When an underlying asset is not storable i.e. the asset is not easy to hold/maintain, then
is expected return during holding period T (in years) and r is cost of carry.
one cannot carry the asset to the future. The cash and carry model is not applicable to
If we use the continuous compounding, we may rewrite the formula as: F= Se(r-q)*T these types of underlying assets.
Let us apply the above formula to the index futures market to find the synthetic futures
Similarly, many a times, the underlying may not be sold short. This is true in case of
price/ future fair price of an index. Suppose, you buy an index in cash market at 10000
seasonal commodities.
level i.e. purchase of all the stocks constituting the index in the same proportion as they
are in the index, cost of financing is 12% and the return on index is 4% per annum Even though this simple form of cash and carry model does not discount for transaction
(spread uniformly across the year). Given this statistics, fair price of index three months cost, taxes etc. we can always upgrade the formula to reflect the impact of these factors
down the line should be: in the model. Margins are not considered while delivering the fair value/ synthetic
= Spot price (1+cost of financing – holding period return) ^ (time to expiration/365)

32 33
futures value. That is why this model is suitable for pricing forward contracts rather than  Futures price give market participants an indication of the expected direction of
futures contracts. movement of the spot price in the future.
Thus, no generalized statement can be made with regard to the use of cash and carry For instance, if futures price is higher than spot price of an underlying asset, market
model for pricing futures contracts. Assumptions of the model and characteristics of participants may expect the spot price to go up in near future. This expectedly rising
underlying asset can help us in deciding whether a specific asset can be priced with the market is called “Contango market”. Similarly, if futures price is lower than spot price of
help of this model or not. Further, suitable adjustments are made in the model to fit in an asset, market participants may expect the spot price to come down in future. This
the specific requirements of the underlying assets. expectedly falling market is called “Backwardation market”.
Convenience Yield Price discovery and convergence of cash and futures prices on the expiry
Let us touch one more concept in futures market called Convenience Yield. We need to It is important to understand what actually futures prices indicate? For instance, if say
go back and have a look at the formula for fair price of futures contract. October 2019 index futures contract is trading at 11900 in August 2019, what does it
Fair price of futures contract = Spot price + Cost of carry – Inflows mean? We can explain this by saying that that market expects the spot index to settle at
As seen earlier inflows may be in the form of dividend (in case of equity) and interest (in 11900 at the closure of the market on last Thursday of October 2019 (i.e., on the last
case of debt). However, sometimes inflows may also be intangibles. Intangible inflows trading day of the contract which is October 31, 2019). Point is that every participant in
essentially mean values perceived by the market participants just by holding the asset. the market is trying to predict the spot index level at a single point in time i.e. at the
These values may be in the form of just convenience or perceived mental comfort by closure of the market on last trading day of the contract, which is Thursday in our
holding the asset. example. This results in price discovery of spot index at a specific point in time. Now, we
may also state that futures prices are essentially expected spot price of the underlying
For instance, in case of natural disaster like flood in a particular region, people start asset, at the maturity of the futures contract. Accordingly, both futures and spot prices
storing essential commodities like grains, vegetables and energy products (heating oil) converge at the maturity of futures contract, as at that point in time there cannot be
etc. As a human tendency we store more than what is required for our real consumption any difference between these two prices. This is the reason why all futures contracts on
during a crisis. If every person behaves in similar way then suddenly a demand is expiry settle at the underlying cash market price. This principal remains same for all the
created for an underlying asset in the cash market. This indirectly increases the price of underlying assets.
underlying assets. In such situations people are deriving convenience, just by holding
the asset. This is termed as convenience return or convenience yield. 3.4 Commodity, Equity & Index Futures
The basic concept of a derivative contract remains the same for all the underlying
Convenience return for a commodity is likely to be different for different people,
assets, whether the underlying happens to be a commodity or equity or index futures.
depending on the way they use it. Further, it may vary over a period. In fact,
Some features are very peculiar to commodity derivative markets. The varying quality of
convenience is a subjective issue and may be very difficult to price.
asset does not really exist as far as financial underlying is concerned but in case of
Convenience yield sometimes may dominate the cost of carry, which leads futures to commodities, the quality of the asset underlying a contract can vary significantly.
trade at a discount to the cash market. In this case, reverse arbitrage is also not possible Financial assets are not bulky and do not need special facility for storage, whereas in
because no one lends traders the assets to sell short in the cash market. In such commodity market, due to the bulky nature of the underlying assets, physical
situations, practically, the cash and carry model breaks down and cannot be applied for settlement in commodity derivatives creates the need for warehousing.
pricing the underlying assets.
3.5 Uses of futures
Expectancy model of futures pricing
According to the expectancy model, it is not the relationship between spot and futures Role of different participants in derivatives markets
prices but that of expected spot and futures prices, which moves the market, especially Hedgers
in cases when the asset cannot be sold short or cannot be stored. It also argues that Corporations, Investing Institutions, Banks and Governments all use derivative products
futures price is nothing but the expected spot price of an asset in the future. This is why to hedge or reduce their exposures to market variables such as interest rates, share
market participants would enter futures contract and price the futures based upon their values, bond prices, currency exchange rates and commodity prices. The classic example
estimates of the future spot prices of the underlying assets. is the farmer who sells futures contracts to lock into a price for delivering a crop on a
According to this model, future date. The buyer might be a food-processing company, which wishes to fix a price
 Futures can trade at a premium or discount to the spot price of underlying asset. for taking delivery of the crop in the future. Another case is that of a company due to
receive a payment in a foreign currency on a future date. It enters into a forward

34 35
transaction with a bank agreeing to sell the foreign currency and receive a upon actual wheat price being more than the contracted futures price at the maturity of
predetermined quantity of domestic currency. futures contract. If it is so, trader would make money otherwise he would lose money.
Speculators/Traders In addition to hedgers and traders, to establish a link between various markets like spot
Derivatives are very well suited to trading on the prices of commodities and financial and derivatives, we need a third party called arbitragers. These arbitragers continuously
assets and on key market variables such as interest rates, stock market indices and hunt for the profit opportunities across the markets and products and seize those by
currency exchange rates. It is much less expensive to create a speculative position using executing trades in different markets and products simultaneously. Importantly,
derivatives than by actually trading the underlying commodity or asset. As a result, the arbitragers generally lock in their profits unlike traders who trade naked contracts.
potential returns are much greater. A classic application is the trader who believes that For example, at the end of day (1st January 2020):
increasing demand or scarce production is likely to boost the price of a commodity. He Market price of underlying asset (in Rs.) 100
has two options with him - first option is to buy and store the physical commodity March futures 110
whereas other option is to go long futures contract. Trader chooses the second option Lot size 50
to go long futures contract on the underlying asset. If commodity price increases, the Here an arbitrageur will buy in the cash market at Rs. 100 and sell in the Futures market
value of the contract will also rise and he can reverse back position to book his profit. at Rs. 110, thereby locking Rs. 10 as his profit on each share.
Arbitrageurs On the expiration date, suppose price (in Rs.) of the underlying asset is 108.
Cash Market Futures
An arbitrage is a deal that produces risk free profits by exploiting a mispricing in the
Buy 100 Sell 110
market. A simple arbitrage occurs when a trader purchases an asset cheaply in one
location/ exchange and simultaneously arranges to sell it at another location/ exchange Sell 108 Buy 108
at a higher price. Such opportunities are unlikely to persist for very long, since +8 +2
arbitrageurs would rush in to buy the asset in the cheap location and simultaneously sell Total profit would therefore be 10*50 = Rs. 500.
at the expensive location, thus reducing the pricing gap. Suppose price (in Rs.) of the underlying asset is 95 on the expiration date.
As mentioned above, there are three major players in derivatives market – Hedgers, Cash Market Futures
Traders, and Arbitrageurs. Hedgers are there to hedge their risk, traders take the risk Buy 100 Sell 110
which hedgers plan to offload from their exposure and arbitragers establish an efficient Sell 95 Buy 95
-5 +15
link between different markets.
Total profit is 10*50 = Rs. 500.
Traders take naked positions in the futures market i.e. they go long or short in various
futures contracts available in the market. Indeed, capacity of derivatives market to In the entire activity, the transaction cost and impact cost have not been considered. In
absorb buying/selling by hedgers is directly dependent upon availability of traders, who real life, the transaction cost has to be considered like the brokerage, service Tax,
act as counter-party to hedgers. Accordingly, Traders form one of the most important Securities Service Tax etc.
participants of the derivatives market, providing depth to the market. Hedgers will not Here, it may be interesting to look at the risks these arbitragers carry. As seen before,
be able to hedge if traders were not present in the system. Therefore, for futures arbitragers are executing positions in two or more markets/products simultaneously.
market to click, presence of both hedgers and traders is a must. Even if the systems are seamless and electronic and both the legs of transaction are
For instance, assume, a farmer expects the price of wheat to fall in near future. He liquid, there is a possibility of some gap between the executions of both the orders. If
wants to hedge his price risk on wheat produce for next 3 months till the time he has either leg of the transaction is illiquid then the risk on the arbitrage deal is huge as only
actual produce in his hands and so would like to lock at the forward/ futures price now. one leg may get executed and another may not, which would open the arbitrager to the
Accordingly, farmer can sell futures contracts on the expected quantity of produce. In naked exposure of a position. Similarly, if contracts are not cash settled in both or one of
order to sell this futures contract, he needs a buyer. This buyer may be someone who the markets, it would need reversal of trades in the respective markets, which would
needs wheat after three months, may be a flour mill or a bakery. However, most of the result in additional risk on unwinding position with regard to simultaneous execution of
times, there is a demand supply mismatch in the market and the trader fills the gap the trades.
between demand and supply.
These profit focused traders and arbitrageurs fetch enormous liquidity to the products
Here trader, counterparty to the farmer, is thinking in contrary i.e. this buyer would buy traded on the exchanges. This liquidity in turn results in better price discovery, lesser
only if he thinks that actual price of wheat is going to be higher than the contract price cost of transaction and lesser manipulation in the market.
for futures three months down the line. Further, the profit of trader would depend

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Uses of Index futures Now, let us get to management of systematic risk. Assume you are having a portfolio
Equity derivatives instruments facilitate trading of a component of price risk, which is worth Rs.9,00,000 in cash market. You see the market may be volatile due to some
inherent to investment in securities. Price risk is nothing but change in the price reasons. You are not comfortable with the market movement in the short run. At this
movement of asset, held by a market participant, in an unfavourable direction. This risk point of time, you have two options: (1) sell the entire portfolio and buy later and (2)
broadly divided into two components - specific risk or unsystematic risk and market risk hedge by the use of Index futures to protect the value of this portfolio from the
or systematic risk. expected fall in the market.
Unsystematic Risk As an investor you are comfortable with the second option. If the prices fall, you make
Specific risk or unsystematic risk is the component of price risk that is unique to loss in cash market but make profits in futures market. If prices rise, you make profits in
particular events of the company and/or industry. This risk is inseparable from investing cash market but losses in futures market.
in the securities. This risk could be reduced to a certain extent by diversifying the
Now, the question arises how many contracts you have to sell to make a perfect hedge?
portfolio. Perfect hedge means if you make Rs. 90,000 loss in cash market then you should make
Systematic Risk Rs. 90,000 profit in futures market. To find the number of contracts for perfect hedge
An investor can diversify his portfolio and eliminate major part of price risk i.e. the ‘hedge ratio’ is used. Hedge ratio is calculated as:
diversifiable/unsystematic risk but what is left is the non-diversifiable portion or the
Number of contracts for perfect hedge = Vp * βp / Vi
market risk-called systematic risk. Variability in a security’s total returns that are directly Vp – Value of the portfolio
associated with overall movements in the general market or economy is called βp– Beta of the portfolio
systematic risk. Thus, every portfolio is exposed to market risk. This risk is separable
Vi – Value of index futures contract
from investment and tradable in the market with the help of index-based derivatives.
When this particular risk is hedged perfectly with the help of index-based derivatives, Value of index futures contract or contract size = futures index level * contract
only specific risk of the portfolio remains. multiplier. Readers may note that for simplification purpose, beta of futures index vis-a-
vis cash index is taken as one.
Therefore, we may say that total price risk in investment in securities is the sum of
systematic risk or market risk and unsystematic risk or specific risk. Let us assume, Beta of your portfolio is 1.3, portfolio value is Rs 9,00,000 and
benchmark index level is 8000, then hedge ratio will be (9,00,000*1.3/8000) = 146.25
Before we get to management of systematic risk with index futures, we need to
indices. Assume one Futures contract has a lot size of 75. You will have to hedge using
understand Beta - a measure of systematic risk of a security that cannot be avoided 146.25/75 = 1.95 contracts. Since you cannot hedge 1.95 contracts, you will have to
through diversification. It measures the sensitivity of a stock / portfolio vis-a-vis index hedge by 2 futures contracts. You have to pay the broker initial margin in order to take a
movement over a period of time, on the basis of historical prices. Suppose a stock has a
position in futures.
beta equal to 2. This means that historically a security has moved 20% when the index
moved 10%, indicating that the stock is more volatile than the index. Stocks / portfolios Hedge against the systematic risk mainly depends upon the relationship of portfolio
having beta more than 1 are called aggressive and having beta less than 1 are called with the index, which is measured by beta. A portfolio has different relationships with
conservative stocks / portfolios. different indices used for hedge hence the hedge ratio would change with the change in
the index. Further, there is an assumption that the past relationship between the stock’s
In order to calculate beta of a portfolio, betas of individual stocks are used. It is
or portfolio’s movement and the index movement would continue in future. This may
calculated as weighted average of betas of individual stocks in the portfolio based on result in some difference between actual and expected numbers.
their investment proportion. For example, if there are four stocks in a portfolio with
betas 0.5, 1.1, 1.30 and 0.90 having weights 35%, 15%, 20% and 30% respectively, the Similarly, we can use single stock futures to manage the risk of the equity investment in
beta of this portfolio would be 0.87 (0.5*0.35 +1.10*0.15 +1.30*0.20 +0.90*0.30). cash market. For instance, use of single stock futures would hedge the market
participant against the whole risk in the equity investment because these futures are
A generalized formula for portfolio beta can be written as W1 β1+W2 β2+…+ Wn βn= βp
comparable with underlying positions. Only difference between an underlying position
Where, W1 is weight of stock 1, β1 is the β of stock 1, W2 is weight of stock 2, β2 is the and single stock futures is on settlement front; in case of cash transactions, settlement
β of stock 2, Wn is weight of stock n, βn is the β of stock n and βp is the β of portfolio. takes place immediately and in case of single stock futures contracts, settlement is
deferred.
Information on beta of individual stocks is readily available in various financial
newspapers, magazines and information vending networks like Bloomberg, Reuters etc.

38 39
Important terms in hedging oil, heating oil or gasoline due to their close association with jet fuel for hedging
Long hedge: Long hedge is the transaction when we hedge our position in cash market purpose. This is an example of cross hedge.
by going long in futures market. For example, we expect to receive some funds in future Indeed, in a crude sense, we may say that when we are using index futures to hedge
and want to invest the same amount in the securities market. We have not yet decided against the market risk on a portfolio, we are essentially establishing a cross hedge
the specific company/companies, where investment is to be made. We expect the because we are not using the exact underlying to hedge the risk against.
market to go up in near future and bear a risk of acquiring the securities at a higher Hedge contract month: Hedge contract month is the maturity month of the contract
price. We can hedge by going long index futures today. On receipt of money, we may
through which we hedge our position. For instance, if we use August 2020 contract to
invest in the cash market and simultaneously unwind corresponding index futures
hedge our portfolio’s market risk, our hedge contract month would be August 2020
positions. Any loss due to acquisition of securities at higher price, resulting from the
contract. Similarly, if we hedge say risk on crude oil price with the help of March 2020,
upward movement in the market over intermediate period, would be partially or fully
hedge contract month would be March 2020.
compensated by the profit made on our position in index futures.
Trading in futures market
Further, while investing, suitable securities at reasonable prices may not be immediately
Traders are risk takers in the derivatives market. And they take positions in the futures
available in sufficient quantity. Rushing to invest all money is likely to drive up the prices market without having position in the underlying cash market. These positions are
to our disadvantage. This situation can also be taken care of by using the futures. We
based upon their expectations on price movement of underlying asset. Traders either
may buy futures today; gradually invest money in the cash market and unwind take naked positions or spread positions.
corresponding futures positions.
A trader takes a naked long position when he expects the market to go up. Money
Similarly, we can take an example from the commodity market, if there is a flour mill comes by reversing the position at higher price later. Similarly, he takes a short position
and it is expecting the price of wheat to go up in near future. It may buy wheat in
when he expects the market to go down to book profit by reversing his position at lower
forwards/ futures market and protect itself against the upward movement in price of
price in the future. For instance, if one month Sensex futures contract is trading at
wheat. This would also be an example of long hedge.
41,000 and a trader expects the spot index at the maturity of the one month contract
Short hedge: Short Hedge is a transaction when the hedge is accomplished by going would settle at a level higher than this, he would take a long position in index futures at
short in futures market. For instance, assume, we have a portfolio and want to liquidate a level of 41,000. If his expectation comes true and index on maturity settles beyond
in near future but we expect the prices to go down in near future. This may go against 41,000, this trader will make money to the extent of the difference between buy price
our plan and may result in reduction in the portfolio value. To protect our portfolio’s and sell price (or, between buy price and settlement price) of the index.
value, today, we can short index futures of equivalent amount. The amount of loss Traders may also take long/short positions in single stock futures. When they expect the
made in cash market will be partly or fully compensated by the profits on our futures
market to go up, they may take long position in these futures and when they expect the
positions. market to go down, they may take short position in single stock futures.
Let us take an example from currency market. Assume Company C is into export and Similarly, if someone wants to trade upon say steel prices, he may take long or short
import business. Company expects some dollars to flow in after say 6 months. Director position on steel futures depending upon his view – long position, if he expects the
Finance of the company is expecting the depreciation in dollar vis-a-vis local currency
market to move upwards and short position, if he expects the market to go downward.
over this period of time. To protect against this risk of adverse movement in exchange
If market moves in the expected direction, trader would end up making profit. Here, it
rate of currency, company C may sell dollars in forward /futures market. This selling may be noted that if market does not move in the expected direction, trader may also
would protect company against any fall of dollar against the local currency.
incur a loss. Because, a position is as exposed to loss as profit, it is called the speculative
Cross hedge: When futures contract on an asset is not available, market participants position.
look forward to an asset that is closely associated with their underlying and trades in the
Naked position is long or short in any of the futures contracts but in case of a spread,
futures market of that closely associated asset, for hedging purpose. They may trade in
two opposite positions (one long and one short) are taken either in two contracts with
futures in this asset to protect the value of their asset in cash market. This is called cross
same maturity on different products or in two contracts with different maturities on the
hedge.
same product. Former is inter-commodity or inter-product spread and latter is calendar
For instance, if futures contracts on jet fuel are not available in the international spread/time spread or horizontal spread. Exchanges need to provide the required inputs
markets then hedgers may use contracts available on other energy products like crude to the system for it to recognize any kind of spread. At present, in equity market, the
system recognizes only calendar spreads. In commodities market, system recognizes

40 41
inter-commodity spread between specific commodities like Gold and Silver; Soybean, If cost of carry is defined in the percentage terms, we may redefine the formula as:
Soybean meal and Soybean oil, etc. F = S(1+r)T
Calendar spread position is always computed with respect to the near month series. For Where r is the carrying cost (in percentage) and T is the Time to expiration (in years).
instance, if Mr. A has say 3 contacts short in one-month futures contract, 2 contracts If we use continuous compounding for computation of the cost, the same formula
long in two-months futures contract and 3 contracts long in three-months futures reduces to:
contract, he would be said to have 2 calendar spreads between first and second months F= SerT
and 1 calendar spread between first and third month. Further, his position in remaining
2 three-months contracts would be treated as naked. A calendar spread becomes a If futures price is higher than fair/theoretical price, there would exist profitable, risk-
naked/open position, when the near month contract expires or either of the legs of free, cash and carry arbitrage opportunity. Thus, unless there are obstacles to such
spread is closed. As spread positions are hedged to a large extent because they are arbitrage the activities of the arbitrageurs would cause spot-futures price relationships
combinations of two opposite positions, they are treated as conservatively speculative to conform to that described by the cost of carry formula. On rare occasions, however,
positions. there is an arbitrage opportunity that exists for some time. Practically, an arbitrage is
feasible and will be undertaken only if it provides net cash inflow after transaction costs,
Arbitrage opportunities in futures market brokerage, margin deposits etc.
Arbitrage is simultaneous purchase and sale of an asset or replicating asset in the
market in an attempt to profit from discrepancies in their prices. Arbitrage involves Illustrations:
activity on one or several instruments/assets in one or different markets, Cash and carry arbitrage
simultaneously. Important point to understand is that in an efficient market, arbitrage The following data is available on stock A as on April 1, 2020.
opportunities may exist only for shorter period or none at all. The moment an arbitrager Cash market price Rs. 1500
spots an arbitrage opportunity, he would initiate the arbitrage to eliminate the arbitrage June Futures Rs. 1550
opportunity. Contract multiplier for stock 100 shares
Arbitrage occupies a prominent position in the futures world as a mechanism that keeps Assume an implied cost of carry of 9% per annum i.e. around 0.75% per month.
the prices of futures contracts aligned properly with prices of the underlying assets. The Theoretically/ fair price of June futures is 1534.13 (= 1500* e0.0075*3 or 1500* e0.09*3/12).
objective of arbitragers is to make profits without taking risk, but the complexity of Going by the theoretical price, we may say that June futures on stock A are overvalued.
activity is such that it may result in losses as well. Well-informed and experienced To take advantage of the mispricing, an arbitrageur may buy 100 shares of stock A and
professional traders, equipped with powerful calculating and data processing tools, sell 1 futures contract on that at given prices. This would result in the arbitrage profit of
normally undertake arbitrage. Rs. 1587 (= 100 X 15.87), which is the difference between actual and fair prices for 100
Arbitrage in the futures market can typically be of three types: shares. Position of the arbitrager in various scenarios of stock price would be as follows:
 Cash and carry arbitrage: Cash and carry arbitrage refers to a long position in the Case I: Stock rises to Rs. 1580 on expiry day
cash or underlying market and a short position in futures market. Profit on underlying = (1580 – 1500) x 100 = Rs. 8000
 Reverse cash and carry arbitrage: Reverse cash and carry arbitrage refers to long Loss on futures = (1580 - 1550) x 100 = Rs. 3000
position in futures market and short position in the underlying or cash market. Gain on Arbitrage = Rs. 5000
 Inter-Exchange arbitrage: This arbitrage entails two positions on the same Cost of Arbitrage in terms of financing (Rs. 34.13 * 100 shares) = Rs. 3413
contract in two different markets/ exchanges. Net gain out of arbitrage = (5000 – 3413) = Rs. 1587
Case II: Stock falls to Rs.1480 on expiry day
These three positions are elaborated with the help of examples. To simplify the
Loss on underlying = (1500 - 1480) x 100 = Rs. 2000
calculations, it is assumed that there is no resistance like transaction costs, impact cost,
Profit on futures = (1550 - 1480) x 100 = Rs. 7000
taxes etc., but in reality, arbitrage may not be as easy and costless as presumed in these
Gain on Arbitrage = Rs. 5000
simplified examples. In a simplified world of the kind described by our assumptions,
Cost of Arbitrage in terms of financing (Rs. 34.13 * 100 shares) = Rs. 3413
actual futures prices are assumed to be exactly equal to the fair price or theoretical
Net gain out of arbitrage = (5000 – 3413) = Rs. 1587
price, which is spot price plus cost of carry.
Reverse cash and carry arbitrage
In the language of simple mathematics, Fair futures price F = S + C
The reverse cash and carry arbitrage is done when the futures are trading at a discount
where S stands for Spot price and C stands for Holding costs/carrying costs. to the cash market price. Let us look at the following data on stock B as on April 1, 2020.

42 43
Cash market price Rs. 100 Inter-market arbitrage
April futures price Rs. 90 This arbitrage opportunity arises because of some price differences existing in same
underlying at two different exchanges. If August futures on stock Z are trading at Rs. 101
The prices trading in the market reflect a negative cost of carry, which offers an
opportunity to the traders to execute reverse cash and carry arbitrage as cost of carry is at NSE and Rs. 100 at BSE, the trader can buy a contract at BSE and sell at NSE. The
expected to reverse to positive at some point in time during contract’s life. Otherwise, positions could be reversed over a period of time when difference between futures
prices squeeze. This would be profitable to an arbitrageur.
also, if the trader carries his position till the expiry, it will yield him an arbitrage profit.
The assumption in implementing this arbitrage opportunity is that the arbitrager has got It is important to note that the cost of transaction and other incidental costs involved in
the stock to sell in the cash market, which will be bought back at the time of reversing the deal must be analysed properly by the arbitragers before entering into the
the position. If stock is not available, arbitrager needs to borrow the stock to implement transaction.
the arbitrage. In that case, while analysing the profitability from the transaction, cost of
In the light of above, we may conclude that futures provide market participants with a
borrowing of stock would also be taken into account. quick and less expensive mode to alter their portfolio composition to arrive at the
Assuming the contract multiplier for futures contract on stock B is 200 shares. To desired level of risk. As they could be used to either add risk to the existing portfolios or
execute the reverse cost and carry, arbitrager would buy one April futures at Rs 90 and reduce risk of the existing portfolios, they are essentially risk management and portfolio
sell 200 shares of stock B at Rs 100 in cash market. This would result in the arbitrage restructuring tools.
profit of Rs 2000 (200 X Rs 10). Position of the arbitrager in various scenarios of stock
price would be as follows:
Case I: Stock rises to Rs. 110 on expiry day
Loss on underlying = (110 - 100) x 200 = Rs. 2000
Profit on futures = (110 - 90) x 200 = Rs. 4000
Net gain out of arbitrage = Rs. 2000
Case II: Stock falls to Rs. 85 on expiry day
Profit on underlying = (100 - 85) x 200 = Rs. 3000
Loss on futures = (90 - 85) x 200 = Rs. 1000
Net gain out of arbitrage = Rs. 2000
On maturity, when the futures price converges with the spot price of underlying, the
arbitrageur is in a position to buy the stock back at the closing price/ settlement price of
the day.
Our assumption in the above example is that both the positions (i.e. in cash and futures)
were held until maturity. However, one can always square off one’s position before the
expiry of the contract, whenever one feels that the market prices are favourable. Let us
understand this point with the help of an example. If in the above example of reverse
cost and carry, on any day in April before the maturity date, spot price of stock B is Rs.
130 and April futures are at Rs. 135, arbitrager could reverse both his positions i.e.,
buying the stock at Rs. 130 and selling futures at Rs. 135. This would result in the
following position:
Loss on underlying = (130 - 100) x 200 = Rs. 6000
Profit on futures = (135 - 90) x 200 = Rs. 9000
Net gain out of arbitrage = Rs. 3000
The above example on reverse cash and carry arbitrage can also be expanded to include
the interest income generated out of investing the sale proceeds of the stock.

44 45
Chapter 4: Introduction to Options 6. Open price : 271.95
7. High price : 310.00
LEARNING OBJECTIVES: 8. Low price : 233.25
After studying this chapter, you should know about: 9. Close price : 245.05
 Concept of Options 10. Traded Volume : 14,941 contracts
11. Open Interest : 9,83,775
 Payoffs in case of option contracts
12. Underlying value : 10154.20
 Fundamentals relating to option pricing
 Option Greeks Quote for Nifty Put option as on March 7, 2018
 Uses of Options 1. Instrument type : Option Index
2. Underlying asset : Nifty 50
3. Expiry date : March 28, 2018
4.1 Basics of options
4. Option type : Put European
As seen in earlier section, forward/futures contract is a commitment to buy/sell the
5. Strike Price : 10000
underlying and has a linear pay off, which indicates unlimited losses and profits. Some
6. Open price : 74.50
market participants desired to ride upside and restrict the losses. Accordingly, options
7. High price : 86.70
emerged as a financial instrument, which restricted the losses with a provision of
8. Low price : 66.55
unlimited profits on buy or sell of underlying asset.
9. Close price : 80.40
An Option is a contract that gives the right, but not an obligation, to buy or sell the 10. Traded Volume : 2,00,111 contracts
underlying asset on or before a stated date/day, at a stated price, for a price. The party 11. Open Interest : 40,83,000
taking a long position i.e. buying the option is called buyer/ holder of the option and the 12. Underlying value : 10154.20
party taking a short position i.e. selling the option is called the seller/ writer of the
Index option: These options have index as the underlying asset. For example, options on
option.
Nifty, Sensex, etc.
The option buyer has the right but no obligation with regards to buying or selling the
Stock option: These options have individual stocks as the underlying asset. For example,
underlying asset, while the option writer has the obligation in the contract. Therefore,
option on ONGC, NTPC etc.
option buyer/ holder will exercise his option only when the situation is favourable to
him, but, when he decides to exercise, option writer would be legally bound to honour Buyer of an option: The buyer of an option is one who has a right but not the obligation
the contract. in the contract. For owning this right, he pays a price to the seller of this right called
‘option premium’ to the option seller.
Options may be categorized into two main types:
 Call Options Writer of an option: The writer of an option is one who receives the option premium
 Put Options and is thereby obliged to sell/buy the asset if the buyer of option exercises his right.
Option, which gives buyer a right to buy the underlying asset, is called Call option and American option: The owner of such option can exercise his right at any time on or
the option which gives buyer a right to sell the underlying asset, is called Put option. before the expiry date/day of the contract.
Option terminology European option: The owner of such option can exercise his right only on the expiry
date/day of the contract. In India, Index options are European.
There are several terms used in the options market. Let us comprehend on each of them
with the help of the following price: Option price/Premium: It is the price which the option buyer pays to the option seller.
In our examples, option price for call option is Rs. 245.05 and for put option is Rs. 80.40.
Quote for Nifty Call option as on March 7, 2018
Premium traded is for single unit of nifty and to arrive at the total premium in a
1. Instrument type : Option Index contract, we need to multiply this premium with the lot size.
2. Underlying asset : Nifty 50
Lot size: Lot size is the number of units of underlying asset in a contract. Lot size of Nifty
3. Expiry date : March 28, 2018
option contracts is 75. Accordingly, in our examples, total premium for call option
4. Option type : Call European
5. Strike Price : 10000
46 47
contract would be Rs 245.05 x 75= Rs 18378.75 and total premium for put option Similarly, for put option which is in-the-money, intrinsic value is the excess of exercise
contract would be Rs 80.40 x 75 = Rs 6030. price (X) over the spot price (S). Thus, intrinsic value of put option can be calculated as
X-S, with minimum value possible as zero.
Expiration Day: The day on which a derivative contract ceases to exist. It is the last
trading date/day of the contract. Like in case of futures, option contracts also expire on Time value: It is the difference between premium and intrinsic value, if any, of an
the last Thursday of the expiry month (or, on the previous trading day, if the last option. ATM and OTM options will have only time value because the intrinsic value of
Thursday is a trading holiday). In our example, since the last Thursday (i.e., March 29, such options is zero.
2018) is a trading holiday, both the call and put options expire one day before that i.e.
Open Interest: As discussed in futures section, open interest is the total number of
on 28 March, 2018. (Please note that Weekly Options expire on Thursday of each week.
option contracts outstanding for an underlying asset.
Weekly Options are the Exchange Traded Options based on a Stock or an Index with
shorter maturity of one or more weeks. If the expiry day of the Weekly Options falls on a Exercise of Options
trading Holiday, then the expiry will be on the previous trading day.) In case of American option, buyers can exercise their option any time before the
maturity of contract. All these options are exercised with respect to the settlement
Spot price (S): It is the price at which the underlying asset trades in the spot market. In
value/ closing price of the stock on the day of exercise of option.
our examples, it is the value of underlying viz. 10154.20.
Assignment of Options
Strike price or Exercise price (X): Strike price is the price per share for which the Assignment of options means the allocation of exercised options to one or more option
underlying security may be purchased or sold by the option holder. In our examples,
sellers. The issue of assignment of options arises only in case of American options
strike price for both call and put options is 10000.
because a buyer can exercise his options at any point of time.
In the money (ITM) option: This option would give holder a positive cash flow, if it were
exercised immediately. A call option is said to be ITM, when spot price is higher than 4.2 Pay off Charts for Options
strike price. And, a put option is said to be ITM when spot price is lower than strike Having gone through the basic terminology used in the options market, let us get to the
price. In our examples, call option is in the money. pay off profile of various option positions.
At the money (ATM) option: At the money option would lead to zero cash flow if it Long on option
were exercised immediately. Therefore, for both call and put ATM options, strike price is Buyer of an option is said to be “long on option”. As described above, he/she would
equal to spot price. have a right and no obligation with regard to buying/ selling the underlying asset in the
Out of the money (OTM) option: Out of the money option is one with strike price worse contract. When you are long on equity option contract:
than the spot price for the holder of option. In other words, this option would give the  You have the right to exercise that option.
holder a negative cash flow if it were exercised immediately. A call option is said to be  Your potential loss is limited to the premium amount you paid for buying the
OTM, when spot price is lower than strike price. And a put option is said to be OTM option.
when spot price is higher than strike price. In our examples, put option is out of the  Profit would depend on the level of underlying asset price at the time of
money. exercise/expiry of the contract.
Intrinsic value: Option premium, defined above, consists of two components - intrinsic Short on option
value and time value. Seller of an option is said to be “short on option”. As described above, he/she would
have obligation but no right with regard to selling/buying the underlying asset in the
For an option, intrinsic value refers to the amount by which option is in the money i.e. contract. When you are short (i.e., the writer of) an equity option contract:
the amount an option buyer will realize, before adjusting for premium paid, if he
 Your maximum profit is the premium received.
exercises the option instantly. Therefore, only in-the-money options have intrinsic value
 You can be assigned an exercised option any time during the life of option
whereas at-the-money and out-of-the-money options have zero intrinsic value. The
contract (for American Options only). All option writers should be aware that
intrinsic value of an option can never be negative.
assignment is a distinct possibility.
Thus, for call option which is in-the-money, intrinsic value is the excess of spot price (S)  Your potential loss is theoretically unlimited as defined below.
over the exercise price (X). Thus, intrinsic value of call option can be calculated as S-X,
Now, let us understand each of these positions in detail:
with minimum value possible as zero because no one would like to exercise his right
under no advantage condition. Long Call

48 49
On March 1, 2018, Nifty is at 10460. You buy a call option with strike price of 10500 at a
premium of Rs. 115 with expiry date March 28, 2018. A Call option gives the buyer the
right, but not the obligation to buy the underlying at the strike price. So in this example,
you have the right to buy Nifty at 10500. You may buy or you may not buy, there is no
compulsion. If Nifty closes above 10500 at expiry, you will exercise the option, else you
will let it expire. What will be your maximum profits/ losses under different conditions
at expiry, we will try to find out using pay off charts.
If Nifty closes at 10400, you will NOT exercise the right to buy the underlying (which you
have got by buying the call option) as Nifty is available in the market at a price lower
than your strike price. Why will you buy something at 10500 when you can have the
same thing at 10400? So you will forego the right. In such a situation, your loss will be
equal to the premium paid, which in this case is Rs. 115.
If Nifty were to close at 10615, you will exercise the option and buy Nifty at 10500 and
make profit by selling it at 10615. In this transaction you will make a profit of Rs. 115,
but you have already paid this much money to the option seller right at the beginning,
when you bought the option. So 10615 is the Break Even Point (BEP) for this option
contract. A general formula for calculating BEP for call options is strike price plus
premium (X + P).
If Nifty were to close at 11000, you will exercise the option and buy Nifty at 10500 and The contract value for a Nifty option with lot size of 75 and strike price of 10500 is 75 *
sell it in the market at 11000, thereby making a profit of Rs. 500. But since you have 10500 = 787500.
already paid Rs. 115 as option premium, your actual profit would be 500 – 115 = 385. The maximum loss for such an option buyer would be equal to 115 * 75 = 8625
For profits/losses for other values, a table is given below. This table is used to draw the As Nifty goes above 10615, you start making profit on exercising the option and if it
pay off chart given in the next page. stays below 10615, you as a buyer always have the freedom not to exercise the option.
But as seen from table and chart you can reduce your losses as soon as nifty goes above
Strike Price (X) 10500
10500. Long call position helps you to protect your loss to a maximum of Rs. 8625 with
Premium 115
unlimited profit.
Pay off for Long Short Call
Nifty at Expiry Premium Paid Buy Nifty at Sell Nifty at Call Position Whenever someone buys a call option, there has to be a counterparty, who has sold
A B C D=A+B+C that call option. If the maximum loss for a long call position is equal to the premium
10200 -115 -10200 10200 -115 paid, it automatically means that the maximum gain for the short call position will be
10300 -115 -10300 10300 -115 equal to the premium received. Similarly, if maximum gain for long call position is
10400 -115 -10400 10400 -115 unlimited, then even maximum loss for the short call position has to be unlimited.
10500 -115 -10500 10500 -115 Lastly, whenever, the long call position is making losses, the short call position will make
10600 -115 -10500 10600 -15 profits and vice versa. Hence, if we have understood long call pay off, short call pay off
10700 -115 -10500 10700 85 chart will be just the water image of the long call pay off. Thus at 10200 Nifty, when long
10800 -115 -10500 10800 185 call position makes a loss of Rs. 115, short call position will make a profit of Rs. 115.
10900 -115 -10500 10900 285 Similarly for 11000, when long call makes a profit of 385, short call position will lose
11000 -115 -10500 11000 385 385.As Nifty starts rising, short call position will go deeper into losses.
11100 -115 -10500 11100 485
11200 -115 -10500 11200 585 Strike Price (X) 10500
11300 -115 -10500 11300 685 Premium 115
11400 -115 -10500 11400 785
50 51
 Pay off for Pay off for Premium is received by the seller of the option. However, he has to pay the margin. This
Premium Buy Nifty Sell Nifty Long Call Short Call is because the option seller has an obligation and since his losses can be unlimited, he
Nifty at Expiry Paid at at Position Position can be a potential risk for the stability of the system.
A B C D = A+B+C -D Long Put
10200 -115 -10200 10200 -115 115 On March 1, 2018, Nifty is at 10460. You buy a put option with strike price of 10500 at a
10300 -115 -10300 10300 -115 115 premium of Rs 160 with expiry date March 28, 2018. A put option gives the buyer of the
10400 -115 -10400 10400 -115 115 option the right, but not the obligation, to sell the underlying at the strike price. In this
10500 -115 -10500 10500 -115 115 example, you can sell Nifty at 10500. When will you do so? You will do so only when
10600 -115 -10500 10600 -15 15 Nifty is at a level lower than the strike price. So if Nifty goes below 10500 at expiry, you
10700 -115 -10500 10700 85 -85 will buy Nifty from market at lower price and sell at strike price. If Nifty stays above
10800 -115 -10500 10800 185 -185 10500, you will let the option expire. The maximum loss in this case as well (like in long
10900 -115 -10500 10900 285 -285 call position) will be equal to the premium paid; i.e. Rs. 160.
11000 -115 -10500 11000 385 -385
What can be the maximum profit? Theoretically, Nifty can fall only till zero. So maximum
11100 -115 -10500 11100 485 -485 profit will be when you buy Nifty at zero and sell it at strike price of 10500. The profit in
11200 -115 -10500 11200 585 -585 this case will be Rs. 10500, but since you have already paid Rs. 160 as premium, your
11300 -115 -10500 11300 685 -685 profit will reduce by that much to 10500 – 160 = 10340.
11400 -115 -10500 11400 785 -785
Breakeven point in this case will be equal to strike price – premium (X – P). In our
The pay off chart for a short call position is shown below. Maximum gain for an option example breakeven point will be equal to 10500 – 160 = 10340. Thus when Nifty starts
seller, as explained earlier, will be equal to the premium received (as long as Nifty stays moving below 10340, will you start making profits.
below strike price) whereas maximum loss can be unlimited (when Nifty starts moving
above BEP). BEP for a short call position will also be equal to X + P. BEP is independent The pay off chart for long put position is drawn using the below table.
of position (long or short), it is instrument specific (call option). Strike Price (X) 10500
Premium 160

Pay off for

Long Put
Nifty at Expiry Premium Paid Buy Nifty at Sell Nifty at Position
A B C D=A+B+C
9700 -160 -9700 10500 640
9800 -160 -9800 10500 540
9900 -160 -9900 10500 440
10000 -160 -10000 10500 340
10100 -160 -10100 10500 240
10200 -160 -10200 10500 140
10300 -160 -10300 10500 40
10400 -160 -10400 10500 -60
10500 -160 -10500 10500 -160
10600 -160 -10600 10600 -160
10700 -160 -10700 10700 -160
10800 -160 -10800 10800 -160
For a lot size of 75, the contract value is 75 * 10500 = 787500.
10900 -160 -10900 10900 -160

52 53
 9700 -160 -9700 10500 640 -640
9800 -160 -9800 10500 540 -540
9900 -160 -9900 10500 440 -440
10000 -160 -10000 10500 340 -340
10100 -160 -10100 10500 240 -240
10200 -160 -10200 10500 140 -140
10300 -160 -10300 10500 40 -40
10400 -160 -10400 10500 -60 60
10500 -160 -10500 10500 -160 160
10600 -160 -10600 10600 -160 160
10700 -160 -10700 10700 -160 160
10800 -160 -10800 10800 -160 160
10900 -160 -10900 10900 -160 160

The maximum loss for the option buyer is the premium paid, which is equal to 160 * 75
= 12000, where 75 is the lot size. Contract value for this put option is 10500 * 75 =
787500.
A put option buyer need not pay any margin. This is because he has already paid the
premium and there is no more risk that he can cause to the system. A margin is paid
only if there is any obligation. An option buyer (either buyer of a call option or a put
option) has no obligation.
Short Put
What will be the position of a put option seller/writer? Just the opposite of that of the
put option buyer. When long put makes profit, short put will make loss. If maximum loss
for long put is the premium paid, then maximum profit for the short put has to be equal
to the premium received. If maximum profit for long put is when price of underlying falls
to zero at expiry, then that also will be the time when short put position makes
maximum loss.
Contract value in this case will be equal to 10500 * 75 = 787500 and premium received
The table below shows the profit/ loss for short put position. An extra column is added will be equal to 160 * 75 = 12000.
to the above table to show positions for short put. The pay off chart is drawn using this
Seller of the put option receives the premium but he has to pay the margin on his
table.
position as he has an obligation and his losses can be huge.
Strike Price (X) 10500
As can be seen above, options are products with asymmetric risk exposure i.e., the gains
Premium 160
when the underlying asset moves in one direction is significantly different from the
losses when the underlying asset moves in the opposite direction. For example, under a
Pay off for Pay off for
call option, when a stock price goes down, the loss incurred by the buyer of this option
Premium Long Put Short Put
is limited to the purchase price of the option. But if the stock price goes up, the buyer of
Nifty at Expiry Paid Buy Nifty at Sell Nifty at Position Position
the call gains in proportion to the rise in the stock’s value, thereby giving asymmetric
A B C D = A+B+C -D pay off. In contrast to this, futures have symmetric risk exposures (symmetric pay off).

54 55
Opening a Position 4.3 Basics of Option Pricing and Option Greeks
An opening transaction is one that adds to, or creates a new trading position. It can be Option pricing fundamentals
either a purchase or a sale. With respect to an option transaction, we will consider both: In our above examples, we have seen that call option premium is Rs. 115 and put option
 Opening purchase (Long on option) – A transaction in which the purchaser’s premium is Rs. 160. The question is from where did we get these values? On what basis
intention is to create or increase a long position in a given series of options. did market participants come to these values of the premiums? What are the
 Opening sale (Short on option) – A transaction in which the seller’s intention is to parameters that affect these values? Are these fixed by the stock exchanges or by SEBI?
create or increase a short position in a given series of options.
The answer lies in understanding what affects options? Prices are never fixed by stock
Closing a position exchanges or SEBI or anybody for that matter. In fact, price discovery is a very critical
A closing transaction is one that reduces or eliminates an existing position by an and basic component of markets. Stock exchanges only provide a platform where buyers
appropriate offsetting purchase or sale. This is also known as “squaring off” your and sellers meet, and SEBI’s role is to ensure smooth functioning of our markets.
position. With respect to an option transaction:
Any option’s value increases or decreases depending upon different variables. Each
 Closing purchase – A transaction in which the purchaser’s intention is to reduce variable has its impact on an option. The impact can be same or different for a call and
or eliminate a short position in a given series of options. This transaction is put option.
frequently referred to as “covering” a short position.
 Closing sale – A transaction in which the seller’s intention is to reduce or As explained in the earlier section, option premium is the sum of intrinsic value and time
eliminate a long position in a given series of options. value. As long as the option is not expired, there will always be some time value.
Intrinsic value may or may not be there, depending upon whether the option is ITM,
Note: A trader does not close out a long call position by purchasing a put (or any other ATM or OTM.
similar transaction). A closing transaction for an option involves the purchase or sale of
an option contract with the same terms. Time value of the option in turn depends upon how much time is remaining for the
option to expire and how volatile is the underlying.
Leverage
An option buyer pays a relatively small premium for market exposure in relation to the Thus there are five fundamental parameters on which the option price depends:
contract value. This is known as leverage. In our examples above (long call and long put), 1) Spot price of the underlying asset
we have seen that the premium paid (Rs 8,625 for long call and Rs 12000 for long put) 2) Strike price of the option
was only a small percentage of the contract value (Rs 7,87,500 in both cases). A trader 3) Volatility of the underlying asset’s price
can see large percentage gains from comparatively small, favourable percentage moves 4) Time to expiration
in the underlying equity. 5) Interest rates

Leverage also has downside implications. If the underlying price does not rise/fall as These factors affect the premium/ price of options (both American & European) in
anticipated during the lifetime of the option, leverage can magnify the trader’s several ways.
percentage loss. Options offer their owners a predetermined, set risk. However, if the Spot price of the underlying asset
owner’s options expire with no value, this loss can be the entire amount of the premium The option premium is affected by the price movements in the underlying instrument. If
paid for the option. price of the underlying asset goes up the value of the call option increases while the
Risk and return profile of option contracts value of the put option decreases. Similarly, if the price of the underlying asset falls, the
Risk Return value of the call option decreases while the value of the put option increases.
Long Premium paid Unlimited Strike Price
Short Unlimited Premium received If all the other factors remain constant but the strike price of option increases, intrinsic
A long option position has limited risk (premium paid) and unlimited profit potential. A value of the call option will decrease and hence its value will also decrease. On the other
short option position has unlimited downside risk, but limited upside potential (to the hand, with all the other factors remaining constant, increase in strike price of option
extent of premium received) increases the intrinsic value of the put option which in turn increases its option value.
Volatility
It is the magnitude of movement in the underlying asset’s price, either up or down. It
affects both call and put options in the same way. Higher the volatility of the underlying

56 57
stock, higher the premium because there is a greater possibility that the option will Call option price can be calculated as: C = SN(d1) - Xe-rt N(d2)
move in-the-money during the life of the contract. And
Higher volatility = Higher premium, Lower volatility = Lower premium (for both call and Put option price can be calculated as: P = Xe-rt N(-d2) - SN(-d1)
put options). Where,
Time to expiration D1=[In(S/X)+(r+v2/2)t]/ vt
The effect of time to expiration on both call and put options is similar to that of volatility D2 = d1-vt
on option premiums. Generally, longer the maturity of the option greater is the And the variables are
uncertainty and hence the higher premiums. If all other factors affecting an option’s  S = stock price
price remain same, the time value portion of an option’s premium will decrease with  X = strike price
the passage of time. This is also known as time decay. Options are known as ‘wasting  t = time remaining until expiration, expressed in years
assets’, due to this property where the time value gradually falls to zero.  r = current continuously compounded risk-free interest rate
It is also interesting to note that of the two component of option pricing (time value and  v = annual volatility of stock price (the standard deviation of the short-term
intrinsic value), one component is inherently biased towards reducing in value; i.e. time returns over one year)
value. So if all things remain constant throughout the contract period, the option price  In = natural logarithm
will always fall in price by expiry. Thus option sellers are at a fundamental advantage as  N(x) = standard normal cumulative distribution function
compared to option buyers as there is an inherent tendency in the price to go down.  e = the exponential function
Interest Rates
Option Greeks
Interest rates are slightly complicated because they affect different options, differently.
Option premiums change with changes in the factors that determine option pricing i.e.
For example, interest rates have a greater impact on options with individual stocks and
factors such as strike price, volatility, term to maturity etc. The sensitivities most
indices compared to options on futures. To put it in simpler way high interest rates will
commonly tracked in the market are known collectively as “Greeks” represented by
result in an increase in the value of a call option and a decrease in the value of a put
Delta, Gamma, Theta, Vega and Rho.
option.
Options Pricing Models Delta (δ or ∆)
There are various option pricing models which traders use to arrive at the right value of The most important of the ‘Greeks’ is the option’s “Delta”. This measures the sensitivity
the option. Some of the most popular models are briefly discussed below: of the option value to a given small change in the price of the underlying asset. It may
also be seen as the speed with which an option moves with respect to price of the
The Binomial Pricing Model
underlying asset.
The binomial option pricing model was developed by William Sharpe in 1978. It has
proved over time to be the most flexible, intuitive and popular approach to option Delta = Change in option premium/ Unit change in price of the underlying asset.
pricing. Delta for call option buyer is positive. This means that the value of the contract
The binomial model represents the price evolution of the option’s underlying asset as increases as the share price rises. To that extent it is rather like a long or ‘bull’ position
the binomial tree of all possible prices at equally-spaced time steps from today under in the underlying asset. Delta for call option seller will be same in magnitude but with
the assumption that at each step, the price can only move up and down at fixed rates the opposite sign (negative).
and with respective simulated probabilities. Delta for put option buyer is negative. The value of the contract increases as the share
This is a very accurate model as it is iterative, but also very lengthy and time consuming. price falls. This is similar to a short or ‘bear’ position in the underlying asset. Delta for
put option seller will be same in magnitude but with the opposite sign (positive).
The Black & Scholes Model
Therefore, delta is the degree to which an option price will move given a change in the
The Black & Scholes model was published in 1973 by Fisher Black and Myron Scholes. It
underlying stock or index price, all else being equal.
is one of the most popular, relative simple and fast modes of calculation. Unlike the
binomial model, it does not rely on calculation by iteration. The knowledge of delta is of vital importance for option traders because this parameter
is heavily used in margining and risk management strategies. The delta is often called
This model is used to calculate a theoretical call price (ignoring the dividends paid during the hedge ratio, e.g. if you have a portfolio of ‘n’ shares of a stock then ‘n’ divided by the
the life of the option) using the five key determinants of an option’s price: stock price, delta gives you the number of calls you would need to be short (i.e. need to write) to
strike price, volatility, time to expiration, and short-term (risk free) interest rate. create a hedge. In such a “delta neutral” portfolio, any gain in the value of the shares

58 59
held due to a rise in the share price would be exactly offset by a loss on the value of the is the option value/premium. In case of at-the-money or out-of-the-money options
calls written, and vice versa. there is no intrinsic value but only time value. Hence, these options remain cheaper
compared to in-the-money options. Therefore, option buyer pays higher premium for
Gamma (γ)
It measures change in delta with respect to change in price of the underlying asset. This in-the-money option compared to at-the-money or out-of-the-money options and thus,
is called a second derivative option with regard to price of the underlying asset. It is the cost factor largely influences the decision of an option buyer.
calculated as the ratio of change in delta for a unit change in market price of the For ATM options, the uncertainty is highest as compared to ITM or OTM options. This is
underlying asset. because we know that when an option is ITM or OTM, even if the price moves
Gamma = Change in an option delta / Unit change in price of underlying asset somewhat, in any direction, still the option will largely remain ITM or OTM as the case
may be.
Gamma works as an acceleration of the delta, i.e. it signifies the speed with which an
option will go either in-the-money or out-of-the-money due to a change in price of the But in case of ATM options, even a small price movement in either direction can tip the
underlying asset. option from ATM to ITM or OTM. There is a huge uncertainty here and this uncertainty
is a function of time to expiry and volatility of the underlying, both of which are
Theta (θ)
It is a measure of an option’s sensitivity to time decay. Theta is the change in option captured in the time value
price given a one-day decrease in time to expiration. It is a measure of time decay. Analysis of Call Option Trading from Buyer’s Perspective
Theta is generally used to gain an idea of how time decay is affecting your option The spot price of Nifty on March 1, 2018, was 10460. Let us consider call options with
positions. strike prices of 10300, 10400, 10500 and 10600. A call option buyer will buy the option
Theta = Change in an option premium / Change in time to expiry and pay the premium upfront. The premiums for various strike prices are as follows:
Usually theta is negative for a long option, whether it is a call or a put. Other things Strike Price Premium
being equal, options tend to lose time value each day throughout their life. This is due 10300 170
to the fact that the uncertainty element in the price decreases. 10400 115
Vega (ν) 10500 72
This is a measure of the sensitivity of an option price to changes in market volatility. It is 10600 34
the change of an option premium for a given change (typically 1%) in the underlying The 10300 strike call option is deep in the money and has an intrinsic value of 10460 –
volatility. 10300 = 160. Hence the option premium will be at least equal to this value. The
Vega = Change in an option premium / Change in volatility remaining portion of the premium is the time value (170 – 160 = 10)
Vega is positive for a long call and a long put. An increase in the assumed volatility of the The 10600 strike call option is out of the money option. There is no intrinsic value here.
underlying increases the expected payout from a buy option, whether it is a call or a The entire option premium is attributed to risk associated with time, i.e. time value.
put. Pay offs for call options with different strikes and premiums
Rho (ρ) Nifty Closing
X 10300 10400 10500 10600
Rho is the change in option price given a one percentage point change in the risk-free P 170 115 72 34
on Expiry
interest rate. Rho measures the change in an option’s price per unit increase in the cost BEP 10470 10515 10572 10634
of funding the underlying.
Rho = Change in an option premium / Change in cost of funding the underlying 10100 -170 -115 -72 -34
10200 -170 -115 -72 -34
4.4 Uses of Options
10300 -170 -115 -72 -34
Perspectives of Option Traders
An important decision that a trader needs to make is which option he should trade: in- 10400 -70 -115 -72 -34
the-money, at-the-money or out-of-the-money. Among other things, a trader must also 10500 30 -15 -72 -34
consider the premium of these three options in order to make an educated decision. As 10600 130 85 28 -34
discussed earlier there are two components in the option premium – intrinsic value and 10700 230 185 128 66
time value. If the option is deeply in-the-money, the intrinsic value will be higher and so 10800 330 285 228 166
10900 430 385 328 266
60 61
 11000 530 485 428 366 Profit on strike price 10600 option = 10700 – 10600 – 34 = 66
11100 630 585 528 466 Return on investment = 66 / 34 = 194%
11200 730 685 628 566
11300 830 785 728 666 Seller of call option
11400 930 885 828 766 A call option seller has a neutral to bearish perspective regarding the underlying price.
Pay offs for call options with different strikes and premiums
X 10300 10400 10500 10600
Nifty Closing
P 170 115 72 34
on Expiry
BEP 10470 10515 10572 10634

10100 170 115 72 34

10200 170 115 72 34
10300 170 115 72 34
10400 70 115 72 34
10500 -30 15 72 34
10600 -130 -85 -28 34
10700 -230 -185 -128 -66
10800 -330 -285 -228 -166
10900 -430 -385 -328 -266
11000 -530 -485 -428 -366
11100 -630 -585 -528 -466
11200 -730 -685 -628 -566
11300 -830 -785 -728 -666
11400 -930 -885 -828 -766
If Nifty closes below 10300 at expiry i.e. on March 28, 2018, all options will expire out of
the money i.e. they are worthless. The greatest loss will be for option with strike price
10300 (Rs 170) and least loss will be incurred on strike 10600 option (Rs 34).
Profitability for call options
As seen earlier when a buyer is bullish on nifty, he can buy call option with any strike
price. The choice of option would be better understood with return on investment
(ROI). In each case, ROI is defined as net profit as a percentage of premium paid by the
option buyer.
To illustrate, if Nifty goes up to 10700 at maturity, then ROI for all the four options will
be as below:
Profit on strike price 10300 option = 10700 – 10300 – 170 = 230
Return on investment = 230 / 170 = 135%

Profit on strike price 10400 option = 10700 – 10400 – 115 = 185

Return on investment = 185 / 115 = 161%

Profit on strike price 10500 option = 10700 – 10500 – 72 = 128

Return on investment = 128 / 72 = 178%

62 63
 Analysis of Put Option Trading from a Buyers’ Perspective
Spot Nifty on March 1, 2018 was 10460. A person bearish on the Nifty can buy a put
option of any strike available. Let us consider put options of strike prices 10300, 10400,
10500 and 10600. The premiums for each of these are given below:
Strike Price Premium
10300 125
10400 173
10500 221
10600 290
The 10600 strike put option is ITM whereas the 10300 strike put option is OTM. In case
of the 10600 strike option, the intrinsic value is 10600 – 10460 = 140 and 290 – 140 =
150 is the time value.
For the other two options, the entire premium is the time value
Pay offs for put options with different strikes and premiums
X 10300 10400 10500 10600
Nifty Closing
P 125 173 221 290
on Expiry
BEP 10175 10227 10279 10310

9500 675 727 779 810

The strike price of 10600 is in the money and hence the sellers are expecting a higher
9600 575 627 679 710
premium of Rs. 290 for it. Similarly strike price 10300 is out of the money and so the
9700 475 527 579 610
contract is selling at low premium of Rs. 125.
9800 375 427 479 510
9900 275 327 379 410 In terms of return on investment criterion, buyer of deep out of the money option will
10000 175 227 279 310 gain the maximum return, if price of the Nifty falls drastically.
10100 75 127 179 210 To illustrate if Nifty falls to 10000 at maturity then ROI for all the three options will be as
10200 -25 27 79 110 below:
10300 -125 -73 -21 10 Profit on strike price 10300 option = 10300 – 10000 – 125 = 175
10400 -125 -173 -121 -90 Return on investment = 175 / 125 = 140%
10500 -125 -173 -221 -190 Profit on strike price 10400 option = 10400 – 10000 – 173 = 227
10600 -125 -173 -221 -290 Return on investment = 227 / 173 = 131%
10700 -125 -173 -221 -290
10800 -125 -173 -221 -290 Profit on strike price 10500 option = 10500 – 10000 – 221 = 279
Return on investment = 279 / 221 = 126%
Profit on strike price 10600 option = 10600 – 10000 – 290 = 310
Return on investment = 310 / 290 = 107%
Seller of put option
Pay offs for put options with different strikes and premiums
X 10300 10400 10500 10600
Nifty Closing
P 125 173 221 290
on Expiry
BEP 10175 10227 10279 10310

64 65
 9500 -675 -727 -779 -810 Chapter 5: Option Trading Strategies
9600 -575 -627 -679 -710
9700 -475 -527 -579 -610 LEARNING OBJECTIVES:
9800 -375 -427 -479 -510 After studying this chapter, you should know about the following option trading
9900 -275 -327 -379 -410 strategies:
10000 -175 -227 -279 -310  Option spreads
10100 -75 -127 -179 -210  Straddle
10200 25 -27 -79 -110  Strangle
10300 125 73 21 -10  Covered call
10400 125 173 121 90  Protective Put
10500 125 173 221 190  Collar
10600 125 173 221 290  Butterfly Spread
10700 125 173 221 290 Having understood the risk/ return profiles for vanilla call/ put options, now we turn to
10800 125 173 221 290 using these products to our advantage – called option strategies. The only limiting factor
for strategies is the thought of the trader/ strategy designer. As long as the trader can
think of innovative combinations of various options, newer strategies will keep coming
to the market. Exotic products (or ‘exotics’) are nothing but a combination of different
derivative products. In this section, we will see some of the most commonly used
strategies.

5.1 Option Spreads

Spreads involve combining options on the same underlying and of same type (call/ put)
but with different strikes and maturities. These are limited profit and limited loss
positions. They are primarily categorized into three sections as:
 Vertical Spreads
 Horizontal Spreads
 Diagonal Spreads
Vertical Spreads
Vertical spreads are created by using options having same expiry but different strike
prices. Further, these can be created either using calls as combination or puts as
combination. These can be further classified as:
 Bullish Vertical Spread
As per the table and charts, the seller of put option has more risk to sell deep in the o Using Calls
money put options even though they fetch higher returns in terms of option premiums. o Using Puts
On the other hand, selling deep out of the money put options is less risky but they come  Bearish Vertical Spread
with low premium. o Using Calls
Summary o Using Puts
From a trader’s perspective, we may say that he has the choice of futures of various Bullish Vertical Spread using Calls
expiries and also options of various expiries and various strikes. Depending upon his A bull spread is created when the underlying view on the market is positive but the
analysis of the then existing market conditions and his risk appetite, he can devise trader would also like to reduce his cost on position. So he takes one long call position
various strategies, which we will see in the next chapter. with lower strike and sells a call option with higher strike. As lower strike call will cost
more than the premium earned by selling a higher strike call, although the cost of

66 67
position reduces, the position is still a net cash outflow position to begin with. Secondly,
as higher strike call is shorted, all gains on long call beyond the strike price of short call
would get negated by losses of the short call. To take more profits from his long call,
trader can short as high strike call as possible, but this will result in his cost coming
down only marginally, as higher strike call will fetch lesser and lesser premium.
Say, for example, a trader is bullish on market, so he decides to go long on 10200 strike
call option by paying a premium of 350 and he expects market to not go above 10800,
so he shorts a 10800 call option and receives a premium of 140. His pay off for various
price moves will be as follows:
Option Call Call
Long/Short Long Short
Strike 10200 10800
Premium 350 140
Spot 10500

CMP Long Call Short Call Net Flow

9500 -350 140 -210
9600 -350 140 -210
9700 -350 140 -210
9800 -350 140 -210
9900 -350 140 -210
As can be seen from the above pay off chart, it is a limited profit and limited loss
10000 -350 140 -210
position. Maximum profit in this position is 390 and maximum loss is 210. BEP for this
10100 -350 140 -210
spread is 10410.
10200 -350 140 -210
10300 -250 140 -110 Bullish Vertical Spread using Puts
10400 -150 140 -10 Here again, the call on the market is bullish, hence, the trader would like to short a put
10500 -50 140 90 option. If prices go up, trader would end up with the premium on sold puts. However, in
10600 50 140 190 case prices go down, the trader would be facing risk of unlimited losses. In order to put
10700 150 140 290 a floor to his downside, he may buy a put option with a lower strike. While this would
10800 250 140 390 reduce his overall upfront premium, benefit would be the embedded insurance against
10900 350 40 390 unlimited potential loss on short put. This is a net premium receipt strategy.
11000 450 -60 390 Let us see this with the help of an example, where the trader goes short in a put option
11100 550 -160 390 of strike 10800 and receives a premium of 300 and goes long in a put option of strike
11200 650 -260 390 10500 and pays a premium of 130:
11300 750 -360 390
11400 850 -460 390
11500 950 -560 390 Option Put Put
Long/Short Short Long
Strike 10800 10500
Premium 300 130
Spot 10500

68 69
 CMP Short Put Long Put Net Flow As can be seen from the picture above, it is a limited profit and limited loss position.
9500 -1000 870 -130 Maximum profit in this position is 170 and maximum loss is 130. BEP for this position is
9600 -900 770 -130 10630.
9700 -800 670 -130 Bearish Vertical Spread using calls
9800 -700 570 -130 Here, the trader is bearish on the market and so he shorts a low strike high premium call
9900 -600 470 -130 option. The risk in a naked short call is that if prices rise, losses could be unlimited. So,
10000 -500 370 -130 to prevent his unlimited losses, he longs a high strike call and pays a lesser premium.
10100 -400 270 -130 Thus in this strategy, he starts with a net inflow.
10200 -300 170 -130
Let us see this with the help of the following table:
10300 -200 70 -130
10400 -100 -30 -130 Option Call Call
10500 0 -130 -130 Long/Short Long Short
10600 100 -130 -30 Strike 10800 10200
10700 200 -130 70 Premium 140 350
10800 300 -130 170 Spot 10500
10900 300 -130 170
11000 300 -130 170 CMP Long Call Short Call Net Flow
11100 300 -130 170 9500 -140 350 210
11200 300 -130 170 9600 -140 350 210
11300 300 -130 170 9700 -140 350 210
11400 300 -130 170 9800 -140 350 210
11500 300 -130 170 9900 -140 350 210
10000 -140 350 210
10100 -140 350 210
10200 -140 350 210
10300 -140 250 110
10400 -140 150 10
10500 -140 50 -90
10600 -140 -50 -190
10700 -140 -150 -290
10800 -140 -250 -390
10900 -40 -350 -390
11000 60 -450 -390
11100 160 -550 -390
11200 260 -650 -390
11300 360 -750 -390
11400 460 -850 -390
11500 560 -950 -390

70 71
 9800 -570 700 130
9900 -470 600 130
10000 -370 500 130
10100 -270 400 130
10200 -170 300 130
10300 -70 200 130
10400 30 100 130
10500 130 0 130
10600 130 -100 30
10700 130 -200 -70
10800 130 -300 -170
10900 130 -300 -170
11000 130 -300 -170
11100 130 -300 -170
11200 130 -300 -170
11300 130 -300 -170
11400 130 -300 -170
11500 130 -300 -170

As can be seen from the picture above, it is a limited profit and limited loss position.
Maximum profit in this position is 210 and maximum loss is 390. BEP for this position is
10410.
Bearish Vertical Spread using puts
Here, again the trader is bearish on the market and so goes long in one put option by
paying a premium. Further, to reduce his cost, he shorts another low strike put and
receives a premium.
For example, if a trader goes long in a put option of strike 10800 and pays a premium of
300 and at the same time to reduce his cost, shorts a 10500 strike put option and earns
a premium of 130, his profits/ losses and pay off would be as under:
Option Put Put
Long/Short Short Long
Strike 10500 10800
Premium 130 300
Spot 10500

CMP Short Put Long Put Net Flow

9500 -870 1000 130
9600 -770 900 130 As can be seen from the picture above, it is a limited profit and limited loss position.
9700 -670 800 130 Maximum profit in this position is 130 and maximum loss is 170. BEP for this position is
10630.

72 73
 Net Flow: 443 – 136 = 307
Horizontal Spread As the stock price keeps moving up, loss on long put position is limited to premium paid,
Horizontal spread involves same strike, same type but different expiry options. This is whereas profit on long call position keeps increasing.
also known as time spread or calendar spread. Here, it is not possible to draw the pay
Thus, it can be seen that for huge swings in either direction the strategy yields profits.
off chart as the expiries underlying the spread are different. Underlying reasoning
However, there would be a band within which the position would result into losses. This
behind horizontal spreads is that these two options would have different time values position would have two Break even points (BEPs) and they would lie at “Strike – Total
and the trader believes that difference between the time values of these two options
Premium” and “Strike + Total Premium”. Combined pay-off may be shown as follows:
would shrink or widen. This is essentially a play on premium difference between two
options prices squeezing or widening. Option Call Put
Long/Short Long Long
Diagonal spread
Strike 6000 6000
Diagonal spread involves combination of options having same underlying but different
Premium 257 136
expiries as well as different strikes. Again, as the two legs in a spread are in different
Spot 6000
maturities, it is not possible to draw pay offs here as well. These are much more
complicated in nature and in execution. These strategies are more suitable for the OTC
market than for the exchange traded markets. CMP Long Call Long Put Net Flow
5000 -257 864 607
5.2 Straddle 5100 -257 764 507
This strategy involves two options of same strike prices and same maturity. A long 5200 -257 664 407
straddle position is created by buying a call and a put option of same strike and same 5300 -257 564 307
expiry whereas a short straddle is created by shorting a call and a put option of same 5400 -257 464 207
strike and same expiry. 5500 -257 364 107
5600 -257 264 7
Let us say a stock is trading at Rs 6,000 and premiums for ATM call and put options are
5700 -257 164 -93
257 and 136 respectively.
5800 -257 64 -193
Long Straddle 5900 -257 -36 -293
If a person buys both a call and a put at these prices, then his maximum loss will be 6000 -257 -136 -393
equal to the sum of these two premiums paid, which is equal to 393. And, price 6100 -157 -136 -293
movement from here in either direction would first result in that person recovering his 6200 -57 -136 -193
premium and then making profit. This position is undertaken when trader’s view on 6300 43 -136 -93
price of the underlying is uncertain but he thinks that in whatever direction the market 6400 143 -136 7
moves, it would move significantly in that direction. 6500 243 -136 107
Now, let us analyse his position on various market moves. Let us say the stock price falls 6600 343 -136 207
to 5300 at expiry. Then, his pay offs from position would be: 6700 443 -136 307
6800 543 -136 407
Long Call: - 257 (market price is below strike price, so option expires worthless)
Long Put: - 136 - 5300 + 6000 = 564 6900 643 -136 507
Net Flow: 564 – 257 = 307 7000 743 -136 607

As the stock price keeps moving down, loss on long call position is limited to premium
paid, whereas profit on long put position keeps increasing.
Now, consider that the stock price shoots up to 6700.
Long Call: -257 – 6000 + 6700 = 443
Long Put: -136

74 75
 1000
Straddle Payoff
5300 257 -564 -307
5400 257 -464 -207
800 5500 257 -364 -107
5600 257 -264 -7
5700 257 -164 93
600
5800 257 -64 193
5900 257 36 293
400 6000 257 136 393
6100 157 136 293
P/ L (Rs.)

200 6200 57 136 193

6300 -43 136 93
6400 -143 136 -7
0
5000 5100 5200 5300 5400 5500 5600 5700 5800 5900 6000 6100 6200 6300 6400 6500 6600 6700 6800 6900 7000 6500 -243 136 -107
6600 -343 136 -207
-200
6700 -443 136 -307
6800 -543 136 -407
-400 6900 -643 136 -507
7000 -743 136 -607
CMP (Rs.) Long Call Long Put Net Flow
-600
600
Short Straddle Payoff
It may be noted from the table and picture, that maximum loss of Rs. 393 would occur
to the trader if underlying expires at strike of option viz. 6000. Further, as long as 400
underlying expires between 6393 and 5607, he would always incur the loss and that
would depend on the level of underlying. His profit would start only after recovery of his
200
total premium of Rs. 393 in either direction and that is the reason there are two
breakeven points in this strategy.
0
Short Straddle 5000 5100 5200 5300 5400 5500 5600 5700 5800 5900 6000 6100 6200 6300 6400 6500 6600 6700 6800 6900 7000
This would be the exact opposite of long straddle. Here, trader’s view is that the price of

P/ L (Rs.)
underlying would not move much or remain stable. So, he sells a call and a put so that -200

he can profit from the premiums. As position of short straddle is just opposite of long
straddle, the pay off chart would be just inverted, so what was loss for long straddle -400
would become profit for short straddle. Position may be shown as follows:
Option Call Put
-600
Long/Short Short Short
Strike 6000 6000
Premium 257 136 -800

Spot 6000
CMP (Rs.) Short Call Short Put Net Flow
-1000
CMP Short Call Short Put Net Flow
5000 257 -864 -607 It should be clear that this strategy is limited profit and unlimited loss strategy and
5100 257 -764 -507 should be undertaken with significant care. Further, it would incur the loss for trader if
5200 257 -664 -407 market moves significantly in either direction – up or down.

76 77
5.3 Strangle 5500 -145 360 215
This strategy is similar to straddle in outlook but different in implementation, aggression 5600 -145 260 115
and cost. 5700 -145 160 15
Long Strangle 5800 -145 60 -85
As in case of straddle, the outlook here (for the long strangle position) is that the market 5900 -145 -40 -185
will move substantially in either direction, but while in straddle, both options have same 6000 -145 -140 -285
strike price, in case of a strangle, the strikes are different. Also, both the options (call 6100 -145 -140 -285
and put) in this case are out-of-the-money and hence the premium paid is low. 6200 -145 -140 -285
6300 -45 -140 -185
Let us say the cash market price of a stock is 6100. 6200 strike call is available at 145 and
6400 55 -140 -85
6000 put is trading at a premium of 140. Both these options are out-of-the-money.
6500 155 -140 15
If a trader goes long on both these options, then his maximum cost would be equal to 6600 255 -140 115
the sum of the premiums of both these options. This would also be his maximum loss in 6700 355 -140 215
worst case situation. However, if market starts moving in either direction, his loss would 6800 455 -140 315
remain same for some time and then reduce. And, beyond a point (BEP) in either 6900 555 -140 415
direction, he would make money. Let us see this with various price points. 7000 655 -140 515
If spot price falls to 5700 on maturity, his long put would make profits while his long call 7100 755 -140 615
option would expire worthless.
1000
Long Strangle Payoff
Long Call: - 145
Long Put: -140 – 5700 + 6000 = 160
Net Position: 160 – 145 = 15 800

As price continues to go south, long put position will become more and more profitable
and long call’s loss would be maximum limited to the premium paid. 600

In case stock price goes to 6800 at expiry, long call would become profitable and long
put would expire worthless.
400
Long Call: -145 – 6200 + 6800 = 455

P/ L (Rs.)
Long Put: -140
Net Position: 455 – 140 = 315 200

The pay off chart for long strangle is shown below:

Option Call Put 0
5100 5200 5300 5400 5500 5600 5700 5800 5900 6000 6100 6200 6300 6400 6500 6600 6700 6800 6900 7000 7100
Long/Short Long Long
Strike 6200 6000
-200
Premium 145 140
Spot 6100
CMP (Rs.) Long Call Long Put Net Flow
-400

CMP Long Call Long Put Net Flow

5100 -145 760 615 In this position, maximum profit for the trader would be unlimited in both the directions
– up or down and maximum loss would be limited to Rs. 285, which would occur if
5200 -145 660 515
underlying expires at any price between 6000 and 6200. Position would have two BEPs
5300 -145 560 415
at 5715 and 6485. Until underlying crosses either of these prices, trader would always
5400 -145 460 315
incur loss.

78 79
Short Strangle 400
Short Strangle Payoff
This is exactly opposite to the long strangle with two out-of-the-money options (call and
put) shorted. Outlook, like short straddle, is that market will remain stable over the life
200
of options. Pay offs for this position will be exactly opposite to that of a long strangle
position. As always, the short position will make money, when the long position is in loss
and vice versa.
0
Option Call Put 5100 5200 5300 5400 5500 5600 5700 5800 5900 6000 6100 6200 6300 6400 6500 6600 6700 6800 6900 7000 7100

Long/Short Short Short

Strike 6200 6000 -200

P/ L (Rs.)
Premium 145 140
Spot 6100
-400

CMP Short Call Short Put Net Flow

5100 145 -760 -615 -600
5200 145 -660 -515
5300 145 -560 -415
5400 145 -460 -315 -800

5500 145 -360 -215

5600 145 -260 -115 CMP (Rs.) Short Call Short Put Net Flow
-1000
5700 145 -160 -15
5800 145 -60 85 In this position, maximum loss for the trader would be unlimited in both the directions –
5900 145 40 185 up or down and maximum profit would be limited to Rs. 285, which would occur if
6000 145 140 285 underlying expires at any price between 6000 and 6200. Position would have two BEPs
6100 145 140 285 at 5715 and 6485. Until underlying crosses either of these prices, trader would always
6200 145 140 285 make profit.
6300 45 140 185
6400 -55 140 85 5.4 Covered Call
6500 -155 140 -15 This strategy is used to generate extra income from existing holdings in the cash market.
6600 -255 140 -115 If an investor has bought shares and intends to hold them for some time, then he would
6700 -355 140 -215 like to earn some income on that asset, without selling it, thereby reducing his cost of
6800 -455 140 -315 acquisition. So how does an investor continue to hold on to the stock, earn income and
6900 -555 140 -415 reduce acquisition cost?
7000 -655 140 -515 Suppose an investor buys a stock in the cash market at Rs. 1590 and also sells a call
7100 -755 140 -615 option with a strike price of 1600, thereby earning Rs. 10 as premium. If the stock price
moves up from 1590 level, he makes profit in the cash market but starts losing in the
option trade. For example, if Stock goes to 1640,
Long Cash: Profit of 1640 – 1590 = 50
Short Call: – 1640 + 1600 + 10 = -30
Net Position: 50 – 30 = 20
If the stock moves below 1590 level, he loses in the cash market, but gets to keep the
premium as income. For example, if Stock goes to 1520,

80 81
Long Cash: 1520 – 1590 = -70 150
Covered Call Payoff
Short Call: + 10 (Long call holder will not exercise his right as he can buy the stock from
the market at a price lower than strike, so he will let the option expire and the seller
gets to keep the premium) 100
Net Position: -70 + 10 = -60
Therefore, combined position of long stock and short call would generate the pay-off as
defined in the table and picture below: 50

Long Stock 1590

P/ L (Rs.)
Strike Price 1600
0
Premium 10 1490 1500 1510 1520 1530 1540 1550 1560 1570 1580 1590 1600 1610 1620 1630 1640 1650 1660 1670 1680 1690

CMP Stock Call Net

-50
1490 -100 10 -90
1500 -90 10 -80
1510 -80 10 -70
-100
1520 -70 10 -60
1530 -60 10 -50
1540 -50 10 -40 Net Stock Call
CMP (Rs.)
1550 -40 10 -30 -150

1560 -30 10 -20 From the table and the pay off chart we can see that the net position of a covered call
1570 -20 10 -10 strategy looks like ‘short put’ with a strike of 1600. This is called synthetic short put
1580 -10 10 0 position.
1590 0 10 10
1600 10 10 20 If at that point of time, a 1600 strike put is available at any price other than Rs.20 (let us
1610 20 0 20 say Rs.17), an arbitrage opportunity exists, where the trader can create a synthetic short
put position (covered call), earn a Rs. 20 premium and use the proceeds to buy a 1600
1620 30 -10 20
put for Rs.17, thereby making a risk free profit of Rs.3. Indeed, one needs to also
1630 40 -20 20
provide for frictions in the market like brokerage, taxes, administrative costs, funding
1640 50 -30 20
costs etc.
1650 60 -40 20
1660 70 -50 20 The most important factor in this strategy is the strike of the sold call option. If strike is
1670 80 -60 20 close to the prevailing price of underlying stock, it would fetch higher premium upfront
1680 90 -70 20 but would lock the potential gain from the stock early. And, if strike is too far from the
1690 100 -80 20 current price of underlying, while it would fetch low upfront premium, would provide
for longer ride of money on underlying stock. One has to decide on this subject based on
one’s view on the stock and choice between upfront premium from the option and
potential gain from underlying.
A simple perspective on strike choice for covered call is that, till the time the cash
market price does not reach the pre-determined exit price, the long cash position can be
used to sell calls of that target strike price. As long as price stays below that target price
(let’s say 1600 in our case), we can write call option of 1600 strike and keep earning the
premium. The moment 1600 is reached in the spot market, we can sell in the cash
market and also cover the short call position.

82 83
5.5 Protective Put 1600 0 -20 -20
Any investor, long in the cash market, always runs the risk of a fall in prices and thereby 1610 10 -20 -10
reduction of portfolio value and MTM losses. A mutual fund manager, who is 1620 20 -20 0
anticipating a fall, can either sell his entire portfolio or short futures to hedge his 1630 30 -20 10
portfolio. In both cases, he is out of the market, as far as profits from upside are 1640 40 -20 20
concerned. What can be done to remain in the market, reduce losses but gain from the 1650 50 -20 30
upside? Buy insurance! 1660 60 -20 40
By buying put options, the fund manager is effectively taking a bearish view on the 1670 70 -20 50
market and if his view turns right, he will make profits on long put, which will be useful 1680 80 -20 60
to negate the MTM losses in the cash market portfolio. 1690 90 -20 70
1700 100 -20 80
Let us say an investor buys a stock in the cash market at 1600 and at the same time buys
a put option with strike of 1600 by paying a premium of Rs 20. 150
Protective Put Payoff
Now, if prices fall to 1530 from here:
Long Cash: Loss of 1600 – 1530 = - 70
Long Put: Profit of – 20 – 1530 + 1600 = 50 100
Net Position: -20
For all falls in the market, the long put will turn profitable and the long cash will turn
loss making, thereby reducing the overall losses only to the extent of premium paid (if 50

strikes are different, losses will be different from premium paid)

In case prices rise to 1660

P/ L (Rs.)
Long Cash: Profit of 1660 – 1600 = 60 0
1500 1510 1520 1530 1540 1550 1560 1570 1580 1590 1600 1610 1620 1630 1640 1650 1660 1670 1680 1690 1700
Long Put: Loss of 20
Net Position: 60 – 20 = 40
As price keeps rising, the profits will keep rising as losses in long put will be maximum to -50

the extent of premium paid, but profits in long cash will keep increasing. Combined
position would look like as follows:
-100
Long Cash 1600
Strike Price 1600
Premium 20 CMP (Rs.) Net Long Cash Long Put
-150

CMP Long Cash Long Put Net A protective put pay off is similar to that of long call. This is called synthetic long call
1500 -100 80 -20 position.
1510 -90 70 -20
1520 -80 60 -20 5.6 Collar
1530 -70 50 -20 A collar strategy is an extension of covered call strategy. Readers may recall that in case
1540 -60 40 -20 of covered call, the downside risk remains for falling prices; i.e. if the stock price moves
1550 -50 30 -20 down, losses keep increasing (covered call is similar to short put). To put a floor to this
downside, we long a put option, which essentially negates the downside of the short
1560 -40 20 -20
underlying/futures (or the synthetic short put).
1570 -30 10 -20
1580 -20 0 -20 In our example, we had assumed that a trader longs a stock @ 1590 and shorts a call
1590 -10 -10 -20 option with a strike price of 1600 and receives Rs. 10 as premium. In this case, the BEP

84 85
was 1580. If price fell below 1580, loss could be unlimited whereas if price rose above
1600, the profit was capped at Rs. 20.
To prevent the downside, let us say, we now buy an out-of-the-money put option of
strike 1580 by paying a small premium of Rs. 7.
Now, if price of underlying falls to 1490 on maturity:
Long Stock: -1590 + 1490 = -100
Short Call: 10
Long Put: -7 – 1490 + 1580 = 83
Net Position: -100 + 10 + 83 = - 7 (in case of covered call this would have been -90)
If price rises to 1690 on maturity:
Long Stock: -1590 + 1690 = 100
Short Call: 10 – 1690 +1600 = - 80
Long Put: - 7
Net Position: 100 – 80 – 7 = 13 (in case of covered call this would have been + 20)
Combined position (i.e. long underlying, short call and long put) is as follows:
Long Stock 1590 Long Put 1580
Short Call 1600 Premium 7
Call Premium 10

CMP Long Stock Short Call Long Put Net It is important to note here is that while the long put helps in reducing the downside
1490 -100 10 83 -7 risk, it also reduces the maximum profit, which a covered call would have generated.
1500 -90 10 73 -7 Also, the BEP has moved higher by the amount of premium paid for buying the out-of-
1510 -80 10 63 -7 the-money put option.
1520 -70 10 53 -7
1530 -60 10 43 -7
5.7 Butterfly Spread
As collar is an extension of covered call, butterfly spread is an extension of short
1540 -50 10 33 -7
straddle. We may recollect that downside in short straddle is unlimited if market moves
1550 -40 10 23 -7
significantly in either direction. To put a limit to this downside, along with short
1560 -30 10 13 -7
straddle, trader buys one out of the money call and one out of the money put.
1570 -20 10 3 -7
Resultantly, a position is created with pictorial pay-off, which looks like a butterfly and
1580 -10 10 -7 -7 so this strategy is called “Butterfly Spread”.
1590 0 10 -7 3
1600 10 10 -7 13 Butterfly spread can be created with only calls, only puts or combinations of both calls
and puts. Here, we are creating this position with help of only calls. To do so, trader has
1610 20 0 -7 13
to take following positions in three different strikes and same maturity options:
1620 30 -10 -7 13
Long Call 1 with strike of 6000 and premium paid Rs. 230
1630 40 -20 -7 13
Short Call 2 with strike of 6100 and premium received Rs. 150
1640 50 -30 -7 13
Long Call 3 with strike of 6200 and premium paid of Rs. 100
1650 60 -40 -7 13
Short Call 2 with strike of 6100 and premium received Rs. 150
1660 70 -50 -7 13
1670 80 -60 -7 13 Let us see what happens if on expiry price is:
1680 90 -70 -7 13  Less than or equal to 6000
1690 100 -80 -7 13  Equal to 6100
 More than or equal to 6200
86 87
Case I: Price at 6000 5900 -230 150 -100 150 -30
Long Call 1: -230 6000 -230 150 -100 150 -30
Short Call 2: 150 6100 -130 150 -100 150 70
Long Call 3: - 100 6200 -30 50 -100 50 -30
Short Call 2: 150 6300 70 -50 0 -50 -30
Net Position: -230 + 150 – 100 + 150 = -30 6400 170 -150 100 -150 -30
For any price lower than 6000, all calls will be out-of-the-money so nobody will exercise. 6500 270 -250 200 -250 -30
Hence buyers will lose premium and sellers/ writers will get to keep the premium. In all 6600 370 -350 300 -350 -30
these situations, trader’s loss would be flat Rs. 30. 6700 470 -450 400 -450 -30
Case II: Price at 6100 6800 570 -550 500 -550 -30
Long Call 1: - 230 – 6000 + 6100 = - 130 6900 670 -650 600 -650 -30
Short Call 2: 150 7000 770 -750 700 -750 -30
Long Call 3: - 100 7100 870 -850 800 -850 -30
Short Call 2: 150
Net Position: - 130 + 150 – 100 + 150 = 70 1000
Butterfly Spread Payoff

This is the maximum profit point for this position. Both the shorted calls earn the 800
premium for the trader. This entire premium is kept by the trader for all prices less than
or equal to 6100. 600

Case III: Price at 6200 or higher

Long Call 1: - 230 – 6000 + 6200 = - 30 (This will keep increasing as price rises)
400

Short Call 2: 150 – 6200 + 6100 = 50 (This will start getting losses as price increases) 200
Long Call 3: - 100

P/ L (Rs.)
Short Call 2: 150 – 6200 + 6100 = 50 (This will start getting losses as price increases) 0
Net Position: - 30 + 50 – 100 + 50 = - 30 5100 5200 5300 5400 5500 5600 5700 5800 5900 6000 6100 6200 6300 6400 6500 6600 6700 6800 6900 7000 7100

From 6200 or higher, the long calls will start making money for the trader whereas the -200

short calls will be in losses. And, total of all 4 would always be equal to –30. Following
table and picture explain this position: -400

Option Call Call Call Call

-600
Long/Short Long Short Long Short
Strike 6000 6100 6200 6100 -800
Premium 230 150 100 150
CMP (Rs.) Long Call 1 Short Call 2 Long Call 3 Short Call 2 Net Flow
Spot 6100 -1000

Cost of creating butterfly spread: -230 + 150 – 100 + 150 = - 30

CMP Long Call 1 Short Call 2 Long Call 3 Short Call 2 Net Flow Lower BEP = 6000 + 30 = 6030
5100 -230 150 -100 150 -30 Higher BEP = 6200 – 30 = 6170
5200 -230 150 -100 150 -30 This position can also be created with the help of only puts or combination of calls and
5300 -230 150 -100 150 -30 puts. To create this position from puts, one needs to buy one highest strike option, sell
5400 -230 150 -100 150 -30 two middle strike options and then again buy one lowest strike option. And, to create
5500 -230 150 -100 150 -30 this position from combination of calls and puts, one need to buy one call at lowest
5600 -230 150 -100 150 -30 strike, sell one call at middle strike, buy one put at highest strike and sell one put at
5700 -230 150 -100 150 -30 middle strike. This is limited profit and limited loss strategy.
5800 -230 150 -100 150 -30

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Chapter 6: Introduction to Trading Systems Trading Member:
They are members of Stock Exchanges. They can trade either on behalf of their clients or
LEARNING OBJECTIVES: on their own account. The exchange assigns a trading member ID to each of its trading
member. A trading member can have more than one user.
After studying this chapter, you should know about the:
 Trading System for futures and options The number of users allowed for each trading member is decided by the exchange from
 Different entities in the trading system time to time. A user must be registered with the exchange where he is assigned a
 Different types of orders in the trading system and order matching rule unique user ID.
 Selection criteria of stocks and index for futures and option trading The unique trading member ID is common for all the users of a particular trading
 Position Limits for equity derivatives member. Therefore, it functions as a reference for all users of a particular trading
member. Trading member is responsible to maintain adequate control over persons
6.1 Trading System having access to the firm’s User IDs.
In this chapter we shall take a brief look at the trading system of futures and options on Trading cum Clearing Member:
exchanges, including various types of orders. However, the best way to develop an A Clearing Member (CM) who is also a Trading Member (TM) of the exchange. Such CMs
understanding of the trading system is to actually watch the screen and observe trading. may clear and settle their own proprietary trades, their clients' trades as well as trades
As stated earlier, futures and options are standardized contracts and like shares, they of other TM's & Custodial Participants.
are traded on exchanges. Markets around the world can be classified into two main Professional Clearing Member:
types based on the methods of booking a trade namely an “open outcry” market and Professional clearing member clears the trades of his associate Trading Member and
the “electronic” market. Open outcry is the way of communication between institutional clients. PCM is not a Trading Member of the exchange. Typically banks or
professionals on an exchange, which involves shouting, or using hand signals to transfer custodians become a PCM and clear and settle for TM's as well as for Custodial
information about buy and sell orders. In an open outcry markets, usually the trading Participants.
takes place in a large hall known as “pit” where members are present and contracts are
traded through continuous bids and offers. Thus, such a market brings together the Self Clearing Member (SCM)
buyers and sellers (through their brokers) on a platform for trading. In case of electronic A Self Clearing Member is also a Trading Member on the exchange. Such CMs may clear
trading, there are screen based broker dealing terminals, instead of the trading pit. and settle only their own proprietary trades and their clients' trades but cannot clear
Futures and options trading in India is electronic in nature, with the bids and offers, and and settle trades of other TM's.
the acceptance being displayed on the terminal continuously. Participants:
All the derivatives exchanges in India provide a fully automated screen-based trading Participant is a client of a trading member. Clients may trade through various trading
platform for index futures, index options, stock futures and stock options. These trading members but settle through a single clearing member.
systems support an order driven market and simultaneously provide complete Authorised Persons (APs): SEBI had earlier allowed spread of sub-brokership as well as
transparency of trading operations. Derivative trading is similar to that of trading of Authorised Person’s network to expand the brokers’ network. However, SEBI Board in
equities in the cash market segment. its meeting held on June 21, 2018 decided that sub-brokers as an intermediary shall
All these exchanges have developed software for the F&O market to facilitate efficient cease to exist with effect from April 01, 2019. All existing sub-brokers would migrate to
and transparent trading in futures and options instruments. become Authorised Persons (APs) or Trading Members if the sub-brokers meet the
eligibility criteria prescribed under Stock Exchange bye-laws and SEBI Regulations and by
Entities in the trading system complying with these Regulations.
Broadly there are four entities in the trading system
 Trading Member Market Timing of Derivative segment
 Trading cum Clearing Member (TM-CM or TCM) Trading on the derivatives segment takes place on all working days of the week between
 Professional Clearing Member (PCM) 9:15 am and 3:30 pm. SEBI, with a view to enable integration of trading of various
 Self Clearing Member (SCM) segments of securities market at the level of exchanges, has permitted Stock Exchanges
to set their trading hours in the Equity Derivatives Segment between 9:00 AM and 11:55
 Participants

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PM, provided that the Stock Exchange and its Clearing Corporation have in place risk Immediate or cancel (IOC): User is allowed to buy/sell a contract as soon as the order is
management system and infrastructure commensurate to the trading hours. released into the trading system. An unmatched order will be immediately cancelled.
Partial order match is possible in this order, and the unmatched portion of the order is
Corporate Hierarchy
In the Futures and options trading software, trading member will have a provision of cancelled immediately.
defining the hierarchy amongst users of the system. This hierarchy comprises: Price condition
 Corporate Manager Limit order: It is an order to buy or sell a contract at a specified price. The user has to
 Branch Manager and specify this limit price while placing the order and the order gets executed only at this
 Dealer specified limit price or at a better price than that (lower in case of buy order and higher
in case of a sell order).
Corporate Manager:
As a user, it is the highest level in a trading firm. Corporate Manager can perform all the Market order: A market order is an order to buy or sell a contract at the best bid/offer
functions such as order and trade related activities, receiving reports for all branches of price currently available in the market. Price is not specified at the time of placing this
the trading member firm and also all dealers of the firm. Along with this he can also order. The price will be the currently available price in the market i.e., a buy market
define exposure limits for the branches of the firm. This facility is available only to the order will get executed at the best price at which the seller is ready to sell and a sell
corporate manager. market order will get executed at the best price at which the buyer is ready to buy.
Branch Manager: Stop-loss order: A stop loss is an order to buy (or sell) a security once the price of the
As a user, it is placed under the corporate manager. Branch Manager can perform and security climbed above (or dropped below) a trigger price. The stop-loss order gets
view order and trade related activities for all dealers under that branch. activated when the trigger price is reached/crossed and enters the market as a market
order or as a limit order, as defined at the time of placing this stop-loss order. To
Dealer:
illustrate, suppose a trader buys ABC Ltd. shares at Rs 100 in expectation that the price
Dealer is at the lowest level of the user hierarchy. He can only view his own orders and
will rise. However, prices start declining below his buy price, trader would like to limit
trades and does not have access to information on other dealers under either the same
his losses. Trader may place a limit sell order specifying a trigger price of Rs 95 and a
branch or in other branches.
limit price of Rs 92. The trigger price has to be between last traded price and limit price
Client Broker Relationship while placing the sell limit order. Once the market price of ABC breaches the trigger
A trading member would be responsible for various compliance related activities price i.e. Rs 95, the order gets converted to a limit sell order at Rs 92. (Trigger Price is
including Know Your Client (KYC) form, execution of Client Broker agreement, timely the price at which the order gets triggered from the stop loss book.)
execution of orders given by clients, collection of adequate margins, maintain separate
Order Matching Rules
client bank account for segregation of client money, ensure timely pay-in and pay-out of
In India, F&O platforms offer an order driven market, wherein orders match
funds, timely issue of contract notes, resolve clients’ complaints, sending periodical
automatically on price time priority basis.
statement of accounts, maintain unique client code, etc.
Orders, as and when they are received, are first time stamped and then immediately
Order types and conditions processed for potential match. If a match is not found, then the orders are stored in
In the trading system, trading members are allowed to enter orders with various different 'books'. Orders are stored in price-time priority in various books in the
conditions attached to them as per their requirements. These conditions are broadly following sequence:
divided into the following categories:  Best Price
 Time conditions  Within Price, by time priority.
 Price conditions The best buy order will match with the best sell order. An order may match partially
 Various combinations of the above are allowed providing flexibility to the users. with another order resulting in multiple trades. For order matching, the best buy order
is the one with highest price and the best sell order is the one with lowest price. This is
Time conditions
because the computer views all buy orders available from the point of view of a seller
Day order: A Day order is an order which is valid for a single day on which it is entered. If
and all sell orders from the point of view of the buyers in the market.
the order is not executed during the day, the trading system cancels the order
automatically at the end of the day. Price Band

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There are no price bands applicable in the derivatives segment. However, in order to 6.2 Selection criteria of Stocks for trading
prevent erroneous order entry, operating ranges and day minimum/maximum ranges
Contract specifications for single stock futures contracts
are kept as below:
 For Index Futures: at 10% of the base price Underlying Individual Securities
 For Futures on Individual Securities: at 10% of the base price Security Descriptor FUTSTK
 For Index and Stock Options: A contract specific price range based on its delta
value is computed and updated on a daily basis. Contract Size (Lot Size) As specified by the exchange (minimum value of Rs 5,00,000)
In view of this, orders placed at prices which are beyond the operating ranges would Price Steps (Tick Size) Rs 0.05
reach the Exchange as a price freeze. 3 month trading cycle - the near month (one), the next month
The Trader Workstation (two) and the far month (three). New contract is introduced
Trading Cycle
on the next trading day following the expiry of near month
The market watch window
contract.
The following windows are displayed on the trader workstation screen:
 Title bar Last Thursday of the expiry month. If the last Thursday is a
Last Trading / Expiration
 Ticker window of futures and options market trading holiday, then the expiry day is the previous trading
Date
 Ticker window of underlying (capital) market day.
 Toolbar
Settlement Basis Mark-to-Market and final settlement are on T+1 basis
 Market watch window
 Inquiry window Daily Settlement price is the closing price of the futures
 Snap quote contract for the trading day (calculated on the basis of the last
 Order/trade window half an hour weighted average price of such contract). In case
 System message window Settlement Price
of un-expired illiquid futures contracts, daily settlement price
is the Theoretical Price computed as per formula F=S * ert.
The best way to familiarize oneself with the screen is to spend some time studying a live
Final settlement price is the closing price of the relevant
screen.
underlying security in the Capital Market segment across
Placing orders on the trading system exchanges, on the last trading day of the futures contracts.
While entering orders on the trading system for both the futures and the options
market, trading member are required to identify orders as being proprietary or clients. Contract specifications for single stock options contracts
‘Pro’ identifies proprietary orders while ‘Cli’ identifies client orders. Client account
number should be provided for client orders. Underlying Individual Security
Futures and Options Market Instruments Security Descriptor OPTSTK
The F&O segment of the derivatives exchanges provides trading facilities for the Option Type European (CE/PE)
following derivative instruments: Strike Price Interval As specified by the exchange
 Index based futures (including futures on foreign stock indices)
 Index based options (including options on foreign stock indices) Contract Size (Lot Size) As specified by the exchange (minimum value of Rs 5,00,000)
 Individual stock options Price Steps (Tick Size) Rs 0.05
 Individual stock futures
3 month trading cycle - the near month (one), the next
month (two) and the far month (three). New contract is
Trading Cycle *
introduced on the next trading day following the expiry of
near month contract.

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 Last Thursday of the expiry month. If the last Thursday is a 6.3 Selection criteria of Index for trading
Last Trading / Eligibility criteria of Indices
trading holiday, then the expiry day is the previous trading
Expiration Date *
day. The Exchange may consider introducing derivative contracts on an index, if weightage of
Settlement Basis Mark-to-Market and final settlement are on T+1 basis. constituent stocks of the index, which are individually eligible for derivatives trading, is
at least 80%. However, no single ineligible stock in the index shall have a weightage of
Final settlement price is the closing price of the relevant more than 5% in the index. The index on which futures and options contracts are
Settlement Price underlying security in the Capital Market segment across permitted shall be required to comply with the eligibility criteria on a continuous basis.
exchanges, on the last trading day of the options contract. The Exchange shall check whether the index continues to meet the aforesaid eligibility
* Please note that Weekly Options expire on Thursday of each week. Weekly Options criteria on a monthly basis. If the index fails to meet the eligibility criteria for three
are the Exchange Traded Options based on a Stock or an Index with shorter maturity of consecutive months, then no fresh contract shall be issued on that index. However, the
one or more weeks. If the expiry day of the Weekly Options falls on a trading Holiday, existing unexpired contracts shall be permitted to trade till expiry and new strikes may
then the expiry will be on the previous trading day. also be introduced in the existing contracts.
For further details on product specifications, please refer to the websites of exchanges The product success framework is applied to all index derivatives (except for the flagship
(www.nseindia.com, www.bseindia.com and www.msei.in). indices of the exchanges) at the underlying level. The criteria for evaluation of the index
derivatives are as follows:
Eligibility Criteria for stock selection
The stock selection criteria for derivatives trading in India ensure that stock is large in  15% of trading members active in all index derivatives or 20 trading members
terms of market capitalization, turnover and has sufficient liquidity in the underlying whichever is lower should have traded in any derivative contract on the index
market and there are no adverse issues related to market manipulation. being reviewed in each of the month during the review period,
 Trading on a minimum of 75% of the trading days during the review period,
Eligibility criteria of stocks
 Average daily turnover of at least INR 10 crore during the review period, and
A stock on which stock option and single stock futures contracts are proposed to be
 Average daily open interest of INR 4 crore during the review period
introduced shall conform to the following broad eligibility criteria for a continuous
period of six months: Once an index is excluded from the derivatives list, it shall not be considered for re-
a) The stock shall be chosen from amongst the top 500 stocks in terms of average inclusion for a period of at least six months. Exchanges may consider re-launching
daily market capitalization and average daily traded value in the previous six derivative contracts on the same index after carrying out suitable modification(s) in
months on a rolling basis. contract specifications based on market feedback, after a cooling off period of at least
b) The stock’s median quarter-sigma order size (MQSOS) over the last six months, six months, subject to SEBI approval.
on a rolling basis, shall not be less than Rs 25 Lakhs.
6.4 Adjustments for Corporate Actions
c) The market wide position limit (MWPL) in the stock shall not be less than Rs 500
Adjustments for Corporate Actions for Stock Options would be as follows:
crores on a rolling basis, and
1. The basis for any adjustment for corporate action shall be such that the value of
d) Average daily delivery value in the cash market shall not be less than Rs 10
the position of the market participants on cum and ex-date for corporate action
crores in the previous six months on a rolling basis.
shall continue to remain the same as far as possible. This will facilitate in
If an existing security fails to meet aforesaid continued eligibility criteria for three retaining the relative status of positions viz. in-the-money, at-the-money and
months consecutively, then no fresh month contract shall be issued on that security. out-of-money. This will also address issues related to exercise and assignments.
However, the existing unexpired contracts may be permitted to trade till expiry and new 2. Adjustments shall mean modifications to positions and/or contract specifications
strikes may also be introduced in the existing contract months. as listed below such that the basic premise of adjustment laid down above is
A stock which is excluded from derivatives trading may become eligible once again. In satisfied:
such instances, the stock is required to fulfill the enhanced eligibility criteria for six a) Strike Price
consecutive months to be re-introduced for derivatives trading. b) Position
c) Market Lot/Multiplier

96 97
 3. Any adjustment for corporate actions shall be carried out on the last day on Underlying close price on the last cum date = P
which a security is traded on a ‘cum’ basis in the underlying cash market, after Issue price of the rights = S
the close of trading hours.
Benefits per share = E
The adjustments shall be carried out on any or all of the above based on the nature of
the corporate action. The adjustments for corporate actions shall be carried out on all Benefit per Right Entitlement = (P – S)
open positions. Benefit per share (E) = (P-S)/(A+B)
The corporate actions may be broadly classified under stock benefits and cash benefits
Adjustment Factor is = (P-E)/P
as follows:
 Bonus Dividend if any, declared by the company along with rights shall be adjusted as per the
 Rights prevailing dividend adjustment policy in F&O Segment.
 Merger/De-merger The above methodology may result in fractions due to the corporate action e.g. a bonus
 Amalgamation ratio of 3:7. With a view to minimizing fraction settlements, the following methodology
 Splits is proposed to be adopted:
 Consolidations (a) Compute value of the position before adjustment
 Hive-off (b) Compute value of the position taking into account the exact adjustment factor
 Warrants (c) Carry out rounding off for the Strike Price and Market Lot
 Secured Premium Notes (SPNs) (d) Compute value of the position based on the revised strike price and market lot
 Extraordinary dividends The difference between (a) and (d) above, if any, shall be decided in the manner laid
Following elaborates the adjustment for Bonus, Stock splits, consolidation and down by the group by adjusting Strike Price or Market Lot, so that no forced closure of
extraordinary dividends open position is mandated.
Bonus, Stock Splits and Consolidations Dividends
Strike Price: The new strike price shall be arrived at by dividing the old strike price by the Dividends which are below 5% of the market value of the underlying stock would be
adjustment factor as under. deemed to be ordinary dividends and no adjustment in the strike price would be made
for ordinary dividends. For extra-ordinary dividends, above 5% of the market value of
Market Lot / Multiplier: The new market lot/multiplier shall be arrived at by multiplying the underlying stock, the Strike Price would be adjusted.
the old market lot by the adjustment factor as under.
For extra-ordinary dividends above 5% of the market value of the underlying security, all
Position: The new position shall be arrived at by multiplying the old position by the positions in existing strike prices shall continue to exist in the corresponding new
adjustment factor as under. adjusted strike prices for respective option contracts. All open positions shall be carried
The adjustment factor for Bonus, Stock Splits and Consolidations is arrived at as follows: forward at the daily settlement price less dividend amount for the respective futures
contract.
Bonus
 To decide whether the dividend is "extra-ordinary" (i.e. at or above 5% of the
Ratio – A: B
market price of the underlying stock.), the market price would mean the closing
Adjustment factor: (A+B)/B price of the stock on the day previous to the date on which the announcement
Stock Splits and Consolidations of the dividend is made by the Company after the meeting of the Board of
Ratio – A: B Directors. However, in cases where the announcement of dividend is made after
the close of market hours, the same day's closing price would be taken as the
Adjustment factor: A/B market price. Further, if the shareholders of the company in the AGM change the
Rights rate of dividend declared by the Board of Directors, then to decide whether the
Number of Existing shares = A dividend is extra-ordinary or not would be based on the rate of dividend
communicated to the exchange after AGM and the closing price of the stock on
Rights Entitlement (Rights to subscribe) = B
the day previous to the date of the AGM.
Total Entitlement = A+B

98 99
  In case of declaration of "extra-ordinary" dividend by any company, the total  Client level position limits security-wise, are made available to members on the
dividend amount (special and / or ordinary) would be reduced from all the strike Exchange website.
prices of the option contracts on that stock.  Any person or persons acting in concert who together own 15% or more of the open
 The revised strike prices would be applicable from the ex-dividend date specified interest on a particular underlying index, is required to report this fact to the
by the exchange. Exchange/ Clearing Corporation. Failure to do so shall be treated as a violation and
shall attract appropriate penal and disciplinary action in accordance with the Rules,
Merger / Demerger
Byelaws and Regulations of the Clearing Corporation.
On announcement of the record date for merger/demerger, the last cum-date for
Market Wide Position Limits (MWPL)
merger/demerger would be determined by the Exchange/ Clearing Corporation. The
 MWPL for futures and options contracts on individual securities shall be 20% of the
date of expiration of all contracts in the underlying which shall cease to exist
number of shares held by non-promoters in the relevant underlying security i.e. 20%
subsequent to the merger/demerger, shall be the last cum date, which shall be
of the free float in terms of the number of shares of a company.
informed to the members.
 The Clearing Corporation shall specify the MWPL on the last trading day of the month
 Pursuant to the announcement of the record date, no fresh month contracts on which shall be reckoned for this purpose during the next month.
Futures and Options would be introduced in the underlying which shall cease to  Trading systems display an alert once the open interest in the futures and options
exist, subsequent to the merger/demerger. contract in a particular security exceeds 60% of the MWPL specified for such security.
 Un-expired contracts in the underlying, which shall cease to exist subsequent to  The aggregate open interest of the security across Exchanges shall be considered for
the merger/demerger, outstanding as on last cum-date shall be compulsorily the purpose of monitoring of MWPL. If the aggregate open interest of the security
settled at the settlement price. The settlement price shall be the last available across Exchanges exceeds 95 per cent of the MWPL, no fresh positions shall be
closing price of such underlying in the Capital Market segment of the Exchanges, permitted for the said security from the subsequent trading day. The normal trading
on the last cum-date. in the security shall be resumed only after the aggregate open outstanding position
6.5 Position Limits across Exchanges comes down to 80% or below of the MWPL.

Trading Member wise Position Limit Apart from the above, additional position limit rules may be applicable to Foreign
 Index Futures: The trading member position limits in equity index futures contracts Portfolio Investors (FPIs), Mutual Funds and Non Resident Individuals (NRIs) as specified
shall be higher of Rs.500 crores or 15% of the total open interest in the market in in SEBI circular IMD/FPI&C/CIR/P/2019/124 dated November 05, 2019 and in the SEBI
equity index futures contracts. This limit would be applicable on open positions in all FPI regulations 2019.
futures contracts on a particular underlying index. 6.6 Using Daily Newspapers to Track Futures and Options
 Index Options: The trading member position limits in equity index option contracts The prices of both spot and F&O markets are published by many major business dailies
shall be higher of Rs.500 crores or 15% of the total open interest in the market in such as Economic Times, Mint, Business Standard, Financial Express, etc. They publish all
equity index option contracts. This limit would be applicable on open positions in all or some of the following details for the derivatives contracts being traded on the
option contracts on a particular underlying index. exchanges.
 Individual Securities: The combined future and options position limit shall be 20% of
Date: This gives the Trade date.
the applicable Market Wide Position Limit (MWPL) per Exchange. The Clearing
Corporation shall specify the trading member-wise position limits on the last trading Symbol: This gives the underlying index or stock e.g. NIFTY, ACC, etc.
day of the month which shall be reckoned for this purpose during the next month. Instrument: This gives the contract descriptor for the various instruments available in
the derivatives segment e.g. FUTSTK, OPTIDX, etc.
Client Level Position Limits
Expiry date: The date on which the contract expires
 Futures and Option contracts on individual securities: The gross open position across
all the derivative contracts for a security for each specific client shall not exceed Option Type: This gives the type of option for the contract. (CE- Call European, PE- Put
higher of: European, CA- Call American, PA- Put American)
o 1% of the free float market capitalization (in terms of number of shares), or Corporate Action level: This is the Corporate Action Flag. This flag changes when there is
o 5% of the open interest in all derivative contracts in the same underlying stock a corporate action on a contract, which could either be a symbol change or a dividend
per Exchange (in terms of number of shares). announced by the company.
Strike Price: This gives the Strike Price of the contract.
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Opening price: This gives the price at which the contract opened for the day. Chapter 7: Introduction to Clearing and Settlement System
High price: This gives the highest price at which the contract was traded during the day.
LEARNING OBJECTIVES:
Low price: This gives the lowest price at which the contract was traded during the day.
After studying this chapter, you should know about:
Closing price: This gives the price of the contract at the end of the day.
 Different types of clearing members
Last traded price: This gives the price at which the last contract of the day was traded.  Clearing and settlement mechanism for equity derivatives
Open Interest: For futures contracts open interest is equivalent to the open positions in  Risk management in equity derivatives segment
that futures contract multiplied by its last available closing price. For option contracts,  Margining system in equity derivatives segment
open interest is equivalent to the open positions multiplied by the notional value.
Notional value with respect to an option contract is computed as the product of the Clearing Corporation is responsible for clearing and settlement of all trades executed on
open position in that option contract multiplied by the last available closing price of the the F&O Segment of the Exchange. Clearing Corporation acts as a legal counterparty to
underlying. all trades on this segment and also guarantees their financial settlement. The Clearing
Total Traded Quantity: This is the total no. of contracts on which business took place and Settlement process comprises of three main activities, viz., Clearing, Settlement and
during the day. Risk Management.
Total Traded Value: The total money value of the business which took place on the Clearing and settlement activities in the F&O segment are undertaken by Clearing
contract during the day. Corporation with the help of Clearing Members and Clearing Banks.
Number of Trades: The total no. of trades which took place on the instrument during the
day. 7.1 Clearing Members
As you may recollect from our discussion in section 6.1, there are broadly three types of
Information on trends in F&O markets: clearing members:
 Positive trend: It gives information about the top gainers in the futures market. 1. Self clearing member: They clear and settle trades executed by them only, either
 Negative trend: It gives information about the top losers in the futures market. on their own account or on account of their clients.
 Futures OI gainers: It lists those futures whose % increase in Open Interest is 2. Trading member–cum–clearing member: They clear and settle their own trades
among the highest on that day. as well as trades of other trading members and custodial participants.
 Futures OI losers: It lists those futures whose % decrease in Open Interest is 3. Professional clearing member: They clear and settle trades executed by trading
among the highest on that day. members.
 Active Calls: Calls with high trading volumes on that particular day. Both trading-cum-clearing member and professional clearing member are required to
 Active Puts: Puts with high trading volumes on that particular day. bring in additional security deposits in respect of every trading member whose trades
 Put/ Call ratio (PCR): It gives the information about the ratio of trading volume of they undertake to clear and settle.
put options to call options. The ratio is calculated either on the basis of options
trading volumes or on the basis of their open interest. Clearing Members handle the responsibility of clearing and settlement of all deals
executed by Trading Members, who clear and settle such deals through them. Clearing
Members perform the following important functions:
 Clearing: Computing obligations of all his trading members i.e., determining
positions to settle.
 Settlement: Performing actual settlement.
 Risk Management: Setting position limits based on upfront deposits / margins for
each TM and monitoring positions on a continuous basis.
Clearing Banks
Funds settlement takes place through clearing banks. For the purpose of settlement all
clearing members are required to open a separate bank account with Clearing
Corporation designated clearing bank for F&O segment.

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Clearing Member Eligibility Norms 2000 respectively. Similarly, we have calculated the long and short positions of XYZ.
 Net-worth of at least Rs.300 lakhs. The Net-worth requirement for a Clearing Clearing member’s open position is arrived by adding long positions and short positions
Member who clears and settles only deals executed by him is Rs. 100 lakhs. of both the clients i.e. 6000 long open positions and 2000 short open positions.
 Deposit of Rs. 50 lakhs to clearing corporation which forms part of the security 7.3 Settlement Mechanism
deposit of the Clearing Member.
Settlement of Futures Contracts
 Additional incremental deposits of Rs.10 lakhs to clearing corporation for each
In Futures contracts, both the parties to the contract have to deposit margin money
additional TM, in case the Clearing Member undertakes to clear and settle deals for
which is called as initial margin. Futures contract have two types of settlements, the
other TMs.
MTM settlement which happens on a continuous basis at the end of each day, and the
7.2 Clearing Mechanism final settlement which happens on the last trading day of the futures contract.
The first step in clearing process is calculating open positions and obligations of clearing o Mark to Market (MTM) Settlement
members. The open position of a CM is arrived at by aggregating the open positions of Mark to Market is a process by which margins are adjusted on the basis of daily price
all the trading members (TMs) and all custodial participants (CPs) clearing though him, changes in the markets for underlying assets. The profits/losses are computed as the
in the contracts which they have traded. The open position of a TM is arrived at by difference between:
adding up his proprietary open position and clients’ open positions, in the contracts a) The trade price and the day's settlement price for contracts executed during the
which they have traded. While entering orders on the trading system, TMs identify day but not squared-off.
orders as either proprietary (Pro) or client (Cli). Proprietary positions are calculated on b) The previous day's settlement price and the current day's settlement price for
net basis (buy-sell) for each contract and that of clients are arrived at by summing brought forward contracts.
together net positions of each individual client. A TM’s open position is the sum of c) The buy price and the sell price for contracts executed during the day and
proprietary open position, client open long position and client open short position. squared-off.
To illustrate, consider a clearing member ‘A’ with trading members clearing through him The clearing member who suffers a loss is required to pay the MTM loss amount
‘PQR’ and ‘XYZ’. which is in turn passed on to the clearing member who has made a MTM profit.
Proprietary Clearing Members are responsible to collect and settle the daily MTM profits/losses
Client 1 Client 2 incurred by the TMs and their clients clearing and settling through them. After
Position Net
completing day’s settlement process, all the open positions are reset to the daily
Buy Sell Net Buy Sell Net Buy Sell Net Member
TM Security settlement price. These positions become the open positions for the next day.
Qty Qty Qty Qty Qty Qty Qty Qty Qty
o Final Settlement
NIFTY On expiration day of the futures contracts, after the close of trading hours, clearing
Long
PQR October 5000 3000 2000 3000 2000 1000 3000 1000 2000 corporation marks all positions of a clearing member to the final settlement price.
5000
contract All long positions are automatically assigned to short positions with the same series,
Long on a random basis, for either cash settlement or for delivery settlement, whichever
NIFTY
1000 is applicable.
XYZ October 1000 2000 (1000) 2000 1000 1000 3000 4000 (1000)
Short Settlement of Options Contracts
contract
2000 Options contracts have two types of settlements: Daily premium settlement and Final
Clearing member A’s open position for Nifty October contract is: settlement.
o Daily Premium Settlement
Member Long Position Short Position
In options contract, buyer of an option pays premium while seller receives premium.
PQR 5000 0 The amount payable and receivable as premium are netted to compute the net
XYZ 1000 2000 premium payable or receivable amount for each client for each option contract.
Total for A 6000 2000 The clearing members who have a premium payable position are required to pay the
premium amount to clearing corporation which in turn passed on to the members
Here in the above example PQR’s Long Position is arrived by summing up net position of who have a premium receivable position. This is known as daily premium
his proprietary position i.e. 2000 and net positions of both his clients 1 & 2 i.e., 1000 and

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 settlement. The premium payable amount and premium receivable amount are receiving members' settlement account in accordance with the pay-out instructions
directly credited/ debited to the clearing member’s clearing bank account. received electronically from the Clearing Corporation on the settlement day.
o Final Exercise Settlement Settlement Price
All the in-the-money stock options contracts, except the Close to Money (CTM)  Daily Settlement Price for mark to market settlement of futures contracts: Daily
options which are explicitly marked as “Do Not Exercise”, shall get automatically settlement price for futures contracts shall be based on the last 30 minutes volume
exercised on the expiry day. All these long positions are automatically assigned to weighted average price of such contract across Exchanges.
the short positions in option contracts with the same series, on a random basis.  For the unexpired futures contracts which are not traded during the last half an hour
Settlement of Admitted Deals on a day, theoretical daily settlement price is computed as: F = S * e rt
Admitted deals executed on a trading day, shall be cleared on a netted basis, by the where: F = theoretical futures price, S = value of the underlying index/individual
Clearing Corporation. The clearing members are responsible for all obligations arising security, r = rate of interest (may be the relevant MIBOR rate or such other rate as
out of such trades including the payment of margins, penalties, any other levies and may be specified) and t = time to expiration.
settlement of obligations of the trades entered by them as trading members and also of  Final Settlement Price for futures contract: Final settlement price for a futures
those trading members and custodial participants for whom they have undertaken to contract shall be based on the last 30 minutes volume weighted average price of the
settle as a clearing member. Where the clearing member is not a trading member of the relevant underlying security/index across Exchanges on the last trading day of such
Exchange then the trades of those trading members and custodial participants of the futures contract.
Exchange for whom the clearing member has undertaken to settle shall be considered  Final exercise settlement price for option contracts: Final Exercise settlement price
for determining the obligations as a clearing member. for an option contract shall be based on the last 30 minutes volume weighted
average price of the relevant underlying security/index across Exchanges, on the last
Settlement Period trading day of the options contract.
The pay-in and pay-out of daily mark to market settlement, final settlement of futures
contracts, premium settlement, the final exercise settlements of options contracts and Settlement Procedure
delivery settlement of futures and options contracts shall be effected in accordance  Daily mark to market settlement and final settlement for futures contract which
with the settlement schedule issued by the Clearing Corporation periodically. The paying are cash settled:
members are required to have clear balance of funds in their clearing account towards o Daily mark to market settlement and final settlement in respect of admitted
their pay-in obligation by the declared pay-in time on the settlement day. The pay-out of deals in futures contracts which are cash settled shall be settled by debit/credit
funds shall be credited to the receiving members clearing account thereafter. of the clearing accounts of clearing members with the respective clearing bank.
Where Cash Settlement is applicable: The pay-in and pay-out of daily mark to market o All positions (brought forward, created during the day, closed out during the
settlement, final settlement of futures contracts which are cash settled, premium day) of a clearing member in futures contracts, at the close of trading hours on a
settlement and the final exercise settlements of options contracts which are cash day, shall be marked to market at the daily settlement price (for daily mark to
settled shall be effected before start of market hours on the next day as per the market settlement) and settled.
settlement schedule specified by the Clearing Corporation. o All positions (brought forward, created during the day, closed out during the
day) of a clearing member in futures contracts, at the close of trading hours on
Where Delivery Settlement is applicable: Final settlement of futures contracts and the the last trading day of the contract which are cash settled, shall be marked to
final exercise settlements of options contracts which are settled by delivery shall be market at final settlement price (for final settlement) and settled.
effected on Expiry+2 days in accordance with the settlement schedule issued by the o Open positions in a futures contract shall cease to exist after its expiration day.
Clearing Corporation periodically. The delivering clearing member shall complete
delivery instructions for transfer of securities to Depository pool account on settlement  Premium settlement for option contracts:
day by 2:00 PM or such cut-off time as stipulated by the respective depositories. The o Premium settlement in respect of admitted deals in options contracts on index
depositories shall credit the receiving members' pool account / clients’ beneficiary and on individual securities shall be cash settled by debit/credit of the clearing
account in accordance with the pay-out instructions received electronically from accounts of clearing members with the respective clearing bank.
Clearing Corporation on the settlement day. The funds paying clearing member shall o The premium payable or receivable value of clearing members shall be
have clear funds in his settlement account on settlement day. The clearing bank shall computed after netting the premium payable or receivable positions at trading
debit the paying members' account by 2:00 PM in accordance with electronic member/Custodial Participant level, for each option contract, at the end of each
instructions received from Clearing Corporation. The Clearing Bank shall credit the trading day.

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 Exercise settlement for option contracts In-the-money call options: Long call exercised shall result into a buy (security
o For Index options: Exercise style of index option contracts is European style receivable) positions and Short call assigned shall result into a sell (security
wherein all in-the-money contracts get automatically exercised on the expiry deliverable) positions.
day. Exercise settlement is effected for all in-the-money option contracts on the In-the-money put options: Long put exercised shall result into a sell (security
last trading day of an option contract. Long positions of in-the money contracts deliverable) positions and Short put assigned shall result into a buy (security
are assigned to short positions in option contracts with the same series on a receivable) positions.
random basis. Exercise settlement in respect of admitted deals in index option o Settlement Obligation Value: Settlement obligations for futures contracts shall
contracts are cash settled by debit/credit of the clearing accounts of the relevant be computed at futures final settlement price of the respective contract. The
clearing members with the respective clearing bank. Index option contracts, difference between previous day settlement price/trade price and final
which have been exercised, shall be assigned and allocated to clearing members settlement price on the expiry date shall be cash settled along with daily MTM
at the client level with the same series. Open positions, in an index option on T+1 basis. For Options contracts, settlement obligation is computed at
contracts, shall cease to exist after its expiration day. respective strike prices of the option contracts.
o For Options on individual securities: Exercise style of option contracts on o The final deliverable/receivable positions at a clearing member shall be arrived
individual securities is European style wherein all in-the-money contracts get after netting the obligations of all clients/constituent/trading members clearing
automatically exercised on the expiry day. Exercise settlement is effected for all through the respective clearing member.
in-the-money option contracts on the last trading day of an option contract. o Delivery settlement of securities shall be done only in dematerialized mode
Long positions of in-the money contracts are assigned to short positions in through the depositories.
option contracts with the same series on a random basis. Option contracts,
7.4 Risk Management
which have been exercised, shall be assigned and allocated to clearing members,
at the client level on a random basis. Exchanges, with the help of Clearing Corporations, manage the risk in the derivatives
o Final exercise settlement: Final exercise settlement is effected for all in-the- segment using a comprehensive risk containment mechanism. The salient features of
money option contracts on the last trading day of an option contract. Long risk containment measures in the F&O segment are:
positions at in-the money strike prices are assigned to short positions in option  Stringent requirements of capital adequacy for membership (Financial strength
contracts with the same series at the client level on a random basis. For option of a member) help in risk management.
contracts that are to be cash settled, it is done by debit/credit of relevant  Clearing corporation charges an upfront initial margin for all the open positions
clearing accounts of relevant clearing members with the respective clearing bank of a Clearing Member (CM). It specifies the initial margin requirements for each
towards the exercise settlement value for each unit of the option contract and futures/ options contract on a daily basis and also follows Value-At-Risk (VAR)
other option contracts are settled through delivery. Open positions in options based margining. Clearing member collects initial margin from the trading
shall cease to exist after exercise or on expiration day, as the case may be. members (TMs) and their respective clients.
o Do not Exercise: A facility has been provided to specify ‘Do not Exercise’  The open positions of the members are settled on an MTM basis for each
instruction on expiry day in options contracts. On the expiry day, members have contract at the end of the day.
been given an option to specify not to exercise in respect of Close To Money  Clearing corporation’s online position monitoring system monitors a CM’s open
(CTM) option strikes. All in-the-money option contracts, not in the ‘CTM’ option position on a real-time basis. It sets limit for each CM based on his effective
series, shall be exercised automatically. For Call Options, 3 in-the-money options deposits and simultaneously generates alert messages whenever a CM reaches
strikes immediately below the final settlement price are considered as ‘CTM’ and certain pre-determined benchmarks of the limit. Clearing corporation monitors
for Put Options, 3 in-the-money options strikes immediately above the final the CMs for Initial Margin violation, Exposure margin violation, while TMs are
settlement price are considered as ‘CTM’. monitored for Initial Margin violation and position limit violation.
 A trading terminal helps the CMs to monitor the open positions of all the TMs
 Delivery Settlement clearing and settling through him. A CM may set limits for a TM clearing and
o Settlement Obligation: The settlement obligations shall be computed as under: settling through him. Clearing corporation assists the CM to monitor the intra-
Unexpired Futures: Long futures shall result into a buy (security receivable) day limits set up by a CM and whenever a TM exceed the limits, it stops that
positions and Short futures shall result into a sell (security deliverable) positions. particular TM from further trading.

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The most critical component of risk containment mechanism for F&O segment is the premium settlement, at the client level. Premium margin shall be levied till the
margining system and online position monitoring. The actual position monitoring and completion of pay-in towards the premium settlement.
margining is carried out online through Parallel Risk Management System (PRISM) using Assignment Margin for Options on Securities
SPAN® (Standard Portfolio Analysis of Risk) system for the purpose of computation of Along with Initial Margin and Premium Margin, assignment margin is required to be paid
online margins, based on the parameters defined by SEBI. on assigned positions of Clearing Members towards final exercise settlement obligations
7.5 Margining and mark to market under SPAN for option contracts on individual securities, till such obligations are fulfilled.
Assignment margin is levied on assigned positions of the clearing members towards final
In order to manage risk efficiently in the Indian securities market, exchanges have
exercise settlement obligations for option contracts on index and individual securities
adopted SPAN (Standard Portfolio Analysis of Risk), a risk management and margining
which are settled in cash. Assignment margin shall be the net exercise settlement value
product designed by Chicago Mercantile Exchange (CME), Chicago, USA. This software
payable by a clearing member towards final exercise settlement. Assignment margin
was developed for calculating initial margins on the various positions of market
shall be levied till the completion of pay-in towards the exercise settlement
participants.
The objective of SPAN is to identify overall potential risk in a portfolio. The program Intra-day crystallised Losses
treats futures and options uniformly, while recognizing the unique exposures associated Clearing Corporation calculates and levy Intraday Crystallised Losses (ICMTM) in the
with options portfolios. following manner:
Since SPAN is used to determine initial margins on various positions, its basic objective is a) ICMTM is computed for all trades which are executed and results into closing out of
to determine the largest possible loss that a portfolio might reasonably be expected to open positions.
suffer from one day to the next. It then sets the initial margins at a level which is b) ICMTM is calculated based on weighted average prices of trades/positions
sufficient to cover this one-day potential loss. c) ICMTM is computed only for futures contracts.
The concept of risk array represents the extent to which a specific derivative instrument d) ICMTM is part of initial margin and shall be adjusted against the liquid assets of
will gain or lose value from the present time to a specific point in time in the near clearing member on a real time basis.
future, over a specific set of market conditions. The time is set to one trading day i.e., e) Crystallised losses at a contract level for a client are adjusted against crystallised
through the use of SPAN the maximum likely loss, which may reasonably occur over one profits, if any, from another contract for the same client to arrive at client level
trading day is being evaluated. profit or loss.
f) All client level losses across all trading members including losses on proprietary
Margins
positions of trading members, if any, are grossed up to arrive at clearing member
The margining system for the equity derivatives segment is as follows:
level ICMTM.
Initial margin g) ICMTM so blocked/ collected is released on completion of daily / final mark to
Margins are computed by clearing corporation upto client level with the help of SPAN. market settlement pay-in
Clearing corporation collects initial margin for all the open positions of a Clearing
Delivery Margins
Member based on the margins computed. Margins are required to be paid up-front on
gross basis at individual client level for client positions and on net basis for proprietary Delivery margins are levied on lower of potential deliverable positions or in-the-money
positions. A Clearing Member collects initial margin from TM whereas TM collects from long option positions, four days prior to expiry of derivative contract, which has to be
his clients. settled through delivery. Example: If expiry of derivative contract is on Thursday, the
delivery margins on potential in-the-money long option position shall be applicable from
Initial margin requirements are based on 99% value at risk over a one-day time horizon.
previous Friday EOD. Delivery margins are part of the initial margins of the clearing
However, in the case of futures contracts (on index or individual securities), where it
member and are computed at a client level settlement obligation for all positions to be
may not be possible to collect mark to market settlement value, before the
settled through delivery. Client level potential in-the-money long option positions are
commencement of trading on the next day, the initial margin is computed over a two-
computed on daily basis. In-the-Money options are identified based on the closing price
day time horizon, applying the appropriate statistical formula. The methodology for
of the security in the underlying Capital Market segment on the respective day. Delivery
computation of Value at Risk percentage is as per the recommendations of SEBI from
margins are levied at client level and collected from clearing member in a staggered
time to time.
manner as under:
Premium Margin
o 20% of Delivery margins computed on Expiry - 4 EOD
Along with Initial Margin, Premium Margin is also charged at client level. Premium
o 40% of Delivery margins computed on Expiry - 3 EOD
margin includes premium amount due to be paid to the Clearing Corporation towards

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 o 60% of Delivery margins computed on Expiry - 2 EOD 4. When a Clearing Member clears for client/ entities in Cash and Derivatives
o 80% of Delivery margins computed on Expiry - 1 EOD segments, he is then required to intimate client details through a Collateral Interface
Post expiry, positions which are converted to settlement by delivery, margins as for Members (CIM) to benefit from Cross margining.
applicable in Capital Market segment (i.e VAR, Extreme Loss Margins, Mark to Market 5. When different Clearing Members clear for client/entities in Cash and Derivatives
margins) shall be applicable and levied as delivery margins. Delivery margins blocked segments they are required to enter into necessary agreements for availing cross
shall be released on completion of settlement. margining benefit.
Exposure Margins 6. Clients who wish to avail cross margining benefit in respect of positions in Index
The VAR and Extreme Loss percentage as computed in the Capital Market segment shall Futures and Constituent Stock Futures only, their clearing member in the Derivatives
be applied on client level settlement obligations. The margins rate shall be updated for segment needs to provide the details of the clients.
every change in margin rate in Capital Market segment. Clearing members are subject to Early Pay-in of Securities and Funds
exposure margins in addition to initial margins. In cases where early pay-in of securities is made by the members, such positions for
Short Option Minimum Charge which early pay-in (EPI) of securities is made shall be exempt from delivery margins.
Short options positions in extremely deep-out-of-the-money strikes may appear to have Clearing members can make the early pay-in of securities through either of the
little or no risk across the entire scanning range. However, in the event that underlying depositories viz., NSDL and CDSL. In NSDL, clearing members shall deliver the securities
market conditions change sufficiently, these options may move into-the-money, thereby to their pool account and execute irreversible delivery out instructions through their
generating large losses for the short positions in these options. To cover the risks Depository Participant for the particular settlement. In CDSL, clearing members can
associated with deep-out-of-the-money short options positions, SPAN assesses a transfer the security to their early pay-in account with CDSL for Capital Market segment
minimum margin for each short option position in the portfolio called the Short Option with Clearing Corporation. Clearing members can provide the details of the clients to
Minimum charge, which is set by the Clearing Corporation. The Short Option Minimum whom early pay-in benefit is to be provided through a file upload. In cases where early
charge serves as a minimum charge towards margin requirements for each short pay-in of funds is made, such positions for which early pay-in of funds is made shall be
position in an option contract. exempt from delivery margins.
Net Option Value Violations and Penalties
Net Option Value is computed as the difference between the long option positions and Non-compliance of any provisions of the Rules, Bye-laws and Regulations by any clearing
the short option positions, valued at the last available closing price of the option member or trading member is treated as a violation and attracts appropriate action
contract and is updated intraday at the current market value of the relevant option which includes penalties. The following are some of the compliance lapses which attract
contracts at the time of generation of risk parameters. The Net Option Value is added to such penal charges:
the Liquid Net Worth of the clearing member. Thus, mark to market gains and losses are  Non fulfilment of initial margin obligations
not settled in cash for options positions.  Non-fulfilment of settlement obligation
Client Margins  Non-fulfilment of securities deliverable obligation
Clearing corporation intimates all members of the margin liability of each of their client.  Non-fulfilment of minimum deposit requirements
Additionally, members are also required to report details of margins collected from  Exposure margin violation
clients to clearing corporation, which holds in trust client margin monies to the extent  Position limit violation
reported by the member as having been collected from their respective clients.  Mis-utilisation of trading member/constituent/client collaterals and deposits
Cross Margin  Violation of exercised positions
 Short or non-reporting of client margin
Salient features of the cross margining available on exchanges are as follows:
 Market wide Position Limit (MWPL) violation
1. Cross margining is available across Cash and Derivatives segment. In the event of a violation, Clearing Corporation may advice the Exchanges to withdraw
2. Cross margining is available to all categories of market participants. any or all of the membership rights of the clearing member including the withdrawal of
3. The positions of clients in both the Capital market and derivatives segments to the trading facilities of all trading members and/or clearing facility of custodial participants
extent they offset each other only are considered for the purpose of cross clearing through such clearing members, without any notice. In addition, the
margining. outstanding positions of such clearing member and/or trading members clearing and
settling through such clearing member, may be closed out and such action shall be final

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and binding on the clearing member and/or trading member. Clearing Corporation can Chapter 8: Legal and Regulatory Environment
also take additional measures like imposing penalties, collecting appropriate deposits,
invoking bank guarantees or fixed deposit receipts, realising money by disposing off the LEARNING OBJECTIVES:
securities, etc. After studying this chapter, you should know about:
 Definition of securities and derivatives as per the Securities Contract
(Regulation) Act, 1956
 Functions of SEBI
 Regulatory framework for derivatives market trading, clearing, settlement
and risk management
 Major recommendation of Dr. L.C Gupta Committee Report and Dr. J.R.
Verma Committee Report

The trading of derivatives is governed by the provisions contained in the Securities

Contracts (Regulation) Act-1956, the Securities Exchange Board of India Act-1992, the
rules and regulations framed there under and other rules and bye–laws of stock
exchanges.

8.1 Securities Contracts (Regulation) Act, 1956

The Act aims to prevent undesirable transactions in securities. It governs the trading of
securities in India. The term “securities” has been defined in the Section 2(h) of SCRA.
The term ‘Securities’ include:
 Shares, scrips, stocks, bonds, debentures, debenture stock or other marketable
securities of a like nature in or of any incorporated company or other body
corporate
 Derivative
 Units or any other instrument issued by any collective investment scheme to the
investors in such schemes
 Security receipt as defined in clause (zg) of section 2 of the Securitisation and
Reconstruction of Financial Assets and Enforcement of Security Interest Act,
2002
 Units or any other such instrument issued to the investors under any mutual
fund scheme (securities do not include any unit linked insurance policy or scrips
or any such instrument or unit, by whatever name called which provides a
combined benefit risk on the life of the persons and investment by such persons
and issued by an insurer refer to in clause (9) of section 2 of the Insurance Act,
1938 (4 of 1938))
 Any certificate or instrument (by whatever name called), issued to an investor by
any issuer being a special purpose distinct entity which possesses any debt or
receivable, including mortgage debt, assigned to such entity, and acknowledging

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 beneficial interest of such investor in such debt or receivable, including 8.3 Regulation in Trading
mortgage debt, as the case may be A 24 member committee under the chairmanship of Dr. L.C.Gupta was set by SEBI to
 Government securities develop the appropriate regulatory framework for derivatives trading in India. On May
11, 1998, SEBI accepted the recommendations of the committee and approved the
 Such other instruments as may be declared by the Central Government to be
phased introduction of derivatives trading in India beginning with stock index futures.
securities (including onshore rupee bonds issued by multilateral institutions like
the Asian Development Bank and the International Finance Corporation) The provisions in the SCRA and the regulatory framework developed there under govern
trading in securities. The amendment of the SCRA to include derivatives within the
 Rights or interests in securities
ambit of ‘securities’ made trading in derivatives possible within the framework of that
According to the act “Derivatives” is defined as: Act.
 A security derived from a debt instrument, share, loan whether secured or  Any Exchange fulfilling the eligibility criteria as prescribed in the L.C. Gupta
unsecured, risk instrument or contract for differences or any other form of committee report can apply to SEBI for grant of recognition under Section 4 of the
security. SCRA, 1956 to start trading derivatives. The derivatives exchange/segment should
 A contract which derives its value from the prices, or index of prices, of have a separate governing council and representation of trading/clearing members
underlying securities. shall be limited to maximum of 40% of the total members of the governing council.
 Commodity derivatives, and The exchange would have to regulate the sales practices of its members and would
 Such other instruments as may be declared by the Central Government to be have to obtain prior approval of SEBI before start of trading in any derivative
derivatives. contract.
 Section 18A provides that notwithstanding anything contained in any other law  The Exchange should have a minimum of 50 members.
for the time being in force, contracts in derivative shall be legal and valid if such  The members of an existing segment of the exchange would not automatically
contracts are: become the members of derivative segment. The members of the derivative
o Traded on a recognized stock exchange segment would need to fulfil the eligibility conditions as laid down by the L.C. Gupta
o Settled on the clearing house of the recognized stock exchange, in committee.
accordance with the rules and bye–laws of such stock exchanges.  The clearing and settlement of derivatives trades would be through a SEBI approved
8.2 Securities and Exchange Board of India Act, 1992 clearing corporation/house. Clearing corporations/houses complying with the
SEBI Act, 1992 provides for establishment of Securities and Exchange Board of India eligibility conditions as laid down by the committee have to apply to SEBI for grant of
(SEBI) with statutory powers for (a) protecting the interests of investors in securities (b) approval.
promoting the development of the securities market and (c) regulating the securities  Derivative brokers/dealers and clearing members are required to seek registration
market. Its regulatory jurisdiction extends over corporate in the issuance of capital and from SEBI. This is in addition to their registration as brokers of existing stock
transfer of securities, in addition to all intermediaries and persons associated with exchanges. The minimum Net-worth for clearing members of the derivatives clearing
securities market. SEBI has been obligated to perform the aforesaid functions by such corporation/house shall be Rs.300 Lakhs. The Net-worth of the member shall be
measures as it thinks fit. In particular, it has powers for: computed as follows:
 Regulating the business in stock exchanges and any other securities markets.  Capital + Free reserves
 Registering and regulating the working of stock brokers, sub–brokers etc.  Less non-allowable assets viz.,
 Promoting and regulating self-regulatory organizations. o Fixed assets
 Prohibiting fraudulent and unfair trade practices. o Pledged securities
 Calling for information from, undertaking inspection, conducting inquiries and o Member’s card
audits of the stock exchanges, mutual funds and other persons associated with o Non-allowable securities (unlisted securities)
the securities market and intermediaries and self–regulatory organizations in the o Bad deliveries
securities market. o Doubtful debts and advances
o Prepaid expenses
 Performing such functions and exercising according to Securities Contracts
o Intangible assets
(Regulation) Act, 1956, as may be delegated to it by the Central Government.
o 30% marketable securities

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 The minimum contract value shall not be less than Rs 5,00,000. Exchanges have to (b) Contracts in securities, and
submit details of the futures contract they propose to introduce. (c) Listing of securities on Stock Exchanges
 The initial margin requirement, exposure limits linked to capital adequacy and A penalty or suspension of registration of a stock - broker under the SEBI (Stock Broker)
margin demands related to the risk of loss on the position will be prescribed by SEBI/ Regulations, 1992 can be ordered if:
Exchange from time to time.  The stock broker violates the provisions of the Act
 The L.C. Gupta committee report requires strict enforcement of “Know your  The stock broker does not follow the code of conduct
customer” rule and requires that every client shall be registered with the derivatives
 The stock broker fails to resolve the complaints of the investors
broker. The members of the derivatives segment are also required to make their
 The stock broker indulges in manipulating, or price rigging or cornering of the
clients aware of the risks involved in derivatives trading by issuing to the client the
market
Risk Disclosure Document and obtain a copy of the same duly signed by the client.
 The stock broker’s financial position deteriorates substantially
 The trading members are required to have qualified approved user and sales person
 The stock broker fails to pay fees
who have passed a certification programme approved by SEBI.
 The stock broker violates the conditions of registration
Members and authorized dealer have to fulfil certain requirements and provide  The stock broker is suspended by the stock exchange
collateral deposits to become members of the F&O segment. All collateral deposits are
Position limits are the maximum exposure levels which the entire market can go up to
segregated into cash component and non-cash component. Cash component means
cash, bank guarantee, fixed deposit receipts, T-bills and dated government securities. and each Clearing Member or investor can go up to. Position limits for the entire market
Non-cash component means all other forms of collateral deposits like deposit of and Clearing Members and investors are defined by SEBI.
approved demat securities. Each Clearing Member may have several Trading Members with him. The trading limits
for each such Trading Member are decided by Clearing Members on the computerized
Net-worth criteria for Clearing Members has been provided by SEBI, while Net-worth
trading system.
criteria for Trading Members and Limited Trading Members have been decided by stock
exchanges. Few exchanges have a special category of members called Limited Trading If the Trading Member reaches his position limit, he will not be able to enter any fresh
Members, who are not cash market members of exchange. transactions which have the impact of increase his exposure. He will enter only those
transactions which have the impact of reducing his exposure. Thus, new positions will
The broker is required to get a Risk Disclosure Document signed by the client, at the
not be permitted, but squaring up will be permitted.
time of client registration. This document informs clients about the kind of risks that
derivatives can involve for the client. It makes the client aware and well informed. 8.4 Regulations in Clearing & Settlement and Risk Management
Apart from other records, Trading Members are required to maintain trade confirmation Anybody interested in taking membership of F&O segment is required to take
slips and exercise notices from the trading system for a period of 5 years. membership of “Capital Market and F&O segment” or “Capital Market, Wholesale Debt
Market and F&O segment”. A membership for Capital Markets and F&O segment
All member brokers in the derivative segment should be inspected by the exchange at
acquires a right to execute trades and to clear and settle the trades executed by the
least once a year.
members in these segments. Similarly, a membership for Capital Market, Wholesale
A default by a member in the derivatives segment will be treated as default in all Debt Market and F&O segment acquires a right to execute trades and to clear and settle
segments of that exchange and as default on all exchanges where he is a member. the trades executed by the members in these segments. An existing member of CM
The purpose of inspection of stock brokers’ records under the SEBI (Stock Broker) segment can also take membership of F&O segment. A trading member can also be a
Regulations, 1992 is to ensure that the books of accounts and other books are being clearing member by meeting additional requirements. There can also be only clearing
maintained in the manner required. members.

The recognition to a stock exchange under the Securities Contract (Regulation) Act 1956 The initial and exposure margin is payable upfront by Clearing Members. Initial margins
can be granted by the Central Government. It provides for direct and indirect control of can be paid by members in the form of Cash, Bank Guarantee, Fixed Deposit Receipts
virtually all aspects of securities trading and the running of Stock Exchanges and aims to and approved securities.
preventing undesirable transactions in securities. It gives Central Government the Clearing members who are clearing and settling for other trading members can specify
regulatory jurisdiction over: the maximum collateral limit towards initial margins, for each trading member and
(a) Stock Exchanges through a process of recognition and continued supervision custodial participant clearing and settling through them.

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Such limits can be set up by the clearing member, through the facility provided on the All active members of the Exchange are required to make initial contribution towards
trading system up to the time specified in this regard. Such collateral limits once set are Trade Guarantee Fund of the Exchange.
applicable to the trading members/custodial participants for that day, unless otherwise
8.5 Major recommendations of Dr. L.C.Gupta Committee
modified by clearing member.
 Margins should be based on Value at Risk Methodology at 99% confidence.
Non-fulfilment of either whole or part of the margin obligations will be treated as a
 Volatility should be monitored online.
violation of the Rules, Bye-Laws and Regulations of clearing corporation and will attract
penalty.  Exposure should be monitored online.
In addition, clearing corporation may at its discretion and without any further notice to  Daily collection of Mark to Market Margins (on the next trading day).
the clearing member, initiate other disciplinary action, inter-alia including, withdrawal of  Market participants should know volatility and margin methodology.
trading facilities and/ or clearing facility, close out of outstanding positions, imposing  Stringent entry norms for derivative broker-members.
penalties, collecting appropriate deposits, invoking bank guarantees/ fixed deposit
 Each dealer should pass SEBI approved certification exams (certificate will have a
receipts, etc.
validity of 3 years).
Clearing member is required to provide liquid assets which adequately cover various  Derivatives segment must be separate from cash segment.
margins and liquid Net-worth requirements. He may deposit liquid assets in the form of
 Grossing up of margins at client level.
cash, bank guarantees, fixed deposit receipts, approved securities and any other form of
collateral as may be prescribed from time to time. The total liquid assets comprise of at  Separate Investor Protection Fund must be created for derivatives segment.
least 50% of the cash component and the rest is non-cash component.  Off line order entry is permitted.
Responsibilities of the Clearing Corporation include:  The derivatives segment should attract at least 50 members.
 Collection of Margins on timely basis  Clearing Members should have a Minimum Net-worth of Rs 3 Crores.
 Smooth operation of the Market  Clearing Members should maintain a Minimum Deposit in Liquid Assets of Rs 50
 Daily Clearing and Settlement lakhs with the exchange or it’s Clearing Corporation.
 To act as a legal counterparty for every contract
 Mark to Margins should be settled only in Cash.
 To monitor positions in derivatives and cash segments
 Both speculators/traders and hedgers are required for a healthy derivatives market.
 Deciding Daily Settlement Prices
 Keep consistent record of margins at client level  Both Exchanges and SEBI should work together in regulating the derivatives market.
 Take care not to appropriate client margins against brokers dues  Exchanges should regulate at operational day to day level, while SEBI will oversee
the process and formulate policy.
The Clearing Corporation can transfer client positions from one broker member to
another broker member in the event of a default by the first broker member.  Mutual Funds should be allowed to hedge in derivatives segment.
Some of the reports which a derivatives segment of a Stock Exchange has to provide to  Derivatives should begin with Index Futures and other products should be
SEBI are: introduced in a phased manner.
 Occasions when the 99% Value at Risk limit has been violated  Members’ exposure should be linked to the amount of liquid assets maintained by
 Defaults by broker-members them with the clearing corporation.
 Daily market activity report  Cross margining (linking overall cash and derivative positions for margining) is not
 Daily market report permitted.
Main objectives of Trade Guarantee Fund (TGF):  All clients should pay margins. Brokers should not fund margins of clients.
 To guarantee settlement of bonafide transactions of the members of the  In the long run, India should have a national level clearing corporation.
exchange.  Clients should be provided with a Risk Disclosure Document by brokers.
 To inculcate confidence in the minds of market participants.
 Brokers should keep margins collected from clients in a separate bank account.
 To protect the interest of the investors in securities.
 Brokers cannot use margins for any purpose except for payment of such margins to
the clearing corporation.
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 Transactions should be entered in the trading system exclusive of brokerage. 8.6 Major recommendations of Prof. J.R.Verma Committee
 Brokerage should be charged separately in the Contract Note.  Calendar spreads on futures will attract lower margins (minimum 1% and maximum
 In case of Clearing Member default, margins paid by the Clearing Member on his 3% - the margin itself being 0.5% per month of spread on the far month value).
own account alone would be used to settle his dues.  Detailed methodology on Value at Risk provided.
 All brokers in the derivatives segment should obtain SEBI Registration.  Volatility should be calculated based on standard deviation of logarithmic daily
returns.
 The clearing function should be organized as a separate entity, preferably in the
form of a Clearing Corporation.  Exponential weighted average method should be used for calculation of Volatility.
 The Clearing Corporation has powers to levy additional margins, special margins,  Initial Margin levels should be dynamic and recalculated continuously based on
define maximum exposure limits and disable brokers from trading. volatility levels.
 At the time of entering into a transaction, the broker must indicate the client on  Exchange should obtain SEBI approval if it wants to change the Initial Margin
whose behalf the transaction is being entered into. Proprietary trading must also be calculation methodology.
clearly identified.  Initial Margin, if changed, will apply to all outstanding contracts and not only to fresh
 SEBI should create a Special Derivatives Cell within itself to understand and contracts.
supervise the market better.  Calendar spreads carry only basis risk and no market risk - hence lower margins are
 SEBI should constitute an Advisory Council for derivatives. adequate.
 Derivatives segment should have a separate Governing Council.  Calendar spreads should be treated as open positions as the near month expires.
 No common members should be allowed between the Cash segment Governing  Differential margins on conversion of Calendar spread positions to open positions
Board and the Derivatives segment Governing Council of the exchanges. should be collected three days before expiry of the near month (technically, Prof.
 The exchange should set up Arbitration and Investor Grievance Cells in at least 4 J.R.Verma Committee recommendation was different, however currently as per SEBI
regions across the country. guidelines, this is the regulation).

 Derivatives trading must be through on-line systems.  Liquid Assets mean Deposits maintained by Clearing Members with the Clearing
Corporation.
 Disaster recovery site (in case of computer failure) is a must.
 Liquid Assets can be in the form of Cash, Cash Equivalents (Government Securities,
 Information about derivatives segment must be disseminated over at least two Fixed Deposits, Treasury Bills, Bank Guarantees, and Investment Grade Debt
information vending networks (e.g. Reuters, Bloomberg). Securities) and Equity Securities.
 All brokers of the Cash segment will not automatically become members of the  Equity Securities can form maximum 50% of Liquid Assets.
Derivative segment.
 Cash and Cash Equivalents must form minimum 50% of Liquid Assets.
 An efficient cash market is a must for a healthy derivatives market.
 Liquid Net-worth is defined as Liquid Assets minus Initial Margin.
 Delivery levels in the cash market should improve and increase.
 Liquid Net-worth of all Clearing Members at all points of time (including intraday)
 Uniform settlement cycle across all exchanges is recommended. should be maintained at Rs 50 lakhs minimum level.
 A separate Governing Board should be constituted for the Clearing Corporation of  Securities placed with the Clearing Corporation shall be marked to market on weekly
the Derivatives segment. basis.
 No broker members should be allowed to sit on the Governing Board of the Clearing  Hair cut on equity securities is 15%.
Corporation.
 Hair cut on debt securities is 10%.
 If your client is a Trust or a Company, you (as a broker) must obtain authorization
from the Board of Trustees or Board of Directors for trading in derivatives on their
behalf
 Providing Client ID for every transaction is mandatory

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  It may be mentioned that at the time when the contract is entered into for
Chapter 9: Accounting and Taxation purchase/ sale of equity index futures, no entry is passed for recording the
contract because no payment is made at that time except for the initial margin.
LEARNING OBJECTIVES:
 At the balance sheet date, the balance in the "Initial Margin - Equity Index/
After studying this chapter, you should know about: Equity Stock Futures Account' should be shown separately under the head
 Accounting treatment for forward and futures contracts 'Currency Assets'.
 Taxation of derivatives transaction in securities  Where any amount has been paid in excess of the initial/ additional margin, the
excess should be disclosed separately as a deposit under the head 'Current
9.1 Accounting Assets'.
Accounting for Forward Contract as per Accounting Standard - 11  Where instead of paying initial margin in cash, the Client provides bank
guarantees or lodges securities with the member, a disclosure should be made in
When forward contract is for hedging
the notes to the financial statements of the Client. This will not require any
 The premium or discount (difference between the value at spot rate and forward accounting entry.
rate) should be amortized over the life of contract.
 Exchange difference (difference between the value of settlement date/ reporting Deposit for Initial Margin Kept
date and value at previous reporting date/ inception of the contract) is Deposit for Initial Margin a/c Dr.
recognized in Profit & Loss statement of the year. To Bank a/c
 Profit/ loss on cancellation/ renewal of forward contract are recognized in P&L of Initial Margin paid / adjusted from deposit
the year. Initial Margin a/c Dr.
When forward contract is for trading/ speculation To Bank a/c/ Deposit for initial Margin a/c
 No premium or discount is recognized.
Initial margin returned /released
 A gain or loss i.e. the difference between the forward rate as per contract/
Bank a/c /Deposit for initial margin a/c Dr.
previous year end valuation rate and the forward rate available at the yearend
To Initial Margin a/c
(reporting date) for remaining maturity period should be recognized in the P&L
of the period. Suppose Mr. X purchases a Futures Contract on March 5, 2018. The initial margin
 Profit/ loss on cancellation / renewal of forward contract are recognized in P&L calculated as per SPAN, is 50000. The margin for the subsequent days, calculated as per
of the year. the SPAN, is as follows:
Accounting of Equity index and Equity stock futures in the books of the client On March 6, 2018 Rs. 55,000
The Institute of Chartered Accountants of India (ICAI) has issued guidance notes on On March 7, 2018 Rs. 45,000
accounting of index futures contracts from the view point of parties who enter into such On March 8, 2018 Rs. 47,000
futures contracts as buyers or sellers. For other parties involved in the trading process, 1. On March 5, 2018
like brokers, trading members, clearing members and clearing corporations, a trade in Initial Margin – Equity Futures a/c. Dr Rs 50,000
equity index futures is similar to a trade in, say shares, and does not pose any peculiar To Bank a/c Rs 50,000
accounting problems. Hence in this section we shall largely focus on the accounting (Being initial margin paid on Equity Futures Contracts)
treatment of equity index futures in the books of the client.
2. On March 6, 2018
Accounting at the inception of the contract (Accounting for Initial Margin)
Initial Margin – Equity Futures a/c. Dr Rs 5,000
 Every client is required to pay to the Trading Member/ Clearing Member, initial To Bank a/c Rs 5,000
margin determined by the Clearing Corporation as per the bye-laws/ regulations (Being additional margin paid to the Exchange)
of the Exchange for entering into equity index/stock futures contracts.
 Such initial margin paid/ payable should be debited to "Initial Margin - Equity 3. On March 7, 2018
Index/Equity stock Futures Account". Additional margins, if any, should also be Bank a/c. Dr Rs 10,000
accounted for in the same manner. To Initial Margin – Equity Futures a/c. Rs 10,000

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(Being margin refunded by the Exchange) Advances" in the balance sheet and the provision created there-against should be
shown as a deduction there from.
4. On March 8, 2018
 On the other hand, the credit balance in the said account, i.e., the net amount
Initial Margin – Equity Futures a/c. Dr Rs 2,000
received from the broker, should be shown as a current liability under the head
To Bank a/c Rs 2,000
"Current Liabilities and Provisions" in the balance sheet.
(Being further margin paid to the Exchange)
 Such provision shall be calculated Index wise/Stock wise that means all series of
Accounting at the time of daily settlement - payment/receipt of mark-to-market stock shall be combined.
margin
Provision for loss on Equity Stock/ Equity Index futures outstanding at Balance sheet
 Payments made or received on account of Daily Settlement by the Client would be
debited or credited to an account titled as "Mark-to-Market Margin - Equity Index/ Opening provision was less hence increased
Equity Stock Futures Account". Profit & Loss a/c Dr
 Mark-to-Market Margin a/c can be maintained Index/ stock-wise so as to facilitate To Provision for loss on Equity Stock/Equity Index future a/c
calculation of provision for loss.
Opening provision was more hence decreased
 Such payment/receipt can be through a bank account or through a deposit kept with
Provision for loss on Equity Stock/Equity Index future a/c Dr
clearing member (and debited to an appropriate account say, "Deposit for Mark-to-
To Profit & Loss a/c
Market Margin Account").
 At the year-end, any balance in the "Deposit for Mark-to-Market Margin Account" To illustrate
should be shown as a deposit under the head "Current Assets". Suppose Mr. A pays an amount of Rs 5000, as Mark-to-Market Margin on Equity Futures
Contract. The following accounting entry would be made in the books of accounts:
Deposit for Mark to Market Margin Kept
Profit & Loss a/c Dr. Rs 5000
Deposit for M to M Margin a/c Dr.
To Provision for loss on Equity Futures a/c Rs 5000
To Bank a/c
(Being provision made for the amount paid to Clearing Member/Trading Member
M to M Margin paid /adjusted from deposit because of movement in the prices of the futures contract)
M to M Margin a/c Dr Accounting at the time of final settlement or squaring-up of the contract
To Bank/Deposit for M to M Margin a/c  At the expiry of a series of equity index futures, the profit/ loss, on final settlement
of the contracts in the series, should be calculated as the difference between final
M to M Margin received settlement price and contract prices of all the contracts in the series.
Bank /Deposit for M to M Margin a/c Dr.  The profit/ loss, so computed, should be recognised in the profit and loss account by
To M to M Margin a/c corresponding debit/ credit to "Mark-to-Market Margin Account".
Accounting for open interests as on the balance sheet date  Same accounting treatment should be made when a contract is squared-up by
entering into a reverse contract.
 Debit/ credit balance in the "Mark-to-Market Margin - Equity Index/Equity Stock
Future Account” the net amount paid/ received on the basis of movement in the  If more than one contract in respect of the relevant series of Equity Index/ Equity
prices of index futures till the balance sheet date. Stock futures contract to which the squared-up contract pertains is outstanding at
the time of the squaring up of the contract, the contract price of the contract so
 Keeping in view "prudence" principle, provisions should be created by a debit to the
squared-up should be determined using weighted average method for calculating
profit and loss account for anticipated loss equivalent to the debit balance in the
profit/ loss on squaring-up.
"Mark-to-Market Margin Account".
 On the settlement of an Equity Index/ Equity Stock futures contract, the initial
 Net amount received (represented by credit balance in the "Mark-to-Market Margin
margin paid in respect of the contract is released which should be credited to Initial
Account") being anticipated profit should be ignored and no credit for the same
Margin Account", and a corresponding debit should be given to the bank account or
should be taken in the profit and loss account.
the deposit account.
 The debit balance in the said "Mark-to-Market Margin Account", i.e., net payment
made to the broker, should be shown under the head "Current Assets, Loans and If profit on Settlement /Squaring off
M to M Margin a/c Dr

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To P & L a/c  Sometimes, the client may deposit a lump sum amount with the Trading/ Clearing
If Loss on Settlement/Squaring off Member in respect of the margin instead of paying/ receiving margin on daily basis.
P & L a/c Dr - In such a case, the amount of margin paid/ received from/ into such account should
To M to M Margin a/c be debited/ credited to the "Deposit for margin account". At the year-end, any
balance in the "Deposit for margin account" should be shown as a deposit under the
Entry for release of Initial Margin will be: head "Current Assets".
Bank a/c /Deposit for initial margin a/c Dr  Entries will be similar to initial margin on futures explained earlier.
To Initial Margin a/c
Accounting for open options as on the balance sheet date
Accounting in case of a default  The "Equity Index/Stock Option Premium Account" should be shown under the
 When a Client default in making payment in respect of Daily Settlement, the "head 'Current Asset' or 'Current Liabilities', as the case may be.
contract is closed out  In case of multiple options, entries recommended above may be made in one
 The amount not paid by the Client is adjusted against the initial margin. Excess “Equity Index/ Stock Option Premium Account”, in respect of options of all stocks.
margin if any is released and shortfall if any will be payable by the client. The balance of this composite account should be shown under the head "Current
 The accounting treatment in this regard will be the same as explained earlier Assets' or "Current Liabilities", as the case may be.
 The amount of profit or loss on the contract so closed out should be calculated and  But for calculating provision for loss, Stock wise / index wise a/c is advisable.
recognised in the profit and loss account in the manner described earlier.  In the books of the buyer/ holder, a provision should be made for the amount by
which the premium paid for the option exceeds the premium prevailing on the
Disclosure
balance sheet date since the buyer/ holder can reduce his loss to the extent of the
 The amount of bank guarantee, and book value as also the market value of securities
premium prevailing in the market, by squaring off the transaction.
lodged should be disclosed in respect of outstanding contracts at the year end,
 The excess of premium prevailing in the market on the balance sheet date over the
where initial margin money has been paid by way of bank guarantee and/or lodging
premium paid is not recognised on the consideration of prudence,
of securities, separately for each type of instruments.
 The provision so created should be credited to "Provision for Loss on Equity Index/
 The number of futures contract not settled (open interests), number of contracts,
stock Option Account". The provision made as above should be shown as deduction
number of units pertaining to those contracts as of the balance sheet date should be
from "Equity Index/ stock Option Premium" which is shown under 'Current Assets'.
disclosed separately for Long and Short Positions, in respect of each of equity index/
 In the books of the seller/ writer, the provision should be made for the amount by
futures i.e. index/ stock wise
which premium prevailing on the balance sheet date exceeds the premium received
Accounting for Equity Index Options in case of cash settled options for that option.
Accounting at the inception of the contract  The excess of premium received over the premium prevailing on the balance sheet
 The seller/ writer of the option is required to pay initial margin for entering into the date is not recognised on the consideration of prudence.
option contract. It should be debited to an appropriate account, say, "Equity Index/  This provision should be credited to "Provision for Loss on Equity Index/ Stock
Stock Option Margin Account". In the balance sheet, such account should be shown Option Account", with a corresponding debit to profit and loss account. "Equity
separately under the head "Current Assets". index/stock Options Premium Account" and "Provision for Loss on Equity Index/
 The buyer/ holder of the option is required to pay the premium. In the books of the Stock Options Account" should be shown under 'Current Liabilities and Provisions'.
buyer/ holder, such premium should be debited to an appropriate account, say,  In case of multiple open options at the year-end, a Stockwise / lndexwise provision
"Equity Index/ Stock Option Premium Account". In the books of the seller/ writer should be made considering all the open options of any strike price and any expiry
such premium received should be credited to an appropriate account, say, "Equity date under that stock/ Index taken together.
Index/ Stock Option Premium Account".  Profit/Loss on bought and sold position of each stock be adjusted and if net result is
loss make provision and if net result is gain ignore it.
Accounting at the time of payment/ receipt of margin  The amount of provision required in respect of each stock or index should be
 Payment made or received by the seller/ writer for the margin would be credited/ aggregated and a composite" Provision for Loss on Equity Stock/ Index Options
debited to the bank account and the corresponding debit or credit for the same Account" should be credited by debiting P&L a/c.
should be made to "Equity Index/ Stock Option Margin Account".  In case any opening balance in such provision account is there the same should be
adjusted against the provision required in the current year and the profit and loss

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 account be debited/ credited with the balance provision required to be made/excess  For a put option buyer/ holder will deliver equity shares for which the put option
provision written back. was entered into. The buyer/ holder should credit the relevant equity shares
Accounting at the time of final settlement account and debit cash/ bank.

In the books of the buyer/ holder: In case of seller/writer:

 The buyer/ holder will recognise premium as an expense in the profit and loss  For a call option the seller/ writer will deliver equity shares for which the call option
account was entered into. The seller/ writer should credit the relevant equity shares account
 On exercise of the option, the buyer/ holder will receive favourable difference, and debit cash/ bank.
between the final settlement price as on the exercise/expiry date and the strike  For a put option the seller/ writer will receive equity shares for which the put option
price, which will be recognised as income. was entered into. The seller/ writer should debit the relevant equity shares account
and credit cash/ bank.
In the books of the seller/writer:  In addition to this entry, the premium paid/received will be transferred to the profit
 The seller/ writer will recognise premium as an income in the profit and loss account and loss account, the accounting entries for which should be the same as those in
 On exercise of the option, the seller/writer will pay the adverse difference, between case of cash settled options.
the final settlement price as on the exercise/ expiry date and the strike price. Such
payment will be recognised as a loss. Disclosure
 The enterprise should disclose the accounting policies and the methods adopted,
 As soon as an option gets exercised, margin paid towards such an option will be
including criteria for recognition and the basis of measurement applied for equity
released by the exchange, which should be credited to "Equity Index/ stock Option
Margin Account" and the bank account will be debited. index options and equity stock options.
 Where initial margin is paid by way of bank guarantee and/or lodging of securities,
Accounting at the time of squaring off of an option contract the amount of such bank guarantee/ book value and market value of securities in
 The difference between the premium paid and received on the squared off respect of outstanding options at the year end.
transactions should be transferred to the profit and loss account.  The buyer/holder and the seller/ writer of the option should give the following
 Accounting treatment is the same as above in the books of the seller/ writer for details in respect of the option contracts outstanding as at the year-end for each
margin money released on the squaring off of an option contract. Method for Equity Index/ Stock Option.
determination of profit/loss in multiple options situation:
Accounting for Equity Stock Options
 For working out profit or loss in case of outstanding multiple options of the same
stock / index with the same strike price and the same expiry date, weighted average Accounting for Equity Stock Options which are settled in Cash
method should be followed on squaring off of transactions or is/ are exercised • Accounting entries for Equity Stock Options settled in cash will be the same as that in
before the expiry date. the case of Equity Index Options.
• This is because in both the cases the settlement is done otherwise than by delivery
Accounting treatment in respect of equity stock options in case of delivery settled
of the underlying assets.
options
 The accounting entries at the time of inception, payment/receipt of margin and Accounting for Equity Stock Options which are settled by delivery
open options at the balance sheet date will be the same as those in case of cash Accounting entries at the time of inception, daily receipt/ payment of margin and open
settled options. options at the balance sheet date will be the same as that in the case of cash settled
 At the time of final settlement, if an option expires unexercised then the accounting options.
entries will be the same as those in case of cash settled options.
 If the option is exercised, then shares will be transferred in consideration for cash at 9.2 Taxation of derivative transaction in securities
the strike price. In such a case, the accounting treatment will be as recommended in Taxation of Profit/Loss on derivative transaction in securities
the following paragraphs. Prior to Financial Year 2005–06, transaction in derivatives were considered as
In case of buyer/holder: speculative transactions for the purpose of determination of tax liability under the
 For a call option the buyer/ holder will receive equity shares for which the call Income tax Act. This is in view of section 43(5) of the Income-tax Act which defined
option was entered into. The buyer/ holder should debit the relevant equity shares speculative transaction as a transaction in which a contract for purchase or sale of any
account and credit cash/ bank. commodity, including stocks and shares, is periodically or ultimately settled otherwise

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than by the actual delivery or transfer of the commodity or stocks. However, such transaction would be similar to a transaction in equity shares where the contract is
transactions entered into by hedgers and stock exchange members in course of jobbing settled by actual delivery of shares. Therefore, the STT rate as applicable to delivery
or arbitrage activity were specifically excluded from the purview of definition of based equity transactions would apply to such derivative transactions too (STT for
speculative transaction. delivery based equity transaction is 0.1 per cent, payable by both the seller and the
In view of the above provisions, most of the transactions entered into in derivatives by purchaser).
investors and traders were considered as speculative transactions. The tax provisions Exchanges adopt the following procedure in respect of the calculation and collection of
provided for differential treatment with respect to set off and carry forward of loss on Securities Transaction Tax:
such transactions. Loss on derivative transactions could be set off only against other  STT is applicable on all sell transactions for both futures and option contracts.
speculative income and the same could not be set off against any other income. This  For the purpose of STT, each futures trade is valued at the actual traded price
resulted in payment of higher taxes by an assessee. and option trade is valued at premium. On this value, the STT rate as prescribed
Finance Act, 2005 has amended section 43(5) so as to exclude transactions in derivatives is applied to determine the STT liability. In case of voluntary or final exercise of
carried out in a “recognized stock exchange” for this purpose. This implies that income an option contract, STT is levied on settlement price on the day of exercise if the
or loss on derivative transactions which are carried out in a “recognized stock exchange” option contract is in the money.
is not taxed as speculative income or loss. Thus, loss on derivative transactions can be  STT payable by the clearing member is the sum total of STT payable by all trading
set off against any other income during the year (except salary income). In case the members clearing under him. The trading member’s liability is the aggregate STT
same cannot be set off, it can be carried forward to subsequent assessment year and set liability of clients trading through him.
off against any other non-speculative business income of the subsequent year. Such
losses can be carried forward for a period of 8 assessment years. It may also be noted
that securities transaction tax paid on such transactions is eligible as deduction under
Income Tax Act, 1961.
Securities Transaction Tax (STT)
STT is the Securities Transaction Tax that is levied on every purchase and sale of
securities that are listed on the Indian stock exchanges. STT is levied on transactions
involving equity, derivatives and equity oriented mutual funds. In case of derivatives
transactions, the exchange on which the transaction took place is required to collect
(deduct) the STT and remit the same to the Government. Traders have to pay securities
transaction tax on the derivatives transactions executed on a recognized exchange as
per the rates given below:
Sr. Taxable securities
STT rate Payable by
No. transaction
1. Sale of an option in securities 0.05 per cent Seller
Sale of an option in
2. securities, where option is 0.125 per cent Purchaser
exercised
3. Sale of a futures in securities 0.01 per cent Seller

Value of taxable securities transaction relating to an “option in securities” shall be the

option premium, in case of sale of an option in securities. Value of taxable securities
transaction relating to an “option in securities” shall be the settlement price, in case of
sale of an option in securities, where option is exercised. Where a derivative contract is
being settled by physical delivery of shares (i.e., in case of physical settlement), such

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Chapter 10: Sales Practices and Investors Protection Unsuitable Investment Recommendations
Some unscrupulous investment advisers convince clients to purchase investment
Services products that don’t meet the objectives of an investor. Unsuitable recommendations
LEARNING OBJECTIVES: can occur when a broker sells speculative transactions such as options, futures, or penny
After studying this chapter, you should know about: stocks to say a senior citizen with low risk tolerance. Investors should be careful to
 Client Identification procedure review the risk profile of each investment recommendation.
 Due Diligence process for customers Churning
 Investor Grievance Mechanism against trading members “Churning” refers to when securities professionals making unnecessary and excessive
 SEBI Complaints Redress System trades in customer accounts for the sole purpose of generating commissions. Investors
should be careful to review their monthly account statements and investigate any
The finance sector has an important role to play in an economy. It has responsibility to
abnormally high trading activity.
ensure stable markets and support the real economy. The primary function of a financial
institution is to be responsible and provide sustainable financial services. Giving good Investor Seminars
advice and having excellent customer service is a precondition for long-term success of Investment advisers commonly invite investors to attend seminars. At these seminars,
any financial institution. advisers often use sales tactics to pitch unsuitable products. Investors should avoid
making rushed decisions at sales seminars and should seek objective third party advice
Financial Institutions should have customer-oriented approach, where sales of products
before committing their funds.
are customer lead and always accompanied by correspondingly efficient and
appropriate advice. It can be summarily stated that: “Customers have the right to get As sales become an integral part in financial services, proper advice to the customers is
good advice; finance employees have the duty to give good advice.” important.
A favourable model should be developed in cooperation between company, its Contact with consumers
employees and intermediaries in the finance sector to ensure the best possible  Sales Agents must only make sales calls on consumers at reasonable times
framework for increasing customer satisfaction. recognizing that what is regarded as reasonable can vary in different locations and in
different types of households. Sales Agents will in any event only call between 9 am
In the recent past, naïve investors have increasingly become targets of financial abuse
and 8 pm, unless it is at the consumer’s request.
and fraud. Investors should be cautious while investing in any of the financial products
 Sales Agents will, as soon as possible on making contact, identify themselves, the
in the market. Some of the areas where investor needs to be careful about his
company they represent and their purpose.
investments are discussed below:
 Sales Agents will take account of the consumer's personal circumstances and, as a
“High Return” or "Risk-Free" Investments minimum, comply with diversity obligations.
Investors should be careful of opportunities that promise spectacular profits or  Sales Agents will end the discussion and leave the premises immediately at the
"guaranteed" returns. The deal sounds too good to resist. An individual may claim that consumer’s request.
unrealistic returns can be realized from "Low-Risk Investment Opportunities", but one  Sales Agents will voluntarily cease contact with a consumer who clearly indicates
has to keep in mind no investment is risk-free. Returns are related to the risk taken and that contact is inconvenient, unwelcome or inappropriate.
hence there cannot be a product in the market that gives high return in risk free  A contact number must be left with any consumer, on request.
manner.  Sales Agents must not exploit a person’s inexperience, vulnerability, credulity or
Investment Advisor Services loyalties.
Investment advisor is an individual or firm responsible for making investments on behalf  Members shall maintain records, including the date of contact with the consumer to
of, and/ or providing advice to, investors. He has a duty to act in the best interest of allow the subsequent identification of the sales agent involved. This will assist in
their clients. Sometimes, however, investment advisors take advantage of their dealing with any complaint or query.
positions of trust and use unauthorized and deceptive methods to misappropriate  Sales agents must at all times:
money directly from their clients. Investors should be careful to review their monthly o Be courteous and professional.
account statements and to conduct annual reviews of their investment plans with their o Seek to avoid the consumer misunderstanding any information given or making
investment adviser. Investors should be watchful for abnormal changes in their monthly false assumptions, in particular over potential returns on their savings.
account statements. o Avoid the use of high pressure/ luring tactics.

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10.1 Understanding risk profile of the client Some of the key parameters on which one’s risk tolerance can depend is age, personal
In the context of investments, “risk” refers not only to the chance that a person may income, combined family income, number of dependents, occupation, marital status,
lose his capital but more importantly to the chance that the investor may not get the education, and access to other inherited sources of wealth.
desired return on an investment vehicle. People invest in various investment products Financial advisors need to know about the time period for which investors plan to
that generally comprise: invest. The objectives of the investors should be made clear to give a proper advice and
 Fixed Income Instruments, and meet his short term as well as long term needs. Generally speaking, the longer the time
 Market oriented investments. horizon, the more risk can be integrated into his financial expectations about the
In the case of former, with a definite interest rate, there is little “risk” of not being able investments.
to get the desired returns (credit or default risk exists though) but in the case of latter, Globally, as well as in India, it is well established, on the basis of track record of
an investor goes with an expectation of a certain amount of return and the term “risk” performance that equities as a class of asset has outperformed other asset classes and
in this context refers to the probability of the investor not getting the desired /expected delivered superior returns over longer periods of time. With these statistics available,
returns. why wouldn’t everyone at all times invest 100 percent in stocks? The answer is, of
Financial advisor should have thorough understanding of risk. There is a risk/ return course, that while over the long term stocks have outperformed, there have been many
trade-off. That is, the greater risk accepted, the greater must be the potential return as short term periods in which they have underperformed, and in fact, have had negative
reward for committing one’s funds to an uncertain outcome. Generally, as the level of returns. Exactly when short term periods of underperformance occur is unknown and
risk rises, the expected rate of return should also rise, and vice versa. thus, there is more risk in owning stocks if one has a short term horizon than if there
exists a long term horizon.
A risk-averse investor would prefer investments that are more secure and thus would
have higher portfolio allocations to debt and fixed income instruments. On the other The risk and complexity vary among derivative products. While some derivatives are
hand an investor who is less risk averse would like to have greater exposure to equity relatively simple, many others, especially options, could be highly complex and would
and other risky investments. require additional safeguards from investors’ viewpoint. Options are a more complex
derivative product than index futures because evaluating the fairness of option
There is need to understand risk tolerance for a variety of reasons some of which are
premium is a complex matter.
specified below:
 To achieve level of financial independence that allows them to meet not only It is essential that broker-client relationship and sales practices for derivatives need
their basic human needs, but also higher level needs for self-development and regulatory focus. The potential risk involved in trading (as opposed to hedging) with
self-improvement in their life. derivatives is not understood widely. In the case of pricing of complex derivatives
 Willingness to accept a certain smaller return rather than a large but uncertain contracts, there is a real danger of unethical sales practices. Clients may be fleeced or
profit from their financial decisions. induced to buy unsuitable derivative contracts at unfair prices and without properly
 Individual’s evaluations of their self-worth and their levels of self-esteem are understanding the risks involved. That is why it has become a standard practice to
related to their levels of satisfaction with their financial situation. require a "risk disclosure document" to be provided by broker/ dealer to every client in
 Individuals need to appreciate their personal comfort zone when they trade-off respect of the particular type of derivatives contracts being sold.
what they are willing to accept in terms of possible losses versus possible gains. Also, derivatives brokers/ dealers are expected to know their clients and to exercise care
 Investor’s objectives are often poorly developed and unrealistic in terms of to ensure that the derivative product being sold by them to a particular client is suitable
investments. to his understanding and financial capabilities. Derivatives may tempt many people
 It is often difficult for people to describe in their own words their attitudes about because of high leverage. The concept of "know-your-client" needs to be implemented
risk. and every broker/ trader should obtain a client identity form.
 There is a good chance that new investors in particular will not understand many Derivatives brokers/ dealers should avoid recommending opening futures/ options
of the financial and risk concepts presented by advisors. transaction unless they have a reasonable basis for believing that the customer has such
 Communication is focused around an explicit and understandable score or knowledge and financial experience that he or she is capable of evaluating, and
profile. financially able to bear, the risks of the transaction.
 Very difficult for the financial advisor to arrive at an accurate risk profile.
 Single Investment model will fit all- lifecycle approach does not work. The broker-dealer must seek to obtain and verify specific categories of information
about its customers including, but not limited to, their Net-worth, annual income and

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investment experience and knowledge. Brokers must ensure that investors are given a  Conduct ongoing due diligence and scrutiny, i.e. perform ongoing scrutiny of the
detailed explanation of the special characteristics and risks applicable to the trading of transactions and account throughout the course of the business relationship to
derivative products. ensure that the transactions being conducted are consistent with the registered
The disclosure document about derivative products contains information describing the intermediary’s knowledge of the customer, its business and risk profile, taking
mechanics and risks of derivatives trading, transaction costs, margin requirements and into account, where necessary, the customer’s source of funds.
tax consequences of margin trading. Policy for acceptance of clients
Written Anti Money Laundering Procedures All registered intermediaries should develop customer acceptance policies and
The term money-laundering offense is defined as “whoever acquires, owns, possess or procedures that aim to identify the types of customers that are likely to pose a higher
transfers any proceeds of crime; or knowingly enters into any transaction which is than the average risk of money laundering or terrorist financing. By establishing such
related to proceeds of crime either directly or indirectly or conceals or aids in the policies and procedures, they will be in a better position to apply customer due
concealment of the proceeds or gains of crime within India or outside India”. The diligence on a risk sensitive basis depending on the type of customer business
Prevention of Money-Laundering Act, 2002 (PMLA), is an act to prevent money- relationship or transaction. In a nutshell, the following safeguards are to be followed
laundering and to provide for confiscation of property derived from, or involved in, while accepting the clients:
money-laundering and for related matters.  No account is opened in a fictitious/benami name or on an anonymous basis.
Each registered intermediary should adopt written procedures to implement the anti-  Factors of risk perception (in terms of monitoring suspicious transactions) of the
money laundering provisions as envisaged under the Anti Money Laundering Act, 2002. client are clearly defined having regard to client’s location (registered office
Such procedures should include inter alia, the following three specific parameters which address, correspondence addresses and other addresses if applicable), nature of
are related to the overall ‘Client Due Diligence Process’: business activity, trading turnover etc. and manner of making payment for
 Policy for acceptance of clients transactions undertaken. The parameters should enable classification of clients
 Procedure for identifying the clients into low, medium and high risk. Clients of special category may, if necessary, be
classified even higher. Such clients require higher degree of due diligence and
 Transaction monitoring and reporting especially Suspicious Transactions
regular update of KYC profile.
Reporting (STR)
 Documentation requirement and other information to be collected in respect of
Customer Due Diligence different classes of clients depending on perceived risk and having regard to the
The customer due diligence (“CDD”) measures comprises the following: requirement to the Prevention of Money Laundering Act 2002, guidelines issued
 Obtaining sufficient information in order to identify persons who beneficially by RBI and SEBI from time to time.
own or control securities account. Whenever it is apparent that the securities  Ensure that an account is not opened where the intermediary is unable to apply
acquired or maintained through an account are beneficially owned by a party appropriate clients due diligence measures/KYC policies. This may be applicable in
other than the client, that party should be identified using client identification cases where it is not possible to ascertain the identity of the client, information
and verification procedures. The beneficial owner is the natural person or provided to the intermediary is suspected to be non-genuine, perceived non-
persons who ultimately own, control or influence a client and/or persons on cooperation of the client in providing full and complete information. The market
whose behalf a transaction is being conducted. It also incorporates those intermediary should not continue to do business with such a person and file a
persons who exercise ultimate effective control over a legal person or suspicious activity report. It should also evaluate whether there is suspicious
arrangement. trading in determining in whether to freeze or close the account. The market
 Verify the customer’s identity using reliable, independent source documents, intermediary should be cautious to ensure that it does not return securities of
data or information; money that may be from suspicious trades. However, the market intermediary
 Identify beneficial ownership and control, i.e. determine which individual(s) should consult the relevant authorities in determining what action it should take
ultimately own(s) or control(s) the customer and/ or the person on whose behalf when it suspects suspicious trading.
a transaction is being conducted;  The circumstances under which the client is permitted to act on behalf of another
 Verify the identity of the beneficial owner of the customer and/or the person on person/entity should be clearly laid down. It should be specified in what manner
whose behalf a transaction is being conducted, corroborating the information the account should be operated, transaction limits for the operation, additional
provided in relation to person; and authority required for transactions exceeding a specified quantity/value and
other appropriate details. Further the rights and responsibilities of both the

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 persons (i.e. the agent- client registered with the intermediary, as well as the Client Identification Procedure
person on whose behalf the agent is acting should be clearly laid down).  The ‘Know your Client’ (KYC) policy should clearly spell out the client
Adequate verification of a person’s authority to act on behalf the customer identification procedure to be carried out at different stages i.e. while
should also be carried out. establishing the intermediary – client relationship, while carrying out
 Necessary checks and balance to be put into place before opening an account so transactions for the client or when the intermediary has doubts regarding the
as to ensure that the identity of the client does not match with any person having veracity or the adequacy of previously obtained client identification data.
known criminal background or is not banned in any other manner, whether in  The client should be identified by the intermediary by using reliable sources
terms of criminal or civil proceedings by any enforcement agency worldwide. including documents/information. The intermediary should obtain adequate
Risk based approach information to satisfactorily establish the identity of each new client and the
It is generally recognized that customers can be classified into a higher or lower risk purpose of the intended nature of the relationship.
category depending on circumstances such as the customer’s background, type of  The information should be adequate to satisfy competent authorities (regulatory
business relationship or transaction etc. As such, the registered intermediaries should / enforcement authorities) in future that due diligence was observed by the
apply each of the customers due diligence measures on a risk sensitive basis. The basic intermediary in compliance with the Guidelines. Each original document should
principle enshrined in this approach is that the registered intermediaries should adopt be seen prior to acceptance of a copy.
an enhanced customer due diligence process for higher risk categories of customers.  Failure by prospective client to provide satisfactory evidence of identity should
Conversely, a simplified customer due diligence process may be adopted for lower risk be noted and reported to the higher authority within the intermediary.
categories of customers. In line with the risk-based approach, the type and amount of  SEBI has prescribed the minimum requirements relating to KYC for certain class
identification information and documents that registered intermediaries should obtain of the registered intermediaries from time to time. Taking into account the basic
necessarily depend on the risk category of a particular customer. principles enshrined in the KYC norms which have already been prescribed or
which are prescribed by SEBI from time to time, all registered intermediaries
Clients of special categories (CSC) should frame their own internal guidelines based on their experience in dealing
Such clients include the following: with their clients and legal requirements as per the established practices.
 Non-resident clients. Further, the intermediary should also maintain continuous familiarity and follow-
 High Net-worth clients. up where it notices inconsistencies in the information provided. The underlying
 Trust, Charities, NGOs and organizations receiving donations. principle should be to follow the principles enshrined in the PML Act, 2002 as
 Companies having close family shareholdings or beneficial ownership. well as the SEBI Act, 1992 so that the intermediary is aware of the clients on
 Politically exposed persons (PEP) of foreign origin. whose behalf it is dealing.
 Current / Former Head of State, Current or Former Senior High profile politicians Documents to be obtained from customers for Customer Identification Procedure
and connected persons (immediate family, Close advisors and companies in under KYC
which such individuals have interest or significant influence).
1. Accounts of Individuals
 Companies offering foreign exchange offerings.
Legal name and any other names used supported by documents given below:
 Clients in high risk countries (where existence / effectiveness of money
(i) Passport (ii) PAN card (iii) Voter’s Identity Card (iv) Driving License (v) Job Card issued
laundering controls is suspect, where there is unusual banking secrecy, Countries
by NREGA duly signed by an officer of the State Government (vi) The letter issued by the
active in narcotics production, Countries where corruption (as per Transparency
Unique Identification Authority of India (UIDAI) containing details of name, address and
International Corruption Perception Index) is highly prevalent, Countries against
Aadhaar number (vii) Identity card (subject to the bank’s satisfaction) (viii) Letter from a
which government sanctions are applied, Countries reputed to be any of the
recognized public authority or public servant verifying the identity and residence of the
following – Havens / sponsors of international terrorism, offshore financial
customer to the satisfaction of bank.
centres, tax havens, countries where fraud is highly prevalent.
 Non face to face clients. Correct Permanent Address supported by any of the following documents:
 Clients with dubious reputation as per public information available. (i) Telephone bill (ii) Bank account statement (iii) Letter from any recognized public
authority (iv) Electricity bill (v) Ration card (vi) Letter from employer (subject to
The above mentioned list is only illustrative and the intermediary should exercise satisfaction of the bank).
independent judgment to ascertain whether new clients should be classified as CSC or
not. 2. Accounts of Company

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 Name of the company acknowledgement towards receipt of complaint is sent to the investor. If the documents
 Principal place of business are inadequate, the investor is advised to set right the deficiencies in the documents.
 Mailing address of the company Redressal of Complaints
 Telephone/Fax number Generally, exchanges initially try to resolve the complaint by following up with the
Documents Required: member and the complainant. The issues raised by the complainant are analyzed and
(i) Certificate of incorporation and Memorandum & Articles of Association (ii) Resolution the complaint is taken up the concerned trading member for resolution / response
of the Board of Directors to open an account and identification of those who have within the set timeframe. Subsequently, the response received from the trading
authority to operate the account (iii) Power of Attorney granted to its managers, officers member is reviewed.
or employees to transact business on its behalf (iv) Copy of PAN allotment letter (v)  If the Trading Member has agreed with the contents of the complaint, he is
Copy of the telephone bill advised to settle the matter immediately and confirm
 If the Trading Member states that he has already settled the complaint, proof of
3. Accounts of Partnership Firms
settlement is solicited and cross confirmation is obtained from the investor
 Legal name
 If the Trading Member raises issues from his side, the comments are analyzed
 Address
and forwarded to the investor for his views and comments. If differences persist
 Names of all partners and their addresses
the Exchange holds meeting with the parties at the Exchange premises for
 Telephone numbers of the firm and partners expeditious resolution of the complaints. In case differences still persist the
Documents required: investor is informed that he may opt for Arbitration proceedings.
(i) Registration certificate, if registered (ii) Partnership deed (iii) Power of Attorney  If the Trading Member has justifiable reasons for his actions which are within the
granted to a partner or an employee of the firm to transact business on its behalf (iv) regulatory framework, the investor is enlightened on the correct position on the
Any officially valid document identifying the partners and the persons holding the Power matter.
of Attorney and their addresses (v) Telephone bill in the name of firm/partners
Nature of complaints
10.2 Investors Grievance Mechanism Exchanges provide assistance if the complaints fall within the purview of the Exchange
Each Exchange has a process for grievance redressal. The general features of these and are related to trades that are executed on the Exchange Platform. These may be of
processes are mentioned below. the following types:
 Non-Receipt of Corporate Benefit (Dividend/Interest/Bonus etc.)
Investor grievance resolution mechanism (against trading members)  Complaints against trading members on account of the following:
All exchanges have a dedicated department to handle grievances of investors against o Non-receipt of funds / securities
the Trading Members and Issuers. Generally, these departments operate from all offices o Non- receipt of documents such as member client agreement, contract
of the exchange so as to provide easy access to investors. All exchanges also have notes, settlement of accounts, order trade log etc.
supervision mechanisms for the functioning of this department/ cell. These include the o Non-Receipt of Funds / Securities kept as margin
Investor Service Committees (ISC) consisting of Exchange officials and independent o Trades executed without adequate margins
experts whose nomination is approved by Securities and Exchange Board of India. SEBI o Delay /non – receipt of funds
also monitors exchange performance related to investor grievance redressal. o Squaring up of positions without consent
Process o Unauthorized transaction in the account
Receipt of Complaints o Excess Brokerage charged by Trading Member
The investor is required to submit his complaint in the prescribed complaint form o Unauthorized transfer of funds from commodities account to other
against the trading member providing the details as specified in the instructions accounts etc.
annexed to the complaint registration form along with supporting documents  Complaints in cases where the member has surrendered his membership and
substantiating his claim. the complainant has approached the Exchange before expiry of the time
On receipt of the complaint, exchanges scrutinize the nature of complaint and adequacy mentioned in the public notice
of documents submitted along with the complaint. If all the relevant documents are Exchanges may not take up the following types of complaints
submitted, the complaint is recorded, a complaint number is assigned and an

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a. Complaints in respect of transactions which are already subject matter of Arbitration up the resolution. It was introduced on June 8, 2011 to facilitate redressal of investor
proceedings, grievances in a speedy manner. The salient features of SCORES are:
b. Complaints involving payment of funds and transfer of securities to entities other (i) Centralised database of investor complaints
than Trading Member, (ii) Online movement of complaints to the concerned listed company or SEBI
c. Claims for mental agony/harassment and expenses incurred for pursuing the matter registered intermediary
with the ISC, (iii) Online upload of Action Taken Reports (ATRs) by the concerned listed company or
d. Claims for notional loss, opportunity loss for the disputed period or trade, SEBI registered intermediary
e. Complaints pertaining to trades not executed on the Exchange by the complainant, (iv) Online viewing by investors of actions taken on the complaint and its current
f. Claims of authorized persons for private commercial dealings with the trading status
member,
g. Claims relating to transactions which are in the nature of loan or financing which are All complaints are lodged electronically at: https://scores.gov.in
not within the framework defined by the Exchange. Investors may contact the Investor Associations (IAs) recognized by SEBI for any
Arbitration assistance in filing complaints on SCORES. The lists of Investor Associations are available
SEBI has instructed the exchange to have arbitration committees so that differences, on SEBI website (www.sebi.gov.in). Investors may also seek assistance in filing
disputes and claims between trading members and investors can be settled effectively complaints on SCORES from SEBIs toll free helpline number 1800 266 7575 or 1800 22
and in a short time. 7575.

Arbitration is a quasi-judicial process of settlement of disputes between Trading The companies are required to view the pending complaints and take action and provide
Members, Investors, Clearing Members and also between Investors and Issuers (Listed resolution along with necessary documents (can be uploaded online). If the company
Companies). Generally, the application for arbitration has to be filed at the Regional fails to provide resolution within specific turn-around time, it will be treated as non-
Arbitration Centres (RAC), established by the exchanges, within three years from the redressal or non-compliance in the SCORES system and the regulator will keep a track of
date of dispute. Arbitration is governed by Bye-laws, Regulations and Circulars issued by such instances.
stock exchanges and SEBI. Process
The parties to arbitration are required to select the arbitrator from the panel of Receipt of Complaints
arbitrators provided by the Exchange. The arbitrator conducts the arbitration The investor is required to submit his complaint in the prescribed complaint form
proceeding and passes the award normally within a period of four months from the date against the trading member providing the details as specified in the instructions
of initial hearing. annexed to the complaint registration form along with supporting documents
The arbitration award is binding on both the parties. However, the aggrieved party, substantiating his claim.
within thirty days of the receipt of the award from the arbitrator, can file an appeal to On receipt of the complaint, the nature of complaint and adequacy of documents
the arbitration tribunal for re-hearing the whole case. On receipt of the appeal, the submitted along with the complaint would be scrutinized and if all the relevant
Exchange appoints an Appellate Bench consisting of three arbitrators who re-hear the documents are submitted, the complaint is recorded, a complaint number is assigned
case and then give the decision. The judgment of the Bench is by a ‘majority’ and is and an acknowledgement towards receipt of complaint is sent to the investor. If the
binding on both the parties. The final award of the Bench is enforceable as if it were the documents are inadequate, the investor is advised to set right the deficiencies in the
decree of the Court. documents.
Any party who is dissatisfied with the Appellate Bench Award may challenge the same in Redressal of Complaints
a Court of Law. Generally, exchanges initially try to resolve the complaint by following up with the
SEBI Complaints Redress System (SCORES) [http://scores.gov.in] member and the complainant. The issues raised by the complainant are analyzed and
SEBI’s web based complaints redressal system is called SCORES (Sebi COmplaints the complaint is taken up to the concerned trading member for resolution / response
REdress System). SCORES is a centralized grievance management system with tracking within the set timeframe. Subsequently, the response received from the trading
mechanism to know the latest updates and time taken for resolution. Each complaint member is reviewed.
will have a unique reference number, which will help customers keep a track and follow  If the Trading Member has agreed with the contents of the complaint, he is
advised to settle the matter immediately and confirm.

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  If the Trading Member states that he has already settled the complaint, proof of as non-redressal of investor complaints by the company. SEBI also mandates that
settlement is solicited and cross confirmation is obtained from the investor. companies desirous of getting their equity shares listed on the stock exchanges should
 If the Trading Member raises issues from his side, the comments are analyzed also obtain authentication on SCORES, before Listing Approval is granted by stock
exchanges.
and forwarded to the investor for his views and comments. If differences persist
the Exchange holds meeting with the parties at the Exchange premises for Investors, who wish to lodge a complaint on SCORES, have to register themselves on
www.scores.gov.in. While filing the registration form, mandatory details like name of
expeditious resolution of the complaints. In case differences still persist the
the investor, address, e-mail id, PAN and Contact details/mobile number needs to be
investor is informed that he may opt for Arbitration proceedings.
furnished. Upon successful registration, a unique user id and a password will be
 If the Trading Member has justifiable reasons for his actions which are within the communicated to the investor through an acknowledgement email. Using the login
regulatory framework, the investor is informed on the correct position on the credentials, the investor can lodge his/her complaint on SCORES. The complainant may
matter. use SCORES to submit the grievance directly to companies / intermediaries and the
complaint shall be forwarded to the entity for resolution. The entity is required to
Nature of Complaints redress the grievance within 30 days, failing which the complaint will be routed to SEBI
Exchanges provide assistance if the complaints fall within the purview of the Exchange directly and a new SCORES registration number for the complaint will be generated.
and are related to trades that are executed on the Exchange Platform such as: When complaints come to SEBI, it forwards the complaint to the concerned entity with
an advice to send a written reply to the investor and file an action taken report (ATR) in
Complaints against Exchange Members:
SCORES.
 Non-issuance of the documents by the Trading Member
If a complaint in SCORES is disposed-off and the investor is not satisfied with the closure
 Non-receipt of funds / securities of the complaint, the investor needs to mandatorily provide the reasons for his/ her
 Non-receipt of margin / security deposit given to the Trading Member (TM) dissatisfaction with the redressal within a period of 15 days from the closure of the
 Non-receipt of corporate benefits (dividend, interest, bonus, etc.) complaint. The said complaint then shall be escalated to the appropriate Supervising
 Auction value / close out value received or paid Officer in SEBI.
 Execution of trades without consent The detailed process of registering into SCORES and filing complaints into the system
 Excess brokerage charged by Trading Member can be accessed from: https://www.sebi.gov.in/sebi_data/faqfiles/apr-2019/1556089488014.pdf.
 Non-receipt of credit balance as per the statement of account General Do's and Don’ts for Investors
 Non-receipt of funds / securities kept as margin Investors must follow some Do’s and Don’ts while transacting in the securities market.
Given below are some general Do’s and Don’ts for investors:
Complaints against Listed Companies:
Do’s
 Regarding non-receipt of allotment advice, securities allotted, refund order Investors must:
 Interest on delay in redemption / refund amount  Always deal with the market intermediaries registered with SEBI / stock exchanges.
 Sale proceeds of fractional entitlement  Carry out due diligence before registering as client with any intermediary. Carefully

 Composite Application Form (CAF) for Rights offer read and understand the contents stated in the Risk Disclosure Document, which
forms part of the investor registration requirement for dealing through brokers.
 Securities purchased through a Rights offer  Collect photocopies of all documents executed for registration as a client,
 Letter of offer for buyback immediately on its execution.
 Regarding non-receipt of dividend, interest, bonus shares, stock split shares, etc.  Ensure that the documents or forms for registration as Client are fully filled in.
 Regarding non-receipt of securities after dematerialization, after transfer /  Give clear and unambiguous instructions to their broker / agent / depository
transmission. participant.
 Always insist on contract notes from their brokers. In case of doubt in respect of the
SEBI mandates that all listed companies are required to view the complaints pending transactions, verify the genuineness of the same from the exchange.
against them and submit ATRs along with supporting documents electronically in  Always settle the dues through the normal banking channels with the market
SCORES. Failure on the part of the company to update the ATR in SCORES will be treated intermediaries.

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 Adopt trading / investment strategies commensurate with their risk-bearing capacity
as all investments carry some risk, the degree of which varies according to the
investment strategy adopted.
 Be cautious about securities which show a sudden spurt in price or trading activity,
especially low price stocks.
 Remember that there are no guaranteed returns on investment in the stock market.
 Read the terms and conditions and understand the risk factors associated with the
commodity market investment
 Always keep copies of all investment documentation (e.g. application forms,
acknowledgements slips, contract notes).
 Send important documents by a reliable mode (preferably through registered post)
to ensure delivery.
 Ensure that they have money and will be able to pay, before you buy.
 Ensure that they hold securities and will be able to deliver, before they sell.
 Follow up diligently and promptly e.g. If the required documentation is not received
within a reasonable time, investors must contact the concerned person at the
Trading Member immediately.
Don’ts
Investors must not:
 Deal with unregistered brokers / sub - brokers, or other unregistered intermediaries.
 Execute any documents with any intermediary without fully understanding its terms
and conditions.
 Leave the custody of their Demat Transaction slip book in the hands of any
intermediary.
 Make any payments in cash
 Accept unsigned/ duplicate or incomplete contract notes
 Deal based on rumours or 'tips'.
 Get swayed by promises of high returns.
 Fall prey to promises of guaranteed returns.
 Get misled by guarantees of repayment of their investments through post-dated
cheques.
 Get carried away by luring advertisements of any nature in print and electronic
media.
 Blindly follow media reports on corporate developments, as some of these could be
misleading.
 Blindly imitate investment decisions of others who may have profited from their
investment decisions.
 Forgo obtaining all documents of transactions, in good faith even from people whom
they ‘know’.
 Delay approaching concerned authorities in case of a dispute. Written complaints
must be filed with the Exchange as soon as possible.

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Appendix A: Sample Questions (c) Buying 1 June XYZ futures contract at 3200
(d) Selling 1 June XYZ futures contract at 3200
1. An index option is a __________________.
(a) Debt instrument 8. Which of the following is closest to the forward price of a share, if Cash Price =
(b) Derivative product Rs.750, Forward Contract Maturity = 6 months from date, Market Interest rate = 12%?
(c) Cash market product (a) 772.5
(d) Money market instrument (b) 795
(c) 840
2. The purchase of a share in one market and the simultaneous sale in a different (d) 940.8
market to benefit from price differentials is known as ____________.
(a) Mortgage 9. If you have sold a XYZ futures contract (contract multiplier 50) at 3100 and bought it
(b) Arbitrage back at 3300, what is your gain/loss?
(c) Hedging (a) A loss of Rs. 10,000
(d) Speculation (b) A gain of Rs. 10,000
(c) A loss of Rs. 5,000
3. Financial derivatives provide the facility for __________. (d) A gain of Rs. 5,000
(a) Trading
(b) Hedging 10. A calendar spread contract in index futures attracts ___________.
(c) Arbitraging (a) Same margin as sum of two independent legs of futures contract
(d) All of the above (b) Lower margin than sum of two independent legs of futures contract
(c) Higher margin than sum of two independent legs of futures contract
4. Operational risks include losses due to ____________. (d) No margin need to be paid for calendar spread positions
(a) Inadequate disaster planning
(b) Too much of management control 11. Client A has purchased 10 contracts of December series and sold 7 contracts of
(c) Income tax regulations January series of the NSE Nifty futures. How many lots will get categorized as regular
(d) Government policies (non-spread) open positions?
(a) 10
5. Impact cost is low when the liquidity in the system is poor. (b) 7
(a) True (c) 3
(b) False (d) 17

6. You sold one XYZ Stock Futures contract at Rs. 278 and the lot size is 1,200. What is 12. An investor, who is anticipating a broad stock market fall, but is not willing to sell his
your profit (+) or loss (-), if you purchase the contract back at Rs. 265? entire portfolio of stocks, can offset his potential losses by shorting a certain number of
(a) 16,600 Index futures.
(b) 15,600 (a) True
(c) -15,600 (b) False
(d) -16,600
13. Margins in 'Futures' trading are to be paid by _______.
7. You have taken a short position of one contract in June XYZ futures (contract (a) Only the buyer
multiplier 50) at a price of Rs. 3,400. When you closed this position after a few days, you (b) Only the seller
realized that you made a profit of Rs. 10,000. Which of the following closing actions (c) Both the buyer and the seller
would have enabled you to generate this profit? (You may ignore brokerage costs.) (d) The clearing corporation
(a) Selling 1 June XYZ futures contract at 3600
(b) Buying 1 June XYZ futures contract at 3600
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14. When the near leg of the calendar spread transaction on index futures expires, the 21. A European call option gives the buyer the right but not the obligation to buy from
farther leg becomes a regular open position. the seller an underlying at the prevailing market price "on or before" the expiry date.
(a) True (a) True
(b) False (b) False

15. Selling short a stock means ___________. 22. A put option gives the buyer a right to sell how much of the underlying to the writer
(a) Seller does not own the stock he is supposed to deliver of the option?
(b) Seller has to deliver the stock within a short time (a) Any quantity
(c) Seller owns the stock he is supposed to deliver (b) Only the specified quantity (lot size of the option contract)
(d) Seller has more than a year's time to deliver the stock which he sold (c) The specified quantity or less than the specified quantity
(d) The specified quantity or more than the specified quantity
16. The buyer of an option cannot lose more than the option premium paid.
(a) True only for European options 23. An in-the-money option is _____________.
(b) True only for American options (a) An option with a negative intrinsic value
(c) True for all options (b) An option which cannot be profitably exercised by the holder immediately
(d) False for all options (c) An option with a positive intrinsic value
(d) An option with zero time value
17. Cost of carry model states that ______________.
(a) Price of Futures = Spot + Cost of Carry 24. An option with a delta of 0.5 will increase in value approximately by how much, if
(b) Price of Futures = Spot - Cost of Carry the underlying share price increases by Rs 2?
(c) Price of Futures = Spot Price (a) Rs 1
(d) Price of Futures = Cost of Carry (b) Rs 2
(c) Rs 4
18. What role do speculators play in the futures market? (d) There would be no change
(a) They take delivery of the commodities at expiration
(b) They produce the commodities traded at futures exchanges 25. Exchange traded options are _______________.
(c) They add to the liquidity in the futures markets (a) Standardised options
(d) They transfer their risk to the hedgers (b) Always in-the-money options
(c) Customised options
19. You sold a Put option on a share. The strike price of the put was Rs245 and you (d) Always out-of-the money options
received a premium of Rs 49 from the option buyer. Theoretically, what can be the
maximum loss on this position? 26. Higher the price volatility of the underlying stock of the put option,
(a) 196 ______________.
(b) 206 (a) Higher would be the premium
(c) 0 (b) Lower would be the premium
(d) 49 (c) Nil (zero) would be the premium
(d) Volatility does not effect put value
20. Current Price of XYZ Stock is Rs 286. Rs. 260 strike call is quoted at Rs 45. What is the
Intrinsic Value? 27. In which option is the strike price better than the market price (i.e., price difference
(a) 19 is advantageous to the option holder) and therefore it is profitable to exercise the
(b) 26 option?
(c) 45 (a) Out-of the money option
(d) 0 (b) In-the -money option
(c) At-the-money option

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(d) Higher-the-money option
34. A trader has bought 100 shares of XYZ at Rs 780 per share. He expects the price to
28. Mr. X purchases 100 put option on stock S at Rs 30 per call with strike price of Rs go up but wants to protect himself if the price falls. He does not want to lose more than
280. If on exercise date, stock price is Rs 350, ignoring transaction cost, Mr. X will Rs1000 on this long position in XYZ. What should the trader do?
choose _____________. (a) Place a limit sell order for 100 shares of XYZ at Rs 770 per share
(a) To exercise the option (b) Place a stop loss sell order for 100 shares of XYZ at Rs770 per share
(b) Not to exercise the option (c) Place a limit buy order for 100 shares of XYZ at Rs 790 per share
(c) May or may not exercise the option depending on whether he is in his hometown or (d) Place a limit buy order for 100 shares of XYZ at Rs770 per share
not at that time
(d) May or may not exercise the option depending on whether he like the company S or 35. Trader A wants to sell 20 contracts of August series at Rs 4500 and Trader B wants to
not sell 17 contracts of September series at Rs 4550. Lot size is 50 for both these contracts.
The Initial Margin is fixed at 6%. How much Initial Margin is required to be collected
29. Three Call series of XYZ stock - January, February and March are quoted. Which will from both these investors (sum of initial margins of A and B) by the broker?
have the lowest Option Premium (same strikes)? (a) 2,70,000
(a) January (b) 5,02,050
(b) February (c) 2,32,050
(c) March (d) 4,10,000
(d) All will be equal
36. A member has two clients C1 and C2. C1 has purchased 800 contracts and C2 has
30. Which is the ratio of change in option premium for the unit change in interest rates? sold 900 contracts in August XYZ futures series. What is the outstanding liability (open
(a) Vega position) of the member towards Clearing Corporation in number of contracts?
(b) Rho (a) 800
(c) Theta (b) 1700
(d) Gamma (c) 900
(d) 100
31. If you sell a put option with strike of Rs 245 at a premium of Rs.40, how much is the
maximum gain that you may have on expiry of this position? 37. A defaulting member's clients’ positions could be transferred to ____________ by
(a) 285 the Clearing Corporation.
(b) 40 (a) Another solvent member
(c) 0 (b) The Exchange
(d) 205 (c) A suspense account
(d) Error account
32. If an investor buys a call option with lower strike price and sells another call option
with higher strike price, both on the same underlying share and same expiration date, 38. Clients' positions cannot be netted off against each other while calculating initial
the strategy is called ___________. margin on the derivatives segment.
(a) Bullish spread (a) True
(b) Bearish spread (b) False
(c) Butterfly spread
(d) Calendar spread 39. Mark-to-market margins are collected ___________.
(a) On a weekly basis
33. On the derivative exchanges, all the orders entered on the Trading System are at (b) Every 2 days
prices exclusive of brokerage. (c) Every 3 days
(a) True (d) On a daily basis
(b) False

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40. Value-at-risk measures ___________. 47. Value-at-risk provides the ______________.
(a) Value of proprietary portfolio (a) Expected maximum loss, which may be incurred by a portfolio over a given period of
(b) Risk level of a financial portfolio time and specified confidence level
(c) Net-worth of an investor (b) Value of securities which are very risky
(d) Credit rating of an investor (c) Value of speculative stocks
(d) Theoretical value of illiquid stocks in a portfolio
41. A penalty or suspension of registration of a stock broker from derivatives
exchange/segment under the SEBI (Stock Broker) Regulations, 1992 can take place if 48. Who is eligible for clearing trades in index options?
_______________. (a) All Indian citizens
(a) The stock broker fails to pay fees (b) All members of the stock exchange
(b) The stock broker violates the conditions of registration (c) All national level distributors
(c) The stock broker is suspended by the stock exchange (d) Only members, who are registered with the Derivatives Segment as Clearing
(d) In any of the above situations Members

42. Clearing corporation on a derivatives exchange becomes a legal counterparty to all 49. If price of a futures contract decreases, the margin account of the buyer of this
trades and be responsible for guaranteeing settlement for all open positions. futures contract is debited for the loss.
(a) True (a) True
(b) False (b) False

43. Initial margin collection is monitored by the _________. 50. When establishing a relationship with a new client, the trading member takes
(a) RBI reasonable steps to assess the background, genuineness, beneficial identify, financial
(b) Clearing Corporation soundness of such person and his investment/trading objectives.
(c) SEBI (a) True
(d) Margin Office (b) False

44. Liquid Assets maintained by Mr A (Clearing Member) are higher than that PLEASE NOTE THAT THESE ARE ONLY SAMPLE QUESTIONS PROVIDED AS A GUIDE TO
maintained by Mr B (Clearing Member). Which of the following statements is true? CANDIDATES AND MAY NOT BEAR ANY RESEMBLANCE TO QUESTIONS IN THE
(a) Mr A can enjoy higher exposure levels in futures than Mr B CERTIFICATION EXAMINATION.
(b) Mr B can enjoy higher exposure levels in futures than Mr A
(c) Both Mr A and Mr B enjoy the same exposure levels
(d) No need to maintain liquid assets for exposure in derivatives markets

45. On the Clearing Council of the Clearing Corporation of the derivatives segment,
broker-members are allowed.
(a) True
(b) False

46. The main objective of Trade Guarantee Fund (TGF) at the exchanges is
_________________.
(a) To guarantee settlement of bonafide transactions of the members of the exchange
(b) To inculcate confidence in the minds of market participants
(c) To protect the interest of the investors in securities
(d) All of the above

156 157
 About NISM
ANSWERS National Institute of Securities Markets (NISM) is an educational institution established by the
Securities and Exchange Board of India (SEBI), the securities market regulator, in 2006. The
1. (b) 26. (a) Institute was established in pursuant to the Union Finance Minister’s proposal, in his 2005-06
2. (b) 27. (b) Budget Speech, to set up an institution ‘for teaching and training intermediaries in the securi-
ties markets and promoting research’.
3. (d) 28. (b)
NISM is committed to its vision ‘to lead, catalyze and deliver educational initiatives to enhance
4. (a) 29. (a)
the quality of securities markets’. The Institute conducts a wide range of capacity building
5. (b) 30. (b) programmes in securities markets - from basic financial literacy to full-time post-graduation
programmes. The Institute’s six Schools of Excellence, viz., School for Certification of Interme-
6. (b) 31. (b) diaries, School for Securities Education, School for Investor Education and Financial Literacy,
School for Regulatory Studies and Supervision, School for Corporate Governance and School
7. (c) 32. (a)
for Securities Information and Research upholds NISM’s vision and works in synergy towards
8. (b) 33. (a) professionalizing the markets.

9. (a) 34. (b) NISM is mandated by SEBI (Certification of Associated Persons in the Securities Markets) Reg-
10. (b) 35. (b) ulations, 2007 to conduct certification examinations and continuing professional education
programs for associated persons engaged by an intermediary. NISM also conducts certifica-
11. (c) 36. (b) tion examinations for other regulators like IBBI and PFRDA. NISM’s certifications establish a
single market-wide knowledge benchmark for different functions in the Indian securities
12. (a) 37. (a) market and enable the associated persons to advance their knowledge and skills.
13. (c) 38. (a)
14. (a) 39. (d)
15. (a) 40. (b) About the Workbook
16. (c) 41. (d)
This workbook has been developed to assist candidates in preparing for the National
17. (a) 42. (a)
Institute of Securities Markets (NISM) Equity Derivatives Certification Examination.
18. (c) 43. (b) NISM-Series-VIII: Equity Derivatives Certification Examination seeks to create common
minimum knowledge benchmark for associated persons functioning as approved users
19. (a) 44. (a) and sales personnel of the trading member of an equity derivatives exchange or equity
20. (b) 45. (b) derivative segment of a recognized stock exchange.

21. (b) 46. (d) The book covers basics of the equity derivatives, trading strategies using equity futures
and equity options, clearing, settlement and risk management as well as the regulatory
22. (b) 47. (a) environment in which the equity derivatives markets operate in India.
23. (c) 48. (d)
24. (a) 49. (a)
25. (a) 50. (a)

NATIONAL INSTITUTE OF SECURITIES MARKETS

NISM Bhavan NISM Campus
NISM Bhavan, Plot No. 82, Sector - 17, Plot No. IS-1 & IS-2, Patalganga Industrial Area,
Vashi, Navi Mumbai, Maharashtra - 400703 Mohopada, Taluka Khalapur, District Raigad,
158 Tele: 022-66735100-02 Maharashtra - 410222
Fax: 022-66735110 Tele: 02192-668300-01

www.nism.ac.in