Workbook

for NISM‐Series‐
VIII: Equity
Derivatives
Certification Examination

National Institute of Securities Markets

www.nism.ac.in

1
This workbook has been developed to assist candidates in preparing for the
National Institute of Securities Markets (NISM) NISM‐Series‐VIII: Equity Derivatives
Certification Examination (NISM‐Series‐VIII: ED Examination).

Workbook Version: March 2018

Published by:
National Institute of Securities Markets
© National Institute of Securities Markets,
2018 NISM Bhavan, Plot 82, Sector 17,
Vashi
Navi Mumbai – 400 703, India

All rights reserved. Reproduction of this publication in any form without prior
permission of the publishers is strictly prohibited.
Foreword

NISM is a leading provider of high end professional education, certifications,

training and research in financial markets. NISM engages in capacity building
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literacy, enhancing governance standards and fostering policy research. NISM works
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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 professionals meet the defined minimum common
knowledge benchmark for various critical market functions.

NISM certification examinations and educational programs cater to different

segments of intermediaries focusing on varied product lines and functional
areas. NISM Certifications have established knowledge benchmarks for various
market products and functions such as Equities, Mutual Funds, Derivatives,
Compliance, Operations, Advisory and Research.

NISM certification examinations and training programs provide a structured learning

plan and career path to students and job aspirants who wish to make a
professional career in the Securities markets. Till May 2017, NISM has certified
nearly 6 lakh individuals through its Certification Examinations and CPE
Programs.

NISM supports candidates by providing lucid and focused workbooks that assist them
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.

Sandip Ghose
Director
Disclaimer
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While the NISM Certification examination will be largely based on material in
this workbook, NISM does not guarantee that all questions in the examination will
be from material covered herein.
Acknowledgement
This workbook has been jointly developed by the Certification Team of National
Institute of Securities Markets and Mr. Manish Bansal and Mr. Ashutosh Wakhare of
Value Ideas Investment Services Pvt. Ltd.
NISM gratefully acknowledges the contribution of the Examination Committee for
NISM‐ Series‐VIII: Equity Derivatives Certification Examination consisting of
representatives of the Equity Derivatives Exchanges.
About NISM
National Institute of Securities Markets (NISM) was established by the Securities
and Exchange Board of India (SEBI), in pursuance of the announcement made by the
Finance Minister in his Budget Speech in February 2005.
SEBI, by establishing NISM, articulated the desire expressed by the Government of
India to promote securities market education and research.
Towards accomplishing the desire of Government of India and vision of SEBI,
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NISM is mandated to implement Certification Examinations for professionals
employed in various segments of the Indian securities markets.
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on securities markets with a view to enhance knowledge levels of participants
in the securities industry.
About NISM Certifications
The School for Certification of Intermediaries (SCI) at NISM is engaged in developing
and administering Certification Examinations and CPE Programs for professionals
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Certification Examinations and Continuing Professional Education Programmes on
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About the Workbook
This workbook has been developed to assist candidates in preparing for the
National Institute of Securities Markets (NISM) Equity Derivatives Certification
Examination. NISM‐Series‐VIII: Equity Derivatives Certification Examination seeks to
create common minimum knowledge benchmark for associated persons functioning
as approved users
and sales personnel eof th trading member of an equity derivatives exchange or equity
derivative segment of a recognized stock exchange.
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.
About the NISM‐Series‐VIII: Equity Derivatives Certification Examination

The examination seeks to create a common minimum knowledge benchmark for

associated persons functioning as approved users and sales personnel of the
trading member of an equity derivatives exchange or equity derivative segment of
a recognized stock exchange.
The examination aims to enable a better understanding of various derivatives
products available in equity derivatives markets, regulations and risks
associated with the products and the exchange mechanisms of clearing and
settlement. The examination also covers knowledge competencies related to the
understanding of the financial 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.

Examination Objectives
On successful completion of the examination the candidate should:
 Know the basics of the Indian equity derivatives market.
 Understand the various trading strategies that can be built using futures
and options on both stocks and stock indices.
 Understand the clearing, settlement and risk management as well as the
operational mechanism related to equity derivatives markets.
 Know the regulatory environment in which the equity derivatives
markets operate in India.

Assessment Structure
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 should be completed in 2 hours. There will be negative marking of 25% of
the marks assigned to each question. The passing score for the examination is
60%.

How to register and take the examination

To find out more and register for the examination please visit www.nism.ac.in
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Table of Contents

Chapter 1: Basics of Derivatives......................................................11

1.1Basics of Derivatives..................................................................11
1.2Derivatives Market – History & Evolution..........................................11
1.3Indian Derivatives Market............................................................12
1.4Market Participants...................................................................13
1.5Types of Derivatives Market.........................................................14
1.6Significance of Derivatives..........................................................15
1.7Various risks faced by the participants in derivatives...........................15

Chapter 2: Understanding Index......................................................17

2.1Introduction to Index.................................................................17
2.2Significance of Index.................................................................17
2.3Types of Stock Market Indices......................................................17
2.4Attributes of an Index................................................................20
2.5Index management...................................................................21
2.6Major Indices in India.................................................................22
2.7Application of Indices................................................................22

Chapter 3: Introduction to Forwards and Futures................................23

3.1Introduction to forward and futures Contracts...................................23
3.2Pay off Charts for Futures contract................................................31
3.3Futures pricing........................................................................33
3.4Commodity, Equity & Index Futures...............................................38
3.5Uses of futures........................................................................38

Chapter 4: Introduction to Options..................................................49

4.1Basics of options......................................................................49
4.2Pay off Charts for Options...........................................................52
4.3Basics of Option Pricing and Option Greeks......................................60
4.4Uses of Options........................................................................63

Chapter 5: Option Trading Strategies...............................................71

5.1Option Spreads........................................................................71
5.2Straddle................................................................................78
5.3Strangle.................................................................................82
5.4Covered Call...........................................................................85
5.5Protective Put.........................................................................88
5.6Collar...................................................................................89
5.7Butterfly Spread.......................................................................91
Chapter 6: Introduction to Trading Systems.......................................95
6.1Trading System........................................................................95
6.2Selection criteria of Stocks for trading............................................99
6.3Selection criteria of Index for trading...........................................102
6.4Adjustments for Corporate Actions...............................................103
6.5Position Limit........................................................................105
6.6Using Daily Newspapers to Track Futures and Options........................106

Chapter 7: Introduction to Clearing and Settlement System..................109

7.1Clearing Members...................................................................109
7.2Clearing Mechanism.................................................................110
7.3Settlement Mechanism.............................................................110
7.4Risk Management....................................................................113
7.5Margining and mark to market under SPAN......................................114

Chapter 8: Legal and Regulatory Environment...................................119

8.1Securities Contracts (Regulation) Act, 1956.....................................119
8.2Securities and Exchange Board of India Act, 1992.............................120
8.3Regulation in Trading...............................................................121
8.4Regulations in Clearing & Settlement and Risk Management.................123
8.5Major recommendations of Dr. L.C.Gupta Committee........................124
8.6Major recommendations of Prof. J.R.Verma Committee......................126

Chapter 9: Accounting and Taxation...............................................129

9.1Accounting............................................................................129
9.2Taxation of derivative transaction in securities................................136

Chapter 10: Sales Practices and Investors Protection Services...............139

10.1Understanding risk profile of the client........................................141
10.2Investors Grievance Mechanism..................................................147

Appendix A: Sample Questions......................................................153

Chapter 1: Basics of Derivatives
LEARNING OBJECTIVES:
After studying this chapter, you should know about:
 Meaning of derivatives and types of derivatives products
 History of derivatives market
 Significance of derivative markets
 Risks in derivatives trading

1.1 Basics of Derivatives

Derivative is a contract or a product whose value is derived from value of some
other asset known as underlying. Derivatives are based on wide range of underlying
assets. These include:
 Metals such as Gold, Silver, Aluminium, Copper, Zinc, Nickel, Tin, Lead etc.
 Energy resources such as Oil (crude oil, products, cracks), Coal,
Electricity, Natural Gas, etc.
 Agri commodities such as wheat, Sugar, Coffee, Cotton, Pulses etc, and
 Financial assets such as Shares, Bonds and Foreign Exchange.

1.2 Derivatives Market – History & Evolution

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:
12th Century‐ In European trade fairs, sellers signed contracts promising future
delivery of the items they sold.
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 merchants.
1634‐1637 ‐ Tulip Mania in Holland: Fortunes were lost in after a speculative
boom in tulip futures burst.
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.
In 1973, Chicago Board Options Exchange (CBOE) became the first marketplace
for trading listed options.
In 1975, CBOT introduced Treasury bill futures contract. It was the first successful
pure interest rate futures.
In 1977, CBOT introduced T‐bond futures
contract. In 1982, CME introduced Eurodollar
futures contract.
In 1982, Kansas City Board of Trade launched the first stock index futures.
In 1983, Chicago Board Options Exchange (CBOE) introduced option on stock
indexes with the S&P 100® (OEX) and S&P 500® (SPXSM) Indexes.
Factors influencing the growth of derivative market globally
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 driving the growth of financial derivatives are:
 Increased fluctuations in underlying asset prices in financial markets.
 Integration of financial markets globally.
 Use of latest technology in communications has helped in reduction of
transaction costs.
 Enhanced understanding of market participants on sophisticated risk
management tools to manage risk.
 Frequent innovations in derivatives market and newer applications of products.

1.3 Indian Derivatives Market

As the initial step towards introduction of derivatives trading in India, SEBI set up a
24– member committee under the Chairmanship of Dr. L. C. Gupta on November 18,
1996 to develop appropriate regulatory framework for derivatives trading in
India. The committee submitted its report on March 17, 1998 recommending
that derivatives should be declared as ‘securities’ so that regulatory framework
applicable to trading of ‘securities’ could also govern trading of derivatives.
Subsequently, SEBI set up a group in June 1998 under the Chairmanship of Prof.
J.R.Verma, to recommend measures for risk containment in derivatives market in
India. The committee submitted its report in October 1998. It worked out the
operational details of margining system, methodology for charging initial margins,
membership details and net‐worth criterion, deposit requirements and real
time monitoring of positions requirements.
In 1999, The Securities Contract Regulation Act (SCRA) was amended to include
“derivatives” within the domain of ‘securities’ and regulatory framework was
developed for governing derivatives trading. In March 2000, government repealed a
three‐decade‐ old notification, which prohibited forward trading in securities.
The exchange traded derivatives started in India in June 2000 with SEBI permitting
BSE and NSE to introduce equity derivative segment. To begin with, SEBIraopvped
trading in index futures contracts based on Nifty and Sensex, which commenced
trading in June
2000. Later, trading in Index options commenced in June 2001 and trading in
options on individual stocks commenced in July 2001. Futures contracts on
individual stocks started in November 2001. Metropolitan Stock Exchange of India
Limited (MSEI) started trading in derivative products in February 2013.
Products in Derivatives Market
Forwards
It is a contractual agreement between two parties to buy/sell an underlying asset at a
certain future date for a particular price that is pre‐decided on the date of
contract. Both the contracting parties are committed and are obliged to honour
the transaction 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. These are Over‐the‐counter (OTC) contracts.
Futures
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 parties. Indeed, we may say futures are exchange traded forward
contracts.
Options
An Option is a contract that gives the right, but not an obligation, to buy or sell
the underlying on or before a stated date and at a stated price. While buyer of
option pays the premium and buys the right, writer/seller of option receives
the premium with obligation to sell/ buy the underlying asset, if the buyer
exercises his right.
Swaps
A swap is an agreement made between two parties to exchange cash flows in the
future according to a prearranged formula. Swaps are, broadly speaking, series
of forward contracts. Swaps help market participants manage risk associated with
volatile interest rates, currency exchange rates and commodity prices.

1.4 Market Participants

There are broadly three types of participants in the derivatives market ‐ hedgers,
traders (also called speculators) and arbitrageurs. An individual may play
different roles in different market circumstances.
Hedgers
They face risk associated with the prices of underlying assets and use
derivatives to reduce their risk. Corporations, investing institutions and banks
all use derivative products to hedge or reduce their exposures to market variables
such as interest rates, share values, bond prices, currency exchange rates and
commodity prices.
Speculators/Traders
They try to predict the future movements in prices of underlying assets and
based on the view, take positions in derivative contracts. Derivatives are
preferred over underlying asset for trading purpose, as they offer leverage, are
less expensive (cost of
transaction is generally lower than that of the underlying) and are faster to execute
in size (high volumes market).
Arbitrageurs
Arbitrage is a deal that produces profit by exploiting a price difference in a
product in two different markets. Arbitrage originates when a trader purchases an
asset cheaply in one location and simultaneously arranges to sell it at a higher price
in another location. Such opportunities are unlikely to persist for very long, since
arbitrageurs would rush in to these transactions, thus closing the price gap at
different locations.

1.5 Types of Derivatives Market

In the modern world, there is a huge variety of derivative products available. They
are either traded on organised exchanges (called exchange traded derivatives) or
agreed directly between the contracting counterparties over the telephone or
through electronic media (called Over‐the‐counter (OTC) derivatives). Few complex
products are constructed on simpleubilding blocks like forwards, futures, options and
swaps to cater to the specific requirements of customers.
Over‐the‐counter market is not a physical marketplace but a collection of broker‐
dealers scattered across the country. Main idea of the market is more a way of
doing business than a place. Buying and selling of contracts is matched through
negotiated bidding process over a network of telephone or electronic media
that link thousands of intermediaries. OTC derivative markets have witnessed a
substantial growth over the past few years, very much contributed by the recent
developments in information technology. The OTC derivative markets have
banks, financial institutions and sophisticated market participants like hedge
funds, corporations and high net‐worth individuals. OTC derivative market is less
regulated market because these transactions occur in private among qualified
counterparties, who are supposed to be capable enough to take care of
themselves.
The OTC derivatives markets – transactions among the dealing counterparties, have
following features compared to exchange traded derivatives:
 Contracts are tailor made to fit in the specific requirements of dealing
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
anonymous auction platform. A clearing house/ clearing corporation,
guarantees contract performance (settlement of transactions).

1.6 Significance of Derivatives

Like other segments of Financial Market, Derivatives Market serves following
specific functions:
 Derivatives market helps in improving price discovery based on actual
valuations and expectations.
 Derivatives market helps in transfer of various risks from those who are
exposed to risk but have low risk appetite to participants with high risk
appetite. For example hedgers want to give away the risk where as traders
are willing to take risk.
 Derivatives market helps shift of speculative trades from unorganized
market to organized market. Risk management mechanism and surveillance
of activities of various participants in organized space provide stability to the
fsitneamn.cial sy

1.7 Various risks faced by the participants in derivatives

Market Participants must understand that derivatives, being leveraged instruments,
have risks like counterparty risk (default by counterparty), price risk (loss on
position because of price move), liquidity risk (inability to exit from a position),
legal or regulatory risk (enforceability of contracts), operational risk (fraud,
inadequate documentation, improper execution, etc.) and may not be an
appropriate avenue for someone of limited resources, trading experience and
low risk tolerance. A market participant should therefore carefully consider
whether such trading is suitable for him/her based on these parameters. Market
participants, who trade in derivatives are advised to carefully read the Model Risk
Disclosure Document, given by the broker to his clients at the time of signing
agreement.
Model Risk Disclosure Document is issued by the members of Exchanges and
contains important information on trading in Equities and F&O Segments of
exchanges. All prospective participants should read this document before
trading on Capital
Market/Cash Segment oreFn&tO segm of the Exchanges.
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Chapter 2: Understanding Index
LEARNING OBJECTIVES:
After studying this chapter, you should know about:
 Meaning of Index and its significance
 Different types of stock market indices
 Index management and maintenance
 Application of indices

2.1 Introduction to Index

Index is a statistical indicator that measures changes in the economy in general
or in 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 value. The base value might be as recent as the previous
day or many years in the past. Thus, the percentage change is more important
than the actual numeric value. Financial 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 participants with the
information regarding average share price movement in the 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.

2.2 Significance of Index

 A stock index is an indicator of the performance of overall market or a
particular sector.
 It serves as a benchmark for portfolio performance ‐ Managed portfolios,
belonging either to individuals or mutual funds; use the stock index as a
measure for evaluation of their performance.
 It is used as an underlying for financial application of derivatives –
Various products in OTC and exchange traded markets are based on indices
as underlying asset.

2.3 Types of Stock Market Indices

Indices can be designed and constructed in various ways. Depending upon their
methodology, they can be classified as under:
Market capitalization weighted index
In this method of calculation, each stock is given weight according to its
market capitalization. So higher the market capitalization of a constituent, higher
is its weight in the index. Market capitalization is the market value of a
company, calculated by multiplying the total number of shares outstanding to
its current market price. For example, ABC company with 5,00,00,000 shares
outstanding and a share price of Rs 120 per share will have market capitalization of
5,00,00,000 x 120 =00R,0s06,0, 0,000 i.e.
600 Crores.
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. Calculate the present value of index based on following
information.
Stock price as Number Today’s
Sr. Stock on January 1, of shares stock price
No. Name 1995 (in Rs.) in lakhs (in Rs.)
1 AZ 150 20 650
2 BY 300 12 450
3 CX 450 16 600
4 DW 100 30 350
5 EU 250 8 500

Old Value
of New Value
Shares Old Portfolio(pr New of portfolio
Old in M. Old ice * New M. New (price *
Price Lakhs Cap weights weightage) price Cap weight weightage)
(in
lakhs)
150 20 3000 0.16 23.94 650 13000 0.31 198.82
300 12 3600 0.19 57.45 450 5400 0.13 57.18
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
250 8 2000 0.11 26.60 500 4000 0.09 47.06
18800 1 296.28 42500 1 525.06
Market capitalization (Mcap) = Number of Shares * Market Price
Old value of portfolio is equated to 100. Therefore, on that scale new value of
portfolio
would be (525.05/ 296.27)*100 = 177.22
Thus, the present value of Index under market capitalization weighted method
is 177.22.
Popular indices in India Sensex and Nifty were earlier designed on market
capitalization weighted method.
Free‐Float Market Capitalization Index
In various businesses, equity holding is divided differently among various stake
holders – promoters, institutions, corporates, individuals etc. Market has started to
segregate this on the basis of what is readily available for trading or what is not.
The one available for immediate trading is categorized as free float. And, if we
compute the index based on weights of each security based on free float market
cap, it is called free float market capitalization index. Indeed, both Sensex and
Nifty, over a period of time, have moved to free float basis. SX40, index of MSEI
is also a free float market capitalization index.
Price‐Weighted Index
A stock index in which each stock influences the index in proportion to its price.
Stocks with a higher price will be given more weight and therefore, will have a
greater influence over the performance of the Index.
Let us take the same example for calculation iogfhpteridce‐weindex.
Stock price as Number Today’s
Sr. Stock on January 1, of shares stock price
No. Name 1995 (in Rs.) in lakhs (in Rs.)
1 AZ 150 20 650
2 BY 300 12 450
3 CX 450 16 600
4 DW 100 30 350
5 EU 250 8 500
Computation of the index would be as follows:

Stock price as Price Today’s Price

Stock on January 1, Price weighted stock price Price weighted
Name 1995 (in Rs.) weights Prices (in Rs.) weights Prices
AZ 150 0.12 18 650 0.254902 166
BY 300 0.24 72 450 0.176471 79
CX 450 0.36 162 600 0.235294 141
DW 100 0.08 8 350 0.137255 48
EU 250 0.2 50 500 0.196078 98
1250 310 2550 532
We equate 310 to 100 to find the current value, which would be
(532/310)*100 =
171.7268
Dow Jones Industrial Average and Nikkei 225 are popular price‐weighted indices.
Equal Weighted Index
An equally‐weighted index makes no distinction between large and small
companies, both of which are given equal weighting. The value of the index is
generated by adding the prices of each stock in the index and dividing that by
the total number of stocks.
Let us take the same example for calculation of equal weighted index.
Stock price as Number Today’s
Sr. Stock on January 1, of shares stock price
No. Name 1995 (in Rs.) in lakhs (in Rs.)
1 AZ 150 20 650
2 BY 300 12 450
3 CX 450 16 600
4 DW 100 30 350
5 EU 250 8 500
Base level of this index would be (150+300+450+100+250)/5 = 250. We equate
this to 100.
Current level of this index would be (650+450+600+350+500)/5 = 510. It means
current level of index on the base of 100 would be (510/250)*100 = 204.
2.4 Attributes of an Index
A good market index should have following attributes:
 It should reflect the market behaviour
 It should be computed by independent third party and be free from
influence of any market participant
 It should be professionally maintained
Impact Cost
Liquidity in the context of stock market means a market where large orders are
executed without moving the prices.
Let us understand this with help of an example. The order book of a stock at a
point in time is as follows:
Buy Sell
Sr. No. Quantity Price (in Rs.) Price (in Rs.) Quantity Sr. No.
1 1000 4.00 4.50 2000 5
2 1000 3.90 4.55 1000 6
3 2000 3.80 4.70 500 7
4 1000 3.70 4.75 100 8
In the order book given above, there are four buy orders and four sell orders.
The difference between the best buy and the best sell orders is 0.50 ‐ called bid‐
ask spread. If a person places a market buy order for 100 shares, it would be
matched against the best available sell order at Rs. 4.50. He would buy 100 shares
for Rs. 4.50. Similarly, if he places a market sell order for 100 shares, it would be
matched against the best available buy order at Rs. 4 i.e. the shares would be
sold at Rs.4.Hence, if a person buys 100 shares and sells them immediately, he is
poorer by the bid‐ask spread i.e. a loss of Rs 50. This spread is regarded as the
transaction cost which the market charges for the privilege of trading (for a
transaction size of 100 shares).
Now, suppose a person wants to buy and then sell 3000 shares. The sell order
will hit the following buy orders:
Sr. No. Quantity Price (in Rs.)
1 1000 4.00
2 1000 3.90
3 1000 3.80
While the buy order will hit the following sell orders:
Quantity Price (in Rs.) Sr. No.
2000 4.50 1
1000 4.55 2
There is increase in the transaction cost for an order size of 3000 shares in
comparison to the transaction cost for order for 100 shares. The “bid‐ask spread”
therefore conveys transaction cost for small trade.
Now, we come across the term called impact cost. We have to start by defining the
ideal price as the average of the best bid and offer price. In our example it is
(4+4.50)/2, i.e. Rs. 4.25. In an infinitely liquid market, it would be possible to
execute large transactions on both buy and sell at prices that are very close to the
ideal price of Rs.4.25. However, while actually trading, you will pay more than
Rs.4.25 per share while buying and will receive less than Rs.4.25 per share
while selling. Percentage degradation, which is experienced vis‐à‐vis the ideal
price, when shares are bought or sold, is called impact cost. Impact cost varies
with transaction size. Also, it would be different for buy side and sell side.
Buy Buy Price (in Sell Price (in Rs.) Sell Quantity
Quantity Rs.)
1000 9.80 9.90 1000
2000 9.70 10.00 1500
3000 9.60 10.10 1000
To buy 1500 shares, Ideal price = (9.8+9.9)/ 2 = Rs.9.85
Actual buy price = [(1000*9.9)+(500*10.00)]/1500 = Rs.9.93
Impact cost for (1500 shares) = {(9.93 ‐ 9.85)/9.85}*100 = 0.84 %

2.5 Index management

Index construction, maintenance and revision process is generally done by
specialized agencies. For instance, NSE indices are managed by a separate company
called “India Index Services and Products Ltd.” (IISL).
Index construction is all about choosing the index stocks and deciding on the
index calculation methodology. Maintenance means adjusting the index for
corporate actions like bonus issue, rights issue, stock split, consolidation, mergers
etc. Revision of index deals with change in the composition of index as such i.e.
replacing some existing stocks by the new ones because of change in the trading
paradigm of the stocks / interest of market participants.
Index Construction
A good index is a trade‐off between diversification and liquidity. A well diversified
index reflects the behaviour of the overall market/ economy. While diversification
helps in 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 reduction in risk. Going beyond 100 stocks gives almost
zero reduction in risk. Hence, there is little to gain by diversifying beyond a
point.
Stocks in the index are chosen based on certain pre‐determined qualitative and
quantitative parameters, laid down by the Index Construction Managers. Once a
stock satisfies the eligibility criterion, it is entitled for inclusion in the index.
Generally, final decision of inclusion or removal of a security from the index is
taken by a specialized committee known as Index Committee.
Index Maintenance and Index Revision
Maintenance and Revision of the indices is done with the help of various
mathematical formulae. In order to keep the index comparable across time, the
index needs to take into account corporate actions such as stock splits, share
issuance, dividends and restructuring events. While indexaimntenance issue
gets triggered by a corporate action, index revision is an unabated
phenomenon to ensure that index captures the most vibrant lot of securities in
the market and continues to correctly reflect the market.
2.6 Major Indices in India
These are few popular indices in India:
 S&P BSE Sensex  Nifty  SX 40
 S&P BSE Midcap  Nifty Next
 S&P BSE 100 50
 S&P BSE 200  Nifty 100
 S&P BSE 500  Nifty 200
2.7 Application of  Nifty 500
Indices
Traditionally, indices were used as a measure to understand the overall
direction of stock market. However, few applications on index have emerged in
the investment field. Few of the applications are explained below.
Index Funds
These types of funds invest in a specific index with an objective to generate
returns equivalent to the return on index. These funds invest in index stocks in the
proportions in which these stocks exist in the index. For instance, Sensex index
fund would get the similar returns as that of Sensex index. Since Sensex has 30
shares, the fund will also invest in these 30 companies in the proportion in
which they exist in the Sensex.
Index Derivatives
Index Derivatives are derivative contracts which have the index as the underlying
asset. Index Options and Index Futures are the most popular derivative contracts
worldwide. Index derivatives are useful as a tool to hedge against the market
risk.
Exchange Traded Funds
Exchange Traded Funds (ETFs) is basket of securities that trade like individual
stock, on an exchange. They have number of advantages over other mutual funds as
they can be bought and sold on the exchange. Since, ETFs are traded on
exchanges intraday
transaction is possible. Further, ETFs cdan be use as basket trading in terms of the
smaller denomination and low transaction cost. The first ETF in Indian Securities
Market was the Nifty BeES, introduced by the Benchmark Mutual Fund in
December 2001. Prudential ICICI Mutual Fund introduced SPIcE in January 2003,
which was the first ETF on Sensex.
Chapter 3: Introduction to Forwards and Futures
LEARNING OBJECTIVES:
After studying this chapter, you should know about:
 Meaning of Forward and Futures Contracts
 Terminology related to futures contract
 Payoff for futures contract
 Pricing of futures contract
 Uses of futures contract and its application by speculators, hedgers
and arbitrageurs
3.1 Introduction to forward and futures Contracts
Forward contract is an agreement made directly between two parties to buy or sell
an asset on a specific date in the future, at the terms decided today. Forwards are
widely used in commodities, foreign exchange, equity and interest rate
markets.
Let us understand with the help of an example. Whateis th basic difference between
cash market and forwards? Assume on March 9, 2018 you wanted to purchase
gold from a goldsmith. The market price for gold on March 9, 2018 was Rs.
30,425 for 10 gram and goldsmith agrees to sell you gold at market price. You paid
him Rs. 30,425 for 10 gram of gold and took gold. This is a cash market
transaction at a price (in this case Rs. 30,425) referred to as spot price.
Now suppose you do not want to buy gold on March 9, 2018, but only after 1
month. Goldsmith quotes you Rs. 30,450 for 10 grams of gold. You agree to the
forward price for 10 grams of gold and go away. Here, in this example, you
have bought forward or 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 the goldsmith pay him Rs. 30,450 and
collect your gold. This is a forward, where both the parties are obliged to go
through with the contract irrespective of the value of the underlying asset (in this
case gold) at the point of delivery.
Essential features of a forward are:
 It is a contract between two parties (Bilateral contract).
 All terms of the contract like price, quantity and quality of underlying,
delivery terms like place, settlement procedure etc. are fixed on the day of
entering into the contract.
In other words, Forwards are bilateral over‐the‐counter (OTC) transactions where
the terms of the contract, such as price, quantity, quality, time and place are
negotiated between two parties to the contract. Any alteration in the terms of
the contract is possible if both parties agree to it. Corporations, traders and
investing institutions extensively use OTC transactions to meet their specific
requirements. The essential idea of entering into a forward is to fix the price and
thereby avoid the price risk. Thus, by entering into forwards, one is assured of
the price at which one can buy/sell an underlying asset.
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 purchase gold at Rs. 30,450 under the contract and sell in cash
market at Rs. 30,500 i.e. net profit of Rs. 50. Similarly, if the spot price is 30,390
then you incur loss of Rs. 60 (buy price – sell price).
Major limitations of forwards
Liquidity Risk
Liquidity is nothing but the ability of the market participants to buy or sell the
desired 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 participants may not be interested in these contracts. Forwards are
not listed or traded on exchanges, which makes it difficult for other market
participants to easily access these contractsntorracctiong parties. The tailor made
contracts and their non‐ 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.
Counterparty risk
Counterparty risk is the risk of an economic loss from the failure of counterparty to
fulfil its contractual obligation. For example, A and B enter into a bilateral
agreement, where A will purchase 100 kg of rice at Rs.20 per kg from B after 6
months. Here, A is counterparty to B and vice versa. After 6 months, if price of
rice is Rs.30riknethe ma then B may forego his obligation to deliver 100 kg of rice at
Rs.20 to A. Similarly, if price of rice falls to Rs.15 then A may purchase from the
market at a lower price, instead of honouring the contract. Thus, a party to the
contract may default on his obligation if there is incentive to default. This risk
is also called default risk or credit risk.
In addition to the illiquidity and counterparty risks, there are several issues like
lack of transparency, settlement complications as it is to be done directly
between the contracting parties. Simple solution to all these issues lies in bringing
these contracts to the centralized trading platform. This is what futures
contracts do.
Futures contract
Futures markets were innovated to overcome the limitations of forwards. A
futures contract is an agreement made through an organized exchange to buy
or sell a fixed amount of a commodity or a financial asset on a future date at an
agreed price. Simply, futures are standardised forward contracts that are traded
on an exchange. The clearinghouse associated with the exchange guarantees
settlement of these trades. A trader, who buys futures contract, takes a long
position and the one, who sells futures, takes a short position. The words buy and
sell are figurative only because no money or underlying asset changes hand,
between buyer and seller, when the deal is signed.
Features of futures contract
In futures market, exchange decides all the contract terms of the contract other
than price. Accordingly, futures contracts have following features:
 Contract between two parties through Exchange
  Centralised trading platform i.e. exchange
 Price discovery through free interaction of buyers and sellers
 Margins are payable by both the parties
 Quality decided today (standardized )
 Quantity decided today (standardized)
Futures terminologies
Let us understand various terms in the futures market with the help of quotes
on Nifty futures from NSE:
Quotes given on the NSE website for Nifty futures as on March 7, 2018
1. Instrument type : Future Index
2. Underlying asset : Nifty 50
3. Expiry date : March 28, 2018
4. Open price (in Rs.) : 10200.00
5. High price (in Rs.) : 10254.00
6. Low price (in Rs.) : 10155.00
7. Closing price (in Rs.) : 10171.55
8. No of contracts traded : 1,98,900
9. Turnover (in Rs. Lakhs) : 15,21,894.99
10.Underlying value (in Rs.) : 10154.20
Spot Price: The price at which an asset trades in the cash market. This is the
underlying value of Nifty on March 7, 2018 which is 10154.20.
Futures Price: The price of the futures contract in the futures market. The closing
price of Nifty in futures trading is Rs. 10171.55. Thus Rs. 10171.55 is the future
price of Nifty, on a closing basis.
Contract Cycle: It is a period over which a contract trades. On March 7, 2018,
the 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 futures contract expires on last Thursday of respective
month or the day before if the last Thursday is a trading holiday (in this case
since Thursday, March 29, 2018 is a trading holiday, the March contract expires on
the day before i.e., on March 28, 2018). And, a new contract (in this example ‐
June 2018) is introduced on the trading day following the expiry day of the
near month contract.
Expiration Day: The day on which a derivative contract ceases to exist. It is last
trading day of the contract. Generally, it is the last Thursday of the expiry
month unless it is a trading holiday on that day. If the last Thursday is a trading
holiday, the contracts expire on the previous trading day. For the March 2018
contract, the expiry date is given as March 28, 2018 since March 29, 2018
(Thursday) is a trading holiday. On expiry date, all the contracts are compulsorily
settled. If a contract is to be continued then it must be rolled to the near future
contract. For a long position, this means selling the expiring contract and buying
the next contract. Both the sides of a roll over should be executed
at the same time. Currently, all equity derivatives contracts (both on indices
and individual stocks) are cash settled.
Tick Size: It is minimum move allowed in the price quotations. Exchanges decide
the tick sizes on traded contracts as part of contract specification. Tick size for
Nifty futures is 5 paisa. Bid price is the price buyer is willing to pay and ask
price is the price seller is willing to sell.
Contract Size and Contract Value: Futures contracts are traded in lots and to
arrive at the contract value we have to multiply the price with contract multiplier
or lot size or contract size.
Basis: The difference between the spot price and the futures price is called basis.
If the futures price is greater than spot price, basis for the asset is negative.
Similarly, if the spot price is greater than futures price, basis for the asset is
positive. On March 7, 2018, spot price < future price thus basis for Nifty futures is
negative i.e. (10154.20 ‐ 10171.55
= ‐ Rs 17.35).
Importantly, basis for one‐month contract would be different from the basis for two
or three month contracts. Therefore, definition of basis is incomplete until we
define the 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 and two months futures contract should essentially be
equal to the cost of carrying the underlying asset between first and second
month. Indeed, this is the fundamental of linking various futures and underlying
cash market prices together.
During the life of the contract, the basis may become negative or positive, as there
is a movement in the futures price and spot price. Further, whatever the basis is,
positive or negative, it turns to zero at maturity of the futures contract i.e. there
should not be any 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 takes place at the closing price of the underlying
asset.
It may be noted that derivatives trading based on the on global indices was also
launched by India derivatives exchanges. These contracts are denominated in Indian
Rupees. For example, NSE introduced derivative contracts on FTSE100, S&P 500
and Dowjones and BSE introduced derivative contracts on iBovespa (Brazilian
index), MICEX (Russian index), Hang Seng (Hongkong index)& FTSE/JSE Top40
(South African index).
The National Stock Exchange has also launched future contracts on India Volatility
Index
(VIX) enabling traders to hedge market risk arising out of volatility.
Cost of Carry
Cost of Carry is the relationship between futures prices and spot prices. It measures
the storage cost (in commodity markets) plus the interest that is paid to finance or
‘carry’ the asset till delivery less the income earned on the asset during the holding
period. For equity derivatives, carrying cost is the interest paid to finance the
purchase less (minus) dividend earned.
For example, assume the share of ABC Ltd is trading at Rs. 100 in the cash
market. A person wishes to buy the share, but does not have money. In that
case he would have to borrow Rs. 100 at the rate of, say, 6% per annum.
Suppose that he holds this share for one year and in that year he expects the
company to give 200% dividend on its face value of Rs. 1 i.e. dividend of Rs. 2.
Thus his net cost of carry = Interest paid – dividend received = 6 – 2 = Rs. 4.
Therefore, break even futures price for him should be Rs.104.
It is important to note that cost of carry will be different for different participants.
Margin Account
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 margins from their customers. Brief about margins is as follows:
Initial Margin
The amount one needs to deposit in the margin account at the time of entering
a futures contract is known as the initial margin. Let us take an example ‐ On
March 8,
2018 a person decidedoto enter int a futures contract. He expects the market to go up
so he takes a long Nifty Futures position for March expiry. On March 7, 2018,
Nifty March month futures contract closes at 10171.55.
The contract value = Nifty futures price * lot size= 10171.55 * 75 = Rs 7,62,866.
Therefore, Rs 7,62,866 is the contract value of one Nifty Future contract
expiring on March 28, 2018.
Assuming that the broker charges 10% of the contract value as initial margin, the
person has to pay him Rs. 76,287 as initial margin. Both buyers and sellers of
futures contract
paygininit,ial mar as there is an obligation on both the parties to honour the contract.
The initial margin is dependent on price movement of the underlying asset. As
high volatility assets carry more risk, exchange would charge higher initial margin
on them.
Marking to Market (MTM)
In futures market, while contracts have maturity of several months, profits and
losses are settled on day‐to‐day basis – called mark to market (MTM)
settlement. The exchange collects these margins (MTM margins) from the loss
making participants and pays to the gainers on day‐to‐day basis.
Let us understand MTM with the help of the example. Suppose a person bought
a futures contract on March 8, 2018 when the Nifty futures contract was
trading at 10171.55. He paid an initial margin of Rs. 76,287 as calculated above. At
the end of that day, Nifty futures contract closes at 10242.95. This means that
he/she benefits due to the 71.4 points gain on Nifty futures contract. Thus,
his/her net gain for the day is Rs
71.4 x 75 = Rs 5355. This money will be credited to his account and next day
his/her position will start from 10242.95 (for MTM computation purpose).
Open Interest and Volumes Traded
An open interest is the total number of contracts outstanding (yet to be settled) for
an underlying asset. It is important to understand that number of long futures
as well as number of short futures is equal to the Open Interest. This is because
total number of long futures will always be equal to total number of short
futures. Only one side of contracts is considered while calculating/mentioning
open interest. The level of open interest indicates depth in the market.
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 life of the contract.
Contract Specifications
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 example contract specification is given below:
NSE’s Nifty Index Futures Contracts
Underlying index Nifty 50
Contract Multiplier (Lot size) 75
Tick size or minimum price 0.05 index point (i.e., Re 0.05 or 5 paise)
difference
Last trading day / Expiration Last Thursday of the expiration month. If it
day happens to be a holiday, the contract will
expire on the previous business day.
Contract months 3 contracts of 1, 2 and 3 month’s maturity.
At the expiry of the nearest month contract,
a new contract with 3 months maturity will
start. Thus, at any point of time, there will
be 3 contracts
available for trading.
Daily settlement price Settlement price of the respective futures
contract.
Final settlement price Settlement price of the cash index on the
expiry
date of the futures contract.
Price band
Price Band is essentially the price range within which a contract is permitted to
trade during a day. The band is calculated with regard to previous day closing
price of a specific contract. For example, previous day closing price of a
contract is Rs.100 and price band for thetrcaocnt is 10% then the contract can
trade between Rs.90 and Rs.110 for next trading day. On the first trading day
of the contract, the price band is decided based on the closing price of the
underlying asset in cash market. For example, Today is first trading day of a
futures contract for an underlying asset i.e. company A. 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 specifications so that
all market participants are aware of the same in advance.
Sometimes, bands are allowed to be expanded at the discretion of the exchanges
with specific trading halts.
Positions in derivatives market
As a market participant, you will always deal with certain terms like long, short and
open positions in the market. Let us understand the meanings of commonly
used terms:
Long position
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 Sensex futures. If Mr. Y buys 4 contracts on Pepper futures then
he would be long on 4 contracts on pepper.
Short Position
Outstanding/ unsettled sell position in a contract is called “Short Position”. For
instance, if Mr. X sells 5 contracts on Sensex futures then he would be short on
5 contracts on Sensex futures. If Mr. Y sells 4 contracts on Pepper futures then
he would be short on 4 contracts on pepper.
Open position
Outstanding/ unsettled either long (buy) or short (sell) position in various derivative
contracts is called “Open Position”. For instance, if Mr. X shorts say 5 contracts
on Infosys futures and longs say 3 contracts on Reliance futures, he is said to be
having open position, which is equal to short on 5 contracts on Infosys and long
on 3 contracts of Reliance. If next day, he buys 2 Infosys contracts of same
maturity, his open position would be – short on 3 Infosys contracts and long on 3
Reliance contracts.
Naked and calendar spread positions
Naked position in futures market simply means a long or short position in any
futures contract without having any position in the underlying asset. Calendar
spread position is 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 month contract coupled with a long position in far
month contract is a calendar spread position. Calendar spread position is computed
with respect to the near month series
and becomes an open position once the near month contract expires of the
oreerith offsetting positions is closed.
A calendar spread is always defined with regard to the relevant months i.e.
spread between August contract and September contract, August contract and
October contract and September contract and October contract etc.
Opening a position
Opening a position means either buying or selling a contract, which increases
client’s open position (long or short).
Closing a position
Closing a position means either buying or selling a contract, which essentially
results in reduction of client’s open position (long or short). A client is said to be
closed a position
if he sells a contract which he had bought before or he buys a contract which
he had sold earlier.
Limitations of Futures Contract
As futures are standardized contracts introduced by the exchanges, they too
have certain limitations in the context of limited maturities, limited underlying
set, lack of flexibility in contract design and increased administrative costs on
account of MTM settlement etc.
Differences between Forwards and Futures
Feature Forward contracts Futures contracts
Operational It is not traded on the It is an exchange‐traded
Mechanism exchanges. contract.
Contract Terms of the contracts differ Terms of the contracts are
specifications from trade to trade (tailor standardized.
made contract) according to
the need
of the participants.
Counter‐party Exists, but at times gets Exists but the clearing agency
risk reduced by a guarantor. associated with exchanges
becomes the counter‐party to
all trades assuring guarantee
on
their settlement.
Liquidation Low, as contracts are tailor High, as contracts are
profile made catering to the needs standardised exchange‐traded
of the parties involved. contracts.
Further, contracts are not
easily accessible to other
market participants.

Price discovery Not Efficient, as markets are Efficient, centralised trading

scattered. platform helps all buyers and
sellers to come together and
discover the price through
common order book.
Quality of Quality of information may Futures are traded nationwide.
information be poor. Speed of Every bit of decision related
and its information dissemination is information is distributed
Dissemination week. very
fast.
Examples Currency markets are an Commodities futures, Currency
example of forwards. Today futures, Index futures and
currency futures and options Individual stock futures in
have been introduced in India.
India, but yet a market for
currency forwards exists
through banks.
3.2 Pay off Charts for Futures contract
Pay off Charts
Pay off on a position is the likely profit/ loss that would accrue to a market
participant 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/slsoes on the Y‐axis.
Pay off charts for futures
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 explained in detail below:
Pay off for buyer of futures: Long futures
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 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 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
chart. The X Axis has the market price of the underlyingya. t expir It increases on the
Right Hand Side (RHS). We do not draw the X Axis on the Left Hand Side (LHS),
as prices cannot go below zero. The Y Axis shows profit & loss. In the upward
direction, we have
profits and in the downward direction, we show leosses chart.
in th The below table and pay off chart show long futures
pay offs:
Long Futures at 100
Market price Long Futures
at expiry Pay off
50 ‐50
60 ‐40
70 ‐30
80 ‐20
90 ‐10
100 0
110 10
120 20
130 30
140 40
150 50
 60
Long Futures Payoff

40

20
Profit/Loss (Rs.)

0
50 60 70 80 90 100 110 120 130 140 150

CMP @ Expiry

-20

-40

Long Futures Payoff

-60

Short Futures pay off

As one person goes long, some other person has to go short, otherwise a deal
will not take place. The profits and losses for the short futures position will be
exactly opposite of the long futures position. This is shown in the below table
and chart:
Short Futures at 100
Market price Short Futures
at expiry Pay off
50 50
60 40
70 30
80 20
90 10
100 0
110 ‐10
120 ‐20
130 ‐30
140 ‐40
150 ‐50
 60
Short Futures Payoff

40

20
Profit/Loss (Rs.)

0
50 60 70 80 90 100 110 120 130 140 150

CMP @ Expiry

-20

-40

Short Futures Payoff

-60

As can be seen, a short futures position makes profits when prices fall. If prices fall
to 60 at expiry, the person who has shorted at Rs.100 will buy from the market at
60 on expiry and sell at 100, thereby making a profit of Rs. 40. This is shown in
the above chart.

3.3 Futures pricing

Pricing of a futures contract depends on the characteristics of underlying asset.
There is no single way to price futures contracts because different assets have
different demand and supply patterns, different characteristics and cash flow
patterns. This makes it difficult to design a single methodology for calculation
of pricing of futurescctso.ntra Market participants use different models for pricing
futures. Here, our discussion is limited to only two popular models of futures
pricing ‐ Cash and Carry model and Expectancy model.
Cash and Carry Model for Futures Pricing
Cash and Carry model is also known as non‐arbitrage model. This model assumes
that in an efficient market, arbitrage opportunities cannot exist. In other words,
the moment 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 thereby eliminating these opportunities. This
trading continues until the prices are aligned across the products/ markets for
replicating assets.
Let us understand the entire concept with the help of an example. Practically,
forward/ futures position in a stock can be created in following manners:
 Enter into a forward/futures contract, or
  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 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 in both the markets are aligned.
The cost of creating a synthetic futures position is the fair price roefsfutucontract. Fair
price of futures contract is nothing but addition of spot price of underlying
asset and 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 charges, financing cost, etc whereas for commodities, it
would also include costs like warehousing cost, insurance cost, etc.
Let us take an example from Bullion Market. The spot price of gold is Rs 15000
per 10 grams. The cost of financing, storage and insurance for carrying the gold
for three months is Rs. 100 per 10 gram. Now you purchase 10 gram of gold
from the market at Rs 15000 and hold it for three months. We may now say
that the value of the gold after 3 months would be Rs 15100 per 10 gram.
Assume the 3‐month futures contract on gold is trading at Rs 15150 per 10
gram. What should one do? Apparently, one should attempt to exploit the
arbitrage opportunity present in the gold market by buying gold in the cash
market and sell 3‐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 our futures contract. Amount received on
honouring the futures contract would be used to repay the financer of our gold
purchase. The net result will be a profit of Rs 50 without taking any risk. (In the
entire process, we have not considered any transaction cost‐brokerage etc.)
Because of this mispricing, as more and more people come to the cash market
to buy gold and sell in futures market, spot gold price will go up and gold
futures price will come down. This arbitrage opportunity continues until the
prices between cash and futures markets are aligned.
Therefore, if futures price is more than the future fair price of asset/ synthetic
futures price, it will trigger cash and carry arbitrage, which will continue until the
prices in both the markets are aligned.
Similarly, if futures prices is less than the future fair price of asset/ synthetic
futures price, it will trigger reverse cash and carry arbitrage i.e. market
participants start buying 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 market sales proceeds. After three months,
they give gold back to the lender on receipt of the same in futures market. This
reverse arbitrage will result in reduction of gold’s
spot price and increase of its futures price, until these prices are aligned to
leave no money on the table.
Cost of transaction and non‐arbitrage bound
Cost components of futures transaction like margins, transaction costs
(commissions), taxes etc. create distortions and take markets away from
equilibrium. In fact, these cost components create a non‐arbitrage bound in the
market i.e. if the futures price is within that bound around the future fair value/
synthetic futures value, arbitrage will not take place. In other words, because of
the frictions in the market, for arbitrage to get triggered, it is important for the
futures price to fall beyond the non arbitrage bound in either direction for the
arbitragers to make profit from the arbitrage opportunities.

Fair Price

Non arbitrage bound

Practically, every component of carrying cost contributes towards widening this

non‐ arbitrage bound. Here, we should appreciate that wider the non‐arbitrage
bound, farther the markets are from the equilibrium. In other words, for markets
to be efficient, different costs of operating in the markets should be as low as
possible. Lower costs would narrow down the non‐arbitrage bound, which in‐turn
would ensure the efficient price alignment across theemtsa.rk
Extension of cash & carry model to the assets generating returns
Let us extend the concept of cash and carry model by adding the inflows during
the holding period of underlying assets. For instance, underlying asset like
securities (equity or bonds) may have certain inflows, like dividend on equity
and interest on debt instruments, during the holding period. These inflows are
adjusted in the future fair price. Thus, modified formula of future fair price or
synthetic futures price is:
Fair price = Spot price + Cost of carry ‐
Inflows In mathematical terms, F = S
(1+r‐q)T
Where F is fair price of the futures contract, S is the Spot price of the underlying
asset, q is expected return during holding period T (in years) and r is cost of
carry.
If we use the continuous compounding, we may rewrite the formula as: F= Se(r‐q)*T
Let us apply the above formula to the index futures market to find the synthetic
futures price/ future fair price of an index. Suppose , you buy an index in cash
market at 10000 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 (spread uniformly across the year). Given this statistics,
fair price of index three months down the line should be:
= Spot price (1+cost of financing – holding period return) ^ (time to expiration/365)
= 10000 (1+0.12‐0.04)^(90/365)
= Rs. 10,191.58
[Alternatively, we could use exponential form for calculating the futures value as
spot price * e(r‐q)T. Value in that case would have been 10000 * e((0.12‐0.04)*90/365) =
Rs. 10,199.22].
If index futures is trading above 10199.22, we can buy index stocks in cash
market and simultaneously sell index futures to lock the gains equivalent to the
difference between futures price and future fair price (the cost of transaction,
taxes, margins etc. are not considered while calculating the future fair value).
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 different market participants is what makes the
market on continuous basis.
Assumptions in cash and carry model
Cash and carry model of futures pricing works under certain assumptions. The
important assumptions are stated below:*
 Underlying asset is available in abundance ihn market.
cas
 Demand and supply in the underlying asset is not seasonal.
 Holding and maintaining of underlying asset is easy and feasible.
 Underlying asset can be sold short.
 No transaction costs.
 No taxes.
 No margin requirements.
[*This is not an exhaustive list of the assumptions of the model but is the list of important assumptions]

The assumption that underlying asset is available in abundance in the cash market
i.e. we can buy and/or sell as many units of the underlying assets as we want.
This assumption does not work especially when underlying asset has seasonal
pattern of demand and supply. The prices of seasonal assets (especially
commodities) vary drastically in different demand‐supply environments. When
supplies arrive to the market place, prices are generally low whereas prices are
generally high immediately before the supply of the underlying.
When an underlying asset is not storable i.e. the asset is not easy to hold/maintain, then
one cannot carry stheet as to the future. The cash and carry model is not applicable to
these types of underlying assets.
Similarly, many a times, the underlying may not be sold short. This is true in
case of seasonal commodities.
Even though this simple form of cash and carry model does not discount for
transaction cost, taxes etc. we can always upgrade the formula to reflect the
impact of these factors in the model. Margins are not considered while
delivering the fair value/ synthetic
futures value. That is why this model is suitable for pricing forward contracts rather
than futures contracts.
Thus, no generalized statement can be made with regard to the use of cash and
carry model for pricing futures contracts. Assumptions of the model and
characteristics of underlying asset can help us in deciding whether a specific asset
can be priced with the help of this model or not. Further, suitable adjustments are
made in the model to fit in the specific requirements of the underlying assets.
Convenience Yield
Let us touch one more concept in futures market called Convenience Yield. We
need to go back and have a look at the formula for fair price of futures
contract.
Fair price of futures contract = Spot price + Cost of carry – Inflows
As seen earlier inflows may be in the form of dividend (in case of equity) and
interest (in case of debt). However, sometimes inflows may also be intangibles.
Intangible inflows essentially mean values perceived by the market participants just
by holding the asset. These values may be in the form of just convenience or
perceived mental comfort by holding the asset.
For instance, in case of natural disaster like flood rinticaulpaar region, people start
storing essential commodities like grains, vegetables and energy products (heating
oil) etc. As a human tendency we store more than what is required for our real
consumption during a crisis. If every person behaves in similar way then
suddenly a demand is created for an underlying asset in the cash market. This
indirectly increases the price of underlying assets. In such situations people are
deriving convenience, just by holding the asset. This is termed as convenience
return or convenience yield.
Convenience return for a commodity is likely to be different for different
people, depending on the way they use it. Further, it may vary over a period.
In fact, convenience is a subjective issue and may be very difficult to price.
Convenience yield sometimes may dominate the cost of carry, which leads futures
to trade at a discount to the cash market. In this case, reverse arbitrage is also not
possible because no one lends traders the assets to sell short in the cash
market. In such situations, practically, the cash and carry model breaks down and
cannot be applied for pricing the underlying assets.
Expectancy model of futures pricing
According to the expectancy model, it is not the relationship between spot and
futures prices but that of expected spot and futures prices, which moves the
market, especially in cases when the asset cannot be sold short or cannot be
stored. It also argues that futures price is nothing but the expected spot price of
an asset in the future. This is why market participants would enter futures contract
and price the futures based upon their estimates of the future spot prices of the
underlying assets.
According to this model,
 Futures can trade at a premium or discount to the spot price of underlying
asset.
  Futures price give market participants an indication of the expected
direction of movement of the spot price in the future.
For instance, if futures price is higher than spot price of an underlying asset,
market participants may expect the spot price to go up in near future. This
expectedlysrini g market is called “Contango market”. Similarly, if futures price are
lower than spot price of an asset, market participants may expect the spot price to
come down in future. This expectedly falling market is called “Backwardation
market”.
Price discovery and convergence of cash and futures prices on the expiry
It is important to understand what actually futures prices indicate? For instance, if
say May 2018 index futures contract is trading today (in March 2018) at 10200, what
does it mean. We can explain this by saying that that market expects the cash
index to settle at 10200 at the closure of the market on last Thursday of May
(i.e., on the last trading day of the contract which is May 31, 2018). Point is
that every participant in the market is trying to predict the cash index level at
a single point in time i.e. at the closure of the market on last trading day of the
contract, which is Thursday in our example. This results in price discovery of cash
index at a specific point in time. Now, we may also state that futures prices are
essentially expected spot price of the underlying asset, at the maturity
of the futures. contract Accordingly, both futures and spot prices converge at the
maturity of futures contract, as at that point in time there cannot be any
difference between these two prices. This is the reason why all futures contracts
on expiry settle at the underlying cash market price. This principal remains
same for all the underlying assets.

3.4 Commodity, Equity & Index Futures

The basic concept of a derivative contract remains the same for all the
underlying assets, whether the underlying happens to be a commodity or equity or
index futures. Some features are very peculiar to commodity derivative
markets. In the case of financial derivatives, most of these contracts are cash
settled whereas in the case of commodity derivatives, some contracts may settle
with physical delivery. Even in the case of physical settlement, financial assets
are not bulky and do not need special facility for storage, whereas in
commodity market, due to the bulky nature of the underlying assets, physical
settlement in commodity derivatives creates the need for warehousing. The
varying quality of asset does not really exist as far as financial underlying is
concerned but in case of commodities, the quality of the asset underlying a
contract can vary significantly.

3.5 Uses of futures

Role of different participants in derivatives
markets Hedgers
Corporations, Investing Institutions, Banks and Governments all use derivative products
to hedge or reduce their exposures to market variables such as interest rates,
share values, bond prices, currency exchange rates and commodity prices. The
classic example is the farmer who sells futures contracts to lock into a price for
delivering a crop on a
future date. The buyer might be a food‐processing company, which wishes to fix a
price 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 transaction with a bank agreeing to sell the foreign
currency and receive a predetermined quantity of domestic currency.
Speculators/Traders
Derivatives are very well suited to trading on the prices of commodities and
financial assets and on key market variables such as interest rates, stock
market indices and currency exchange rates. It is much less expensive to create a
speculative position using derivatives than by actually trading the underlying
commodity or asset. As a result, the potential returns are much greater. A classic
application is the trader who believes that increasing demand or scarce production
is likely to boost the price of a commodity. He has two options with him ‐ first
option is to buy and store the physical commodity whereas other option is to go
long futures contract. Trader chooses the second option to go long futures contract
on the underlying asset. If commodity price increases, the value of the contract
will also rise and he can reverse back position to book his profit.
Arbitrageurs
An arbitrage is a deal that produces risk free profits by exploiting a mispricing
in the 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 at a higher price. Such opportunities are unlikely to
persist for very long, since arbitrageurs would rush in to buy the asset in the
cheap location and simultaneously sell at the expensive location, thus reducing
the pricing gap.
As mentioned above, there are three major players in derivatives market –
Hedgers, Traders, and Arbitrageurs. Hedgers are there to hedge their risk, traders
take the risk which hedgers plan to offload from their exposure and arbitragers
establish an efficient link between different markets.
Traders take naked positions in the futures market i.e. they go long or shortioinusvar
futures contracts available in the market. Indeed, capacity of derivatives market to
absorb buying/selling by hedgers is directly dependent upon availability of traders,
who act as counter‐party to hedgers. Accordingly, Traders form one of the most
important participants of the derivatives market, providing depth to the market.
Hedgers will not be able to hedge if traders were not present in the system.
Therefore, for futures market to click, presence of both hedgers and traders is
a must.
For instance, assume, a farmer expects the price of wheat to fall in near
future. He wants to hedge his price risk on wheat produce for next 3 months till
the time he has actual produce in his hands and so would like to lock at the
forward/ futures price now. Accordingly, farmer can sell futures contracts on the
expected quantity of produce. In order to sell this futures contract, he needs a
buyer. This buyer may be someone who needs wheat after three months, may be
a flour mill or a bakery. However, most of the times, there is a demand supply
mismatch in the market and the trader fills the gap between demand and
supply.
Here trader, counterparty to the farmer, is thinking in contrary i.e. this buyer
would buy only if he thinks that actual price of wheat is going to be higher than
the contract price for futures three months down the line. Further, the profit
of trader would depend upon actual wheat price being more than the contracted
futures price at the maturity of futures contract. If it is so, trader would make
money otherwise he would lose money.
In addition to hedgers and traders, to establish a link between various markets like
spot and derivatives, we need a third party called arbitragers. These arbitragers
continuously hunt for the profit opportunities across the markets and products
and seize those by executing trades in different markets and products
simultaneously. Importantly, arbitragers generally lock in their profits unlike
traders who trade naked contracts.
For example at the end of day (1st March 2018):
Market price of underlying asset (in Rs.) 100
March futures 110
Lot size 50
Here an arbitrageur will buy in the cash market at Rs. 100 and sell in the Futures
market at Rs. 110, thereby locking Rs. 10 as his profit on each share.
On the expiration date, suppose price (in Rs.) of the underlying asset is 108.
Cash Market Futures
Buy 100 Sell 110
Sell 108 Buy 108
+8 +2
Total profit would therefore be 10*50 = Rs. 500.
Suppose price (in Rs.) of the underlying asset is 95 on the expiration date.
Cash Market Futures
Buy 100 Sell 110
Sell 95 Buy 95
‐5 +15
Total profit is 10*50 = Rs. 500.
In the entire activity, the transaction cost and impact cost have not been
considered. In real life, the transaction cost has to be considered like the
brokerage, service Tax, Securities Service Tax etc.
Here, it may be interesting to look at the risks these arbitragers carry. As seen
before, arbitragers are executing positions in two or more markets/products
simultaneously. Even if the systems are seamless and electronic and both the
legs of transaction are liquid, there is a possibility of some gap between the
executions of both the orders. If either legaonfstahcetiotrn is illiquid then the
risk on the arbitrage deal is huge as only one leg may get executed and another may
not, which would open the arbitrager to the naked exposure of a position.
Similarly, if contracts are not cash settled in both or one of the markets, it would
need reversal of trades in the respective markets, which would result in additional
risk on unwinding position with regard to simultaneous execution of the trades.
These profit focused traders and arbitrageurs fetch enormous liquidity to the
products traded on the exchanges. This liquidity in turn results in better price
discovery, lesser cost of transaction and lesser manipulation in the market.
Uses of Index futures
Equity derivatives instruments facilitate trading of a component of price risk, which
is inherent to investment in securities. Price risk is nothing but change in the
price movement of asset, held by a market participant, in an unfavourable
direction. This risk broadly divided into two components ‐ specific risk or
unsystematic risk and market risk or systematic risk.
Unsystematic Risk
Specific risk or unsystematic risk is the component of price risk that is unique
to particular events of the company and/or industry. This risk is inseparable from
investing in the securities. This risk could be reduced to a certain extent by
diversifying the portfolio.
Systematic Risk
An investor can diversify his portfolio and eliminate major part of price risk i.e.
the diversifiable/unsystematic risk but what is left is the non‐diversifiable portion
or the market risk‐called systematic risk. Variability in a security’s total returns that
are directly associated with overall movements in the general market or
economy is called systematic risk. Thus, every portfolio is exposed to market risk.
This risk is separable 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, only specific risk of the portfolio remains.
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.
Before we get to management of systematic risk with index futures, we need to
understand Beta ‐ a measure of systematic risk of a security that cannot be
avoided through diversification. It measures the sensitivity of a stock / portfolio
vis‐a‐vis index movement over a period of time, on the basis of historical prices.
Suppose a stock has a beta equal to 2. This means that historically a security has
moved 20% when the index
moved 10%, indicatingttha the stock is more volatile than the index. Stocks / portfolios
having beta more than 1 are called aggressive and having beta less than 1 are
called conservative stocks / portfolios.
In order to calculate beta of a portfolio, betas of individual stocks are used. It
is calculated as weighted average of betas of individual stocks in the portfolio
based on 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 beta of this portfolio would be 0.87 (0.5*0.35 +1.10*0.15
+1.30*0.20 +0.90*0.30).
A generalized formula for portfolio beta can be written as W1 β1+W2 β2+…+ Wn βn=
βp
Where, W1 is weight of stock 1, β1 is the β of stock 1, W2 is weight of stock 2, β2 is
the
β of stock 2, Wn is weight of stock n, βn is the β of stock n and βp is the β of
portfolio.
Information on beta of individual stocks is readily available in various financial
newspapers, magazines and information vending networks like Bloomberg, Reuters
etc.
Now, let us get to management of systematic risk. Assume you are having a
portfolio worth Rs.9,00,000 in cash market. You see the market may be volatile
due to some reasons. You are not comfortable with the market movement in
the short run. At this point of time, you have two options: (1) sell the entire
portfolio and buy later and (2) hedge by the use of Index futures to protect the
value of this portfolio from the expected fall in the market.
As an investor you are comfortable with the second option. If the prices fall, you
make loss in cash market but make profits in futures market. If prices rise, you
make profits in cash market but losses in futures market.
Now, the question arises how many contracts you have to sell to make a perfect
hedge? Perfect hedge means if you make Rs. 90,000 loss in cash market then
you should make Rs. 90,000 profit in futures market. To find the number of
contracts for perfect hedge ‘hedge ratio’ is used. Hedge ratio is calculated as:
Number of contracts for perfect hedge = Vp *
βp / Vi Vp – Value of the portfolio
βp– Beta of the portfolio
Vi – Value of index futures contract
Value of index futures contract or contract size = futures index level * contract
multiplier. Readers may note that for simplification purpose, beta of futures index
vis‐a‐ vis cash index is taken as one.
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 indices. Assume one Futures contract has a lot size of 75.You will have
to hedge using 146.25/ 75 = 1.95 contracts. Since you cannot hedge 1.95
contracts, you will have to hedge by 2 futures contracts. You have to pay the
broker initial margin in order to take a position in futures.
Hedge against the systematic risk mainly depends upon the relationship of
portfolio with the index, which is measured by beta. A portfolio has different
relationships with 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 or portfolio’s movement and the index movement
would continue in future. This may result in some difference between actual and
expected numbers.
Similarly, we can use single stock futures to manage the risk of the equity
investment in 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 comparable with underlying positions. Only difference
between an underlying position
and single stock futures is on settlement front; in case of cash transactions,
settlement takes place immediately and in case of single stock futures
contracts, settlement is deferred.
Important terms in hedging
Long hedge: Long hedge is the transaction when we hedge our position in cash
market by going long in futures market. For example, we expect to receive some
funds in future and want to invest the same amount in the securities market. We
have not yet decided the specific company/companies, where investment is to
be made. We expect the
market to go up in near future and bear ak ris of acquiring the securities at a higher
price. We can hedge by going long index futures today. On receipt of money,
we may invest in the cash market and simultaneously unwind corresponding
index futures positions. Any loss due to acquisition of securities at higher price,
resulting from the upward movement in the market over intermediate period,
would be partially or fully compensated by the profit made on our position in
index futures.
Further, while investing, suitable securities at reasonable prices may not be
immediately available in sufficient quantity. Rushing to invest all money is likely to
drive up the prices to our disadvantage. This situation can also be taken care of
by using the futures. We may buy futures today; gradually invest money in the
cash market and unwind corresponding futures positions.
Similarly, we can take an example from the commodity market, if there is a
flour mill and it is expecting the price of wheat to go up in near future. It may
buy wheat in forwards/ futures market and protect itself against the upward
movement in price of wheat. This would also be an example of long hedge.
Short hedge: Short Hedge is a transaction when the hedge is accomplished by
going short in futures market. For instance, assume, we have a portfolio and want
to liquidate in near future but we expect the prices to go down in near future.
This may go against our plan and may result in reduction in the portfolio value.
To protect our portfolio’s value, today, we can short index futures of
equivalent amount. The amount of loss made in cash market will be partly or
fully compensated by the profits on our futures positions.
Let us take an example from currency market. Assume Company C is into
export and import business. Company expects some dollars to flow in after say 6
months. Director Finance of the company is expecting the depreciation in dollar
vis‐a‐vis local currency over this period of time. To protect against this risk of
adverse movement in exchange rate of currency, company C may sell dollars in
forward /futures market. This selling would protect company against any fall of
dollar against the local currency.
Cross hedge: When futures contract on an asset is not available, market
participants look forward to an asset that is closely associated with their underlying
and trades in the futures market of that closely associated asset, for hedging
purpose. They may trade in futures in this asset to protect the value of their asset
in cash market. This is called cross hedge.
For instance, if futures contracts on jet fuel are not available in the
international markets then hedgers may use contracts available on other energy
products like crude oil, heating oil or gasoline due to their close association with
jet fuel for hedging purpose. This is an example of cross hedge.
Indeed, in a crude sense, we may say that when we are using index futures to
hedge against the market risk on a portfolio, we are essentially establishing a
cross hedge because we are not using the exact underlying to hedge the risk
against.
Hedge contract month: Hedge contract month is the maturity month of the
contract through which we hedge our position. For instance, if we use August
2018 contract to hedge our portfolio’s market risk, our hedge contract month
would be August 2018 contract. Similarly, if we hedge say risk on crude oil price
with the help of March 2019, hedge contract month would be March 2019.
Trading in futures market
Traders are risk takers in the derivatives market. And they take positions in the
futures market without having position in the underlying cash market. These
positions are based upon their expectations on price movement of underlying
asset. Tradersheeirt take naked positions or spread positions.
A trader takes a naked long position when he expects the market to go up.
Money comes by reversing the position at higher price later. Similarly, he takes a
short position when he expects the market to go down to book profit by reversing
his position at lower price in the future. For instance, if one month Sensex
futures contract is trading at 27900 and trader expects the cash index at the
maturity of the one month contract should settle at a level higher than this, he
would take a long position in index futures at a level of 27900. If his expectation
comes true and index on maturity settles beyond 27900, this trader will make
money to the extent of the difference between buy and sell/settlement price
of the index.
Traders may also take long/short positions in single stock futures. When they
expect the market to go up, they may take long position in these futures and when
they expect the market to go down, they may take short position in single stock
futures.
Similarly, if someone wants to trade upon say steel prices, he may take long or
short position on steel futures depending upon his view – long position, if he
expects the market to move upwards and short position, if he expects the market
to go downward. If market moves in the expected direction, trader would end up
making profit. Here, it may be noted that if market does not move in the
expected direction, trader may also incur a loss. Because, a position is as exposed
to loss as profit, it is called the speculative position.
Naked position is long or short in any of the futures contracts but in case of a
spread, two opposite positions (one long and oneosrht) are taken either in two
contracts with same maturity on different products or in two contracts with
different maturities on the same product. Former is inter‐commodity or inter‐
product spread and latter is calendar spread/time spread or horizontal spread.
Exchanges need to provide the required inputs
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 inter‐commodity spread between specific commodities like Gold
and Silver; Soybean, Soybean meal and Soybean oil, etc.
Calendar spread position is always computed with respect to the near month series.
For instance, if Mr. A has say 3 contacts short in one month futures contract, 2
contracts long in two months futures contract and 3 contracts long in three
months futures contract, he would be said to have 2 calendar spreads between
first and second months 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 naked/open position, when the near
month contract expires or either of the legs of
spread is closed. As spread positionsdagreed he to a large extent because they are
combinations of two opposite positions, they are treated as conservatively
speculative positions.
Arbitrage opportunities in futures market
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 activity on one or several instruments/assets in one or different
markets, simultaneously. Important point to understand is that in an efficient
market, arbitrage opportunities may exist only for shorter period or none at all.
The moment an arbitrager spots an arbitrage opportunity, he would initiate the
arbitrage to eliminate the arbitrage opportunity.
Arbitrage occupies a prominent position in the futures world as a mechanism that
keeps the prices of futures contracts aligned properly with prices of the underlying
assets. The objective of arbitragers is to make profits without taking risk, but
the complexity of activity is such that it may result in losses as well. Well‐
informed and experienced professional traders, equipped with powerful
calculating and data processing tools, normally undertake arbitrage.
Arbitrage in the futures market can typically be of three types:
 Cash and carry arbitrage: Cash and carry arbitrage refers to a long position
in the cash or underlying market and a short position in futures market.
 Reverse cash and carry arbitrage: Reverse cash and carry arbitrage refers to
long position in futures market and short position in the underlying or cash
market.
 Inter‐Exchange arbitrage: This arbitrage entails two positions on the
same contract in two different markets/ exchanges.
These three positions are elaborated with the help of examples. To simplify the
calculations, it is assumed that there is no resistance like transaction costs, impact
cost, taxes etc., but in reality, arbitrage may not be as easy and costless as
presumed in these simplified examples. In a simplified world of the kind
described by our assumptions, actual futures prices are assumed to be exactly
equal to the fair price or theoretical price, which is spot price plus cost of
carry.
In the language of simple mathematics, Fair futures price F = S + C
where S stands for Spot price and C stands for Holding costs/carrying costs.
If cost of carry is defined in the percentage terms, we may redefine the
formula as: F = S(1+r)T
Where r is the carrying cost (in percentage) and T is the Time to expiration (in years).
If we use continuous compounding for computation of the cost, the same
formula reduces to:
F= SerT
If futures price is higher than fair/theoretical price, there would exist profitable,
risk‐ free, cash and carry arbitrage opportunity. Thus, unless there are
obstacles to such arbitrage the activities of the arbitrageurs would cause spot‐
futures price relationships to conform to that described by the cost of carry
formula. On rare occasions, however, 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, brokerage, margin deposits etc.
Illustrations:
Cash and carry arbitrage
The following data is available on stock A as on March 1,
2018. Cash market price Rs. 1500
June Futures Rs. 1520
Contract multiplier for stock 100 shares
Assume an implied cost of carry of 8% p.a. i.e. 0.75% per
month.
Theoretically/ fair price of June futures is 1504.69 (= 1500* e0.0075*5/12). Going by
the theoretical price, we may say that June futures on stock A are overvalued.
To take advantage of the mispricing, an arbitrageur may buy 100 shares of
stock A and sell 1 futures contract on that at given prices. This would result in the
arbitrage profit of Rs. 1531 (= 100 X 15.31), which is the difference between
actual and fair prices for 100 shares. Position of the arbitrager in various
scenarios of stock price would be as follows:
Case I: Stock rises to Rs. 1550 on expiry day
Profit on underlying = (1550 – 1500) x 100 = Rs. 5000
Loss on futures = (1550 ‐ 1520) x 100 = Rs.
3000 Gain on Arbitrage = Rs. 2,000
Cost of Arbitrage in terms of financing (Rs. 4.69 for 100 shares) =
Rs. 469 Net gain out of arbitrage = (2000 – 469)= Rs 1531
Case II: Stock falls to Rs.1480 on expiry day
Loss on underlying = (1500‐ 1480) x 100 = Rs.
2000 Profit on futures = (1520‐1480) x 100 =
Rs. 4000 Gain on Arbitrage = Rs. 2000
Cost of Arbitrage in terms of financing (Rs. 4.69 for 100 shares) =
Rs. 469 Net gain out of arbitrage = (2000 – 469) = Rs. 1531
Reverse cash and carry arbitrage
The reverse cash and carry arbitrage is done when the futures are trading at a
discount to the cash market price. Let us look at the following data on stock A
as on March 1, 2018.
Cash market price Rs. 100
March futures price Rs. 90
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 expected to reverse to positive at some point in time during contract’s life.
Otherwise, 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 the stock to sell in the cash market, which will be bought
back at the time of reversing
the position. If stock is not available,earrbitrag needs to borrow the stock to implement
the arbitrage. In that case, while analyzing the profitability from the transaction,
cost of borrowing of stock would also be taken into account.
Assuming the contract multiplier for futures contract on stock A is 200 shares. To
execute the reverse cost and bcaitrrrayg, earr would buy one March futures at Rs 90
and
sell 200 shares of stock A at Rs 100 in cash market. This would result in the
arbitrage 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 March before the
maturity date, spot price of stock A is Rs. 130 and March 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.
Inter‐market arbitrage
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 at NSE and Rs. 100 at BSE, the trader can buy a contract at
BSE and sell at NSE. The positions could be reversed over a period of time when
difference between futures prices squeeze. This would be profitable to an
arbitrageur.
It is important to note that the cost of transaction and other incidental costs
involved in the deal must be analyzed properly by the arbitragers before
entering into the transaction.
In the light of above, we may conclude that futures provide market participants
with a quick and less expensive mode to alter their portfolio composition to
arrive at the desired level of risk. As they could be used to either add risk to the
existing portfolios or reduce risk of the existing portfolios, they are essentially risk
management and portfolio restructuring tool.
Chapter 4: Introduction to Options
LEARNING OBJECTIVES:
After studying this chapter, you should know about:
 Concept of Options
 Payoffs in case of option contracts
 Fundamentals relating to option pricing
 Option Greeks
 Uses of Options

4.1 Basics of options

As seen in earlier section, forward/futures contract is a commitment to buy/sell
the underlying and has a linear pay off, which indicates unlimited losses and
profits. Some market participants desired to ride upside and restrict the losses.
Accordingly, options emerged as a financial instrument, which restricted the
losses with a provision of unlimited profits on buy or sell of underlying asset.
An Option is a contract that gives the right, but not an obligation, to buy or sell
the underlying asset on or before a stated date/day, at a stated price, for a price.
The party taking a long position i.e. buying the option is called buyer/ holder of the
option and the party taking a short position i.e. selling the option is called the
seller/ writer of the option.
The option buyer has the right but no obligation with regards to buying or
selling the underlying asset, while the option writer has the obligation in the
contract. Therefore, 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 the contract.
Options may be categorized into two main types:‐
 Call Options
 Put Options
Option, which gives buyer a right to buy the underlying asset, is called Call
option and the option which gives buyer a right to sell the underlying asset, is
called Put option.
Option terminology
There are several terms used in the options market. Let us comprehend on each of
them with the help of the following price:
Quote for Nifty Call option as on March 7, 2018
1. Instrument type : Option Index
2. Underlying asset : Nifty 50
3. Expiry date : March 28, 2018
4. Option type : Call European
5. Strike Price : 10000
6. Open price : 271.95
7. High price : 310.00
8. Low price : 233.25
9. Close price : 245.05
10. Traded Volume : 14,941
contracts
11. Open Interest : 9,83,775
12. Underlying value : 10154.20
Quote for Nifty Put option as on March 7, 2018
1. Instrument type : Option Index
2. Underlying asset : Nifty 50
3. Expiry date : March 28, 2018
4. Option type : Put European
5. Strike Price : 10000
6. Open price : 74.50
7. High price : 86.70
8. Low price : 66.55
9. Close price : 80.40
10.Traded Volume : 2,00,111 contracts
11.Open Interest : 40,83,000
12.Underlying value : 10154.20
Index option: These options have index as the underlying asset. For example
options on Nifty, Sensex, etc.
Stock option: These options have individual stocks as the underlying asset. For
example, option on ONGC, NTPC etc.
Buyer of an option: The buyer of an option is one who has a right but not the
obligation in the contract. For owning this right, he pays a price to the seller of
this right called ‘option premium’ to the option seller.
Writer of an option: The writer of an option is one who receives the option
premium and is thereby obliged to sell/buy the asset if the buyer of option
exercises his right.
American option: The owner of such option can exercise his right at any time
on or before the expiry date/day of the contract.
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.
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. Premium traded is for single unit of nifty and to arrive at the total
premium in a contract, we need to multiply this premium with the lot size.
Lot size: Lot size is the number of units of underlying asset in a contract. Lot size
of Nifty option contracts is 75. Accordingly, in our examples, total premium for
call option
contract would be Rs 245.05 x 75= Rs 18378.75 and total premium for put
option contract would be Rs 80.40 x 75 = Rs 6030.
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 the last Thursday of the expiry month (or, on the previous trading
day, if the last Thursday is a trading holiday). In our example, since the last
Thursday (i.e., March 29, 2018) is a trading holiday, both the call and put options
expire one day before that i.e. on 28 March, 2018. (Please note that Weekly
Options expire on Thursday of each week. 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 trading Holiday,
then the expiry will be on the previous trading day.)
Spot price (S): It is the price at which the underlying asset trades in the spot
market. In our examples, it is the value of underlying viz. 10154.20.
Strike price or Exercise price (X): Strike price is the price per share for which
the underlying security may be purchased or sold by the option holder. In our
examples, strike price for both call and put options is 10000.
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 strike price. And, a put option is said to be ITM when spot price is
lower than strike price. In our examples, call option is in the money.
At the money (ATM) option: At the money option would lead to zero cash flow
if it were exercised immediately. Therefore, for both call and put ATM options,
strike price is equal to spot price.
Out of the money (OTM) option: Out of the money option is one with strike price worse
than the spot price for the holder of.option In other words, this option would give the
holder a negative cash flow if it were exercised immediately. A call option is said
to be OTM, when spot price is lower than strike price. And a put option is said
to be OTM when spot price is higher than strike price. In our examples, put
option is out of the money.
Intrinsic value: Option premium, defined above, consists of two components ‐
intrinsic value and time value.
For an option, intrinsic value refers to the amount by which option is in the money i.e.
the amount an option buyer will realize,rebefo adjusting for premium paid, if he
exercises the option instantly. Therefore, only in‐the‐money options have intrinsic
value whereas at‐the‐money and out‐of‐the‐money options have zero intrinsic
value. The intrinsic value of an option can never be negative.
Thus, for call option which is in‐the‐money, intrinsic value is the excess of spot
price (S) over the exercise price (X). Thus, intrinsic value of call option can be
calculated as S‐X, with minimum value possible as zero because no one would
like to exercise his right under no advantage condition.
Similarly, for put option which is in‐the‐money, intrinsic value is the excess of
exercise 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.
Time value: It is the difference between premium and intrinsic value, if any,
of an option. ATM and OTM options will have only time value because the
intrinsic value of such options is zero.
Open Interest: As discussed in futures section, open interest is the total
number of option contracts outstanding for an underlying asset.
Exercise of Options
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 value/ closing price of the stock on the day of exercise of option.
Assignment of Options
Assignment of options means the allocation of exercised optionseto on or more option
sellers. The issue of assignment of options arises only in case of American
options because a buyer can exercise his options at any point of time.

4.2 Pay off Charts for Options

Having gone through the basic terminology used in the options market, let us get to
the pay off profile of various option positions.
Long on option
Buyer of an option is said to be “long on option”. As described above, he/she
would have a right and no obligation with regard to buying/ selling the underlying
asset in the contract. When you are long on equity option contract:
 You have the right to exercise that option.
 Your potential loss is limited to the premium amount you paid for buying
the option.
 Profit would depend on the level of underlying asset price at the time of
exercise/expiry of the contract.
Short on option
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 contract. When you are short (i.e., the writer of) an equity option
contract:
 Your maximum profit is the premium received.
 You can be assigned an exercised option any time during the life of
option contract (for American Options only). All option writers should be
aware that assignment is a distinct possibility.
 Your potential loss is theoretically unlimited as defined
below. Now, let us understand each of these positions in
detail:
Long Call
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 conditions
ufenrdeenrt dif 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
sell it ien th market at 11000, thereby making a profit of Rs. 500. But since you have
already paid Rs. 115 as option premium, your actual profit would be 500 – 115 = 385.
For profits/losses for other values, a table is given below. This table is used to draw
the pay off chart given in the next page.
Strike Price (X) 10500
Premium 115
Pay off for Long
Nifty at Premium Paid Buy Nifty at Sell Nifty at Call Position
Expiry
A B C D=A+B+C
10200 ‐115 ‐10200 10200 ‐115
10300 ‐115 ‐10300 10300 ‐115
10400 ‐115 ‐10400 10400 ‐115
10500 ‐115 ‐10500 10500 ‐115
10600 ‐115 ‐10500 10600 ‐15
10700 ‐115 ‐10500 10700 85
10800 ‐115 ‐10500 10800 185
10900 ‐115 ‐10500 10900 285
11000 ‐115 ‐10500 11000 385
11100 ‐115 ‐10500 11100 485
11200 ‐115 ‐10500 11200 585
11300 ‐115 ‐10500 11300 685
11400 ‐115 ‐10500 11400 785
The contract value for a Nifty option with lot size of 75 and strike price of
10500 is 75 * 10500 = 787500.
The maximum loss for such an option buyer would be equal to 115 * 75 = 8625
As Nifty goes above 10615, you start making profitcoisninegxer the option and if it
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 10500. Long call position helps you to protect your loss to a
maximum of Rs. 8625 with unlimited profit.
Short Call
Whenever someone buys a call option, there has to be a counterparty, who has
sold that call option. If the maximum loss for a long call position is equal to the
premium
paid, it automatically means that the maximumegain for th short call position will be
equal to the premium received. Similarly, if maximum gain for long call
position is unlimited, then even maximum loss for the short call position has to
be unlimited. Lastly, whenever, the long call position is making losses, the short
call position will make profits and vice versa. Hence, if we have understood long
call pay off, short call pay off chart will be just the water image of the long call
pay off. Thus at 10200 Nifty, When long call position makes a loss of Rs. 115,
short call position will make a profit of Rs. 115. Similarly for 11000, when long
call makes a profit of 385, short call position will lose 385.As Nifty starts rising,
short call position will go deeper into losses.

Strike Price (X) 10500

Premium 115
 Pay off for Pay off for
Premium Buy Nifty Sell Nifty Long Call Short Call
Nifty at Paid at at Position Position
Expiry
A B C D= ‐D
A+B+C
10200 ‐115 ‐10200 10200 ‐115 115
10300 ‐115 ‐10300 10300 ‐115 115
10400 ‐115 ‐10400 10400 ‐115 115
10500 ‐115 ‐10500 10500 ‐115 115
10600 ‐115 ‐10500 10600 ‐15 15
10700 ‐115 ‐10500 10700 85 ‐85
10800 ‐115 ‐10500 10800 185 ‐185
10900 ‐115 ‐10500 10900 285 ‐285
11000 ‐115 ‐10500 11000 385 ‐385
11100 ‐115 ‐10500 11100 485 ‐485
11200 ‐115 ‐10500 11200 585 ‐585
11300 ‐115 ‐10500 11300 685 ‐685
11400 ‐115 ‐10500 11400 785 ‐785
The pay off chart for a short call position is shown below. Maximum gain for an
option seller, as explained earlier, will be equal to the premium received (as long
as Nifty stays below strike price) whereas maximum loss can be unlimited (when
Nifty starts moving above BEP). BEP for aosrht call position will also be equal to X
+ P. BEP is independent of position (long or short), it is instrument specific (call

option).
For a lot size of 75, the contract value is 75 * 10500 = 787500.
Premium is received by the seller of the option. However he has to pay the margin.
This is because the option seller has an obligation and since his losses can be
unlimited, he can be a potential risk for the stability of the system.
Long Put
On March 1, 2018, Nifty is at 10460. You buy a put option with strike price of
10500 at a premium of Rs 160 with expiry date March 28, 2018. A put option
gives the buyer of the option the right, but not the obligation, to sell the
underlying at the strike price. In this example, you can sell Nifty at 10500. When
will you do so? You will do so only when Nifty is at a level lower than the strike
price. So if Nifty goes below 10500 at expiry, you will buy Nifty from market at
lower price and sell at strike price. If Nifty stays above 10500, you will let the
option expire. The maximum loss in this case as well (like in long call position) will
be equal to the premium paid; i.e. Rs. 160.
What can be the maximum profit? Theoretically, Nifty can fall only till zero. So
maximum profit will be when you buy Nifty at zero and sell it at strike price of
10500. The profit in this case will be Rs. 10500, but since you have already paid
Rs. 160 as premium, your profit will reduce by that much to 10500 – 160 =
10340.
Breakeven point insthi case will be equal to strike price – premium (X – P). In our
example breakeven point will be equal to 10500 – 160 = 10340. Thus when Nifty
starts moving below 10340, will you start making profits.
The pay off chart for long put position is drawn using the below table.
Strike Price (X) 10500
Premium 160

Pay off for

Long Put
Nifty at Premium Paid Buy Nifty at Sell Nifty at Position
Expiry
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
10900 ‐160 ‐10900 10900 ‐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.
The table below shows the profit/ loss for short put position. An extra column is
added to the above table to show positions for short put. The pay off chart is
drawn using this table.
Strike Price (X) 10500
Premium 160

Pay off Pay off for

Premium for Long Short Put
Nifty at Expiry Paid Buy Nifty at Sell Nifty at Put Position
Position
A B C D = A+B+C ‐D
 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

Contract value in this case will be equal to 10500 * 75 = 787500 and premium
received will be equal to 160 * 75 = 12000.
Seller of the put option receives the premium but he has to pay the margin on
his position as he has an obligation and his losses can be huge.
As can be seen above, options are products with asymmetric risk exposure i.e., the
gains 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 call option, when a stock price goes down, the loss incurred
by the buyer of this option is limited to the purchase price of the option. But if
the stock price goes up, the buyer of the call gains in proportion to the rise in the
stock’s value, thereby giving asymmetric pay off. In contrast to this, futures have
symmetric risk exposures (symmetric pay off).
Opening a Position
An opening transaction is one that adds to, or creates a new trading position. It
can be either a purchase or a sale. With respect to an option transaction, we will
consider both:
 Opening purchase (Long on option) – A transaction in which the
purchaser’s intention is to create or increase a long position in a given
series of options.
 Opening sale (Short on option) – A transaction in which the seller’s intention
is to create or increase a short position in a given series of options.
Closing a position
A closing transaction is one that reduces or eliminates an existing position by
an appropriate offsetting purchase or sale. This is also known as “squaring off”
your position. With respect to an option transaction:
 Closing purchase – A transaction in which the purchaser’s intention is to
reduce or eliminate a short position in a given series of options. This
transaction is frequently referred to as “covering” a short position.
 Closing sale – A transaction in which the seller’s intention is to reduce or
eliminate a long position in a given series of options.
Note: A trader does not close out a long call position by purchasing a put (or
any other similar transaction). A closing transaction for an option involves the
purchase or sale of an option contract with the same terms.
Leverage
An option buyer pays a relatively small premium for market exposure in relation to
the contract value. This is known as leverage. In our examples above (long call and
long put), we have seen that the premium paid (Rs 8,625 for long call and Rs
12000 for long put) was only a small percentage of the contract value (Rs 7,87,500
in both cases). A trader can see large percentage gains from comparatively small,
favourable percentage moves in the underlying equity.
Leverage also has downside implications. If the underlying price does not rise/fall
as anticipated during the lifetime of the option, leverage can magnify the
trader’s percentage loss. Options offer their owners a predetermined, set risk.
However, if the owner’s options expire with no value, this loss can be the entire
amount of the premium paid for the option.
Risk and return profile of option contracts
Risk Return
Long Premium paid Unlimited
Short Unlimited Premium received
A long option position has limited risk (premium paid) and unlimited profit
potential. A short option position has unlimited downside risk, but limited upside
potential (to the extent of premium received)
4.3 Basics of Option Pricing and Option Greeks
Option pricing fundamentals
In our above examples, we have seen that call option premium is Rs. 115 and put
option premium is Rs. 160. The question is from where did we get these values?
On what basis did market participants come to these values of the premiums?
What are the parameters that affect these values? Are these fixed by the stock
exchanges or by SEBI?
The answer lies in understanding what affects options? Prices are never fixed by
stock exchanges or SEBI or anybody for that matter. In fact price discovery is a
very critical and basic component of markets. Stock exchanges only provide a
platform where buyers and sellers meet, and SEBI’s role is to ensure smooth
functioning of our markets.
Any option’s value increases or decreases depending upon different variables.
Each variable has its impact on an option. The impact can be same or different
for a call and put.option
As explained in the earlier section, option premium is the sum of intrinsic value and
time 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, ATM or OTM.
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.
Thus there are five fundamental parameters on which the option price depends:
1) Spot price of the underlying asset
2) Strike price of the option
3) Volatility of the underlying asset’s price
4) Time to expiration
5) Interest rates
These factors affect the premium/ price of options (both American &
European) in several ways.
Spot price of the underlying asset
The option premium is affected by the price movements in the underlying
instrument. If price of the underlying asset goes up the value of the call option
increases while the value of the put option decreases. Similarly if the price of the
underlying asset falls, the value of the call option decreases while the value of
the put option increases.
Strike Price
If all the other factors remain constant but the strike price of option increases,
intrinsic value of the call option will decrease and hence its value will also
decrease. On the other hand, with all the other factors remaining constant,
increase in strike price of option 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
stock, higher the premium because there is a greater possibility that the option
will move in‐the‐money during the life of the contract.
Higher volatility = Higher premium, Lower volatility = Lower premium (for both call
and put options).
Time to expiration
The effect of time to expiration on both call and put options is similar to that of
volatility on option premiums. Generally, longer the maturity of the option
greater is the uncertainty and hence the higher premiums. If all other factors
affecting an option’s price remain same, the time value portion of an option’s
premium will decrease with the passage of time. This is also known as time
decay. Options are known as ‘wasting assets’, due to this property where the
time value gradually falls to zero.
It is also interesting to note that of the two component of option pricing (time
value and intrinsic value), one component is inherently biased towards reducing in
value; i.e. time value. So if all things remain constant throughout the contract
period, the option price will always fall in price by expiry. Thus option sellers are
at a fundamental advantage as compared to option buyers as there is an inherent
tendency in the price to go down.
Interest Rates
Interest rates are slightly complicated because they affect different options,
differently. For example, interest rates have a greater impact on options with
individual stocks and indices compared to options on futures. To put it in simpler
way high interest rates will
result in in the value of a call option and a decrease in the value of a put
aneincreas option.
Options Pricing Models
There are various option pricing models which traders use to arrive at the right
value of the option. Some of the most popular models are briefly discussed
below:
The Binomial Pricing Model
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 pricing.
The binomial model represents the price evolution of the option’s underlying asset
as the binomial tree of all possible prices at equally‐spaced time steps from today
under the assumption that at each step, the price can only move up and down
at fixed rates and with respective simulated probabilities.
This is a very accurate model as it is iterative, but also very lengthy and time
consuming.
The Black & Scholes Model
The Black & Scholes model was published in 1973 by Fisher Black and Myron
Scholes. It 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.
This model is used to calculate a theoretical call price (ignoring the dividends paid
during the life of the option) using the five key determinants of an option’s price:
stock price, strike price, volatility, time to expiration, and short‐term (risk
free) interest rate.
The original formula for calculating the theoretical Option Price
(OP) is: OP = SN(d1)‐XertN(d2)
Where,
D1=[In(s/n)+(r+(v2/2)t]/ vt
D2 = d1‐vt
And the variables are
 S = stock price
 X = strike price
 t = time remaining until expiration, expressed in years
 r = current continuously compounded risk‐free interest
rate othret ‐term
 v = annual volatility of stock price (the standard deviation sh
of returns over one year)
 In = natural logarithm
 N(x) = standard normal cumulative distribution function
 e = the exponential function

Option Greeks
Option premiums change with changes in the factors that determine option pricing
i.e. factors such as strike price, volatility, term to maturity etc. The
sensitivities most commonly tracked in the market are known collectively as
“Greeks” represented by Delta, Gamma, Theta, Vega and Rho.
Delta (δ or ∆)
The most important of the ‘Greeks’ is the option’s “Delta”. This measures the
sensitivity 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 underlying asset.
Delta = Change in option premium/ Unit change in price of the underlying asset.
Delta for call option buyer is positive. This means that the value of the
contract increases as the share price rises. To that extent it is rather like a long or
‘bull’ position in the underlying asset. Delta for call option seller will be same in
magnitude but with the opposite sign (negative).
Delta for put option buyer is negative. The value of the contract increases as the
share 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).
Therefore, delta is the degree to which an option price will move given a change in
the underlying stock or index price, all else being equal.
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 the hedge ratio, e.g. if you have a portfolio of ‘n’ shares of a stock
then ‘n’ divided by the delta gives you the number of calls you would need to be
short (i.e. need to write) to create a hedge. In such a “delta neutral” portfolio,
any gain in the value of the shares
held due to a rise in the share price would be exactly offset by a loss on the
value of the calls written, and vice versa.
Gamma (γ)
It measures change in delta with respect to change in price of the underlying asset.
This is called a second derivative option with regard to price of the underlying
asset. It is calculated as the ratio of change in delta for a unit change in
market price of the underlying asset.
Gamma = Change in an option delta / Unit change in price of underlying asset
Gamma works as an acceleration lotfa,the dei.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 underlying asset.
Theta (θ)
It is a measure of an option’s sensitivity to time decay. Theta is the change in
option price given a one‐day decrease in time to expiration. It is a measure of
time decay. Theta is generally used to gain an idea of how time decay is
affecting your option positions.
Theta = Change in an option premium / Change in time to expiry
Usually theta is negative for a long option, whether it is a call or a put. Other
things being equal, options tend to lose time value each day throughout their life.
This is due to the fact that the uncertainty element in the price decreases.
Vega (ν)
This is a measure of the sensitivity of an option price to changes in market
volatility. It is the change of an option premium for a given change (typically
1%) in the underlying volatility.
Vega = Change in an option premium / Change in volatility
Vega is positive for a long call and a long put. An increase in the assumed volatility
of the underlying increases the expected payout from a buy option, whether it
is a call or a put.
Rho (ρ)
Rho is the change in option price given a one percentage point change in the risk‐free
interest rate. Rho in an option’s price per unit increase in the cost
measuresatnhgeech of funding
the underlying.
Rho = Change in an option premium / Change in cost of funding the underlying
4.4 Uses of Options
Perspectives of Option Traders
An important decision that a trader needs to make is which option he should
trade: in‐ the‐money, at‐the‐money or out‐of‐the‐money. Among other things, a
trader must also consider the premium of these three options in order to make an
educated decision. As discussed earlier there are two components in the option
premium – intrinsic value and time value. If the option is deeply in‐the‐money, the
intrinsic value will be higher and so
is the option value/premium. In case of at‐the‐money or out‐of‐the‐money
options 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 in‐the‐money option compared to at‐the‐money or out‐of‐the‐
money options and thus, the cost factor largely influences the decision of an
option buyer.
For ATM options, the uncertainty is highest as compared to ITM or OTM options.
This is because we know that when an option is ITM or OTM, even if the price
moves somewhat, in any direction, still the option will largely remain ITM or
OTM as the case may be.
But in case of ATM options, even a small price movement in either direction can tip the
option from ATM to ITM or OTM. There is a huge uncertainty heredan this uncertainty
is a function of time to expiry and volatility of the underlying, both of which
are captured in the time value
Analysis of Call Option Trading from Buyer’s Perspective
The spot price of Nifty on March 1, 2018, was 10460. Let us consider call
options with strike prices of 10300, 10400, 10500 and 10600. A call option
buyer will buy the option and pay the premium upfront. The premiums for
various strike prices are as follows:
Strike Price Premium
10300 170
10400 115
10500 72
10600 34
The 10300 strike call option is deep in the money and has an intrinsic value of
10460 – 10300 = 160. Hence the option premium will be at least equal to this
value. The remaining portion of the premium is the time value (170 – 160 = 10)
The 10600 strikellca option is out of the money option. There is no intrinsic value here.
The entire option premium is attributed to risk associated with time, i.e. time value.
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%
Profit on strike price 10600 option = 10700 – 10600 – 34 = 66
Return on investment = 66 / 34 = 194%

Seller of call option

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
 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 if OTM.
In case of the 10600 strike option, the intrinsic value is 10600 – 10460 = 140 and
270 – 140 = 130 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

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

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 / 141.5 = 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
 9500 ‐675 ‐727 ‐779 ‐810
9600 ‐575 ‐627 ‐679 ‐710
9700 ‐475 ‐527 ‐579 ‐610
9800 ‐375 ‐427 ‐479 ‐510
9900 ‐275 ‐327 ‐379 ‐410
10000 ‐175 ‐227 ‐279 ‐310
10100 ‐75 ‐127 ‐179 ‐210
10200 25 ‐27 ‐79 ‐110
10300 125 73 21 ‐10
10400 125 173 121 90
10500 125 173 221 190
10600 125 173 221 290
10700 125 173 221 290
10800 125 173 221 290

As per the table and charts, the seller of put option has more risk to sell deep
in the money put options even though they fetch higher returns in terms of option
premiums. On the other hand, selling deep out of the money put options is less
risky but they come with low premium.
Summary
From a trader’s perspective, we may say that he has the choice of futures of
various expiries and also options of various expiries and various strikes.
Depending upon his analysis of the then existing market conditions and his risk
appetite, he can devise various strategies, which we will see in the next
chapter.
This page has been
intentionally kept
blank
Chapter 5: Option Trading Strategies
LEARNING OBJECTIVES:
After studying this chapter, you should know about the following option trading
strategies:
 Option spreads
 Straddle
 Strangle
 Covered call
 Protective Put
 Collar
 Butterfly Spread
Having understood the risk/ return profiles for vanilla call/ put options, now we
turn to 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 createdinbgy us 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
o Using Calls
o Using Puts
 Bearish Vertical Spread
o Using Calls
o Using Puts
Bullish Vertical Spread using Calls
A bull spread is created when the underlying view on the market is positive but
the trader would also like to reduce his cost on position. So he takes one long
call position 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 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 getengated 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
10000 ‐350 140 ‐210
10100 ‐350 140 ‐210
10200 ‐350 140 ‐210
10300 ‐250 140 ‐110
10400 ‐150 140 ‐10
10500 ‐50 140 90
10600 50 140 190
10700 150 140 290
10800 250 140 390
10900 350 40 390
11000 450 ‐60 390
11100 550 ‐160 390
11200 650 ‐260 390
11300 750 ‐360 390
11400 850 ‐460 390
11500 950 ‐560 390
As can be seen from the above pay off chart, it is a limited profit and limited
loss position. Maximum profit in this position is 390 and maximum loss is 210.
BEP for this spread is 10410.
Bullish Vertical Spread using Puts
Here again, the call on the market is bullish, hence, the trader would like to short
a put option. If prices go up, trader would end up with the premium on sold puts.
However, in case prices go down, the trader would be facing risk of unlimited
losses. In order to put a floor to his downside, he may buy a put option with a
lower strike. While this would reduce his overall upfront premium, benefit would
be the embedded insurance against unlimited potential loss on short put. This is
a net premium receipt strategy.
Let us see this with the help of an example, where the trader goes short in a
put option of strike 10800 and receives a premium of 300 and goes long in a put
option of strike 10500 and pays a premium of 130:

Option Put Put

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

CMP Long Call Short Call Net Flow

9500 ‐140 350 210
9600 ‐140 350 210
9700 ‐140 350 210
9800 ‐140 350 210
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
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
9700 ‐670 800 130
 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 130 and maximum loss is 170. BEP
for this position is 10630.
Horizontal Spread
Horizontal spread involves same strike, same type but different expiry options. This
is also known as time spread or calendar spread. Here, it is not possible to draw
the pay off chart as the expiries underlying the spread are different.
Underlying reasoning behind horizontal spreads is that these two options would
have different time values and the trader believes that difference between the
time values of these two options would shrink or widen. This is essentially a play
on premium difference between two options prices squeezing or widening.
Diagonal spread
Diagonal spread involves combination of options having same underlying but
different expiries as well as different strikes. Again, as the two legs in a spread
are in different 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.

5.2 Straddle
This strategy involves two options of same strike prices and same maturity. A
long straddle position is created by buying a call and a put option of same
strike and same expiry whereas a short straddle is created by shorting a call
and a put option of same strike and samereyx. pi
Let us say a stock is trading at Rs 6,000 and premiums for ATM call and put
options are 257 and 136 respectively.
Long Straddle
If a person buys both a call and a put at these prices, then his maximum loss
will be equal to the sum of these two premiums paid, which is equal to 393.
And, price movement from here in either direction would first result in that person
recovering his premium and then making profit. This position is undertaken
when trader’s view on price of the underlying is uncertain but he thinks that in
whatever direction the market moves, it would move significantly in that
direction.
Now, let us analyze his position on various market moves. Let us say the stock price
falls to 5300 at expiry. Then, his pay offs from position would be:
Long Call: ‐ 257 (market price is below strike price, so option expires
worthless) Long Put: ‐ 136 ‐ 5300 + 6000 = 564
Net Flow: 564 – 257 = 307
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
Net Flow: 443 – 136 = 307
As the stock price keeps moving up, loss on long put position is limited to premium
paid, whereas profit on long call position keeps increasing.
Thus, it can be seen that for huge swings in either direction the strategy yields
profits. However, there would be a band within which the position would result into
losses. This position would have two Break even points (BEPs) and they would
lie at “Strike – Total Premium” and “Strike + Total Premium”. Combined pay‐off
may be shown as follows:
Option Call Put
Long/Short Long Long
Strike 6000 6000
Premium 257 136
Spot 6000

CMP Long Call Long Put Net Flow

5000 ‐257 864 607
5100 ‐257 764 507
5200 ‐257 664 407
5300 ‐257 564 307
5400 ‐257 464 207
5500 ‐257 364 107
5600 ‐257 264 7
5700 ‐257 164 ‐93
5800 ‐257 64 ‐193
5900 ‐257 ‐36 ‐293
6000 ‐257 ‐136 ‐393
6100 ‐157 ‐136 ‐293
6200 ‐57 ‐136 ‐193
6300 43 ‐136 ‐93
6400 143 ‐136 7
6500 243 ‐136 107
6600 343 ‐136 207
6700 443 ‐136 307
6800 543 ‐136 407
6900 643 ‐136 507
7000 743 ‐136 607
 1000
Straddle Payoff

800

600

400
P/ L (Rs.)

200

0
5000 5100 5200 5300 5400 5500 5600 5700 5800 5900 6000 6100 6200 6300 6400 6500 6600 6700 6800 6900 7000

-200

-400

Long CallLong PutNet Flow

CMP (Rs.)
-600

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 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 total premium of Rs. 393 in either direction and
that is the reason there are two breakeven points in this strategy.
Short Straddle
This would be the exact opposite of long straddle. Here, trader’s view is that the
price of underlying would not move much or remain stable. So, he sells a call
and a put so that 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 would become profit for short straddle. Position
may be shown as follows:
Option Call Put
Long/Short Short Short
Strike 6000 6000
Premium 257 136
Spot 6000

CMP Short Call Short Put Net Flow

5000 257 ‐864 ‐607
5100 257 ‐764 ‐507
5200 257 ‐664 ‐407
 5300 257 ‐564 ‐307
5400 257 ‐464 ‐207
5500 257 ‐364 ‐107
5600 257 ‐264 ‐7
5700 257 ‐164 93
5800 257 ‐64 193
5900 257 36 293
6000 257 136 393
6100 157 136 293
6200 57 136 193
6300 ‐43 136 93
6400 ‐143 136 ‐7
6500 ‐243 136 ‐107
6600 ‐343 136 ‐207
6700 ‐443 136 ‐307
6800 ‐543 136 ‐407
6900 ‐643 136 ‐507
7000 ‐743 136 ‐607

600
Short Straddle Payoff

400

200

0
5000 5100 5200 5300 5400 5500 5600 5700 5800 5900 6000 6100 6200 6300 6400 6500 6600 6700 6800 6900 7000
P/ L (Rs.)

-200

-400

-600

-800

Short CallShort PutNet Flow

CMP (Rs.)
-1000

It should be clear that this strategy is limited profit and unlimited loss strategy
and should be undertaken with significant care. Further, it would incur the loss for
trader if market moves significantly in either direction – up or down.
5.3 Strangle
This strategy is similar to straddle in outlook but different in implementation,
aggression and cost.
Long Strangle
As in case of straddle, the outlook here (for the long strangle position) is that the
market will move substantially in either direction, but while in straddle, both
options have same strike price, in case of a strangle, the strikes are different. Also,
both the options (call and put) in this case are out‐of‐the‐money and hence the
premium paid is low.
Let us say the cash market price of a stock is 6100. 6200 strike call is available at
145 and 6000 put is trading at a premium of 140. Both these options are out‐of‐
the‐money.
If a trader goes long on both these options, then his maximum cost would be
equal to the sum of the premiums of both these options. This would also be his
maximum loss in worst case situation. However, if market starts moving in either
direction, his loss would remain same for some time and then reduce. And,
beyond a point (BEP) in either direction, he would make money. Let us see this
with various price points.
If spot price falls to 5700 on maturity, his long put would make profits while his
long call option would expire worthless.
Long Call: ‐ 145
Long Put: ‐140 – 5700 + 6000 = 160
Net Position: 160 – 145 = 15
As price continues to go south, long put position will become more and more
profitable
and long call’suloldss wo be maximum limited to the premium paid.
In case stock price goes to 6800 at expiry, long call would become profitable
and long put would expire worthless.
Long Call: ‐145 – 6200 + 6800 = 455
Long Put: ‐140
Net Position: 455 – 140 = 315
The pay off chart for long strangle is shown below:
Option Call Put
Long/Short Long Long
Strike 6200 6000
Premium 145 140
Spot 6100

CMP Long Call Long Put Net Flow

5100 ‐145 760 615
5200 ‐145 660 515
5300 ‐145 560 415
5400 ‐145 460 315
 5500 ‐145 360 215
5600 ‐145 260 115
5700 ‐145 160 15
5800 ‐145 60 ‐85
5900 ‐145 ‐40 ‐185
6000 ‐145 ‐140 ‐285
6100 ‐145 ‐140 ‐285
6200 ‐145 ‐140 ‐285
6300 ‐45 ‐140 ‐185
6400 55 ‐140 ‐85
6500 155 ‐140 15
6600 255 ‐140 115
6700 355 ‐140 215
6800 455 ‐140 315
6900 555 ‐140 415
7000 655 ‐140 515
7100 755 ‐140 615

1000
Long Strangle Payoff

800

600

400
P/ L (Rs.)

200

0
5100 5200 5300 5400 5500 5600 5700 5800 5900 6000 6100 6200 6300 6400 6500 6600 6700 6800 6900 7000 7100

-200

Long CallLong PutNet Flow

CMP (Rs.)
-400

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 underlying expires at any price between 6000 and 6200. Position would have two
BEPs at 5715 and 6485. Until underlying crosses either of these prices, trader would
always incur loss.
Short Strangle
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 of options. Pay offs for this position will be exactly opposite to that
of a longnsgtlrea position. As always, the short position will make money, when the
long position is in loss and vice versa.
Option Call Put
Long/Short Short Short
Strike 6200 6000
Premium 145 140
Spot 6100

CMP Short Call Short Put Net Flow

5100 145 ‐760 ‐615
5200 145 ‐660 ‐515
5300 145 ‐560 ‐415
5400 145 ‐460 ‐315
5500 145 ‐360 ‐215
5600 145 ‐260 ‐115
5700 145 ‐160 ‐15
5800 145 ‐60 85
5900 145 40 185
6000 145 140 285
6100 145 140 285
6200 145 140 285
6300 45 140 185
6400 ‐55 140 85
6500 ‐155 140 ‐15
6600 ‐255 140 ‐115
6700 ‐355 140 ‐215
6800 ‐455 140 ‐315
6900 ‐555 140 ‐415
7000 ‐655 140 ‐515
7100 ‐755 140 ‐615
 400
Short Strangle Payoff

200

0
5100 5200 5300 5400 5500 5600 5700 5800 5900 6000 6100 6200 6300 6400 6500 6600 6700 6800 6900 7000 7100

-200
P/ L (Rs.)

-400

-600

-800

Short CallShort PutNet Flow

CMP (Rs.)
-1000

In this position, maximum loss for the trader would be unlimited in both the
directions – up or down and maximum profit would be limited to Rs. 285, which
would occur if underlying expires at any price between 6000 and 6200. Position
would have two BEPs at 5715 and 6485. Until underlying crosses either of these
prices, trader would always make profit.

5.4 Covered Call

This strategy is used to generate extra income from existing holdings in the cash
market. If an investor has bought shares and intends to hold them for some
time, then he would like to earn some income on that asset, without selling it,
thereby reducing his cost of acquisition. So how does an investor continue to hold
on to the stock, earn income and reduce acquisition cost? Lets us see:
Suppose an investor buys a stock in the cash market at Rs. 1590 and also sells a
call 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,
Long Cash: 1520 – 1590 = ‐70
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)
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:
Long Stock 1590
Strike Price 1600
Premium 10

CMP Stock Call Net

1490 ‐100 10 ‐90
1500 ‐90 10 ‐80
1510 ‐80 10 ‐70
1520 ‐70 10 ‐60
1530 ‐60 10 ‐50
1540 ‐50 10 ‐40
1550 ‐40 10 ‐30
1560 ‐30 10 ‐20
1570 ‐20 10 ‐10
1580 ‐10 10 0
1590 0 10 10
1600 10 10 20
1610 20 0 20
1620 30 ‐10 20
1630 40 ‐20 20
1640 50 ‐30 20
1650 60 ‐40 20
1660 70 ‐50 20
1670 80 ‐60 20
1680 90 ‐70 20
1690 100 ‐80 20
 150
Covered Call Payoff

100

50
P/ L (Rs.)

0
1490 1500 1510 1520 1530 1540 1550 1560 1570 1580 1590 1600 1610 1620 1630 1640 1650 1660 1670 1680 1690

-50

-100

NetStockCall
CMP (Rs.)
-150

From the table and the pay off chart we can see that the net position of a
covered call strategy looks like ‘short put’ with a strike of 1600. This is called
synthetic short put position.
If at that point of time, a 1600 strike put is available at iacney pr other than Rs.20
(let us
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 put for Rs.17, thereby making a risk free profit of Rs.3. Indeed,
one needs to also provide for frictions in the market like brokerage, taxes,
administrative costs, funding costs etc.
The most important factor in this strategy is the strike of the sold call option. If
strike is close to the prevailing price of underlying stock, it would fetch higher
premium upfront but would lock the potential gain from the stock early. And, if
strike is too far from the 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 thekstoc 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.
5.5 Protective Put
Any investor, long in the cash market, always runs the risk of a fall in prices and
thereby reduction of portfolio value and MTM losses. A mutual fund manager,
who is anticipating a fall, can either sell his entire portfolio or short futures to
hedge his portfolio. In both cases, he is out of the market, as far as profits
from upside are concerned. What can be done to remain in the market, reduce
losses but gain from the upside? Buy insurance!
By buying put options, the fund manager is effectively taking a bearish view on the
market and if his vrniesw tu right, he will make profits on long put, which will be useful
to negate the MTM losses in the cash market portfolio.
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.
Now, if prices fall to 1530 from here:
Long Cash: Loss of 1600 – 1530 = ‐ 70
Long Put: Profit of – 20 – 1530 + 1600
= 50 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 strikes are different, losses will be different from premium
paid)
In case prices rise to 1660
Long Cash: Profit of 1660 – 1600
= 60 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 the extent of premium paid, but profits in long cash will keep
increasing. Combined position would look like as follows:
Long Cash 1600
Strike Price 1600
Premium 20

CMP Long Cash Long Put Net

1500 ‐100 80 ‐20
1510 ‐90 70 ‐20
1520 ‐80 60 ‐20
1530 ‐70 50 ‐20
1540 ‐60 40 ‐20
1550 ‐50 30 ‐20
1560 ‐40 20 ‐20
1570 ‐30 10 ‐20
1580 ‐20 0 ‐20
1590 ‐10 ‐10 ‐20
 1600 0 ‐20 ‐20
1610 10 ‐20 ‐10
1620 20 ‐20 0
1630 30 ‐20 10
1640 40 ‐20 20
1650 50 ‐20 30
1660 60 ‐20 40
1670 70 ‐20 50
1680 80 ‐20 60
1690 90 ‐20 70
1700 100 ‐20 80

150
Protective Put Payoff

100

50
P/ L (Rs.)

0
1500 1510 1520 1530 1540 1550 1560 1570 1580 1590 1600 1610 1620 1630 1640 1650 1660 1670 1680 1690 1700

-50

-100

NetLong CashLong Put

CMP (Rs.)
-150

A protective put pay off is similar to that of long call. This is called synthetic
long call position.

5.6 Collar
A collar strategy is an extension of covered call strategy. Readers may recall that in
case of covered call, the downside risk remains for falling prices; i.e. if the stock
price moves 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 underlying/futures (or the synthetic short put).
In our example, we had assumed that a trader longs a stock @ 1590 and shorts
a call option with a strike price of 1600 and receives Rs. 10 as premium. In this
case, the BEP
 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
Short Call 1600 Long Put 1580
Call 10 Premium 7
Premium
CMP Long Stock Short Call Long Put Net
1490 ‐100 10 83 ‐7
1500 ‐90 10 73 ‐7
1510 ‐80 10 63 ‐7
1520 ‐70 10 53 ‐7
1530 ‐60 10 43 ‐7
1540 ‐50 10 33 ‐7
1550 ‐40 10 23 ‐7
1560 ‐30 10 13 ‐7
1570 ‐20 10 3 ‐7
1580 ‐10 10 ‐7 ‐7
1590 0 10 ‐7 3
1600 10 10 ‐7 13
1610 20 0 ‐7 13
1620 30 ‐10 ‐7 13
1630 40 ‐20 ‐7 13
1640 50 ‐30 ‐7 13
1650 60 ‐40 ‐7 13
1660 70 ‐50 ‐7 13
1670 80 ‐60 ‐7 13
1680 90 ‐70 ‐7 13
1690 100 ‐80 ‐7 13
 150
Collar Payoff

100

50
P/ L (Rs.)

-50

-100

NetLong StockShort CallLong Put

CMP (Rs.)
-150

It is important to note here is that while the long put helps in reducing the
downside risk, it also reduces the maximum profit, which a covered call would
have generated. Also, the BEP has moved higher by the amount of premium paid
for buying the out‐of‐ the‐money put option.

5.7 Butterfly Spread

As collar is an extension of covered call, butterfly spread is an extension of
short straddle. We may recollect that downside in short straddle is unlimited if
market moves significantly in either direction. To put a limit to this downside,
along with short straddle, trader buys one out of the money call and one out of
the money put. Resultantly, a position is created with pictorial pay‐off, which
looks like a butterfly and so this strategy is called “Butterfly Spread”.
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 to take following positions in three different strikes and same
maturity options:
Long Call 1 with strike of 6000 and premium paid Rs.
230 Short Call 2 with strike of 6100 and premium received
Rs. 150 Long Call 3 with strike of 6200 and premium
paid of Rs. 100 Short Call 2 with strike of 6100 and
premium received Rs. 150
Let us see what happens if on expiry price is:
 Less than or equal to 6000
 Equal to 6100
 More than or equal to 6200
Case I: Price at
6000 Long Call 1: ‐
230 Short Call 2:
150
Long Call 3: ‐ 100
Short Call 2: 150
Net Position: ‐230 + 150 – 100 + 150 = ‐30
For any price lower than 6000, all calls will be out‐of‐the‐money so nobody will
exercise.
Hence buyers will lose premium anditseerllsers/ wr will get to keep the premium. In all
these situations, trader’s loss would be flat Rs.
30.
Case II: Price at 6100
Long Call 1: ‐ 230 – 6000 + 6100 = ‐ 130
Short Call 2: 150
Long Call 3: ‐ 100
Short Call 2: 150
Net Position: ‐ 130 + 150 – 100 + 150 = 70
This is the maximum profit point for this position. Both the shorted calls earn
the premium for the trader. This entire premium is kept by the trader for all prices
less than or equal to 6100.
Case III: Price at 6200 or higher
Long Call 1: ‐ 230 – 6000 + 6200 = ‐ 30 (This will keep increasing as price
rises) Short Call 2: 150 – 6200 + 6100 = 50 (This will start getting losses as price
increases) Long Call 3: ‐ 100
Short Call 2: 150 – 6200 + 6100 = 50 (This will start getting losses as price
increases) Net Position: ‐ 30 + 50 – 100 + 50 = ‐ 30
From 6200 or higher, the long calls will start making money for the trader whereas
the short calls will be in losses. And, total of all 4 would always be equal to –
30. Following table and picture explain this position:
Option Call Call Call Call
Long/Short Long Short Long Short
Strike 6000 6100 6200 6100
Premium 230 150 100 150
Spot 6100

CMP Long Call 1 Short Call 2 Long Call 3 Short Call 2 Net Flow
5100 ‐230 150 ‐100 150 ‐30
5200 ‐230 150 ‐100 150 ‐30
5300 ‐230 150 ‐100 150 ‐30
5400 ‐230 150 ‐100 150 ‐30
5500 ‐230 150 ‐100 150 ‐30
5600 ‐230 150 ‐100 150 ‐30
5700 ‐230 150 ‐100 150 ‐30
5800 ‐230 150 ‐100 150 ‐30
 5900 ‐230 150 ‐100 150 ‐30
6000 ‐230 150 ‐100 150 ‐30
6100 ‐130 150 ‐100 150 70
6200 ‐30 50 ‐100 50 ‐30
6300 70 ‐50 0 ‐50 ‐30
6400 170 ‐150 100 ‐150 ‐30
6500 270 ‐250 200 ‐250 ‐30
6600 370 ‐350 300 ‐350 ‐30
6700 470 ‐450 400 ‐450 ‐30
6800 570 ‐550 500 ‐550 ‐30
6900 670 ‐650 600 ‐650 ‐30
7000 770 ‐750 700 ‐750 ‐30
7100 870 ‐850 800 ‐850 ‐30

1000
Butterfly Spread Payoff

800

600

400

200
P/ L (Rs.)

0
5100 5200 5300 5400 5500 5600 5700 5800 5900 6000 6100 6200 6300 6400 6500 6600 6700 6800 6900 7000 7100

-200

-400

-600

-800

Long Call 1Short Call 2Long Call 3Short Call 2Net Flow
CMP (Rs.)
-1000

Cost of creating butterfly spread: ‐230 + 150 – 100 + 150

= ‐ 30 Lower BEP = 6000 + 30 = 6030
Higher BEP = 6200 – 30 = 6170
This position can also be created with the help of only puts or combination of
calls and puts. To create this position from puts, one needs to buy one highest
strike option, sell two middle strike options and then again buy one lowest
strike option. And, to create this position from combination of calls and puts,
one need to buy one call at lowest strike, sell one call at middle strike, buy
one put at highest strike and sell one put at middle strike. This is limited profit
and limited loss strategy.
This page has been
intentionally kept
blank
Chapter 6: Introduction to Trading Systems
LEARNING OBJECTIVES:
After studying this chapter, you should know about the:
 Trading System for futures and options
 Different entities in the trading system
 Different types of orders in the trading system and order matching
rule
 Selection criteria of stocks and index for futures and option trading
 Position Limits for equity derivatives
6.1 Trading System
In this chapter we shall take a brief look at the trading system of futures and
options on exchanges, including various types of orders. However, the best way
to develop an understanding of the trading system is to actually watch the screen
and observe trading.
As stated earlier, futures and options are standardized contracts and like shares,
they are traded on exchanges. Markets around the world can be classified into
two main types based on the methods of booking a trade namely an “open
outcry” market and the “electronic” market. Open outcry is the way of
communication between professionals on an exchange, which involves shouting, or
using hand signals to transfer information about buy and sell orders. In an open
outcry markets, usually the trading 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 buyers and sellers (through their
brokers) on a platform for trading. In case of electronic trading, there are screen
based broker dealing terminals, instead of the trading pit. Futures and options
trading in India is electronic in nature, with the bids and offers, and the
acceptance being displayed on the terminal continuously.
All the exchanges in India (BSE, NSE and MSEI) provide a fully automated screen‐
based trading platform for index futures, index options, stock futures and stock
options. These trading systems support an order driven market and simultaneously
provide complete transparency of trading operations. Derivative trading is
similar to that of trading of equities in the cash market segment.
All these exchanges have developed software for the F&O market to facilitate
efficient and transparent trading in futures and options instruments.
Entities in the trading system
Broadly there are four entities in the trading system
 Trading Member
 Trading cum Clearing Member (TM‐CM or TCM)
 Professional Clearing Member (PCM)
 Self Clearing Member (SCM)
 Participants
Trading Member:
They are members of Stock Exchanges. They can trade either on behalf of their
clients or 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.
The number of users allowed for each trading member is decided by the exchange
from time to time. A user must be registered with the exchange where he is
assigned a unique user ID.
The unique trading member ID is common for all the users of a particular
trading 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 having access to the firm’s User IDs.
Trading cum Clearing Member:
A Clearing Member (CM) who is also a Trading Member (TM) of the exchange.
Such CMs may clear and settle their own proprietary trades, their clients' trades as
well as trades of other TM's & Custodial Participants
Professional Clearing Member:
Professional clearing member clears the trades of his associate Trading Member
and institutional clients. PCM is not a Trading Member of the exchange. Typically
banks or custodians become a PCM and clear and settle for TM's as well as for
Custodial Participants
Self Clearing Member (SCM)
A Self Clearing Member is also a Trading Member on the exchange. Such CMs
may clear and settle only their own proprietary trades and their clients' trades
but cannot clear and settle trades of other TM's.
Participants:
Participant is a client of a trading member. Clients may trade through various trading
members but settle through a single clearing member.
Market Timing of Derivative segment
Trading on the derivatives segment takes place on all working days of the week
between 9:15 am and 3:30 pm.
Corporate Hierarchy
In the Futures and options trading software, trading member will have a
provision of defining the hierarchy amongst users of the system. This hierarchy
comprises:
 Corporate Manager
 Branch Manager and
 Dealer
Corporate Manager:
As a user, it is the highest level in a trading firm. Corporate Manager can performlal the
functions such as order and trade related activities, receiving reports for all
branches of the trading member firm and also all dealers of the firm. Along with
this he can also
define exposure limits for the branches of the firm. This facility is available only to the
corporate manager.
Branch Manager:
As a user, it is placed under the corporate manager. Branch Manager can
perform and view order and trade related activities for all dealers under that
branch.
Dealer:
Dealer is at the lowest level of the user hierarchy. He can only view his own
orders and trades and does not have access to information on other dealers under
either the same branch or in other branches.
Client Broker Relationship
A trading member would be responsible for various compliance related
activities including Know Your Client (KYC) form, execution of Client Broker
agreement, timely execution of orders given by clients, collection of adequate
margins, maintain separate client bank account for segregation of client money,
ensure timely pay‐in and pay‐out of funds, timely issue of contract notes, resolve
clients’ complaints, sending periodical statement of accounts, maintain unique
client code, etc.
Order types and conditions
In the trading system, trading members are allowed to enter orders with
various conditions attached to them as per their requirements. These conditions
are broadly divided into the following categories:
 Time conditions
 Price conditions
 Various combinations of the above are allowed providing flexibility to the users.
Time conditions
Day order: A Day order is an order which is valid for a single day on which it is
entered. If the order is not executed during the day, the trading system cancels
the order automatically at the end of the day.
Immediate or cancel (IOC): User is allowed to buy/sell a contract as soon as the
order is 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 cancelled immediately.
Price condition
Limit order: It is an order to buy or sell a contract at a specified price. The
user has to specify this limit price while placing the order and the order gets
executed only at this specified limit price or at a better price than that (lower in
case of buy order and higher in case of a sell order).
Market order: A market order is an order to buy or sell a contract at the best
bid/offer price currently available in the market. Price is not specified at the time
of placing this order. The price will be the currently available price in the
market i.e., a buy market
order will get executed at the best price at which the seller is ready to sell and
a sell market order will get executed at the best price at which the buyer is
ready to buy.
Stop‐loss order: A stop loss is an order to buy (or sell) a security once the price
of the security climbed above (or dropped below) a trigger price. The stop‐loss
order gets 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 illustrate, suppose a trader buys ABC Ltd. shares at Rs 100
in expectation that the price will rise. However, prices starts declining below his
buy price, trader would like to limit his losses. Trader may place a limit sell
order specifying a trigger price of Rs 95 and a limit price of Rs 92. The trigger
price has to be between last traded price and limit price while placing the sell
limit order. Once the market price of ABC breaches the trigger price i.e. Rs 95,
the order gets converted to a limit sell order at Rs 92. (Trigger Price is the
price at which the order gets triggered from the stop loss book.)
Order Matching Rules
In India, F&O platforms offer an order driven market, wherein orders match
automatically on price time priority basis.
Orders, as and when they are received, are first time stamped and then
immediately processed for potential match. If a match is not found, then the
orders are stored in different 'books'. Orders are stored in price‐time priority in
various books in the following sequence:
 Best Price
 Within Price, by time priority.
The best buy order will match with the best sell order. An order may match
partially 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 because the computer views all buy orders available
from the point of view of a seller and all sell orders from the point of view of
the buyers in the market.
Price Band
There are no price bands applicable in the derivatives segment. However, in order to
ponreevoeunst order entry, operating ranges and day minimum/maximum ranges
err
are kept as
below:
 For Index Futures: at 10% of the base price
 For Futures on Individual Securities: at 10% of the base price
 For Index and Stock Options: A contract specific price range based on its
delta value is computed and updated on a daily basis.
In view of this, orders placed at prices which are beyond the operating ranges
would reach the Exchange as a price freeze.
The Trader Workstation
The market watch window
The following windows are displayed on the trader workstation screen:
 Title bar
  Ticker window of futures and options market
 Ticker window of underlying (capital) market
 Toolbar
 Market watch window
 Inquiry window
 Snap quote
 Order/trade window
 System message window
The best way to familiarize oneself with the screen is to spend some time studying
a live screen.
Placing orders on the trading system
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. ‘Pro’ identifies proprietary orders while ‘Cli’ identifies client
orders. Client account
number should be provided ftor clien orders.
Futures and Options Market Instruments
The F&O segment of the derivatives exchanges provides trading facilities for the
following derivative instruments:
 Index based futures (including futures on foreign stock indices)
 Index based options (including options on foreign stock indices)
 Individual stock options
 Individual stock futures

6.2 Selection criteria of Stocks for trading

Contract specifications for single stock futures contracts
Underlying Individual Securities
Security Descriptor FUTSTK
Contract Size (Lot Size) As specified by the exchange (minimum value of Rs
5,00,000)
Price Steps (Tick Size) Rs 0.05
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.
Last Thursday of the expiry month. If the last Thursday
Last Trading / Expiration
is a trading holiday, then the expiry day is the previous
Date
trading day.
 Mark‐to‐Market and final settlement are cash settled on
Settlement Basis
T+1 basis
 Daily Settlement price is the closing price of the futures
contract for the trading day (calculated on the basis of the
last half an hour weighted average price of such contract)
Settlement Price
and the final settlement price is the closing price of the
relevant underlying security in the Capital Market
segment of the exchange, on the last trading day of the
futures contracts.

Contract specifications for single stock options contracts

Underlying Individual Security
Security Descriptor OPTSTK
Option Type European (CE/PE)
Strike Price Interval As specified by the exchange
Contract Size (Lot As specified by the exchange (minimum value of Rs
Size) 5,00,000)
Price Steps (Tick Size) Rs 0.05
3 month trading cycle ‐ the near month (one), the
next month (two) and the far month (three). New
Trading Cycle *
contract is introduced on the next trading day
following the expiry of near month contract.
Last Thursday of the expiry month. If the last Thursday
Last Trading /
is a trading holiday, then the expiry day is the previous
Expiration Date
trading day.
*
Mark‐to‐Market and final settlement are cash settled on
Settlement Basis
T+1 basis.
Premium settlement is cash settled with the pay‐in and
Daily settlement
pay‐ out of the premium settlement is on T+1 day.
Closing price of such underlying security on the last
Final Settlement Price
trading day of the options contract.
* Please note that Weekly Options expire on Thursday of each week. 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 trading Holiday, then the expiry will be on the previous trading day.
For further details on product specifications, please refer to the websites of
exchanges:
www.nseindia.co
m
www.bseindia.co
m www.msei.in
Eligibility Criteria for stock selection
The stock selection criteria for derivatives trading in India ensure that stock is large
in terms of market capitalization, turnover and has sufficient liquidity in the
underlying market and there are no adverse issues related to market
manipulation.
Eligibility criteria of stocks
A stock on which stock option and single stock futures contracts are proposed
to be introduced shall conform to the following broad eligibility criteria:
a) The stock shall be chosen from amongst the top 500 stocks in terms of
average daily market capitalization and average daily traded value in the
previous six months on a rolling basis.
b) The stock’s median quarter‐sigma order size (MQSOS) over the last six
months shall be not less than Rs.10 Lakhs (Rupees Ten Lakhs). For this
purpose, a stocks quarter‐sigma order size shall mean the order size (in
value terms) required to cause a change in the stock price equal to one‐
quarter of a standard deviation.
c) The market wide position limit (MWPL) in the stock shall not be less than
Rs.300 crores (Rupees Three Hundred crores). The market wide position
limit (number of shares) shall be valued taking the closing prices of
stocks in the underlying cash market on the date of expiry of contract in
the month. The market wide position limit of open position (in terms of
the number of underlying stock) on futures and option contracts on a
particular underlying stock shall be 20% of the number of shares held by non‐
promoters in the relevant underlying security i.e. free‐float holding.
Continued eligibility criteria for stocks in equity derivatives
The criteria for retention of stock in equity derivatives segment are as under:
a) The stock’s median quarter‐sigma order size over last six months shall not
be less than Rs. 5klahs (Rupees Five Lakhs).
b) The market wide position limit (MWPL) of the stock shall not be less than Rs.
200 crores (Rupees Two Hundred crores).
c) The stock’s average monthly turnover in derivatives segment over last
three months shall not be less than Rs. 100 crores (Rupees Hundred
crores).
If a stock fails to meet these retention criteria for three months consecutively,
then no fresh month contract shall be issued on that stock. However, the
existing unexpired contracts may be permitted to trade till expiry and new strikes
may also be introduced in the existing contract months.
Further, once the stock is excluded from the F&O list, it shall not be considered for
re‐ inclusion for a period of one year.
Re‐introduction of excluded stocks
A stock which is excluded from derivatives trading may become eligible once again.
In such instances, the stock is required to fulfil the eligibility criteria for three
consecutive months to be re‐introduced for derivatives trading. Derivative
contracts on such stocks may be re‐introduced by the exchange subject to SEBI
approval.
 Recently approved changes ‐ Inclusion and Exclusion of stocks for derivatives
trading SEBI in its Board Meeting on March 28, 2018 took the following decisions
in order to rationalize and strengthen the framework of the equity derivatives
market in India:
(i) To facilitate greater alignment of the cash and derivative market, physical
settlement for all stock derivatives shall be carried out in a phased and
calibrated manner.
(ii) To update and strengthen the existing entry criteria for introduction of stocks
into the derivative segment in line with the increase in market capitalization
since the last revision of the criteria in 2012. Accordingly, existing criteria like
market wide position limit and median quarter‐sigma order size shall be
revised upward from current level of INR 300 crore and INR 10 lakh
respectively to INR 500 crore and INR 25 lakh respectively. An additional
criterion, of average daily ‘deliverable’ value in the cash market of INR 10
Crore, has also been prescribed. The enhanced criteria are to be met for a
continuous period of six months.
(iii) To begin with, stocks which are currently in derivatives but fail to meet any
of the enhanced criteria, would be physically settled. Such stocks would exit
the derivative segment if they fail to meet any of the enhanced criteria within a
period of one year from the specified date or fail to meet any of the current
existing criteria for a continuous period of three months.
(iv) Stocks which are currently in derivatives and meet the enhanced criteria
shall be cash settled. Such stocks if they fail to meet any one of the
enhanced criteria for a continuous period of three months shall move from
cash settlement to physical settlement. After moving to physical settlement if
such stock does not meet any of the current existing criteria for a continuous
period of three months, then it would exit out of derivatives. After a period of
one year from the specified date, only those stocks which meet the enhanced
criteria would remain in derivatives.
(v) To reflect global initiatives on product suitability, a framework has been
approved. Individual investors may freely take exposure in the market (cash and
derivatives) upto a computed exposure based on their disclosed income as per
their Income Tax Return (ITR) over a period of time. For exposure beyond
the computed exposure, the intermediary would be required to undertake
rigorous due diligence and take appropriate documentation from the investor.

6.3 Selection criteria of Index for trading

Eligibility criteria of Indices
The Exchange may consider introducing derivative contracts on an index, if
weightage of 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 more than 5% in the index. The index on which futures
and options contracts are permitted shall be required to comply with the
eligibility criteria on a continuous basis. The Exchange shall check whether the
index continues to meet the aforesaid eligibility criteria on a monthly basis. If the
index fails to meet the eligibility criteria for three consecutive months, then no
fresh contract shall be issued on that index. However, the
existing unexpired contracts shall be permitted to trade till expiry and new strikes
may also be introduced in the existing contracts.

6.4 Adjustments for Corporate Actions

Adjustments for Corporate Actions for Stock Options would be as follows:
1. The basis for any adjustment for corporate action shall be such that the
value of the position of the market participants on cum and ex‐date for
corporate action shall continue to remain the same as far as possible.
This will facilitate in retaining the relative status of positions viz. in‐the‐
money, at‐the‐money and out‐of‐money. This will also address issues related
to exercise and assignments.
2. Any adjustment for corporate actions shall be carried out on the last day
on which a security is traded on a ‘cum’ basis in the underlying cash market,
after the close of trading hours.
3. Adjustments shall mean modifications to positions and/or contract specifications
as listed below such that the basic premise of adjustment laid down in the
above paragraph is satisfied:
(a) Strike Price
(b) Position
(c) Market Lot/Multiplier
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 open positions. The corporate actions may be broadly classified
under stock benefits and cash benefits as follows:
 Bonus
 Rights
 Merger/De‐merger
 Amalgamation
 Splits
 Consolidations
 Hive‐off
 Warrants
 Secured Premium Notes (SPNs)
 Extraordinary dividends
Following elaborates the adjustment for Bonus, Stock splits, consolidation and
extraordinary dividends
Bonus, Stock Splits and Consolidations
Strike Price: The new strike price shall be arrived at by dividing the old strike price
by the adjustment factor as under.
Market Lot / Multiplier: The new market lot/multiplier shall be arrived at by
multiplying the old market lot by the adjustment factor as under.
Position: The new position shall be arrived at by multiplying the old position by
the adjustment factor as under.
The adjustment factor for Bonus, Stock Splits and Consolidations is arrived at as
follows:
Bonus
Ratio – A: B Adjustment factor: (A+B)/B
Stock Splits and Consolidations
Ratio – A: B Adjustment factor: A/B
The above methodology may result in fractions due to the corporate action e.g. a
bonus ratio of 3:7. With a view to minimizing fraction settlements, the following
methodology is proposed to be adopted:
(a) Compute value of the position before adjustment
(b) Compute value of the position taking into account the exact adjustment factor
(c) Carry out rounding off for the Strike Price and Market Lot
(d) Compute value of the position based on the revised strike price and market lot
The difference between (a) and (d) above, if any, shall be decided in the
manner laid down by the group by adjusting Strike Price or Market Lot, so that
no forced closure of open position is mandated.
Dividends
Dividends which are below 10% of the market value of the underlying stock
would be deemed to be ordinary dividends and no adjustment in the Strike Price
would be made for ordinary dividends. For extra‐ordinary dividends, above 10% of
the market value of the underlying stock, the Strike Price would be adjusted.
 To decide whether the dividend is "extra‐ordinary" (i.e. over 10% of the
market price of the underlying stock.), the market price would mean the
closing price of the stock on the day previous to the date on which the
announcement of the dividend is made by the Company after theemeting
of the Board of 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 market price. Further, if the shareholders of
the company in the AGM change the rate of dividend declared by the Board
of Directors, then to decide whether the 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 the day
previous to the date of the AGM.
 In case of declaration of "extra‐ordinary" dividend by any company, the
total dividend amount (special and / or ordinary) would be reduced from all
the strike prices of the option contracts on that stock.
 The revised strike prices would be applicable from the ex‐dividend date
specified by the exchange.
The basis for any adjustment for corporate actions shall be such that the value
of the position of the market participants, on the cum‐ and ex‐dates for the
corporate action,
shall continue to remain the same as far as possible. This will facilitate in retaining
the relative status of positions viz. in‐the‐money, at‐the‐money and out‐of‐money.
This will also address issues related to exercise and assignments.
6.5 Position Limit
Index Options Index Futures Stock Options Stock Futures
The gross open position across all derivative contracts on a particular
Client /
underlying stock, of each specific client, FPI (Category III) or scheme of
FPI
MF, should not exceed the higher of:
(Category
1% of the free float market capitalization (in terms of number of
III) /
shares). or
Scheme
5% of the open interest in the derivative contracts in the same underlying
of MF
stock
(in terms of number of shares).
The position
The position
limits of Trading
limits of Trading
members / FPIs
members / FPIs
(Category I & II)
(Category I & II) /
/ Mutual Funds in
Mutual Funds in
equity index The position limits of Trading
equity index
futures contracts members / FPIs (Category I & II)
Trading option contracts
is higher of / Mutual Funds in individual
Members is higher of
Rs.500 crores or stocks is related to the market‐
/ FPIs Rs.500 crores or
15% of the total wide position limit for the
(Category 15% of the total
open interest in individual stocks. The combined
I & II) * / open interest in
the market in futures and options position
Mutual the market in
equity index limit shall be 20% of the
Funds * equity index
futures applicable Market Wide Position
option
contracts. This Limit (MWPL).
contracts. This limit
limit is
would be
applicable on
applicable on open
open positions in
positions in all
all futures
option contracts
contracts on a
on a particular
particular
underlying index.
underlying index.
 At the end of each day the
Exchange disseminates the
aggregate open interest across all
Exchanges in the futures and
options on individual scrips along
with the market wide position
limit for that scrip and tests
whether the aggregate open
interest for any scrip exceeds
There is no
There is no 95% of the market wide position
market wide
Market market wide limit for that scrip. If yes, the
position limits
wide position limits Exchange takes note of open
specified for
specified for positions of all client/ TMs as at
index futures
index options the end of that day in that scrip,
contracts.
contracts. and from next day onwards the
client/ TMs should trade only to
decrease their positions through
offsetting positions till the normal
trading in the scrip is resumed.
The normal trading in the scrip
is resumed only after the
aggregate open interest across
Exchanges comes down to 80% or
below of the
market wide position limit.
* In addition to the above limits, in index futures and options, FPI Category (I
&II)/MFs shall take exposure in equity index derivatives subject to the
following limits:

 Short positions in index derivatives (short futures, short calls and long
puts) not exceeding (in notional value) the FPI Category (I &II)/ MFs
holding of stocks.
 Long positions in index derivatives (long futures, long calls and short
puts) not exceeding (in notional value) the FPI Category (I &II)/MFs
holding of cash, government securities, T‐Bills, money market mutual
funds and gilt funds and similar instruments.

In this regard, if the open position of an FPI Category (II&)/I MF exceeds the limits as
stated for Index Futures or Index Options, such surplus would be deemed to
comprise of short and long positions in the same proportion of the total open
positions individually. Such short and long positions in excess of the said limits shall
be compared with the FPI Category (I &II) /MFs holding in stocks, cash etc. as
stated above.
6.6 Using Daily Newspapers to Track Futures and Options
The prices of both spot and F&O markets are published by many major business
dailies such as Economic Times, Mint, Business Standard, Financial Express, etc.
They publish all or some of the following details for the derivatives contracts
being traded on the exchanges.
Date: This gives the Trade date.
Symbol: This gives the underlying index or stock e.g. NIFTY, ACC, etc.
Instrument: This gives the contract descriptor for the various instruments available
in the derivatives segment e.g. FUTSTK, OPTIDX, etc.
Expiry date: The date on which the contract expires
Option Type: This givesethe typ of option for the contract. (CE‐ Call European, PE‐ Put
European, CA‐ Call American, PA‐ Put American)
Corporate Action level: This is the Corporate Action Flag. This flag changes when
there is a corporate action on a contract, which could either be a symbol
change or a dividend announced by the company.
Strike Price: This gives the Strike Price of the contract.
Opening price: This gives the price at which the contract opened for the day.
High price: This gives the highest price at which the contract was traded during
the day. Low price: This gives the lowest price at which the contract was traded
during the day. Closing price: This gives the price of the contract at the end of
the day.
Last traded price: This gives the price at which the last contract of the day was
traded.
Open Interest: For futures contracts open interest is equivalent to the open
positions in that futures contract multiplied by its last available closing price. For
option contracts, 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 open position in that option contract multiplied
by the last available closing price of the underlying.
Total Traded Quantity: This is the total no. of contracts on which business took
place during the day.
Total Traded Value: The total money value of the business which took place on
the contract during the day.
Number of Trades: The total no. of trades which took place on the instrument
during the day.
Information on trends in F&O markets:
 Positive trend: It gives information about the top gainers in the futures market.
 Negative trend: It gives information about the top losers in the futures market.
 Futures OI gainers: It lists those futures whose % increase in Open
Interest is among the highest on that day.
 Futures OI losers: It lists those futures whose % decrease in Open Interest
is among the highest on that day.
 Active Calls: Calls with high trading volumes on that particular day.
 Active Puts: Puts with high trading volumes on that particular day.
 Put/ Call ratio (PCR): It gives the information about the ratio of trading
volume of put options to call options. The ratio is calculated either on the
basis of options
trading volumes or on the basiseoirf th open interest.
This page has been
intentionally kept
blank
Chapter 7: Introduction to Clearing and Settlement System
LEARNING OBJECTIVES:
After studying this chapter, you should know about:
 Different types of clearing members
 Clearing and settlement mechanism for equity derivatives
 Risk management in equity derivatives segment
 Margining system in equity derivatives segment
Clearing Corporation/ Clearing House is responsible for clearing and settlement of
all trades executed on the F&O Segment of the Exchange. Clearing Corporation
acts as a legal counterparty to all trades on this segment and also guarantees
their financial settlement. The Clearing and Settlement process comprises of three
main activities, viz., Clearing, Settlement and Risk Management.
Clearing and settlement activities in the F&O segment are undertaken by
Clearing Corporation with the help of the following entities: Clearing Members
and Clearing Banks.

7.1 Clearing Members

As you may recollect from our discussion in section 6.1, there are broadly three types of
clearing members:
1. Self clearing member: They clear and settle trades executed by them only,
either on their own account or on account of their clients.
2. Trading member–cum–clearing member: They clear and settle trades
theirnow as well as trades of other trading members and custodial
participants.
3. Professional clearing member: They clear and settle trades executed by
trading members.
Both trading‐cum‐clearing member and professional clearing member are required
to bring in additional security deposits in respect of every trading member whose
trades they undertake to clear and settle.
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.
Clearing Member Eligibility Norms
 Net‐worth of at least Rs.300 lakhs. The Net‐worth requirement for a
Clearing Member who clears and settles only deals executed by him is Rs.
100 lakhs.
 Deposit of Rs. 50 lakhs to clearing corporation which forms part of the
security deposit of the Clearing Member.
 Additional incremental deposits of Rs.10 lakhs tnog corporation for each
cleari
additional TM, in case the Clearing Member undertakes to clear and settle deals
for other TMs.
7.2 Clearing Mechanism
The first step in clearing process is calculating open positions and obligations of
clearing members. The open positions of a CM is arrived at by aggregating the
open positions of all the trading members (TMs) and all custodial participants (CPs)
clearing though him, in the contracts which they have traded. The open position
of a TM is arrived at by adding up his proprietary open position and clients’
open positions, in the contracts which they have traded. While entering orders
on the trading system, TMs identify orders as either proprietary (Pro) or client
(Cli). Proprietary positions are calculated on net basis (buy‐sell) for each contract
and that of clients are arrived at by summing together net positions of each
individual client. A TM’s open position is the sum of proprietary open position,
client open long position and client open short position.
To illustrate, consider a clearing member ‘A’ with trading through him
membersrcinlega ‘PQR’ and ‘XYZ’.
Proprietary
Client 1 Client 2
Position Net
Member
Buy Sell Net Buy Sell Net Buy Sell Net
TM Security
Qty Qty Qty Qty Qty Qty Qty Qty Qty
NIFTY
Long
PQR October 5000 3000 2000 3000 2000 1000 3000 1000 2000
5000
contract
Long
NIFTY
1000
XYZ October 1000 2000 (1000) 2000 1000 1000 3000 4000 (1000)
Short
contract
2000
Clearing member A’s open position for Nifty October contract is:
Member Long Position Short Position
PQR 5000 0
XYZ 1000 2000
Total for A 6000 2000
Here in the above example PQR’s Long Position is arrived by summing up net
position of his proprietary position i.e. 2000 and net positions of both his clients 1
& 2 i.e. 1000 and 2000 respectively. Similarly, we have calculated the long and
short positions of XYZ. Clearing member’s open position is arrived by adding long
positions and short positions of both the clients i.e. 6000 long open positions and
2000 short open positions.
7.3 Settlement Mechanism
In India, SEBI has given the stock exchanges the flexibility to offer:
a) Cash settlement (settlement by payment of differences) for both stock
options and stock futures; or
 b) Physical settlement (settlement by delivery of underlying stock) for both
stock options and stock futures; or
c) Cash settlement for stock options and physical settlement for stock futures; or
d) Physical settlement for stock options and cash settlement for stock futures.
A Stock Exchange may introduce physical settlement in a phased manner. On
introduction, however, physical settlement for all stock options and/or all stock
futures, as the case may be, must be completed within six months. The settlement
mechanism shall be decided by the Stock Exchanges in consultation with the
Depositories.
On expiry / exercise of physically settled stock derivatives, the risk
management framework (i.e., margins and default) of the cash segment shall
be applicable. Settlements of cash and equity derivative segments shall continue
to remain separate.
The Stock Exchanges interested to introduce physical settlement should:
a. Put in place proper systems and procedures for smooth implementation
of physical settlement.
b. Make necessary amendments to the relevant bye‐laws, rules and regulations
for implementation of physical settlement.
c. Bring the provisions of this circular to the notice of all categories of
market participants, including the general public, and also to disseminate
the same on their websites.
The Stock Exchanges interested to offer physical settlement should submit to SEBI
for approval, a detailed framework for implementation of physical settlement
of stock derivatives. After opting for a particular mode of settlement for stock
derivatives, a Stock Exchange may change to another mode of settlement after
seeking prior approval of SEBI.
Settlement Schedule
Theesnetttlem of trades is on T+1 working day basis. Members with a funds pay‐in
obligation are required to have clear funds in their primary clearing account on
or before 10.30 a.m. on the settlement day. The payout of funds is credited to the
primary clearing account of the members thereafter.
Settlement of Futures Contracts on Index or Individual Securities
In Futures contracts, both the parties to the contract have to deposit margin
money which is called as initial margin. Futures contract have two types of
settlements, the
MTM settlement which happens on a continuous basis at the end of the
eachdday, an final settlement which happens on the last trading day of the
futures contract.
Mark to Market (MTM) Settlement
Mark to Market is a process by which margins are adjusted on the basis of daily
price changes in the markets for underlying assets. The profits/ losses are
computed as the difference between:
1. The trade price and the day's settlement price for contracts executed during
 the day but not squared up.
2. The previous day's settlement price and the current day's settlement price
for brought forward contracts.
 3. The buy price and the sell price for contracts executed during the day
and squared up.
The clearing member who suffers a loss is required to pay the MTM loss amount
in cash which is in turn passed on to the clearing member who has made a MTM
profit. The pay‐in and pay‐out of the mark‐to‐market settlement are affected on
the day following the trade day (T+1) where trading member is responsible to
collect/ pay funds from/ to clients by the next day. Clearing Members are
responsible to collect and settle the daily MTM profits/losses incurred by the TMs
and their clients clearing and settling through them. After completing day’s
settlement process, all the open positions are reset to the daily settlement price.
These positions become the open positions for the next day.
Final Settlement
On expiration day of the futures contracts, after the close of trading hours,
clearing corporation marks all positions of a clearing member to the final
settlement price and the resulting profit/ loss is settled in cash. Final
settlement loss/profit amount is debited/ credited to the relevant clearing
member’s clearing bank account on the day following expiry day of the contract.
All long positions are automatically assigned to short positions in option
contracts with the same series, on a random basis.
Settlement of Options Contracts on Index or Individual Securities
Options contracts have two types of settlements. These are as follows
1) Daily premium settlement,
2) Final settlement
Daily Premium Settlement
In options contract, buyer of an option pays premium while seller receives
premium. The amount payable and receivable as premium are netted to
compute the net premium payable or receivable amount for each client for
each option contract.
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 who have a premium receivable position. This is known as daily premium
settlement. The pay‐in and pay‐out of the premium settlement is on T+1 day
(T=Trade day). The premium payable amount and premium receivable amount
areediitredct/ly cr debited to the clearing member’s clearing bank account.
Final Exercise Settlement
All the in the money stock options contracts shall get automatically exercised
on the expiry day. All the unclosed long/ short positions are automatically assigned
to short/ long positions in option contracts with the same series, on the random
basis.
Profit/ loss amount for options contract on index and individual securities on
final settlement is credited/debited to the relevant clearing members clearing
bank account on T+1 day i.e. a day after expiry day. Open positions, in option
contracts, cease to exist after their expiration day.
The pay‐in/ pay‐out of funds for a clearing member on a day is the net amount
across settlements and all trading members/ clients, in Future & Option
Segment.
Settlement of Custodial Participant (CP) Deals
Clearing corporation provides a facility to entities like institutions to execute
trades through any trading member, which may be cleared and settled by their own
CM. Such entities are called Custodial Participants (CP). A CP is required to register
with clearing
corporation through thisrcinlega member, which allots them a unique CP code. The CP
and the CM are required to enter into an agreement. All trades executed by
such CP through any TM are required to have the CP code in the relevant field
on the F&O
trading system at the time of oy.rder entr Without confirmation from CM, the
responsibility of settlement of such trade vests with the CM of the TM while such
trades form part of the obligations of the CM of the CP when they are
confirmed from CM. They shall be responsible for all obligations arising out of
such trades including the payment of margins and settlement of obligations.
Settlement Price
Settlement price for various contracts is determined as follows:
Product Settlement Schedule
Futures Contracts on Closing price of the futures contracts on the
Index or Global trading day. (closing price for a futures contract
Index Individual Daily shall be calculated on the basis of the last half an
Security Settlement hour weighted average price of such contract)
Un-expired illiquid
futures contracts
(including Global Daily Theoretical Price computed as per formula F=S *
Indices) Settlement ert
Closing price of the relevant underlying index /
Futures Contracts on security in the Capital Market segment of the
Index or Individual Final exchange, on the last trading day of the futures
Securities Settlement contracts.
The Special Opening Quotation (SOQ) of the
Futures Contracts on Final Global Indices on the last trading day of the
Global Indices Settlement futures contracts
Options Contracts on Closing price of such underlying security (or
Index and Individual Final Exercise index) on the last trading day of the options
Securities Settlement contract.
The Special Opening Quotation (SOQ) of the
Options Contracts on Final Exercise Global Indices on the last trading day of the
Global Indices Settlement options contracts

7.4 Risk Management

For the F&O segment, a comprehensive risk containment mechanism has been
developed by clearing corporation. The salient features of risk containment
measures on the F&O segment are:
 Stringent requirements of capital adequacy for membership (Financial
strength of a member) helps in risk management.
  Clearing corporation charges an upfront initial margin for all the open
positions of a Clearing Member (CM). It specifies the initial margin
requirements for each futures/ options contract on a daily basis and also
follows Value‐At‐Risk (VAR) based margining. Clearing member collects
initial margin from the trading members (TMs) and their respective
clients.
 The open positions of the members are settled on an MTM basis for each
contract at the end of the day. The difference is settled in cash on a T+1
basis.
 Clearing corporation’s on‐line position monitoring system monitors a CM’s
open position on a real‐time basis. It sets limit for each CM based on his
effective deposits and simultaneously generates alert messages whenever a
CM reaches certain pre‐determined benchmarks of the limit. Clearing
corporation monitors the CMs for Initial Margin violation, Exposure margin
violation, while TMs are monitored for Initial Margin violation and
position limit violation.
 A trading terminal helps the CMs to monitor the open positions of all the
TMs clearing and settling through him. A CM may set limits for a TM
clearing and settling through him. Clearing corporation assists the CM to
monitor the intra‐ day limits set up by a CM and whenever a TM exceed
the limits, it stops that particular TM from further trading.
The most critical component of risk containment mechanism for F&O segment
is the margining system and on‐line position monitoring. The actual position
monitoring and margining is carried out on‐line through Parallel Risk Management
System (PRISM) using SPAN® (Standard Portfolio Analysis of Risk) system for the
purpose of computation of on‐line margins, based on the parameters defined by
SEBI.
7.5 Margining and mark to market under SPAN
In order to manage risk efficiently in the Indian securities market, exchanges
have adopted SPAN (Standard Portfolio Analysis of Risk), a risk management and
margining product designed by Chicago Mercantile Exchange (CME), Chicago, USA.
This software was developed for calculating initial margins on the various
positions of market participants.
The objective of SPAN is to identify overall potential risk in a portfolio. The
program treats futures and options uniformly, while recognizing the unique
exposures associated with options portfolios.
Since SPAN is used to determine initial margins/ performance bond
requirements on various positions, its basic objective is to determine the
largest possible loss that a portfolio might reasonably be expected to suffer from
one day to the next. It then sets the initial margins/ performance bond
requirement at a level, which is sufficient to cover this one‐day potential loss.
The concept of risk array represents the extent to which a specific derivative
instrument will gain or lose value from the present time to a specific point in
time in the near future, over a specific set of market conditions. The time is
set to one trading day i.e. through the use of SPAN the maximum likely loss, which
may reasonably occur over one trading day is being evaluated.
 Margins
The margining system for F&O segment is as below:
Initial margin
Margins are computed by clearing corporation upto client level with the help of
SPAN. Clearing corporation collects initial margin for all the open positions of a
Clearing 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 positions. A Clearing Member collects initial margin from TM
whereas TM collects from his clients.
Initial margin requirements are based on 99% value at risk over a one day time
horizon. However, in the case of futures contracts (on index or individual
securities), where it may not be possible to collect mark to market settlement
value, before the commencement of trading on the next day, the initial margin is
computed over a two‐ day time horizon, applying the appropriate statistical
formula. The methodology for computation of Value at Risk percentage is as per
the recommendations of SEBI from time to time.
Premium Margin
Along with Initial Margin, Premium Margin is also charged at client level. This
margin is required to be paid by a buyer of an option till the premium
settlement is complete.
Assignment Margin for Options on Securities
Along with Initial Margin and Premium Margin, assignment margin is required to be
paid on assigned positions of Clearing Members towards final exercise settlement
obligations for option contracts on individual securities, till such obligations are
fulfilled. The margin is charged on the neteerxcise settlement value payable by a
Clearing Member towards final exercise settlement.
Exposure Margins
Clearing members are subject to exposure margins in addition to initial
margins. The exposure margins for options and futures contracts are as
follows:
 For Index options and Index futures contracts: 3% of the notional value of a
futures contract. In case of options it is charged only on short positions and is 3% of
the notional value of open positions.
 For option contracts and Futures Contract on individual Securities:
The higher of 5% or 1.5 standard deviation of the notional value of gross open
position in futures on individual securities and gross short open positions in options
on individual securities in a particular underlying. The standard deviation of daily
logarithmic returns of prices in the underlying stock in the cash market in the
last six months is computed on a rolling and monthly basis at the end of each
month.
For this purpose notional value means:
‐ For a futures contract ‐ the contract value at last traded price/ closing price.
‐ For aonsopti contract ‐ the value of an equivalent number of shares as conveyed by
the options contract, in the underlying market, based on the last available closing
price. In case of calendar spread positions in futures contract, exposure margins are
levied on
one third of the value of open position ofrthe fa month futures contract. The calendar
spread position is granted calendar spread treatment till the expiry of the near
month contract.
Client Margins
Clearing corporation intimates all members of the margin liability of each of their
client. Additionally members are also required to report details of margins
collected from clients to clearing corporation, which holds in trust client margin
monies to the extent reported by the member as having been collected from
their respective clients.
Cross Margin
Salient features of the cross margining available on exchanges are as follows:
1. Cross margining is available across Cash and Derivatives segment.
2. Cross margining is available to all categories of market participants.
3. When a Clearing Member clears for client/ entities in Cash and Derivatives
segments, he is then required to intimate client details through a Collateral
Interface for Members (CIM) to benefit from Cross margining.
4. When different Clearing Members clear for client/entities in Cash and Derivatives
segmentsythe are required to enter into necessary agreements for availing cross
margining benefit.
5. Clients who wish to avail cross margining benefit in respect of positions in
Index Futures and Constituent Stock Futures only, their clearing member in the
Derivatives segment needs to provide the details of the clients.
Penalties
rAgepenal cha will be levied on the amount in default as per the byelaws relating to
failure to meet funds / settlement obligations by any Clearing Member. The
following penal charges are levied for failure to pay funds/ settlement
obligations:
Penalty Charge
Type of Default Chargeable to
per day
Overnight settlement
shortage of value more 0.07% Clearing Member
than Rs.5 lakhs
Security Deposit Shortage 0.07% Clearing Member
Shortage of Capital 0.07% Clearing Member
Cushion
Any violations by the custodial participants shall be treated in line with those
by the trading member and as a result action shall be initiated against the
concerned clearing member.
Short Reporting of Margins in Client Margin Reporting Files
The following penalty shall be levied in case of short reporting by
trading/clearing member per instance.
Short collection for each client Penalty percentage
(< Rs 1 lakh) And (< 10% of applicable margin) 0.5%
(= Rs 1 lakh) Or (= 10% of applicable margin) 1.0%
If short/non‐collection of margins for a client continues for more than 3
consecutive days, then penalty of 5% of the shortfall amount shall be levied for
each day of continued shortfall beyond the 3rd day of shortfall.
If short/non‐collection of margins for a client takes place for more than 5 days
in a month, then penalty of 5% of the shortfall amount shall be levied for each
day, during the month, beyond the 5th day of shortfall.
Notwithstanding the above, if short collection of margin from clients is caused due
to movement of 3% or more in the Nifty 50 (close to close) on a given day, (day
T), then, the penalty for short collection shall be imposed only if the shortfall
continues to T+2 day.
All instances of non‐reporting are treated as 100% short reporting for the
purpose of levy of penalty.
Penalty and penal charges for margin/limit violation
Penalty for margin / limit violation is levied on a monthly basis based on slabs
as mentioned below or such other amount as specified by the Clearing Corporation
from time to time.
Instances of Disablement Penalty to be levied
1st instance 0.07% per day
0.07% per day + Rs.5,000/‐ per instance from
2nd to 5th instance of
2nd
disablement
to 5th instance
0.07% per day + Rs.20,000/‐ ( for 2nd to
6th to 10th instance of 5th instance) + Rs.10000/‐ per instance from
disablement 6th to
10th instance
0.07% per day + Rs.70,000/‐ (for 2nd to
10th instance) + Rs.10,000/‐ per instance
11th instance onwards from 11th instance onwards.
Additionally, the member will be referred to
the
Disciplinary Action Committee for suitable
action
Instances as mentioned above refer to all disablements during market hours in
a calendar month. The penal charge of 0.07% per day is applicable on all
disablements due to margin violation anytime during the day.
FII/Mutual Fund position limit violation
In case of violation of FII/ Mutual Fund limits a penalty of Rs. 5,000/‐ would be
levied for each instance of violation.
Client wise/NRI/sub account of FII/scheme of MF position limit violation
In case of open position of any Client / NRI / sub‐account of FII / scheme of MF
exceeding, the specified limit following penalty would be charged on trhineg
clea member for each day of violation:
1% of the value of the quantity in violation (i.e., excess quantity over the allowed
quantity, valued at the closing price of the security in the normal market of the Capital
Market segment of the Exchange) per client or Rs.1,00,000 per client,
whichever is lower, subject to a minimum penalty of Rs.5,000/‐ per violation /
per client.
When the client level/NRI/sub‐account of FII/scheme of mutual fund violation
is on account of open position exceeding 5% of the open interest, a penalty of
Rs.5,000 per instance would be levied to the clearing member.
Market wide Position Limit violation
At the end of each day during which the ban on fresh positions is in force for
any security, when any member or client has increased his existing positions or has
created a new position in that security the client/trading members will be subject
to a penalty 1% of the value of increased position subject to a minimum of Rs.5000
and maximum of Rs.100000. The positions, for this purpose, will be valued at the
underlying close price.
Chapter 8: Legal and Regulatory Environment
LEARNING OBJECTIVES:
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 wssheiscshespo any debt or
receivable, including mortgage debt, assigned to such entity, and acknowledging
 beneficial interest of such investor in such debt or receivable, including
mortgage debt, as the case may be
 Government securities
 Such other instruments as may be declared by the Central Government
to be securities (including onshore rupee bonds issued by multilateral
institutions like the Asian Development Bank and the International
Finance Corporation)
 Rights or interests in securities
According to the act “Derivatives” is defined
as:‐
 A security derived from a debt instrument, share, loan whether secured or
unsecured, risk instrument or contract for differences or any other form
of security.
 A contract which derives its value from the prices, or index of prices, of
underlying securities.
 Commodity derivatives, and
 Such other instruments as may be declared by the Central Government
to be derivatives.
 Section 18A provides that notwithstanding anything contained in any other law
for the time being in force, contracts in derivativegsahlall and valid if such
be le contracts are:
o Traded on a recognized stock exchange
o Settled on the clearing house of the recognized stock exchange, in
accordance with the rules and bye–laws of such stock exchanges.

8.2 Securities and Exchange Board of India Act, 1992

SEBI Act, 1992 provides for establishment of Securities and Exchange Board of
India (SEBI) with statutory powers for (a) protecting the interests of investors in
securities (b) promoting the development of the securities market and (c)
regulating the securities market. Its regulatory jurisdiction extends over corporate
in the issuance of capital and transfer of securities, in addition to all
intermediaries and persons associated with securities market. SEBI has been
obligated to perform the aforesaid functions by such measures as it thinks fit. In
particular, it has powers for:
 Regulating the business in stock exchanges and any other securities markets.
 Registering and regulating the working of stock brokers, sub–brokers etc.
 Promoting and regulating self‐regulatory organizations.
 Prohibiting fraudulent and unfair trade practices.
 Calling for information from, undertaking inspection, conducting inquiries
and audits of the stock exchanges, mutual funds and other persons
associated with the securities market and intermediaries and self–regulatory
organizations in the securities market.
 Performing such functions and exercising according to Securities
Contracts (Regulation) Act, 1956, as may be delegated to it by the
Central Government.
8.3 Regulation in Trading
A 24 member committee under the chairmanship of Dr. L.C.Gupta was set by
SEBI to develop the appropriate regulatory framework for derivatives trading in
India. On May 11, 1998, SEBI accepted the recommendations of the committee
and approved the phased introduction of derivatives trading in India beginning
with stock index futures.
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 ambit of ‘securities’ made trading in derivatives possible within the
framework of that Act.
 Any Exchange fulfilling the eligibility criteria as prescribed in the L.C. Gupta
committee report can apply to SEBI for grant of recognition under Section 4
of the SCRA, 1956 to start trading derivatives. The derivatives
exchange/segment should have a separate governing council and representation
of trading/clearing members shall be limited to maximum of 40% of the total
members of the governing council. The exchange would have to regulate the
sales practices of its members and would have to obtain prior approval of SEBI
before start of trading in any derivative contract.
 The Exchange should have a minimum of 50 members.
 The members of an existing segment of the exchange would not
automatically become the members of derivative segment. The members of
the derivative segment would need to fulfil the eligibility conditions as laid
down by the L.C. Gupta committee.
 The clearing and settlement of derivatives trades would be through a SEBI
approved clearing corporation/house. Clearing corporations/houses complying
withe th eligibility conditions as laid down by the committee have to apply to
SEBI for grant of approval.
 Derivative brokers/dealers and clearing members are required to seek
registration from SEBI. This is in addition to their registration as brokers of
existing stock exchanges. The minimum Net‐worth for clearing members of the
derivatives clearing corporation/house shall be Rs.300 Lakhs. The Net‐worth
of the member shall be computed as follows:
 Capital + Free reserves
 Less non‐allowable assets viz.,
o Fixed assets
o Pledged securities
o Member’s card
o Non‐allowable securities (unlisted securities)
o Bad deliveries
o Doubtful debts and advances
o Prepaid expenses
o Intangible assets
o 30% marketable securities
 The minimum contract value shall not be less than Rs 5,00,000. Exchanges have
to submit details of the futures contract they propose to introduce.
 The initial margin requirement, exposure limits linked to capital adequacy
and margin demands related to the risk of loss on the position will
beepsrcribed by SEBI/ Exchange from time to time.
 The L.C. Gupta committee report requires strict enforcement of “Know your
customer” rule and requires that every client shall be registered with the
derivatives broker. The members of the derivatives segment are also
required to make their clients aware of the risks involved in derivatives trading
by issuing to the client the Risk Disclosure Document and obtain a copy of the
same duly signed by the client.
 The trading members are required to have qualified approved user and sales
person who have passed a certification programme approved by SEBI.
Members and authorized dealer have to fulfil certain requirements and provide
collateral deposits to become members of the F&O segment. All collateral deposits
are segregated into cash component and non‐cash component. Cash component
means cash, bank guarantee, fixed deposit receipts, T‐bills and dated government
securities. Non‐cash component mean all other forms of collateral deposits like
deposit of approved demat securities.
Net‐worth criteria for Clearing Members has been provided by SEBI, while Net‐
worth 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 Members, who are not cash market members of
exchange.
The broker is required to get a Risk Disclosure Document signed by the client,
at the 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
wmedl .infor
Apart from other records, Trading Members are required to maintain trade
confirmation slips and exercise notices from the trading system for a period of 5
years.
All member brokers in the derivative segment should be inspected by the exchange
at least once a year.
A default by a member in the derivatives segment will be treated as default in
all segments of that exchange and as default on all exchanges where he is a
member.
The purpose of inspection of stock brokers’ records under the SEBI (Stock Broker &
Sub‐ Brokers) Regulations, 1992 is to ensure that the books cocfoaunts and other
books are being maintained in the manner required.
The recognition to a stock exchange under the Securities Contract (Regulation) Act
1956 can be granted by the Central Government.
A penalty or suspension of registration of a stock ‐ broker under the SEBI (Stock
Broker & Sub ‐ Broker) Regulations, 1992 can be ordered if:
 The stock broker violates the provisions of the Act
 The stock broker does not follow the code of conduct
  The stock broker fails to resolve the complaints of the investors
 The stock broker indulges in manipulating, or price rigging or cornering
of the market
 The stock broker’s financial position deteriorates substantially
 The stock broker fails to pay fees
 The stock broker violates the conditions of registration
 The stock broker is suspended by the stock exchange
Position limits are the maximum exposure levels which the entire market can go up
to and each Clearing Member or investor can go up to. Position limits for the entire
market and Clearing Members and investors are defined by SEBI.
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 trading system.
If the Trading Member reaches his position limit, he will not be able to enter
any fresh 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 not be permitted, but squaring up will be permitted.

8.4 Regulations in Clearing & Settlement and Risk Management

Anybody interested in taking membership of F&O segment is required to take
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 acquires a right to execute trades and to clear and settle the trades
executed by the members in these segments. Similarly a membership for
Capital Market, Wholesale Debt Market and F&O segment acquires a right to
execute trades and to clear and settle the trades executed by the members in
these segments. An existing member of CM segment can also take membership
of F&O segment. A trading member can also be a clearing member by meeting
additional requirements. There can also be only clearing members.
The initial and exposure margin is payable upfront by Clearing Members. Initial
margins can be paid by members in the form of Cash, Bank Guarantee, Fixed
Deposit Receipts and approved securities.
Clearing members who are clearing and settling for other trading members can
specify the maximum collateral limit towards initial margins, for each trading
member and custodial participant clearing and settling through them.
Such limits can be set up by the clearing member, through the facility provided
on the trading system up to the time specified in this regard. Such collateral limits
once set are applicable to the trading members/custodial participants for that day,
unless otherwise modified by clearing member.
Non‐fulfilment of either whole or part of the margin obligations will be treated
as a violation of the Rules, Bye‐Laws and Regulations of clearing corporation and
will attract penalty.
In addition clearing corporation may at its discretion and without any further notice
to the clearing member, initiate other disciplinary action, inter‐alia including,
withdrawal of trading facilities and/ or clearing facility, close out of outstanding
positions, imposing penalties, collecting appropriate deposits, invoking bank
guarantees/ fixed deposit receipts, etc.
Clearing member is required to provide liquid assets which adequately cover
various margins and liquid Net‐worth requirements. He may deposit liquid assets in
the form of 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 least 50% of the cash component and the rest is non
cash component.
Responsibilities of the Clearing Corporation include:
 Collection of Margins on timely basis
 Smooth operation of the Market
 Daily Clearing and Settlement
 To act as a legal counterparty for every contract
 To monitor positions in derivatives and cash segments
 Deciding Daily Settlement Prices
 Keep consistent record of margins at client level
 Take care not to appropriate client margins against brokers dues
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.
Some of the reports which a derivatives segment of a Stock Exchange has to
provide to SEBI are:
 Occasions when the 99% Value at Risk limit has been violated
 Defaults by broker‐members
 Daily market activity report
 Daily market report
Main objectives of Trade Guarantee Fund (TGF):
 To guarantee settlement of bonafide transactions ethrse of the
of exchange. memb
 To inculcate confidence in the minds of market participants.
 To protect the interest of the investors in securities.
All active members of the Exchange are required to make initial contribution
towards Trade Guarantee Fund of the Exchange.

8.5 Major recommendations of Dr. L.C.Gupta Committee

 Margins should be based on Value at Risk Methodology at 99% confidence.
 Volatility should be monitored online.
 Exposure should be monitored online.
 Daily collection of Mark to Market Margins (on the next trading day).
 Market participants should know volatility and margin methodology.
 Stringent entry norms for derivative broker‐members.
 Each dealer should pass SEBI approved (certificate will have a
certificationsexam validity of 3 years).
 Derivatives segment must be separate from cash
segment.
 Grossing up of margins at client level.
 Separate Investor Protection Fund must be created for derivatives segment.
 Off line order entry is permitted.
 The derivatives segment should attract at least 50 members.
 Clearing Members should have a Minimum Net‐worth of Rs 3 Crores.
 Clearing Members should maintain a Minimum Deposit in Liquid Assets of Rs
50 lakhs with the exchange or it’s Clearing Corporation.
 Mark to Margins should be settled only in Cash.
 Both speculators/traders and hedgers are required for a healthy derivatives market.
 Both Exchanges and SEBI should work together in regulating the derivatives market.
 Exchanges should regulate at operational day to day level, while SEBI will
oversee the process and formulate policy.
 Mutual Funds should be allowed to hedge in derivatives segment.
 Derivatives should begin with Index Futures and other products should be
introduced in a phased manner.
 Members’ exposure should be linked to the amount of liquid assets
maintained by them with the clearing corporation.
 Cross margining (linking overall cash and derivative positions for margining) is
not permitted.
 All clients should pay margins. Brokers should not fund margins of clients.
 In the long run, India should have a national level clearing corporation.
 Clients should be provided with a Risk Disclosure Document by brokers.
 Brokers should keep margins collected from clients in a separate bank account.
 Brokers cannot use margins for any purpose except for payment of such margins
to the clearing corporation.
 Transactions should be entered in the trading system exclusive of brokerage.
 Brokerage should be charged separately in the Contract Note.
 In case of Clearing Member default, margins paid by the Clearing Member on
his own account alone would be used to settle his dues.
 All brokers in the derivatives segment should obtain SEBI Registration.
 The clearing function should be organized as a separate entity, preferably in
the form of a Clearing Corporation.
 The Clearing Corporation has powers to levy additional margins, special
margins, define maximum exposure limits and disable brokers from trading.
 At the time of entering into a transaction, the broker must indicate the
client on whose behalf the transaction is being entered into. Proprietary
trading must also be clearly identified.
 SEBI should create a Special Derivatives Cell within itself to understand and
supervise the market better.
 SEBI should constitute an Advisory Council for derivatives.
 Derivatives segment should have a separate Governing Council.
 No common members should be allowed between the Cash segment
Governing Board and the Derivatives segment Governing Council of the
exchanges.
 The exchange should set up Arbitration and Investor Grievance Cells inaast le
4 regions across the country.
 Derivatives trading must be through on‐line systems.
 Disaster recovery site (in case of computer failure) is a must.
 Information about derivatives segment must be disseminated over at least
two information vending networks (e.g. Reuters, Bloomberg).
 All brokers of the Cash segment will not automatically become members of
the Derivative segment.
 An efficient cash market is a must for a healthy derivatives market.
 Delivery levels in the cash market should improve and increase.
 Uniform settlement cycle across all exchanges is recommended.
 A separate Governing Board should be constituted for the Clearing Corporation
of the Derivatives segment.
 No broker members should be allowed to sit on the Governing Board of the
Clearing Corporation.
 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

8.6 Major recommendations of Prof. J.R.Verma Committee

 Calendar spreads on futures will attract lower margins (minimum 1% and
maximum 3% ‐ the margin itself being 0.5% per month of spread on the far
month value).
 Detailed methodology on Value at Risk provided.
 Volatility should be calculated based on standard deviation of logarithmic
daily returns.
 Exponential weighted average method should be used for calculation of Volatility.
 Initial Margin levels should be dynamic and recalculated continuously based
on volatility levels.
 Exchange should obtain SEBI approval if it wants to change the Initial Margin
calculation methodology.
 Initial Margin, if changed, will apply to all outstanding contracts and not only to
fresh contracts.
 Calendar spreads carry only basis risk and no market risk ‐ hence lower margins
are adequate.
 Calendar spreads should be treated as open positions as the near month expires.
 Differential margins on conversion of Calendar spread positions to open
positions should be collected three days before expiry of the near month
(technically, Prof. J.R.Verma Committee recommendation was different,
however currently as per SEBI guidelines, this is the regulation).
 Liquid Assets mean Deposits maintained by Clearing Members with the
Clearing Corporation.
 Liquid Assets can be in the form of Cash, Cash Equivalents (Government
Securities, Fixed Deposits, Treasury Bills, Bank Guarantees, and Investment
Grade Debt Securities) and Equity Securities.
 Equity Securities can form maximum 50% of Liquid Assets.
 Cash and Cash Equivalents must form minimum 50% of Liquid Assets.
 Liquid Net‐worth is defined as Liquid Assets minus Initial Margin.
 Liquid Net‐worth of all Clearing Members at all points of time (including
intraday) should be maintained at Rs 50 lakhs minimum level.
 Securities placed with the Clearing Corporation shall be marked to market on
weekly basis.
 Hair cut on equity securities is 15%.
 Hair cut on debt securities is 10%.
This page has been
intentionally kept
blank
Chapter 9: Accounting and Taxation
LEARNING OBJECTIVES:
After studying this chapter, you should know about:
 Accounting treatment for forward and futures contracts
 Taxation of derivatives transaction in securities

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

Deposit for Mark to Market Margin

Kept Deposit for M to M Margin a/c
Dr.
To Bank a/c

M to M Margin paid /adjusted from

deposit M to M Margin a/c Dr
To Bank/Deposit for M to M Margin a/c

M to M Margin received
Bank /Deposit for M to M Margin a/c
Dr. To M to M Margin a/c

Accounting for open interests as on the balance sheet date

 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 prices of index futures till the balance sheet date.
 Keeping in view "prudence" principle, provisions should be created by a debit to
the profit and loss account for anticipated loss equivalent to the debit
balance in the "Mark‐to‐Market Margin Account".
 Net amount received (represented by credit balance in the "Mark‐to‐Market
Margin Account") being anticipated profit should be ignored and no credit
for the same should be taken in the profit and loss 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
 Advances" in the balance sheet and the provision created there‐against should
be shown as a deduction there from.
 On the other hand, the credit balance in the said account, i.e., the net
amount received from the broker, should be shown as a current liability
under the head "Current Liabilities and Provisions" in the balance sheet.
 Such provision shall be calculated Index wise/Stock wise that means all
series of stock shall be combined.
Provision for loss on Equity Stock/ Equity Index futures outstanding at Balance
sheet
Opening provision was less hence
increased Profit & Loss a/c Dr
To Provision for loss on Equity Stock/Equity Index future a/c

Opening provision was more hence decreased

Provision for loss on Equity Stock/Equity Index future a/c
Dr To Profit & Loss a/c

To illustrate
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: Profit & Loss a/c Dr. Rs 5000
To Provision for loss on Equity Futures a/c Rs 5000
(Being provision made for the amount paid to Clearing Member/Trading Member
because of movement in the prices of the futures contract)
Accounting at the time of final settlement or squaring‐up of the contract
 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 settlement price and contract prices of all the contracts in the
series.
 The profit/ loss, so computed, should be recognised in the profit and loss
account by corresponding debit/ credit to "Mark‐to‐Market Margin Account".
 Same accounting treatment should be made when a contract is squared‐up
by entering into a reverse contract.
 If more than one contract in respect of the relevant series of Equity Index/
Equity 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 squared‐up should be determined using weighted
average method for calculating profit/ loss on squaring‐up.
 On the settlement of an Equity Index/ Equity Stock futures contract, the
initial margin paid in respect of the contract is released which should be
credited to Initial Margin Account", and a corresponding debit should be given to
the bank account or the deposit account.
If profit on Settlement /Squaring
off M to M Margin a/c Dr
To P & L a/c
If Loss on Settlement/Squaring
off P & L a/c Dr ‐
To M to M Margin a/c
Entry for release of Initial Margin will be:
Bank a/c /Deposit for initial margin
a/c Dr To Initial Margin a/c

Accounting in case of a default

 When a Client default in making payment in respect of Daily Settlement,
the contract is closed out
 The amount not paid by the Client is adjusted against the initial margin.
Excess margin if any is released and shortfall if any will be payable by the
client.
 The accounting treatment in this regard will be the same as explained earlier
 The amount of profit or loss on the contract so closed out should be
calculated and recognised in the profit and loss account in the manner
described earlier.
Disclosure
 The amount of bank guarantee, and book value as also the market value of
securities lodged should be disclosed in respect of outstanding contracts at
the year end, where initial margin money has been paid by way of bank
guarantee and/or lodging of securities, separately for each type of
instruments.
 The number of futures contract not settled (open interests), number of
contracts, number of units pertaining to those contracts as of the balance sheet
date should be disclosed separately for Long and Short Positions, in respect of
each of equity index/ futures i.e. index/ stock wise
Accounting for Equity Index Options in case of cash settled
options Accounting at the inception of the contract
 The seller/ writer of the option is required to pay initial margin for entering into
the
option contract. It should be debited to an appropriate account, say, "Equity
Index/ Stock Option Margin Account". In the balance sheet, such account should
be shown separately under the head "Current Assets".
 The buyer/ holder of the option is required to pay the premium. In the
books of the buyer/ holder, such premium should be debited to an
appropriate account, say, "Equity Index/ Stock Option Premium Account". In
the books of the seller/ writer such premium received should be credited to
an appropriate account, say, "Equity Index/ Stock Option Premium Account".
Accounting at the time of payment/ receipt of margin
 Payment made or received by the seller/ writer for the margin would be
credited/ debited to the bank account and the corresponding debit or credit
for the same should be made to "Equity Index/ Stock Option Margin
Account".
 Sometimes, the client may deposit a lump sum amount with the Trading/
Clearing Member in respect of the margin instead of paying/ receiving margin
on daily basis. In such a case, the amount of margin paid/ received from/ into
such account should 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 head "Current Assets".
 Entries will be similar to initial margin on futures explained earlier.
Accounting for open options as on the balance sheet date
 The "Equity Index/Stock Option Premium Account" should be shown under
the "head 'Current Asset' or 'Current Liabilities', as the case may be.
 In case of multiple options, entries recommended above may be made in
one “Equity Index/ Stock Option Premium Account”, in respect of options of all
stocks. The balance of this composite account should be shown under the
head "Current Assets' or "Current Liabilities", as the case may be.
 But for calculating provision for loss, Stock wise / index wise a/c is advisable.
 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 balance sheet date since the buyer/ holder can reduce his
loss to the extent of the premium prevailing in the market, by squaring off
the transaction.
 The excess of premium prevailing in the market on the balance sheet date over
the premium paid is not recognised on the consideration of prudence,
 The provision so created should be credited to "Provision for Loss on Equity
Index/ stock Option Account". The provision made as above should be shown as
deduction from "Equity Index/ stock Option Premium" which is shown under
'Current Assets'.
 In the books of the seller/ writer, the provision should be made for the
amount by which premium prevailing on the balance sheet date exceeds the
premium received for that option.
 The excess of premium received over the premium prevailing on the balance
sheet date is not recognised on the consideration of prudence.
 This provision should be credited to "Provision for Loss on Equity Index/
Stock Option Account", with a corresponding debit to profit and loss
account. "Equity index/stock Options Premium Account" and "Provision for
Loss on Equity Index/ Stock Options Account" should be shown under 'Current
Liabilities and Provisions'.
 In case of multiple open options at the year‐end, a Stockwise / lndexwise
provision should be made considering all the open options of any strike price
and any expiry date under that stock/ Index taken together.
 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.
 The amount of provision required in respect of each stock or index should
be aggregated and a composite" Provision for Loss on Equity Stock/ Index
 Options Account" should be credited by debiting P&L a/c.
 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
 account be debited/ credited with the balance provision required to be
made/excess provision written back.
Accounting at the time of final
settlement In the books of the buyer/
holder:
 The buyer/ holder will recognise premium as an expense in the profit and loss
account
 On exercise of the option, the buyer/ holder will receive favourable
difference, between the final settlement price as on the exercise/expiry
date and the strike price, which will be recognised as income.
In the books of the seller/writer:
 The seller/ writer will recognise premium as an income in the profit and loss
account
 On exercise of the option, the seller/writer will pay the adverse difference,
between the final settlement price as on the exercise/ expiry date and the
strike price. Such payment will be recognised as a loss.
 As soon as an option gets exercised, margin paid towards such an option will
be released by the exchange, which should be credited to "Equity Index/ stock
Option Margin Account" and the bank account will be debited.
Accounting at the time of squaring off of an option contract
 The difference between the premium paid and received on the squared off
transactions should be transferred to the profit and loss account.
 Accounting treatment is the same as above in the books of the seller/ writer
for margin money released on the squaring off of an option contract.
Method for determination of profit/loss in multiple options situation:
 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 method should be followed on squaring off of transactions
or is/ are exercised before the expiry date.
Accounting treatment in respect of equity stock options in case of delivery
settled options
 The accounting entries at the time of inception, payment/receipt of margin
and open options at the balance sheet date will be the same as those in
case of cash settled options.
 At the time of final settlement, if an option expires unexercised then the
accounting 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 the strike price. In such a case, the accounting treatment will be as
recommended in the following paragraphs.
In case of buyer/holder:
 For a call option the buyer/ holder will receive equity shares for which the
call option was entered into. The buyer/ holder should debit the relevant
equity shares account and credit cash/ bank.
 For a put option buyer/ holder will deliver equity shares for which the put
option was entered into. The buyer/ holder should credit the relevant
equity shares account and debit cash/ bank.
In case of seller/writer:
 For a call option the seller/ writer will deliver equity shares for which the call
option was entered into. The seller/ writer should credit the relevant equity
shares account and debit cash/ bank.
 For a put option the seller/ writer will receive equity shares for which the put
option was entered into. The seller/ writer should debit the relevant equity
shares account and credit cash/ bank.
 In addition to this entry, the premium paid/received will be transferred to the
profit and loss account, the accounting entries for which should be the same
as those in case of cash settled options.
Disclosure
 The enterprise should disclose the accounting policies and the methods
adopted, including criteria for recognition and the basis of measurement
applied for equity index options and equity stock options.
 Where initial margin is paid by way of bank guarantee and/or lodging of
securities, the amount of such bank guarantee/ book value and market value
of securities in respect of outstanding options at the year end.
 The buyer/holder and the seller/ writer of the option should give the
following details in respect of the option contracts outstanding as at the
year‐end for each Equity Index/ Stock Option.
Accounting for Equity Stock Options
Accounting for Equity Stock Options which are settled in Cash
• Accounting entries for Equity Stock Options settled in cash will be the same as
that in the case of Equity Index Options.
• This is because in both the cases the settlement is done otherwise than by
delivery of the underlying assets.
Accounting for Equity Stock Options which are settled by delivery
Accounting entries at the time of inception, daily receipt/ payment of margin and
open options at the balance sheet date will be the same as that in the case of
cash settled options.

9.2 Taxation of derivative transaction in securities

Taxation of Profit/Loss on derivative transaction in securities
Prior to Financial Year 2005–06, transaction in derivatives were considered as
speculative transactions for the purpose of determination of tax liability under
the Income ‐tax Act. This is in view of section 43(5) of the Income‐tax Act
which defined speculative transaction as a transaction in which a contract for
purchase or sale of any commodity, including stocks and shares, is periodically or
ultimately settled otherwise
than by the actual delivery or transfer of the commodity or stocks. However,
such transactions entered into by hedgers and stock exchange members in course
of jobbing or arbitrage activity were specifically excluded from the purview of
definition of speculative transaction.
In view of the above provisions, most of the transactions entered into in derivatives
by investors and traders were considered as speculative transactions. The tax
provisions provided for differential treatment with respect to set off and carry
forward of loss on such transactions. Loss on derivative transactions could be set
off only against other speculative income and the same could not be set off
against any other income. This resulted in payment of higher taxes by an
assessee.
Finance Act, 2005 has amended section 43(5) so as to exclude transactions in
derivatives carried out in a “recognized stock exchange” for this purpose. This
implies that income or loss on derivative transactions which are carried out in a
“recognized stock exchange” is not taxed as speculative income or loss. Thus, loss
on derivative transactions can be set off against any other income during the
year (except salary income). In case the same cannot be set off, it can be carried
forward to subsequent assessment year and set 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)
Trading member has to pay securities transaction tax on the transaction executed
on the exchange shall be as under:
Sr. Taxable securities
STT rate Payable by
No. transaction
1. Sale of an option in 0.05 per cent Seller
securities
Sale of an option in
2. securities, where option 0.125 per Purchaser
is cent
exercised
3. Sale of a futures in 0.01 per cent Seller
securities
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.
Exchanges adopt the following procedure in respect of the calculation and
collection of Securities Transaction Tax:
 STT is applicable on all sell transactions for both futures and option contracts.
 For the purpose of STT, each futures trade is valued at the actual traded
price and option trade is valued at premium. On this value, the STT rate as
prescribed is applied to determine the STT liability. In case of voluntary or
final exercise of
 an option contract STT is levied on settlement price on the day of exercise if
the option contract is in the money.
 STT payable by the clearing member is the sum total of STT payable by all
trading members clearing under him. The trading member’s liability is the
aggregate STT liability of clients trading through him.
Chapter 10: Sales Practices and Investors Protection
Services
LEARNING OBJECTIVES:
After studying this chapter, you should know about:
 Client Identification procedure
 Due Diligence process for customers
 Investor Grievance Mechanism against trading members
 SEBI Complaints Redress System
The finance sector has an important role to play in an economy. It has
responsibility to 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 advice and having excellent customer service is a
precondition for long‐term success of any financial institution.
Financial Institutions should have customer‐oriented approach, where sales of
products are customer lead and always accompanied by correspondingly
efficient and appropriate advice. It can be summarily stated that: “Customers
have the right to get good advice; finance employees have the duty to give good
advice.”
A favourable model should be developed in cooperation between company, its
employees and intermediaries in the finance sector to ensure the best possible
framework for increasing customer satisfaction.
In the recent past, naïve investors have increasingly become targets of financial
abuse and fraud. Investors should be cautious while investing in any of the financial
products in the market. Some of the areas where investor needs to be careful
about his investments are discussed below:
“High Return” or "Risk‐Free" Investments
Investors should be careful of opportunities that promise spectacular profits or
"guaranteed" returns. The deal soundsotdoo go to resist. An individual may claim that
unrealistic returns can be realized from "Low‐Risk Investment Opportunities", but
one has to keep in mind no investment is risk‐free. Returns are related to the risk
taken and hence there cannot be a product in the market that gives high return
in risk free manner.
Investment Advisor Services
Investment advisor is an individual or firm responsible for making investments on
behalf of, and/ or providing advice to, investors. He has a duty to act in the
best interest of their clients. Sometimes, however, investment advisors take
advantage of their positions of trust and use unauthorized and deceptive
methods to misappropriate money directly from their clients. Investors should be
careful to review their monthly account statements and to conduct annual reviews
of their investment plans with their investment adviser. Investors should be
watchful for abnormal changes in their monthly account statements.
Unsuitable Investment Recommendations
Some unscrupulous investment advisers convince clients to purchase
investment products that don’t meet the objectives of an investor. Unsuitable
recommendations can occur when a broker sells speculative transactions such as
options, futures, or penny stocks to say a senior citizen with low risk tolerance.
Investors should beecfuarl to review the risk profile of each investment
recommendation.
Churning
“Churning” refers to when securities professionals making unnecessary and
excessive trades in customer accounts for the sole purpose of generating
commissions. Investors should be careful to review their monthly account
statements and investigate any abnormally high trading activity.
Investor Seminars
Investment advisers commonly invite investors to attend seminars. At these
seminars, 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 before committing their funds.
As sales become an integral part in financial services
advice to the customers
andpperro is important.
Contact with consumers
 Sales Agents must only make sales calls on consumers at reasonable times
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 and 8 pm, unless it is at the consumer’s request.
 Sales Agents will, as soon as possible on making contact, identify themselves,
the company they represent and their purpose.
 Sales Agents will take account of the consumer's personal circumstances and, as
a minimum, comply with diversity obligations.
 Sales Agents will end the discussion and leave the premises immediately at
the consumer’s request.
 Sales Agents will voluntarily cease contact with a consumer who clearly
indicates that contact is inconvenient, unwelcome or inappropriate.
 A contact number must be left with any consumer, on request.
 Sales Agents must not exploit a person’s inexperience, vulnerability, credulity
or loyalties.
 Members shall maintain records, including the date of contact with the
consumer to allow the subsequent identification of the Sales Agent involved.
This will assist in dealing with any complaint or query.
 Sales Agents must at all times:
o Be courteous and professional.
o Seek to avoid the consumer misunderstanding any information given or
making false assumptions, in particular over potential returns on their
savings.
o Avoid the use of high pressure/ luring tactics.
10.1 Understanding risk profile of the client
In the context of investments, “risk” refers not only to the chance that a
person may lose his capital but more importantly to the chance that the
investor may not get the desired return on an investment vehicle. People invest in
various investment products that generally comprise:
 Fixed Income Instruments, and
 Market oriented investments.
In the case of former, with a definite interest rate, there is little “risk” of not
being able to get the desired returns (credit or default risk exists though) but in the
case of latter, an investor goes with an expectation of a certain amount of return
and the term “risk” in this context refers to the probability of the investor not
getting the desired /expected returns.
Financial advisor should have thorough understanding of risk. There is a risk/
return trade‐off. That is, the greater risk accepted, the greater must be the
potential return as reward for committing one’s funds to an uncertain outcome.
Generally, as the level of risk rises, the expected rate of return should also rise,
and vice versa.
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 hand an investor who is less risk averse would like to have greater
exposure to equity and other risky investments.
There is need to understand risk tolerance for a variety of reasons some of
which are specified below:
 To achieve level of financial independence that to meet not only
allowsmthe
their basic human needs, but also higher level needs for self
development and self improvement in their life.
 Willingness to accept a certain smaller return rather than a large but
uncertain profit from their financial decisions.
 Individual’s evaluations of their self‐worth and ethlseir of self‐esteem are
lev
related to their levels of satisfaction with their financial situation.
 Individuals need to appreciate their personal comfort zone when they trade‐
off what they are willing to accept in terms of possible losses versus possible
gains.
 Investor’s objectives are often poorly developed and unrealistic in terms
of investments.
 It is often difficult for people to describe in their own words their attitudes
about risk.
 There is a good chance that new investors in particular will not understand
many of the financial and risk concepts presented by advisors.
 Communication is focused around an explicit and understandable score
 or profile.
 Very difficult for the financial advisor to arrive at an accurate risk profile.
 Single Investment model will fit all‐ lifecycle approach does not work.
Some of the key parameters on which one’s risk tolerance can depend is age,
personal income, combined family income, sex, number of dependents, occupation,
marital status, education, access to other inherited sources of wealth.
Financial advisors need to know about the time period for which investors plan
to invest. The objectives of the investors should be made clear to give a proper
advice and meet his short term as well as long term needs. Generally speaking, the
longer the time horizon, the more risk can be integrated into his financial
expectations about the investments.
Globally, as well as in India, it is well established, on the basis of track record
of performance that equities as a class of asset has outperformed other asset
classes and delivered superior returns over longer periods of time. With these
statistics available, why wouldn’t everyone at all times invest 100 percent in
stocks? The answer is, of course, that while over the long term stocks have
outperformed, there have been many short term periods in which they have
underperformed, and in fact, have had negative returns. Exactly when short term
periods of underperformance occurs is unknown and thus, there is more risk in
owning stocks if one has a short term horizon than if there exists a long term
horizon.
The risk and complexity vary among derivative products. While some derivatives
are relatively simple, many others, especially options, could be highly complex and
would require additional safeguards from investors’ viewpoint. Options are a more
complex derivative product than index futures because evaluating the fairness
of option premium is a complex matter.
It is essential that broker‐client relationship and sales practices for derivatives
need regulatory focus. The potential risk involved in trading (as opposed to
hedging) with derivatives is not understood widely. In the case of pricing of
complex derivatives contracts, there is a real danger of unethical sales practices.
Clients may be fleeced or induced to buy unsuitable derivative contracts at unfair
prices and without properly understanding the risks involved. That is why it has
become a standard practice to require a "risk disclosure document" to be provided
by broker/ dealer to every client in respect of the particular type of derivatives
contracts being sold.
Also, derivatives brokers/ dealers are expected to know their clients and to
exercise care to ensure that the derivative product being sold by them to a
particular client is suitable to his understanding and financial capabilities.
Derivatives may tempt many people because of high leverage. The concept of
"know‐your‐client" needs to be implemented and every broker/ trader should
obtain a client identity form.
Derivatives brokers/ dealers should avoid recommending opening futures/
options transaction unless they have a reasonable basis for believing that the
customer has such knowledge and financial experience that he or she is capable
of evaluating, and financially able to bear, the risks of the transaction.
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
investment experience and knowledge. Brokers must ensure that investors are
given a detailed explanation of the special characteristics and risks applicable to
the trading of derivative products.
The disclosure document about derivative products contains information describing
the mechanics and risks of derivatives trading, transaction costs, margin
requirements and
tax consequencesrogfinma trading.
Written Anti Money Laundering Procedures
Each registered intermediary should adopt written procedures to implement the
anti money laundering provisions as envisaged under the Anti Money Laundering
Act, 2002. Such procedures should include inter alia, the following three specific
parameters which are related to the overall ‘Client Due Diligence Process’:
 Policy for acceptance of clients
 Procedure for identifying the clients
 Transaction monitoring and reporting especially Suspicious Transactions
Reporting (STR)
Customer Due Diligence
The customer due diligence (“CDD”) measures comprises the following:
 Obtaining sufficient information in order to identify persons who beneficially
own or control securities account. Whenever it is apparent that the
securities acquired or maintained through an account are beneficially
owned by a party other than the client, that party should be identified
using client identification and verification procedures. The beneficial
owner is the natural person or
persons who ultimately own, control or influence aenctli and/or persons on
whose behalf a transaction is being conducted. It also incorporates those
persons who exercise ultimate effective control over a legal person or
arrangement.
 Verify the customer’s identity using reliable, independent source
documents, data or information;
 Identify beneficial ownership and control, i.e. determine which individual(s)
ultimately own(s) or control(s) the customer and/ or the person on whose
behalf a transaction is being conducted;
 Verify the identity of the beneficial owner of the customer and/or the
person on whose behalf a transaction is being conducted, corroborating the
information provided in relation to person; and
 Conduct ongoing due diligence and scrutiny, i.e. perform ongoing scrutiny of
the transactions and account throughout the course of the business
relationship to ensure that the transactions being conducted are consistent
with the registered intermediary’s knowledge of the customer, its business
and risk profile, taking into account, where necessary, the customer’s
source of funds.
Policy for acceptance of clients
All registered intermediaries should develop customer acceptance policies and
procedures that aim to identify the types of customers that are likely to pose a
higher
than the average risk of money laundering or terrorist financing. By establishing
such policies and procedures, they will be in a better position to apply
customer due diligence on a risk sensitive basis depending on the type of
customer business relationship or transaction. In a nutshell, the following
safeguards are to be followed while accepting the clients:
 No account is opened in a fictitious/benami name or on an anonymous basis.
 Factors of risk perception (in terms of monitoring suspicious transactions) of
the client are clearly defined having regard to client’s location
(registered office address, correspondence addresses and other addresses if
applicable), nature of business activity, trading turnover etc. and manner
of making payment for transactions undertaken. The parameters should
enable classification of 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 regular update of KYC profile.
 Documentation requirement and other information to be collected in respect
of different classes of clients depending on perceived risk and having regard
to the requirement to the Prevention of Money Laundering Act 2002,
guidelines issued by RBI and SEBI from time to time.
 Ensure that an account is not opened where the intermediary is unable to
apply appropriate clients due diligence measures/KYC policies. This may be
applicable in cases where it is not possible to ascertain the identity of the
client, information provided to the intermediary is suspected to be non
genuine, perceived non cooperation of the client in providing full and
complete information. The market intermediary should not continue to do
business with such a person and file a suspicious activity report. It should
also evaluate whether there is suspicious trading in determining in
whether to freeze or close the account. The market intermediary should
be cautious to ensure that it does not return securities of money that may
be from suspicious trades. However, the market intermediary should consult
the relevant authorities in determining what action it should take when it
suspects suspicious trading.
 The circumstances under which the client is permitted to act on behalf of
another person/entity should be clearly laid down. It should be specified in
what manner the account should be operated, transaction limits for the
operation, additional authority required for transactions exceeding a
specified quantity/value and other appropriate details. Further the rights
and responsibilities of both the persons (i.e. the agent‐ client registered
with the intermediary, as well as the person on whose behalf the agent is
acting should be clearly laid down). Adequate verification of a person’s
authority to act on behalf the customer should also be carried out.
 Necessary checks and balance to be put into place before opening an account
so as to ensure that the identity of the client does not match with any person
having known criminal background or is not banned in any other manner,
whether in terms of criminal or civil proceedings by any enforcement
agency worldwide.
Risk based approach
It is generally recognized that customers can be classified into a higher or
lower risk category depending on circumstances such as the customer’s
background, type of business relationship or transaction etc. As such, the
registered intermediaries should apply each of the customers due diligence
measures on a risk sensitive basis. The basic principle enshrined in this approach is
that the registered intermediaries should adopt an enhanced customer due
diligence process for higher risk categories of customers. Conversely, a simplified
customer due diligence process may be adopted for lower risk categories of
customers. In line with the risk‐based approach, the type and amount of
identification information and documents that registered intermediaries should
obtain necessarily depend on the risk category of a particular customer.
Clients of special categories (CSC)
Such clients include the following:
 Non resident clients.
 High Net‐worth clients.
 Trust, Charities, NGOs and organizationsgreceivin donations.
 Companies having close family shareholdings or beneficial ownership.
 Politically exposed persons (PEP) of foreign origin.
 Current / Former Head of State, Current or Former Senior High profile
politicians and connected persons (immediate family, Close advisors and
companies in which such individuals have interest or significant
influence).
 Companies offering foreign exchange offerings.
 Clients in high risk countries (where existence / effectiveness of money
laundering controls is suspect, where there is unusual banking secrecy,
Countries active in narcotics production, Countries where corruption (as per
Transparency International Corruption Perception Index) is highly prevalent,
Countries against which governmentcstiaonns are applied, Countries reputed
to be any of the following – Havens / sponsors of international terrorism,
offshore financial centres, tax havens, countries where fraud is highly
prevalent.
 Non face to face clients.
 Clients with dubious reputation as per public information available.etc.
The above mentioned list is only illustrative and the intermediary should
exercise independent judgment to ascertain whether new clients should be
classified as CSC or not.
Client Identification Procedure
 The ‘Know your Client’ (KYC) policy should clearly spell out the client
identification procedure to be carried out at different stages i.e. while
establishing the intermediary – client relationship, while carrying out
transactions for the client or when the intermediary has doubts
 regarding the veracity or the adequacy of previously obtained client
identification data.
 The client should be identified by the intermediary by using reliable
sources including documents/information. The intermediary should obtain
adequate
 information to satisfactorily establish the identity of each new client and
the purpose of the intended nature of the relationship.
 The information should be adequate to satisfy competent authorities
(regulatory
/ enforcement authorities) in future that due diligence was observed by
the intermediary in compliance with the Guidelines. Each original document
should be seen prior to acceptance of a copy.
 Failure by prospective client to provide satisfactory evidence of identity
should be noted and reported to the higher authority within the
intermediary.
 SEBI has prescribed the minimum requirements relating to KYC for certain
class of the registered intermediaries from time to time. Taking into account
the basic principles enshrined in the KYC norms which have already been
prescribed or which are prescribed by SEBI from time to time, all
registered intermediaries should frame their own internal guidelines based
on their experience in dealing with their clients and legaleqr uirements
as per the established practices. Further, the intermediary should also
maintain continuous familiarity and follow‐ up where it notices
inconsistencies in the information provided. The underlying principle should
be to follow the principles enshrined in the PML Act, 2002 as well as the
SEBI Act, 1992 so that the intermediary is aware of the clients on whose
behalf it is dealing.
Documents to be obtained from customers for Customer Identification
Procedure under KYC
1.Accounts of Individuals
Legal name and any other names used supported by documents given below:
(i) Passport (ii) PAN card (iii) Voter’s Identity Card (iv) Driving License (v) Job Card
issued by NREGA duly signed by an officer of the State Govt (vi) The letter issued by
the Unique
Identification Authority of India ( UIDAI) containing details of name, address
and Aadhaar number (vii) Identity card (subject to the bank’s satisfaction) (viii)
Letter from a recognized public authority or public servant verifying the identity
and residence of the customer to the satisfaction of bank
Correct Permanent Address supported by any of the following documents:
(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 satisfaction of the bank)
2.Accounts of Company
 Name of the company
 Principal place of business
 Mailing address of the company
 Telephone/Fax number
Documents Required:
(i) Certificate of incorporation and Memorandum & Articles of Association (ii)
Resolution of the Board of Directors to open an account and identification of
those who have
authority to operate the account (iii) Power of Attorney granted to its managers,
officers or employees to transact business on its behalf (iv) Copy of PAN
allotment letter (v) Copy of the telephone bill
3.Accounts of Partnership Firms
 Legal name
 Address
 Names of all partners and their addresses
 Telephone numbers of the firm and partners
Documents required:
(i) Registration certificate, if registered (ii) Partnership deed (iii) Power of Attorney
granted to a partner or an employee of the firm to transact business on its
behalf (iv) Any officially valid document identifying the partners and the persons
holding the Power of Attorney and their addresses (v) Telephone bill in the
name of firm/partners

10.2 Investors Grievance Mechanism

Each Exchange has a process for grievance redressal. The general features of
these processes are mentioned below.
Investor grievance resolution mechanism (against trading members)
All exchanges have a dedicated department to handle grievances of investors
against the Trading Members and Issuers. Generally these departments operate
from all offices of the exchange so as to provide easy access to investors. All
exchanges also have supervision mechanisms for the functioning of this
department/ cell. These include the Investor Service Committees (ISC) consisting of
Exchange officials and independent experts whose nomination is approved by
Securities and Exchange Board of India. SEBI also monitors exchange performance
related to investor grievance redressal.
Process
Receipt of Complaints
The investor is required to submit his complaint in the prescribed complaint
form against the trading member providing the details as specified in the
instructions annexed to the complaint registration form along with supporting
documents substantiating his claim.
On receipt of the complaint, exchanges scrutinize the nature of complaint and
adequacy of documents submitted along with the complaint. If all the relevant
documents are submitted, the complaint is recorded, a complaint number is
assigned and an acknowledgement towards receipt of complaint is sent to the
investor. If the documents are inadequate, the investor is advised to set right the
deficiencies in the documents.
Redressal of Complaints
Generally, exchanges initially try to resolve the complaint by following up with
the member and the complainant. The issues raised by the complainant are
analyzed and the complaint is taken up the concerned trading member for
resolution / response
within the set timeframe. Subsequently, the response received from the
trading member is reviewed.
 If the Trading Member has agreed with the contents of the complaint, he
is advised to settle the matter immediately and confirm
 If the Trading Member states that he has already settled the complaint,
proof of settlement is solicited and cross confirmation is obtained from
the investor
 If the Trading Member raises issues from his side, the comments are
analyzed 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 expeditious resolution of the complaints. In case
differences still persist the investor is informed that he may opt for
Arbitration proceedings.
 If the Trading Member has justifiable reasons for his actions which are within
the regulatory framework, the investor is enlightened on the correct
position on the matter.
Nature of complaints
Exchanges provide assistance if the complaints fall within the purview of the
Exchange and are related to trades that are executed on the Exchange Platform.
These may be of the following types:
 Non‐Receipt of Corporate Benefit (Dividend/Interest/Bonus etc.)
 Complaints against trading members on account of the following :
o Non‐receipt of funds / securities
o Non‐ receipt of documents such as member client agreement,
contract notes, settlement of accounts, order trade log etc.
o Non‐Receipt of Funds / Securities kept as margin
o Trades executed without adequate margins
o Delay /non – receipt of funds
o Squaring up of positions without consent
o Unauthorized transaction in the account
o Excess Brokerage charged by Trading Member / Sub‐broker
o Unauthorized transfer of funds from commodities account to
other accounts etc.
 Complaints in cases where the member has surrendered his membership
and the complainant has approached the Exchange before expiry of the
time mentioned in the public notice
Exchanges may not take up the following types of complaints
a. Complaints in respect of transactions which are already subject matter of
Arbitration proceedings,
b. Complaints involving payment of funds and transfer of securities to entities
other than Trading Member,
c. Claims for mental agony/harassment and expenses incurred for pursuing the
matter with the ISC,
d. Claims for notional loss, opportunity loss for the disputed period or trade,
e. Complaints pertaining to trades not executed on the Exchange by the complainant,
f. Claims of sub‐broker/authorized persons for private commercial dealings with
the trading member,
g. Claims relating to transactions which are in the nature of loan or financing
which are not within the framework defined by the Exchange.
Arbitration
SEBI has instructed the exchange to have arbitration committees so that
differences, disputes and claims between trading members and investors can be
settled effectively and in a short time. Arbitration is also governed by Exchange
Bye‐laws.
Arbitration is a quasi judicial process of settlement of disputes between
Trading Members, Investors, Sub‐brokers & Clearing Members and between
Investors and Issuers (Listed Companies). Generally the application for arbitration
has to be filed at the Arbitration Centres established by the exchanges.
The parties to arbitration are required to select the arbitrator from the panel
of arbitrators provided by the Exchange. The arbitrator conducts the
arbitration proceeding and passes the award normally within a period of four
months from the date of initial hearing.
The arbitration award is binding on both the parties. However, the aggrieved
party, within fifteen days of the receipt of the award from the arbitrator, can file
an appeal to the arbitration tribunal for re‐hearing the whole case. On receipt
of the appeal, the Exchange appoints an Appellate Bench consisting of five
arbitrators who re‐hear the case and then give the decision. The judgment of
the Bench is by a ‘majority’ and is binding on both the parties. The final award of
the Bench is enforceable as if it were the decree of the Court.
Any party who is dissatisfied with the Appellate Bench Award may challenge the
same in a Court of Law.
SEBI Complaints Redress System (SCORES) [http://scores.gov.in]
SEBI launched a centralized web based complaints redress system (SCORES). This
would enable investors to lodge and follow up their complaints and track the
status of redressal of such complaints from anywhere. This would also enable
the market intermediaries and listed companies to receive the complaints from
investors against them, redress such complaints and report redressal. All the
activities starting from lodging of a complaint till its disposal by SEBI would be
carried online in an automated environment and the status of every complaint
can be viewed online at any time. An investor, who is not familiar with SCORES or
does not have access to SCORES, can lodge complaints in physical form. However,
such complaints would be scanned and uploaded in SCORES for processing. SCORES
would expedite disposal of investors’ complaints as this would obviate the need for
physical movement of complaints and the possibility of loss, damage or
misdirection of the complaints would be avoided. It would facilitate easy
retrieval and tracking of complaints at any time.
SCORES is web enabled and provides online access 24 x 7. This has the following
salient features:
 Complaints and reminders thereon are lodged online at anytime from anywhere;
 An email is generated instantaneously acknowledging the receipt of the
complaint and allotting a unique complaint registration number for future
reference and tracking;
 The complaint moves online to the entity (intermediary or listed company)
concerned for its redressal;
 The entity concerned uploads an Action Taken Report (ATR) on the complaint;
 SEBI peruses the ATR and disposes of the complaint if it is satisfied that the
complaint has been redressed adequately;
 The concerned investor can view the status of the complaint online;
 The entity concerned and the concerned investor can seek and provide
clarification(s) online to each other;
 The life cycle of a complaint has an audit trail; and
 All the complaints are saved in a central database which would generate
relevant MIS reports to enable SEBI to take appropriate policy decisions and
or remedial actions.
SEBI mandates that all listed companies are required to view the complaints
pending against them and submit ATRs along with supporting documents
electronically in SCORES. Failure on the part of the company to update the ATR in
SCORES will be treated as non‐redressal of investor complaints by the company.
SEBI also mandates that companies desirous of getting their equity shares listed on
the stock exchanges should also obtain authentication on SCORES, before Listing
Approval is granted by stock exchanges.
Effective from August 01, 2018, following procedure shall be followed for filing
and redressal of investor grievances using SCORES:
Investors who wish to lodge a complaint on SCORES have to register themselves
on www.scores.gov.in. While filing the registration form, details like Name of the
investor, PAN, Contact details, Email id, Aadhaar card number (optional), CKYC
ID(optional) etc. may be provided for effective communication and speedy
redressal of the grievances. Upon successful registration, a unique user id and a
password will be communicated to the investor through an acknowledgement email
/ SMS. Using the login credentials, the investor can lodge his/her complaint on
SCORES. The complainant may 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 redress the grievance within 30 days, failing
which the complaint shall be registered in SCORES.
General Do's and Don’ts for Investors
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:
Do’s
Investors must:
 Always deal with the market intermediaries registered with SEBI / stock
exchanges.
 Carry out due diligence before registering as client with any intermediary.
Carefully read and understand the contents stated in the Risk Disclosure
Document, which forms part of the investor registration requirement for
dealing through brokers.
 Collect photocopies of all documents executed for registration as a client,
immediately on its execution.
 Ensure that the documents or forms for registration as Client are fully filled in.
 Give clear and unambiguous instructions to their broker / agent /
depository participant.
 Always insist on contract notes from their brokers/sub‐brokers. In case of doubt
in respect of the transactions, verify the genuineness of the same from the
exchange.
 Always settle the dues through the normal banking channels with the
market intermediaries.
 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.
Appendix A: Sample Questions
1.An index option is a .
(a)Debt instrument
(b)Derivative product
(c)Cash market product
(d)Money market instrument

2. The purchase of a share in one market and the simultaneous sale in a

different market to benefit from price differentials is known as .
(a)Mortgage
(b)Arbitrage
(c)Hedging
(d)Speculation

3.Financial derivatives provide the facility for .

(a)Trading
(b)Hedging
(c)Arbitraging
(d)All of the above

4. Operational risks include losses due to .

(a)Inadequate disaster planning
(b)Too much of management control
(c)Income tax regulations
(d)Government policies

5. Impact cost is low when the liquidity in the system is poor.

(a)True
(b)False

6. You sold one XYZ Stock Futures contract at Rs. 278 and the lot size is 1,200.
What is your profit (+) or loss (‐), if you purchase the contract back at Rs. 265?
(a) 16,600
(b) 15,600
(c) ‐15,600
(d) ‐16,600

7. You have taken a short position of one contract in June XYZ futures
(contract multiplier 50) at a price of Rs. 3,400. When you closed this position after
a few days, you realized that you made a profit of Rs. 10,000. Which of the
following closing actions would have enabled you to generate this profit? (You
may ignore brokerage costs.)
(a)Selling 1 June XYZ futures contract at 3600
(b)Buying 1 June XYZ futures contract at 3600
(c)Buying 1 June XYZ futures contract at 3200
(d)Selling 1 June XYZ futures contract at 3200

8. Which of the following is closest to the forward price of a share, if Cash

Price = Rs.750, Forward Contract Maturity = 6 months from date, Market
Interest rate = 12%? (a) 772.5
(b) 795
(c) 840
(d) 940.8

9. If you have sold a XYZ futures contract (contract multiplier 50) at 3100 and
bought it back at 3300, what is your gain/loss?
(a)A loss of Rs. 10,000
(b)A gain of Rs. 10,000
(c)A loss of Rs. 5,000
(d)A gain of Rs. 5,000

10.A calendar spread contract in index futures attracts .

(a)Same margin as sum of two independent legs of futures contract
(b)Lower margin than sum of two independent legs of futures contract
(c)Higher margin than sum of two independent legs of futures contract
(d)No margin need to be paid for calendar spread positions

11. Client A has purchased 10 contracts of December series and sold 7 contracts
of January series of the NSE Nifty futures. How many lots will get categorized
as regular (non‐spread) open positions?
(a)10
(b)7
(c)3
(d)17

12. In an equity scheme, fund can hedge its equity exposure by selling stock
index futures.
(a)True
(b)False

13.Margins in 'Futures' trading are to be paid by .

(a)Only the buyer
(b)Only the seller
(c)Both the buyer and the seller
(d) rTinhge clea corporation

14. When the near leg of the calendar spread transaction on index futures expires,
the farther leg becomes a regular open position.
(a)True
(b)False

15.Selling short a stock means .

(a)Seller does not own the stock he is supposed to deliver
(b)Seller has to deliver the stock within a short time
(c)Seller owns the stock he is supposed to deliver
(d)Seller has more than a year's time to deliver the stock which he sold

16.The buyer of an option cannot lose more than the option premium paid.
(a)True only for European options
(b)True only for American options
(c)True for all options
(d)False for all options

17.Cost of carry model states that .

(a)Price of Futures = Spot + Cost of Carry
(b)Price of Futures = Spot ‐ Cost of Carry
(c)Price of Futures = Spot Price
(d)Price of Futures = Cost of Carry

18.What role do speculators play in the futures market?

(a)They take delivery of the commodities at expiration
(b)They produce the commodities traded at futures exchanges
(c)They add to the liquidity in the futures markets
(d)They transfer their risk to the hedgers

19. You sold a Put option on a share. The strike price of the put was Rs245 and
you received a premium of Rs 49 from the option buyer. Theoretically, what
can be the maximum loss on this position?
(a) 196
(b) 206
(c)0
(d)49

20.Current Price of XYZ Stock is Rs 286. Rs. 260 strike call is quoted at Rs 45. What
is the Intrinsic Value?
(a)19
(b)26
(c)45
(d)0

21. A European call option gives the buyer the right but not the obligation to
buy from the seller an underlying at the prevailing market price "on or before"
the expiry date.
(a)True
(b)False

22. A put option gives the buyer a right to sell how much of the underlying to
the writer of the option?
(a)Any quantity
(b)Only the specified quantity (lot size of the option contract)
(c)The specified quantity or less than the specified quantity
(d)The specified quantity or more than the specified quantity

23.An in‐the‐money option is .

(a)An option with a negative intrinsic value
(b)An option which cannot be profitably exercised by the holder immediately
(c)An option with a positive intrinsic value
(d)An option with zero time value

24. An option with a delta of 0.5 will increase in value approximately by how
much, if the underlying share price increases by Rs 2?
(a)Rs 1
(b)Rs 2
(c)Rs 4
(d)There would be no change

25.Exchange traded options are .

(a)Standardised options
(b)Always in‐the‐money options
(c)Customised options
(d)Always out‐of‐the money options

26. Higher the price volatility of the underlying stock of the put option,
.
(a)Higher would be the premium
(b)Lower would be the premium
(c)Nil (zero) would be the premium
(d)Volatility does not effect put value

27. In which option is the strike price better than the market price (i.e., price
difference is advantageous to the option holder) and therefore it is profitable to
exercise the option?
(a)Out‐of the money option
(b)In‐the ‐money option
(c) At‐ythe‐mone option
(d)Higher‐the‐money option
28. Mr. X purchases 100 put option on stock S at Rs 30 per call with strike price of Rs
280. If on exercise date, stock price is Rs 350, ignoring transaction cost, Mr. X
will choose .
(a)To exercise the option
(b)Not to exercise the option
(c)May or may not exercise the option depending on whether he is in his
hometown or not at that time
(d) May or may not exercise the option depending on whether he like the
company S or not

29. Three Call series of XYZ stock ‐ January, February and March are quoted. Which
will have the lowest Option Premium (same strikes)?
(a)January
(b)February
(c)March
(d)All will be equal

30.Which is the ratio of change in option premium for the unit change in interest
rates?
(a)Vega
(b)Rho
(c)Theta
(d)Gamma

31. If you sell aopnut opti 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?
(a) 285
(b)40
(c)0
(d) 205

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, the strategy is called .
(a)Bullish spread
(b)Bearish spread
(c)Butterfly spread
(d)Calendar spread

33. On the derivative exchanges, all the orders entered on the Trading System
are at prices exclusive of brokerage.
(a)True
(b)False
34. A trader has bought 100 shares of XYZ at Rs 780 per share. He expects the
price to go up but wants to protect himself if the price falls. He does not want
to lose more than Rs1000 on this long position in XYZ. What should the trader
do?
(a)Place a limit sell order for 100 shares of XYZ at Rs 770 per share
(b)Place a stop loss sell order for 100 shares of XYZ at Rs770 per share
(c)Place a limit buy order for 100 shares of XYZ at Rs 790 per share
(d)Place a limit buy order for 100 shares of XYZ at Rs770 per share

35.Trader A wants to sell 20 contracts of August series at Rs 4500 and Trader B

wants to 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 from both these investors (sum of initial margins of A
and B) by the broker?
(a) 2,70,000
(b) 5,02,050
(c) 2,32,050
(d) 4,10,000

36. A member has two clients C1 and C2. C1 has purchased 800 contracts and
C2 has sold 900 contracts in August XYZ futures series. What is the outstanding
liability (open position) of the member towards Clearing Corporation in number
of contracts?
(a) 800
(b) 1700
(c) 900
(d) 100

37. A defaulting member's clients’ positions could be transferred to by

the Clearing Corporation.
(a)Another solvent member
(b)The Exchange
(c)A suspense account
(d)Error account

38. Clients' positions cannot be netted off against each other while calculating
initial margin on the derivatives segment.
(a)True
(b)False

39.Mark‐to‐market margins are collected .

(a)On a weekly basis
(b)Every 2 days
(c)Every 3 days
(d)On a daily basis
40.Value‐at‐risk measures .
(a)Value of proprietary portfolio
(b)Risk level of a financial portfolio
(c)Net‐worth of an investor
(d)Credit rating of an investor

41. A penalty or suspension of registration of a stock broker from derivatives

exchange/segment under the SEBI (Stock Broker and Sub‐broker) Regulations, 1992
can take place if .
(a)The stock broker fails to pay fees
(b)The stock broker violates the conditions of registration
(c)The stock broker is suspended by the stock exchange
(d)In any of the above situations

42. Clearing corporation on a derivatives exchange becomes a legal counterparty to

all trades and be responsible for guaranteeing settlement for all open positions.
(a)True
(b)False

43.Initial margin collection is monitored by the .

(a)RBI
(b)Clearing Corporation
(c)SEBI
(d)Margin Office

44. Liquid Assets maintained by Mr A (Clearing Member) are higher than that
maintained by Mr B (Clearing Member). Which of the following statements is
true?
(a)Mr A can enjoy higher exposure levels in futures than Mr B
(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
47.Value‐at‐risk provides the .
(a)Expected maximum loss, which may be incurred by a portfolio over a given
period of time and specified confidence level
(b)Value of securities which are very risky
(c)Value of speculative stocks
(d)Theoretical value of illiquid stocks in a portfolio

48.Who is eligible for clearing trades in index options?

(a)All Indian citizens
(b)All members of the stock exchange
(c)All national level distributors
(d) Only members, who are registered with the Derivatives Segment as Clearing
Members

49. If price of a futures contract decreases, the margin account of the buyer of
this futures contract is debited for the loss.
(a)True
(b)False

50. When establishing a relationship with a new client, the trading member
takes reasonable steps to assess the background, genuineness, beneficial identify,
financial soundness of such person and his investment/trading objectives.
(a)True
(b)False
ANSWERS

1. (b) 26. (a)

2. (b) 27. (b)
3. (d) 28. (b)
4. (a) 29. (a)
5. (b) 30. (b)
6. (b) 31. (b)
7. (c) 32. (a)
8. (b) 33. (a)
9. (a) 34. (b)
10. (b) 35. (b)
11. (c) 36. (b)
12. (a) 37. (a)
13. (c) 38. (a)
14. (a) 39. (d)
15. (a) 40. (b)
16. (c) 41. (d)
17. (a) 42. (a)
18. (c) 43. (b)
19. (a) 44. (a)
20. (b) 45. (b)
21. (b) 46. (d)
22. (b) 47. (a)
23. (c) 48. (d)
24. (a) 49. (a)
25. (a) 50. (a)