1.

1 INTRODUCTION:-

Derivatives are a wide group of financial securities defined on the basis of other financial
securities, i.e., the price of a derivative is dependent on the price of another security, called
the underlying. These underlying securities are usually shares or bonds, although they can be
various other financial products, even other derivatives. As a quick example, let’s consider
the derivative called a ‘call option’, defined on a common share. The buyer of such a product
gets the right to buy the common share by a future date. But she might not want to do so—
there’s no obligation to buy it, just the choice, the option. Let’s now flesh out some of the
details. The price at which she can buy the underlying is called the strike price, and the date
after which this option expires is called the strike date. In other words, the buyer of a call
option has the right, but not the obligation to take a long position in the underlying at the
strike price on or before the strike date. Call options are further classified as being European,
if this right can only be exercised on the strike date and American, if it can be exercised any
time up and until the strike date.

Derivatives are amongst the widely traded financial securities in the world. Turnover in the
futures and options markets are usually many times the cash (underlying) markets. Our
treatment of derivatives in this module is somewhat limited: we provide a short introduction
about of the major types of derivatives traded in the markets and their pricing
.
Financial derivatives came into spotlight in the year 1970 period due to growing instability in
the financial markets. However since their emergence, these accounted for about two-third of
totals transactions in derivatives products. In recent years, the market for financial derivatives
has grown tremendously in terms of variety of instruments available, there complexity & also
turn over. In the class of equity derivatives Futures & options on stock also turn over. In the
class of equity derivatives, futures & options on stock indicates gained more popularly than
individual stocks.

1.2 SCOPE OF THE STUDY

 The scope of the study is limited to “DERIVATIVES” with the special reference to
Indian context and the National stock exchange has been taken as a representative
sample for the study. The study includes futures and options.
  My analysis part is limited to selecting the investment option it means that whether
we have to invest cash market or derivatives market.
 I have taken only four different organizations from four different industries to analyze
and interpret the results.
 Based upon four criteria’s only open interest is evaluated for analyzing the trend of
market as well as price movement.
 The study is not Based on the international perspective of derivatives markets, which
exists in NASDAQ, CBOT etc.
 This study mainly covers the area of hedging and speculation. The main aim of the
study is to prove how risks in investing in equity shares can be reduced and how to
make maximum return to the other investment.

1.3 STATEMENT OF THE PROBLEM

The main problem in the derivatives is we can’t able to decide that time and
derivative product which is more risky and return depend upon the time and product only we
can earn more returns with taking more risk. In this following project I came to know that
based upon some valuations and time conditions we can easily identify that which product is
more efficient for earning more returns. In this research I used only two derivative products
they are FUTURES and OPTIONS. Another one is OPEN INTEREST concept it is very new
to market. This additional work proposes based upon open interest and volume we can tell
the when the market is bullish as well as bearish and identifies that price movements easily
when they are going to rise and when they are coming fall depends upon price volume
changes.

1.4 OBJECTIVES OF THE STUDY

The objectives for my research are as below

 To calculate the risk and return of investment in futures and investment in options
 To identifies the market trend and price movement based upon the open interest
changes
 To analyze the role of futures and options in Indian financial system
 To understand about the derivatives market.
 To know why derivatives is considered safer than cash market.
 To construct portfolio and analyses the risk return relationship.
  To hedge the most profitable portfolio.

1.5 LIMITATIONS

 Share market is so much volatile and it is difficult to forecast any thing about it
whether you trade through online or offline

 The time available to conduct the study was only 2 ½ months. It being a wide topic
had a limited time.

1.6 RESEARCH METHODOLOGY

Research Methodology is a systematic procedure of collecting information in order to

analyse and verify a phenomenon. the collection of information is done in two principle
sources. They are as follows

1. Primary Data
2. Secondary Data

Primary Data: It is the information collected directly without any references. In this study it
is gathered through interviews with concerned officers and staff, either individually or
collectively, sum of the information has been verified or supplemented with personal
observation in trading times and conducting personal interviews with the concerned officers
of INDIABULLS SECURITIES LTD.

Secondary Data: The secondary data was collected from already published sources such as,
NSE websites, internal records, reference from text books and journal relating to derivatives.
The data collection includes:

a) Collection of required data from NSE and BSE websites

b) Reference from text books and journals relating to Indian stock market system and
financial derivatives.

1.7 CONCEPTUAL AND THEORITICAL REVIEW

INTRODUCTION OF DERIVATIVES

DEFINITION:-
 Derivative is a product whose value is derived from the value of one or more basic
variables, called bases (underlying asset, index, or reference rate), in a contractual manner.
The underlying asset can be equity, forex, commodity or any other asset. For example, wheat
farmers may wish to sell their harvest at a future date to eliminate the risk of a change in
prices by that date. Such a transaction is an example of a derivative. The price of this
derivative is driven by the spot price of wheat which is the "underlying".
FACTORS DRIVING THE GROWTH OF DERIVATIVES
Over the last three decades, the derivatives market has seen a phenomenal growth. A
large variety of derivative contracts have been launched at exchanges across the world. Some
of the factors driving the growth of financial derivatives are:
1. Increased volatility in asset prices in financial markets,
2. Increased integration of national financial markets with the international markets,
3. Marked improvement in communication facilities and sharp decline in their costs,
4. Development of more sophisticated risk management tools, providing economic agents a
wider choice of risk management strategies, and
5. Innovations in the derivatives markets, which optimally combine the risk and returns over

a large number of financial assets leading to higher returns, reduced risk as well as

transactions costs as compared to individual financial assets.

HISTORICAL VIEW OF FUTURES AND OPTIONS

Early forward contracts in the US addressed merchants' concerns about ensuring that
there were buyers and sellers for commodities. However 'credit risk" remained a serious
problem. To deal with this problem, a group of Chicago businessmen formed the Chicago
Board of Trade (CBOT) in 1848. The primary intention of the CBOT was to provide a
centralized location known in advance for buyers and sellers to negotiate forward contracts.
In 1865, the CBOT went one step further and listed the first 'exchange traded" derivatives
contract in the US, these contracts were called 'futures contracts". In 1919, Chicago Butter
and Egg Board, a spin-off of CBOT, was reorganized to allow futures trading. Its name was
changed to Chicago Mercantile Exchange (CME). The CBOT and the CME remain the two
largest organized futures exchanges, indeed the two largest "financial" exchanges of any kind
in the world today. The first stock index futures contract was traded at Kansas City Board of
Trade. Currently the most popular stock index futures contract in the world is based on S&P
500 index, traded on Chicago Mercantile Exchange. Index futures, futures on T-bills and
Euro-Dollar futures are the three most popular futures contracts traded today. Other popular
international exchanges that trade derivatives are LIFFE in England, DTB in Germany, SGX
in Singapore, TIFFE in Japan, MATIF in France, Euro ex etc.

INDEX FUTURES (JUNE 12, 2000)

INDEX OPTIONS (JUNE 4, 2001)

STOCK OPTIONS (JULY 2, 2001)

STOCK FUTURES (NOVEMBER 9, 2001)

Flow of futures and options in NSE

Risks involved in Derivatives:

Derivatives are used to separate risks from traditional instruments and transfer these
risks to parties willing to bear these risks. The fundamental risks involved in derivative
business includes
A. Credit Risk: This is the risk of failure of a counterpart to perform its obligation as per
the contract. Also known as default or counterpart risk, it differs with different
instruments.
B. Market Risk: Market risk is a risk of financial loss as result of adverse movements of
prices of the underlying asset/instrument.
C. Liquidity Risk: The inability of a firm to arrange a transaction at prevailing market
prices is termed as liquidity risk. A firm faces two types of liquidity risks:
 Related to liquidity of separate products.
 Related to the funding of activities of the firm including derivatives.
D. Legal Risk: Derivatives cut across judicial boundaries, therefore the legal aspects
associated with
The deal should be looked into carefully.

MAJOR PLAYERS IN DERIVATIVE MARKET:

There are three major players in their derivatives trading.

 1. Hedgers.
2. Speculators.
3. Arbitrageurs.
Hedgers: The party, which manages the risk, is known as “Hedger”. Hedgers seek to
protect themselves against price changes in a commodity in which they have an interest.

Speculators: They are traders with a view and objective of making profits. They are willing
to take risks and they but upon whether the markets would go up or come down.

Arbitrageurs: Risk less profit making is the prime goal of arbitrageurs. They could be
making money even with out putting their own money in, and such opportunities often come
up in the market but last for very short time frames. They are specialized in making
purchases and sales in different markets at the same time and profits by the difference in
prices between the two centres.

MAJOR PLAYERS
IN
DERIVATIVE MARKET

HEDGERS SPECULATORS ARBITRAGEURS

MAJOR PLAYERS IN DERIVATIVE MARKET:

Contract Periods:

At any point of time there will be always be available nearly 3months contract periods
in Indian Markets. These were

1) Near Month
2) Next Month
3) Far Month

For example in the month of September 2008 one can enter into September futures
contract or October futures contract or November futures contract. The last Thursday
 of the month specified in the contract shall be the final settlement date for the contract
at both NSE as well as BSE It is also know as Expiry Date.
Settlement:

The settlement of all derivative contracts is in cash mode. There is daily as well as
final settlement. Outstanding positions of a contract can remain open till the last Thursday of
the month. As long as the position is open, the same will be marked to market at the daily
settlement price, the difference will be credited or debited accordingly and the position shall
be brought forward to the next day at the daily settlement price. Any position which remains
open at the end of the final settlement day (i.e. last Thursday) shall closed out by the
exchanged at the final settlement price which will be the closing spot value of the underlying
asset.

Margins:

There are two types of margins collected on the open position, viz., initial margin which is
collected upfront which is named as “SPAN MARGIN” and mark to market margin, which is
to be paid on next day. As per SEBI guidelines it is mandatory for clients to give margins,
fail in which the outstanding positions or required to be closed out.

Members of F & O segment:

There are three types of members in the futures and options segment. They are
trading members, trading cum clearing member and professional clearing members.

 Trading members are the members of the derivatives segment and carrying on the
transaction on the respective exchange.

 The clearing members are the members of the clearing corporation who deal with
payments of margin as well as final settlements.

 The professional clearing member is a clearing member who is not a trading member.
Typically, banks and custodians become professional clearing members.

 It is mandatory for every member of the derivatives segment to have approved users
who passed SEBI approved derivatives certification test, to spread awareness among
investors.

FUTURES
 A futures contract is an agreement between two parties to buy or sell an asset at a
certain time in the future at a certain price. The futures contracts are standardized and
exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain
standard features of the contract. It is a standardized contract with standard underlying
instrument, a standard quantity and quality of the underlying instrument that can be delivered,
(or which can be used for reference purposes in settlement) and a standard timing of such
settlement.
The standardized items in a futures contract are:
 Quantity of the underlying
 Quality of the underlying
 The date and the month of delivery
 The units of price quotation and minimum price change
 Location of settlement
 Futures contracts in physical commodities such as wheat, cotton, gold, silver, cattle,
etc. have existed for a long time. Futures in financial assets, currencies, and interest
bearing instruments like treasury bills and bonds and other innovations like futures
contracts in stock indexes are relatively new developments.

 The futures market described as continuous auction markets and exchanges providing
the latest information about supply and demand with respect to individual
commodities, financial instruments and currencies, etc

 Futures exchanges are where buyers and sellers of an expanding list of commodities;
financial instruments and currencies come together to trade. Trading has also been
initiated in options on futures contracts. Thus, option buyers participate in futures
markets with different risk. The option buyer knows the exact risk, which is unknown
to the futures trader.

Future Contract
 Suppose you decide to buy a certain quantity of goods. As the buyer, you enter into
an agreement with the company to receive a specific quantity of goods at a certain
price every month for the next year. This contract made with the company is
similar to a futures contract, in that you have agreed to receive a product at a future
date, with the price and terms for delivery already set. You have secured your price
for now and the next year - even if the price of goods rises during that time. By
 entering into this agreement with the company, you have reduced your risk of
higher prices.
 So, a futures contract is an agreement between two parties: a short position - the
party who agrees to deliver a commodity - and a long position - the party who
agrees to receive a commodity. In every futures contract, everything is specified:
the quantity and quality of the commodity, the specific price per unit, and the date
and method of delivery. The “price” of a futures contract is represented by the
agreed-upon price of the underlying commodity or financial instrument that will be
delivered in the future.
Features of Futures Contracts:

 The principal features of the contract are as fallows.

 Organized Exchanges: Unlike forward contracts which are traded in an over – the -
counter market, futures are traded on organized exchanges with a designated physical
location where trading takes place. This provides a ready, liquid market which
futures can be bought and sold at any time like in a stock market.

 Standardization: In the case of forward contracts the amount of commodities to be

delivered and the maturity date are negotiated between the buyer and seller and can be
tailor made to buyer’s requirement. In a futures contract both these are standardized
by the exchange on which the contract is traded.

 Margins: In order to avoid unhealthy competition among clearing members in

reducing margins to attract customers, a mandatory minimum margins are obtained by
the members from the customers. Such a stop insures the market against serious
liquidity crises arising out of possible defaults by the clearing members. The
members collect margins from their clients has may be stipulated by the stock
exchanges from time to time and pass the margins to the clearing house on the net
basis i.e. at a stipulated percentage of the net purchase and sale position.

FUTURES TERMINOLOGY
Spot price: The price at which an asset trades in the spot market.
Futures price: The price at which the futures contract trades in the futures market.
Contract cycle: The period over which a contract trades. The index futures contracts on the
NSE have one- month, two-months and three months expiry cycles which expire on the last
Thursday of the month. Thus a January expiration contract expires on the last Thursday of
January and a February expiration contract ceases trading on the last Thursday of February.
On the Friday following the last Thursday, a new contract having a three- month expiry is
introduced for trading.
Expiry date: It is the date specified in the futures contract. This is the last day on which the
contract will be traded, at the end of which it will cease to exist.
Contract size: The amount of asset that has to be delivered under one contract. Also called
as lot size.
Basis: In the context of financial futures, basis can be defined as the futures price minus the
spot price. There will be a different basis for each delivery month for each contract. In a
normal market, basis will be positive. This reflects that futures prices normally exceed spot
prices.
Cost of carry: The relationship between futures prices and spot prices can be summarized in
terms of what is known as the cost of carry. This measures the storage cost plus the interest
that is paid to finance the asset less the income earned on the asset.
Initial margin: The amount that must be deposited in the margin account at the time a
futures contract is first entered into is known as initial margin.
Marking-to-market: In the futures market, at the end of each trading day, the margin
account is adjusted to reflect the investor's gain or loss depending upon the futures closing
price. This is called marking-to-market.
Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure
that the balance in the margin account never becomes negative. If the balance in the margin
account falls below the maintenance margin, the investor receives a margin call and is
expected to top up the margin account to the initial margin level before trading commences
on the next day.

TYPES OF FUTURES

On the basis of the underlying asset they derive, the futures are divided into two types:

 Stock Futures

 Index Futures

PARTIES IN THE FUTURES CONTRACT

There are two parties in a futures contract, the buyers and the seller. The buyer of the futures
contract is one who is LONG on the futures contract and the seller of the futures contract is
who is SHORT on the futures contract.The

pay-off for the buyers and the seller of the futures of the contracts are as follows

P
PROFIT

E 2
F E1
LOSS

CASE 1:- The buyers bought the futures contract at (F); if the futures

Price Goes to E1 then the buyer gets the profit of (FP).

CASE 2:- The buyers gets loss when the futures price less then (F); if

P
PROFIT

E 2
E 1 F

LOSS

L
 F= FUTURES PRICE E 1, E2 =

SATTLEMENT PRICE

CASE 1:- The seller sold the future contract at (F); if the future goes to

E1 Then the seller gets the profit of (FP).

CASE 2:- The seller gets loss when the future price goes greater than (F);

If the future price goes to E2 then the seller get the loss of (FL).

HOW THE FUTURE MARKET WORKS

The futures market is a centralized marketplace for buyers and sellers from around
the world who meet and enter into futures contracts. Pricing can be based on an open
outcry system, or bids and offers can be matched electronically. The futures contract
will state the price that will be paid and the date of delivery. Almost all futures
contracts end without the actual physical delivery of the commodity.

2.4 OPTIONS

INTRODUCTION TO OPTIONS

In this section, we look at the next derivative product to be traded on the NSE,
namely options. Options are fundamentally different from forward and futures contracts. An
option gives the holder of the option the right to do something. The holder does not have to
exercise this right. In contrast, in a forward or futures contract, the two parties have
committed themselves to doing something. Whereas it costs nothing (except margin
requirement) to enter into a futures contracts, the purchase of an option requires as up-front
payment.

DEFINITION :- Options are of two types- calls and puts. Calls give the buyer the right but
not the obligation to buy a given quantity of the underlying asset, at a given price on or
before a given future date. Puts give the buyers the right, but not the obligation to sell a
given quantity of the underlying asset at a given price on or before a given date.
PROPERTIES OF OPTION :- Options have several unique properties that set them apart
from other securities. The following are the properties of option:

 Limited Loss
 High leverages potential
 Limited Life
PARTIES IN AN OPTION CONTRACT

There are two participants in Option Contract.

Buyer/Holder/Owner of an Option:

The Buyer of an Option is the one who by paying the option premium buys the right
but not the obligation to exercise his option on the seller/writer.

Seller/writer of an Option:

The writer of a call/put option is the one who receives the option premium and is
thereby obliged to sell/buy the asset if the buyer exercises on him.

Characteristics of Options:

The following are the main characteristics of options:

1. Options holders do not receive any dividend or interest.

2. Options only capital gains.

3. Options holder can enjoy a tax advantage.
4. Options holders are traded an O.T.C and in all recognized stock exchanges.
5. Options holders can control their rights on the underlying asset.
6. Options create the possibility of gaining a windfall profit.
7. Options holders can enjoy a much wider risk-return combinations.
8. Options can reduce the total portfolio transaction costs.
9. Options enable with the investors to gain a better return with a limited amount of
investment.
TYPES OF OPTIONS

The Options are classified into various types on the basis of various variables. The
following are the various types of options.
1. On the basis of the underlying asset:
On the basis of the underlying asset the option are divided in to two types:

 Clearing House: The exchange acts a clearinghouse to all contracts struck on the
trading floor. For instance a contract is struck between capital A and B. upon
entering into the records of the exchange, this is immediately replaced by two
contracts, one between A and the clearing house and another between B and the
clearing house. In other words the exchange interposes itself in every contract and
deal, where it is a buyer to seller, and seller to buyer. The advantage of this is that A
and B do not have to undertake any exercise to investigate each other’s credit
worthiness. It also guarantees financial integrity of the market. The enforce the
delivery for the delivery of contracts held for until maturity and protects itself from
default risk by imposing margin requirements on traders and enforcing this through a
system called marking – to – market.

 Actual delivery is rare: In most of the forward contracts, the commodity is actually
delivered by the seller and is accepted by the buyer. Forward contracts are entered
into for acquiring or disposing of a commodity in the future for a gain at a price
known today. In contrast to this, in most futures markets, actual delivery takes place
in less than one present of the contracts traded. Futures are used as a device to hedge
against price risk and as a way of betting against price movements rather than a means
of physical acquisition of the underlying asset. To achieve, this most of the contracts
entered into are nullified by the matching contract in the opposite direction before
maturity of the first.

 Index options:These options have the index as the underlying. Some options are
European while others are American. Like index futures contracts, index options
contracts are also cash settled.

Stock options:

Stock Options are options on individual stocks. Options currently trade on over 500
stocks in the United States. A contract gives the holder the right to buy or sell shares at the
specified price.
2. On the basis of the market movements :
On the basis of the market movements the option are divided into two types. They are:

Call Option:

A call Option gives the holder the right but not the obligation to buy an asset by a certain
date for a certain price. It is brought by an investor when he seems that the stock price moves
upwards.

Put Option:

A put option gives the holder the right but not the obligation to sell an asset by a certain date
for a certain price. It is bought by an investor when he seems that the stock price moves
downwards.

3. On the basis of exercise of option:

On the basis of the exercise of the Option, the options are classified into two
Categories.

American Option:

American options are options that can be exercised at any time up to the expiration date.
Most exchange –traded options are American.

European Option:

European options are options that can be exercised only on the expiration date itself.
European options are easier to analyse than American options, and properties of an American
option are frequently deduced from those of its European counterpart.

PAY-OFF PROFILE FOR BUYER OF A CALL OPTION

The Pay-off of a buyer options depends on a spot price of an underlying asset. The
following graph shows the pay-off of buyers of a call option.
 PROFIT
R

ITM

ATM E 1
OTM

E2 LOSS P

S= Strike price ITM = In the Money

Sp = premium/loss ATM = At the Money

E1 = Spot price 1 OTM = Out of the Money

E2 = Spot price 2

SR = Profit at spot price E1

CASE 1: (Spot Price > Strike price)

As the Spot price (E1) of the underlying asset is more than strike price (S).

The buyer gets profit of (SR), if price increases more than E 1 then profit also increase more
than (SR)

CASE 2: (Spot Price < Strike Price)

As a spot price (E2) of the underlying asset is less than strike price (S)
The buyer gets loss of (SP); if price goes down less than E 2 then also his loss is limited to his
premium (SP)

PAY-OFF PROFILE FOR SELLER OF A CALL OPTION

The pay-off of seller of the call option depends on the spot price of the underlying asset. The
following graph shows the pay-off of seller of a call option:

PROFIT

P
ITM ATM

E 1 E2
S
OTM

LOSS

S= Strike price ITM = In the Money

SP = Premium / profit ATM = At The money

E1 = Spot Price 1 OTM = Out of the Money

E2 = Spot Price 2

SR = loss at spot price E2

CASE 1: (Spot price < Strike price) As the spot price (E 1) of the underlying is less than strike
price (S). The seller gets the profit of (SP), if the price decreases less than E 1 then also profit
of the seller does not exceed (SP).

CASE 2: (Spot price > Strike price)

As the spot price (E2) of the underlying asset is more than strike price (S) the Seller gets loss
of (SR), if price goes more than E2 then the loss of the seller also increase more than (SR).

PAY-OFF PROFILE FOR BUYER OF A PUT OPTION

The Pay-off of the buyer of the option depends on the spot price of the underlying asset. The
following graph shows the pay-off of the buyer of a call option.

PROFIT
R

ITM
S
2
E
1
E ATM
OTM

P LOSS

S = Strike price ITM = In the Money

SP = Premium / loss ATM = At the Money

E1 = Spot price 1 OTM = Out of the Money

SR = Profit at spot price E1

CASE 1: (Spot price < Strike price)

As the spot price (E 1) of the underlying asset is less than strike price (S). The buyer
gets the profit (SR), if price decreases less than E1 then profit also increases more than (SR).

CASE 2: (Spot price > Strike price)

 As the spot price (E2) of the underlying asset is more than strike price (S),

The buyer gets loss of (SP), if price goes more than E 2 than the loss of the buyer is limited to
his premium (SP).

CASE 1: (Spot price < Strike price)

As the spot price (E1) of the underlying asset is less than strike price (S). The buyer gets the
profit (SR), if price decreases less than E1 then profit also increases more than (SR).

CASE 2: (Spot price > Strike price)

As the spot price (E2) of the underlying asset is more than strike price (S),

The buyer gets loss of (SP), if price goes more than E 2 than the loss of the buyer is limited to
his premium (SP).

PAY-OFF PROFILE FOR SELLER OF A PUT OPTION

The pay-off of a seller of the option depends on the spot price of the underlying asset. The
following graph shows the pay-off of seller of a put option.

PROFIT
P
ITM
E1 ATM
E
S 2
OTM

LOSS
 S = Strike price ITM = In the Money

SP = Premium/profit ATM = At the Money

E1 = Spot price 1 OTM = Out of the Money

E2 = Spot price 2

SR = Loss at spot price E1

CASE 1: (Spot price < Strike price)

As the spot price (E1) of the underlying asset is less than strike price (S), the seller gets the
loss of (SR), if price decreases less than E1 than the loss also increases more than (SR).

CASE 2: (Spot price > Strike price)

As the spot price (E2) of the underlying asset is more than strike price (S), the seller gets
profit of (SP), of price goes more than E 2 than the profit of seller is limited to his premium
(SP).

FACTORS AFFECTING THE PRICE OF AN OPTION

The following are the various factors that affect the price of an option they are:

Stock Price:

The pay-off from a call option is an amount by which the stock price exceeds the
strike price. Call options therefore become more valuable as the stock price increases and
vice versa. The pay-off from a put option is the amount; by which the strike price exceeds
the stock price. Put options therefore become more valuable as the stock price increases and
vice versa.

Strike price:

In case of a call, as a strike price increases, the stock price has to make a larger
upward move for the option to go in-the –money. Therefore, for a call, as the strike price
increases option becomes less valuable and as strike price decreases, option become more
valuable
 Time to expiration:

Both put and call American options become more valuable as a time to expiration
increases.

Volatility:

The volatility of a stock price is measured of uncertain about future stock price
movements. As volatility increases the chance that the stock will do very well or very poor
increases. The value of both calls and puts therefore increases as volatility increase.

Risk- free interest rate:

The put option prices decline as the risk-free rate increases where as the price of call
always increases as the risk-free interest rate increases.

Dividends:

Dividends have the effect of reducing the stock price on the X- dividend rate. This has
a negative effect on the value of call options and a positive effect on the value of put options.

OPTIONS TERMINOLOGY

Option price/premium:

Option price is the price which the option buyer pays to the option seller. It is also
referred to as the option premium.

Expiration date:

The date specified in the options contract is known as the expiration date, the exercise
date, the strike date or the maturity.

Strike price:

The price specified in the option contract is known as the strike price or the exercise
price.

Intrinsic value and time value for calls:

 In the case of a call, intrinsic value is the amount by which the underlying futures
price exceeds the strike price:
Futures Price – Strike Price = Intrinsic Value
(must be positive or 0)
Example: June CME Live Cattle futures are trading at 82.50 cents/lb. and the June 80 CME
Live Cattle call option is trading at 3.50 cents/lb. What are the time value and intrinsic value
components of the premium?
Futures Price – Strike Price = Intrinsic Value
82.50 – 80.00 = 2.50
Time value represents the amount option traders are willing to pay over intrinsic value, given
the amount of time left to expiration for the futures to advance in the case of
calls, or decline in the case of puts.
Options Premium – Intrinsic Value = Time Value
3.50 – 2.50 = 1.00
Time Value + Intrinsic Value = Premium
1.00 + 2.50 = 3.50
Intrinsic value and time value for puts:
In the case of a put, intrinsic value is the amount by which the underlying futures price is
below the strike price:
Intrinsic Value = Strike Price – Futures Price (must be positive or 0)
Time Value = Put Option Premium – Intrinsic Value
Put Option Premium = Put Time Value + Put Intrinsic Value
Example: What are the time value and intrinsic value of a CME Eurodollar 95.00 put if the
underlying futures are trading at 94.98 and the option premium is 0.03?
Strike Price – Futures Price = Intrinsic Value
95.00 – 94.98 = 0.02
There are 0.02 points of intrinsic value.
Options Premium – Intrinsic Value = Time Value
0.03 – 0.02 = 0.01
2.5 ELIGIBILITY CRITERIA FOR SECURITIES/INDICES TRADED IN F&O
Eligibility criteria of stocks
1. The stock is chosen from amongst the top 500 stocks in terms of average daily market
capitalization and average daily traded value in 206 the previous six months on a
rolling basis.
 2. The stock's median quarter-sigma order size over the last six months should be not
less than Rs. 1 lakh. For this purpose, a stock's quarter sigma order size should mean
the order size (in value terms) required to cause a change in the stock price equal to
one-quarter of a standard deviation.
3. The market wide position limit in the stock should not be less than Rs.50 crore. The
market wide position limit (number of shares) is 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 should be
lower of:- 20% of the number of shares held by non-promoters in the relevant
underlying security i.e. free-float holding.
4. If an existing security fails to meet the eligibility criteria for three months
consecutively then no fresh month contract will be issued on that security.
5. However, the existing unexpired contracts can be permitted to trade till expiry and
new strikes can also be introduced in the existing contract months.
6. For unlisted companies coming out with initial public offering, if the net public offer
is Rs.500 crores or more, then the exchange may consider introducing stock options
and stock futures on such stocks at the time of its listing in the cash market.
Eligibility criteria of indices
The exchange may consider introducing derivative contracts on an index if the stocks
contributing to 80% weightage of the index are individually eligible for derivative trading.
However, no single ineligible stocks in the index should have a weightage of more than 5%
in the index. The above criteria is applied every month, if the index fails to meet the
eligibility criteria for three months consecutively, then no fresh month contract would be
issued on that index, However, the existing unexpired contacts will be permitted to trade till
expiry and new strikes can also be introduced in the existing contracts.
2.6 TRADING MECHANISM OF FUTURES AND OPTIONS
The futures and options trading system of NSE, called NEAT-F&O trading system,
provides a fully automated screen-based trading for Index futures &options and Stock futures
& options on a nationwide basis and an online monitoring and surveillance mechanism. It
supports an anonymous order driven market which provides complete transparency of trading
operations and operates on strict price-time priority. It is similar to that of trading of equities
in the Cash Market (CM) segment. The NEAT-F&O trading system is accessed by two types
of users. The Trading Members (TM) have access to functions such as order entry, order
matching, order and trade management. It provides tremendous flexibility to users in terms of
kinds of orders that can be placed on the system. Various conditions like Immediate or
Cancel, Limit/Market price, Stop loss, etc. can be built into an order. The Clearing Members
(CM) use the trader workstation for the purpose of monitoring the trading member(s) for
whom they clear the trades. Additionally, they can enter and set limits to positions, which a
trading member can take.

PRICING FUTURES
Forwards/ futures contract are priced using the cost of carry model. The cost of
carry model calculates the fair value of futures contract based on the current spot price of the
underlying asset. The formula used for pricing futures is given below:
F = SerT
Where :
F = Futures Price
S = Spot price of the underlying asset
R = Cost of financing (using a continuously compounded interest rate)
T = Time till expiration in years
E = 2.71828 (The base of natural logarithms)

Example: Security of ABB Ltd trades in the spot market at Rs. 850. Money can be invested at
11% per annum.
The fair value of a one-month futures contract on ABB is calculated as
follows:
850 * 12 857.80
1
0.1 1
F = SerT = e
The presence of arbitrageurs would force the price to equal the fair value of the asset. If the
futures price is less than the fair value, one can profit by holding a long position in the futures
and a short position in the underlying. Alternatively, if the futures price is more than the fair
value, there is a scope to make a profit by holding a short position in the futures and a long
position in the underlying. The increase in demand/ supply of the futures (and spot) contracts
will force the futures price to equal the fair value of the asset.
PRICING OPTIONS
 Our brief treatment of options in this module initially looks at pay-off diagrams,
which chart the price of the option with changes in the price of the underlying and then
describes how call and option prices are related using put-call parity. We then briefly
describe the celebrated Black-Scholes formula to price a European option.
Payoffs from an option contract refer to the value of the option contract for the parties (buyer
and seller) on the date the option is exercised. For the sake of simplicity, we do not consider
the initial premium amount while calculating the option payoffs. In case of call options, the
option buyer would exercise the option only if the market price on the date of exercise is
more than the strike price of the option contract. Otherwise, the option is worthless since it
will expire without being exercised. Similarly, a put option buyer would exercise her right if
the market price is lower than the exercise price.

The payoff of a call option buyer at expiration is:

Max [(Market price of the share – Exercise Price), 0]
The following figures shows the payoff diagram for call options buyer and seller (assumed
exercise price is 100)

The payoff for a buyer of a put option at expiration is:

Max [(Exercise price –Market price of the share), 0]

The payoff diagram for put options buyer and seller (assumed exercise price is 100)
2.7 STEPS INVOVED IN F & O TRADING PROCESS
1. PLACING THE ORDER
For placing an order, if it’s a buy order press F11 and to place a sell order
press F12.
The following details have to be entered to place a buy / sell order
 Client id every client have an unique ID which has to be entered before placing an
order.
 Quantity of the order
 OPTIDX / OPTSTK select the suitable option, whether to trade on index or stock
options.
 MARKET/LIMIT
 INDEX choose the index under which you want to trade
  Trigger price its a stop loss order beyond at which loss is not bearable. An order
placed with a broker to buy or sell at a specified price (or better) after a given stop
price has been reached or passed.
 Disc qty the quantity of the order can be disclosed
 Strike price the price specified in the options contract is known as the strike price
or the exercise price.
 DAY/IOC it’s an order
 CALL/PUT
2. ORDER CONFORMATION
It’s a confirmation from the exchange that the orders have been executed. It
gives the information about online order reference number, exchange order number, trade
number, quantity of the order and the client id.

3. DOCUMENTS SUBMITED TO THE CLIENT

 CONTRACT NOTE
 At the end of the day digital contract note is sent to each and every client regarding
the details about the each and every transaction done on that specific day, the
brokerage amount and taxes levied.
 CLIENT LEDGER
 It gives the details of the client’s debts and credits.
4. CLIENT SUPPORT
5. COMPLIANCE POLICY
 CALLS RECORD: Every order placed through telephone is recorded
 CONFIRMATION OF ORDERS: Every order which is executed will be
intimated to the client
 SIGNATURES of walking clients have to be verified every time
6. RISK MANAGEMENT SYSTEM (RMS): It specifies the initial margin requirements
for each futures and options contract on a daily basis