PROJECT REPORT ON:

“A STUDY ON DERIVATIVES MARKET IN INDIA –

REFERENCE TO BANK NIFTY”

At
QUANTUM GLOBAL SECURITIES LTD

SUBMITTED BY:

MADHU RAKESH TIWARI

MASTERS OF MANAGEMENT STUDIES

Academic Year: 2018-19

PROJECT GUIDE:

PROF. TAPAS MITRA

ATHARVA INSTITUTE OF MANAGEMENT STUDIES

Malad-Marve Road, Charkop Naka, Malad (W), Mumbai

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 A STUDY ON
DERIVATIVES
MARKET IN INDIA
REFERENCE TO
BANK NIFTY

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 Table of Contents

No. Chapter Name Page no

1 Declaration 4

2 Certificate 5

3 Acknowledgement 6

4 Executive Summary 7

5 Internship Certificate 8

6 Appreciation Certificate 9

7 Company profile 10-13

8 My work at Quantum Global 14

9 Introduction and Objective of the Study 15-16

10 Indian Derivatives Market 17-21

11 Literature review 22-23

12 Introduction to forward and futures Contracts 24-29

13 Introduction to Options 30-40

14 Bank Nifty 41-42

15 Strategies 43-46

16 Recommendations 47

17 Conclusion 48

18 Bibliography 49

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 DECLARATION

I, Madhu R. Tiwari of M.M.S (Masters of Management Studies) hereby

declare that project entitled “A Study on Derivatives market in India-
Reference to Bank Nifty” submitted as a part of the study in the academic year
2018-2019 is my original work and the project has not formed the basis for the
award of any other degree, associate ship, fellowship, or any other similar titles.

The information submitted in the project is true and original and whenever the
matter is collected from published books, magazines etc. the same is mentioned in
the reference given.

Place:

Date:

Signature of Student

(Madhu R. Tiwari)

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 CERTIFICATE

This is to certify that the project entitled “A Study on Derivatives market in India-
Reference to Bank Nifty” is the bona fide work carried out by MADHU RAKESH
TIWARI student of M.M.S., Atharva Institute of Management Studies during the
year 2018-2019 in the partial fulfilment of the requirements for the degree of Master
of Management Studies and that the project has not formed the basis for the award of
any other degree, associateship, fellowship or any other similar titles.

Place:

Date:

Signature of the Guide Signature of Director

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 ACKNOWLEDGEMENT

I extend my gratitude to Prof. Tapas Mitra for providing guidance and support
during the course of project. He has been a great help through the making of the
project. I thank the University of Mumbai for giving me the opportunity to work on
such a relevant topic. I also thank the college faculties, the librarian, Director. Sujata
Pandey mam for their help and others who are indirectly responsible for the
completion of this project. I am thankful to Quantum Global Securities Ltd. for
giving me an opportunity to do summer training in the company.

Date –

Signature of student

(Madhu R. Tiwari)

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 EXECUTIVE SUMMARY

“A Study on Derivatives Capital Market with Special Reference to Bank Nifty”

has given me exposure to investment scenario in India with special emphasis on
derivative industry. The main motive of the said research is to analyse investors’
perception with investment behaviour in the Indian Derivative Market. The first
chapter INTRODUCTION gives an overview of the derivatives and type of
derivatives currently operational in Indian and world market. There are two
well-defined groups of derivative contracts and the derivatives traded on OVER
THE COUNTER (OTC) as well as Exchanges. In the over the counter market,
the trading taking place with two parties directly and exchange traded
derivatives are concerned, the trading take place in the various stock exchanges.
The main features of over the counter derivatives, i.e. Forwards and swaps
which help in hedging risk, and are also flexible in nature. In India, we can see
that various regulators including RBI, SEBI and Forward Commission to
regulate number of derivative transaction. Unlike OTC derivatives, Exchange
traded derivatives have a specific format and are based on standardized terms
and conditions.

There are a number of regulatory bodies which manage the irregularities in the
market. A number of laws and regulations have been formulated by the
government of India and overview of which has been given in the first chapter.
The chapter also discusses the issues related to derivative operations in the
Indian Capital Market.

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INTERNSHIP CERTIFICATE

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APPRECIATION CERTIFICATE

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Company profile

INTRODUCTION TO COMPANY

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Quantum global Securities limited is an independent Share Broking and
financial advisory firm focused on managing individuals’ investments.

Company’s advisors are trained, qualified & certified by various financial

regulatory authorities like SEBI, IRDA, AMFI, and AFP & well experienced in
helping individuals & families to create, grow and preserve wealth. Quantum
has advised unbiased & conflict-free advice and counsel on your investments to
help you reach your personal & wealth goals.

It started its operations in the year 1995 by the name of “Quantum Global”.
With an objective of being a full service brokerage house and to provide
comprehensive advisory services to its clients, which would enable managing
complete financial planning needs.

For investors, Quantum Global is a great place to start your investment journey.
The unique trading account give you freedom to transfer funds from more than
50 banks to your trading account and links your Bank Savings Account, a Demat
and your Quantum Global account.You can invest into Equities, Deposits,
Mutual Funds including Tax Savings Schemes and various other products at the
click of a button. And because all your investments are at one place it is much
easier to manage. Our research can guide you with your investments. Once you
consolidate your portfolio on your Quantum Global account , you will never
need to worry on tracking your investment performance.

PRODUCTS AND ADVISORY

1. Equity

 Cash Trading
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 Margin Product

 Cover Order Product

 Call & Trade

 Market Order

 Limit Order

2. Derivatives

 Futures

Through Quantum Global, you can now trade in index and stock futures on the
NSE. In futures trading, you take buy/sell positions in index or stock(s) contracts
having a longer contract period of up to 3 months. If, during the course of the
contract life, the price moves in your favor (i.e. rises in case you have a buy
position or falls in case you have a sell position), you make a profit.

 Options

An option is a contract, which gives the buyer the right to buy or sell shares at a
specific price, on or before a specific date. For this, the buyer has to pay to the
seller some money, which is called premium. There is no obligation on the
buyer to complete the transaction if the price is not favorable to him.

3. Commodity

Commodity can be defined as any kind of movable property other than

actionable claims, money and securities. It is a physical substance, such as food,
grains, and metals, which is interchangeable with another product of the same

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type, and which investors buy or sell, usually through futures contracts. The
price of the commodity is subject to supply and demand.

4. Mutual Fund Investing

If you have an Quantum Global account, login to your account and select the
Mutual Fund selection.

If the Mutual Fund section is not enabled either you have not opted for the
facility or may not be KYC (Know-Your-Customer) Compliant. KYC is
mandatory for all investments in Mutual Fund as per the Securities and
Exchange Board of India.

5. Bonds

Bond refers to a security issued by a company, financial institution or

government which offers regular or fixed payment of interest in return on the
amount borrowed money for a certain period of time.

6. IPO’s

The primary market provides investor’s opportunities to buy shares at a

reasonable price prior to its listing price. Additionally retail investors also enjoy
discounted rates while applying for IPO ‘s. Holding on to the shares also provide
an opportunity to participate in the future success of these companies.

MAJOR COMPETITORS OF QUANTUM GLOBAL SECURITIES:

 Angel Broking
 Anand Rathi
 Motilal Oswal
 Share khan

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 MY WORK AT QUANTUM GLOBAL SECURITIES
INVOLVED

1. Business development by acquiring new franchisee partners and clients

for the company. The targets given by the company were successfully
achieved by me and I was also awarded with the appreciation certificate.
2. Organised an investor awareness program in the office premises and also
focused on the Derivatives market.
3. Understanding the pattern and mode of investment in equity and
derivatives.
4. Also during the course of internship I did trading in derivatives market
basically in Options.

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 A STUDY ON DERIVATIVES MARKET IN INDIA –
REFERENCE TO BANK NIFTY

Derivatives are tradable products whose price is based upon Indian market. In
recent years, derivative security has become increasingly important in the finance
field. It is important for investor to analyse & understand the significance of
Derivatives market, types of instruments present in the Indian Stock Market.
Through the use of derivative products, it is possible to partially or fully transfer
price risks by locking-in asset prices. However, by locking-in asset prices,
derivative products minimize the impact of fluctuations in asset prices on the
probability and cash flow situation of risk-averse investors. This project tries to
explain the in depth concepts, about the history, growth and pros and cons in
investing and dealing with the derivative instruments and deals with choosing the
best available option in terms of returns. Derivatives provide a diversification
channel for investors to protect themselves from the vagaries of the financial
markets. Also Derivatives market useful to raise funds using stocks and also lend
funds against stock.

Derivatives will benefit investors in the long run

 Likely increase in trading volumes

 In Sync with global markets
 Hedging

OBJECTIVES OF THE STUDY

 To study the derivatives Future and Option in detail with the idea of
suggesting the strategies in this markets.

 To know the performance of derivative hedging & understanding about

how derivative help people to manage the risk & sustain the profitability.

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To make the investors aware that, out of many investment avenues available in the
market, the return that derivative market has given is tremendous and Bank Nifty
provides investors and market intermediaries a benchmark that captures the capital
market performance of Indian banking sector. As inflation rate is increasing and
the fix deposit rates are decreasing day by day thus people are reverting their
investment from FD’s to equity & derivatives. So in the coming future, derivative
market will see a jump in its turnover and the returns will be commendable. So one
can think for investing in derivative market for higher returns.

RESEARCH METHODOLOGY

1. Data collection methods:

The entire data was collected from the secondary source. Internet is main source of
secondary sources of date collection used. Business Magazines, Newspapers and
Journals were also used for collecting data.

LIMITATIONS
 It was hard to acquire knowledge about this field in such short span of time
 Derivative market is very vast & fast sector thus it was very difficult to
cope-up with the environment in such short span of time.
 This field is requiring with very deep technical knowledge.

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 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,
SEBI approved trading in index futures contracts based on CNX Nifty and BSE
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. MCX‐SX (renamed as MSEI) started trading in all
these products (Futures and options on index SX40 and individual stocks) in
February 2013.

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There are a lot of investment avenues available today in the financial market for an
investor with an investable surplus. One can invest in Bank Deposits, Corporate
Debentures, and Bonds where there is low risk but also low return.

CONCEPT OF DERIVATIVES:
Derivatives are financial contracts that derive their value from an underlying asset.
These could be stocks, indices, commodities, currencies, exchange rates, or the rate
of interest. These financial instruments help you make profits by betting on the
future value of the underlying asset. So, their value is derived from that of the
underlying asset. This is why they are called ‘Derivatives’.
For example, a stock’s value may rise or fall, the exchange rate of a pair of
currencies may change, indices may fluctuate, commodity prices may increase or
decrease. These changes can help an investor make profits. They can also cause
losses. This is where derivatives come handy. It could help you make additional
profits by correctly guessing the future price, or it could act as a safety net from
losses in the spot market, where the underlying assets are traded.

WHAT IS THE USE OF DERIVATIVES:

Earn money on shares that are lying idle:

So you don’t want to sell the shares that you bought for long term, but want to take
advantage of price fluctuations in the short term. You can use derivative
instruments to do so. Derivatives market allows you to conduct transactions
without actually selling your shares – also called as physical settlement.

Benefit from arbitrage:

When you buy low in one market and sell high in the other market, it called
arbitrage trading. Simply put, you are taking advantage of differences in prices in
the two markets.

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Protect your securities against:
fluctuations in prices The derivative market offers products that allow you to hedge
yourself against a fall in the price of shares that you possess. It also offers products
that protect you from a rise in the price of shares that you plan to purchase. This is
called hedging.

Transfer of risk:
By far, the most important use of these derivatives is the transfer of market risk
from risk-averse investors to those with an appetite for risk. Risk-averse investors
use derivatives to enhance safety, while risk-loving investors like speculators
conduct risky, contrarian trades to improve profits. This way, the risk is
transferred. There are a wide variety of products available and strategies that can
be constructed, which allow you to pass on your risk.

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 financial
system.

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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.

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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.

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Literature review

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Behavior of Stock Market Volatility after Derivatives By Golaka C Nath
Research Paper (NSE):
Financial market liberalization since early 1990s has brought about major changes
in the financial markets in India. The creation and empowerment of Securities and
Exchange Board of India (SEBI) has helped in providing higher level
accountability in the market. New institutions like National Stock Exchange of
India (NSEIL), National Securities Clearing Corporation (NSCCL), National
Securities Depository (NSDL) have been the change agents and helped cleaning
the system and provided safety to investing public at large. With modern
technology in hand, these institutions did set benchmarks and standards for others
to follow.

Do Futures and Options trading increase stock market volatility? By Dr.

Premalata Shenbagaraman, Research Paper (NSE):
Numerous studies on the effects of futures and options listing on the underlying
cash market volatility have been done in the developed markets. The empirical
evidence is mixed and most suggest that the introduction of derivatives do not
destabilize the underlying market.

Derivative Instruments and Their Use for Hedging by U.S. Non-Financial

Firms:
The development of the option pricing models by Black and Scholes (1973) and by
Merton (1973) has made it possible for derivatives markets to develop and for
these financial instruments to become a potentially important tool in risk
management. Derivatives are now an important part of the world economy, with a
notional value of more than $200 trillion of these derivatives traded on organized
and OTC markets in 2004 (Bank for International Settlements, 2005).

An Overview Of The Literature About Derivatives By Chiara Oldani:

A derivative is defined by the BIS (1995) as “a contract whose value depends on
the price of underlying assets, but which does not require any investment of
principal in those assets. As a contract between two counterparts to exchange

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payments based on underlying prices or yields, any transfer of ownership of the
underlying asset and cash flows becomes unnecessary”.

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.
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Forwards are widely used in commodities, foreign exchange, equity and interest
rate markets. 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.

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 contracts or contracting 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.30 in the market 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
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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.

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. In futures market, exchange
decides all the contract terms of the contract other than price.

FUTURES TERMINOLOGIES
Instrument type Future Index
Underlying asset Nifty
Expiry date September 24, 2015
Open price (in Rs.) 7897.00
High price (in Rs.) 7919.00
Low price (in Rs.) 7852.45
Closing price (in Rs.) 7,897.65
No of contracts traded 4,48,314
Turnover in lakhs 8,84,278.07
Underlying value (in Rs.) 7899.15

Spot Price: The price at which an asset trades in the cash market. This is the
underlying value of Nifty on September 16, 2015 which is 7899.15.

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 Futures Price: The price of the futures contract in the futures market. The
closing price of Nifty in futures trading is Rs. 7897.65. Thus Rs. 7897.65 is the
future price of Nifty, on a closing basis.

Contract Cycle: It is a period over which a contract trades. On September 16,

2015, the maximum number of index futures contracts is of 3 months contract
cycle‐ the near month (September 2015), the next month (October 2015) and the
far month (November 2015). Every futures contract expires on last Thursday of
respective month (in this case September 24, 2015). And, a new contract (in this
example - December 2015) 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. The expiry date in the quotes given is September
24, 2015. It is the last Thursday of the expiry month. If the last Thursday is a
trading holiday, the contracts expire on the previous trading day. 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.

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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 August 9, 2010, spot price > future price thus basis for nifty futures
is positive i.e. (7899.15 ‐ 7897.65 = Rs 1.50).

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.

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
November 3, 2015 a person decided to enter into a futures contract. He expects
the market to go up so he takes a long Nifty Futures position for November
expiry. Assume that, on November 3, 2015 Nifty November month futures
closes at 8000. The contract value = Nifty futures price * lot size = 8000 * 75 =
Rs 6,00,000. Therefore, Rs 6,00,000 is the contract value of one Nifty Future
contract expiring on November 26, 2015. Assuming that the broker charges
10% of the contract value as initial margin, the person has to pay him Rs. 60,000
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as initial margin. Both buyers and sellers of futures contract pay initial margin,
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.

Maintenance Margin

This is the balance a trader must maintain in his or her account as the balance
changes due to price fluctuations. It is some fraction - perhaps 75% - of initial
margin for a position. If the balance in the trader's account drops below this
margin, the trader is required to deposit enough funds or securities to bring the
account back up to the initial margin requirement. Such a demand is referred to
as a margin call. The trader can close his position in this case but he is still
responsible for the loss incurred. However, if he closes his position, he is no
longer at risk of the position losing additional funds.

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 November 3, 2015, when Nifty was at 8000. He paid an
initial margin of Rs. 60,000 as calculated above. On the next trading day i.e., on
November 4, 2015 Nifty futures contract closes at 8100. This means that he/she
benefits due to the 100 points gain on Nifty futures contract. Thus, his/her net
gain is Rs 100 x 75 = Rs 7,500. This money will be credited to his account and
next day the position will start from 8100

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Introduction to options

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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
Instrument type Option Index Option Index
Underlying asset Nifty Nifty
Expiry date September 24, 2015 September 24, 2015
Option type Call option Put option
Strike Price 8,000 8000
Open price 68.00 190.00
High price 78.00 205.75
Low price 58.65 157.00
Close price 71.70 174.80
Traded Volume 6,59,304 contracts 85,027 contracts
Open Interest 43,58,775 30,47,325
Underlying value 7,899.15 7,899.15

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Index option: These options have index as the underlying asset. For Example
options on Bank Nifty, 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, all options are European Options.

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. 71.70 and for
put option is Rs. 174.80. 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. 71.70 x 75 = 5.377.50 and total premium
for put option contract would be Rs. 174.80 x 75 = 13,110.

Expiration Day: The day on which a derivative contract ceases to exist. It is the
last trading date/day of the contract. In our example, the expiration day of
contracts is the last Thursday of September month i.e. 24 September, 2015.
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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. 7,899.15.

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 8000.

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, put 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, call 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, before 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
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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 options to one 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.

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:

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 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.

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.

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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.

Option pricing fundamentals

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

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.

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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.
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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 an increase in the value of a call
option and a decrease in the value of a put option.

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
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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 of the
delta, i.e. it signifies the speed with which an option will go either in‐the‐money
or out‐of‐the‐money due to a change in price of the 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
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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 measures the change in an option’s price per unit
increase in the cost of funding the underlying. Rho = Change in an option
premium/ Change in cost of funding the underlying

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. 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.

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Bank nifty

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Bank Nifty is the bank index traded in the F&O segment of NSE. It comprises of
most liquid banking stocks listed on NSE. This index provides investors and market
intermediaries with a benchmark that captures the capital market performance of
Indian Banks. The index has 12 most liquid and large capitalised stocks from the
banking sector which trade on the National Stock Exchange. It said that Bank Nifty
contracts will expire on every Thursday of week. In case, Thursday is a trading
holiday, the contracts will expire on the previous trading day.

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 STRATEGIES

LONG CALL: Buying a call is the most basic of all options strategies. It
constitutes the first options trade for someone already familiar with buying /
selling stocks and would now want to trade options. Buying a call is an easy
strategy to understand. When you buy it means you are bullish. Buying a Call
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means you are very bullish and expect the underlying stock / index to rise in
future.

When to Use: Investor is very bullish on the stock / index. Risk: Limited to the
Premium. (Maximum loss if market expires at or below the option strike price).

Reward: Unlimited

Breakeven: Strike Price + Premium

SHORT CALL: A Call option means an Option to buy. Buying a Call option
means an investor expects the underlying price of a stock / index to rise in
future. Selling a Call option is just the opposite of buying a Call option. Here the
seller of the option feels the underlying price of a stock / index is set to fall in
the future. When to use: Investor is very aggressive and he is very bearish about
the stock / index. Risk: Unlimited

Reward: Limited to the amount of premium Break-even Point: Strike Price +

Premium

LONG PUT: A long Put is a Bearish strategy. To take advantage of a falling

market an investor can buy Put options. When to use: Investor is bearish about
the stock / index.

Risk: Limited to the amount of Premium paid. (Maximum loss if stock / index
expires at or above the option strike price).

Reward: Unlimited Break-even Point: Stock Price - Premium

SHORT PUT: When to Use: Investor is very Bullish on the stock / index. The
main idea is to make a short term income.

Risk: Put Strike Price – Put Premium.

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Reward: Limited to the amount of Premium received. Breakeven: Put Strike
Price - Premium

COVERED CALL: When to Use: This is often employed when an investor has
a short-term neutral to moderately Bullish view on the stock he holds.

Risk: If the Stock Price falls to zero, the investor loses the entire value of the
Stock but retains the premium, since the Call will not be exercised against him.
So maximum risk = Stock Price Paid – Call Premium Upside capped at the
Strike price plus the Premium received. So if the Stock rises beyond the Strike
price the investor (Call seller) gives up all the gains on the stock.

Reward: Limited to (Call Strike Price – Stock Price paid) + Premium received
Breakeven: Stock Price paid - Premium Received

COVERED PUT: When to Use: If the investor is of the view that the markets
are moderately bearish.

Risk: Unlimited if the price of the stock rises substantially

Reward: Maximum is (Sale Price of the Stock – Strike Price) + Put Premium
Breakeven: Sale Price of Stock + Put Premium

LONG STRADDLE: When to Use: The investor thinks that the underlying
stock / index will experience significant volatility in the near term.

Risk: Limited to the initial premium paid.

Reward: Unlimited Breakeven: · Upper Breakeven Point = Strike Price of Long

Call + Net Premium Paid · Lower Breakeven Point = Strike Price of Long Put -
Net Premium Paid

SHORT STRADDLE: When to Use: The investor thinks that the underlying
stock / index will experience very little volatility in the near term. Risk:
Unlimited Reward: Limited to the premium received Breakeven: · Upper
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Breakeven Point = Strike Price of Short Call + Net Premium Received · Lower
Breakeven Point = Strike Price of Short Put - Net Premium Received

LONG STRANGLE: When to Use: The investor thinks that the underlying
stock / index will experience very high levels of volatility in the near term.

Risk: Limited to the initial premium paid

Reward: Unlimited Breakeven: · Upper Breakeven Point = Strike Price of Long

Call + Net Premium Paid · Lower Breakeven Point = Strike Price of Long Put -
Net Premium Paid

SHORT STRANGLE: When to Use: This options trading strategy is taken

when the options investor thinks that the underlying stock will experience little
volatility in the near term. Risk: Unlimited

Reward: Limited to the premium received Breakeven: · Upper Breakeven Point

= Strike Price of Short Call + Net Premium Received · Lower Breakeven Point
= Strike Price of Short Put - Net Premium Received

RECOMMENDATIONS
 Options prices change in the blink of an eye, please ensure to buy/sell
using limit orders and always have a stop loss.
 As a general rule, trade in At the money (ATM) strike prices.

46 | P a g e
 Keep a check on the option premium and time till expiry. An
unexpectedly high premium on both call and put indicates that the market
is expecting some dramatic movement in either direction such as election
results, quarterly results or any positive announcement etc.
 All options expire on the last Thursday on each month, except bank nifty
which has weekly expiry options which expire every Thursday so, be very
careful while placing trades, that you have selected on the basis of proper
knowledge & analysis.

CONCLUSION
 DO NOT enter into trades on the advice of someone, always form a basis
or reasoning for entering into a trade yourself, it maybe with the help or
guidance of someone else, because in the end it is about learning and not
making small profits.
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  You will benefit in the long run if you have developed a clear reasoning
system for trading and it will help you grow in the field.
 When volatility is high, options buyers should be cautious about straight
options buying. Rather, they should typically be looking to sell instead.
Low volatility, on the other hand, generally takes place in quieter markets,
and it can mean a better situation for buyers.
 Contrary to popular belief, there is no such thing as a no-trading day if
you trade in indices like bank nifty, you always have sufficient open
interest for ATM strike prices and you can potentially make profit if you
enter and exit at the right times every day.
 Never speculate in Options specially, Bank Nifty due to higher volatility.

BIBLIOGRAPHY
https://en.wikipedia.org/wiki/Derivatives_market

https://rmoneyindia.com/research-blog-beginners/introduction-derivative-market

https://www.isda.org/a/ghiDE/derivatives-market-analysis-jan-2016-final1.pdf

https://www.investopedia.com/terms/d/derivative.asp

http://shodhganga.inflibnet.ac.in/bitstream/10603/146490/13/12..chapter%203.pdf
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https://www.nseindia.com/content/ncfm/sm_otsm.pdf

https://www.indiainfoline.com/article/article-latest/what-is-a-derivative-market-
117042700195_1,html

http://www.rediff.com/money/2007/aug/01cspec.htm

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